1. Chapter 13 Aggregate Demand and Aggregate Supply

2. Learning Objectives • Define the aggregate demand curve • Explain why it slopes downward • Explain why it shifts • Define the aggregate supply curve • Explain why it slopes downward • Explain why it shifts • Show how aggregate supply and demand determine short-run output and inflation • Show how aggregate demand, aggregate supply, and the long-run aggregate supply curve determine long-run output and inflation

3. Learning Objectives • Analyze how the economy adjusts to expansionary and recessionary gaps • Relate this to the idea of a self-correcting economy • Use the aggregate demand – aggregate supply model to study the sources of inflation in the short run and in the long run

4. Introduction • The Keynesian model assumes that producers meet demand at preset prices. • Does not explain inflation • Output gaps can cause inflation to increase or decrease • The aggregate demand - aggregate supply model shows both inflation and output • Effective for analyzing macroeconomic policies

5. Interest in the Keynesian Model – An Example • Components of aggregate spending are C = 640 + 0.8 (Y – T) – 400 r IP = 250 – 600 r G = 300 NX = 20 T = 250 • PAE = 1,010 – 1,000 r + 0.8 Y

6. Planned Aggregate Expenditures • Suppose the real interest rate is 5%, or 0.05 • Planned aggregate expenditures becomes PAE = 1,010 – 1,000 (0.05) + 0.8 Y PAE = 960 + 0.8 Y • Short-run equilibrium output is PAE = Y Y = 960 + 0.8 Y 0.2 Y = 960 Y = $4,800

7. Fed Fights Inflation • Expansionary gap can lead to inflation • Planned spending is greater than potential output • The output level of full employment • Demand for output exceeds normal rate of production • If gap persists, prices will increase • The Fed attempts to close expansionary gaps • Raise real interest rate • Decrease consumption and planned investment • Decrease planned aggregate expenditures • Decrease equilibrium output

8. Fed Controls the Nominal Interest Rate • Fed policy is stated in terms of interest rates • The tool they use is the supply of money • Initial equilibrium at E • Fed increases the money supply to MS' • New equilibrium at F • Interest rated decrease to i'to convince the marketto hold the new, largeramount of money MS MS' Nominal interest rate (i) F E i i' MD M Money (M) M'

9. The Fed Fights Inflation Y = PAE Expenditure line (r = 5%) Expenditure line (r = 9%) E Planned aggregate expenditure (PAE) An increase in r shifts the expenditure line down and closes the expansionary gap G 4,600 Y* 4,800 Output (Y)

10. Monetary Policy Rule (MPR) • The monetary policy reaction function shows the action a central bank takes in response to changes in the economy • Target inflation rate, *, is the Fed's long-term goal for inflation • Target real interest rate, r*, is the Fed's long-term goal for the real interest rate • If  > *, then r > r* • If  < *, then r < r* Slope = g MPR A r* Real interest rate set by Fed (r) * Inflation ()

11. Inflation, the Fed, and the AD Curve • A primary objective of the Fed is to maintain a low and stable inflation rate • When inflation increases, the Fed increases the nominal interest rate which, in turn, increases real interest rates

12. The Aggregate Demand Curve • Aggregate demand (AD) curve shows the relationship between short-run equilibrium output, Y, and the rate of inflation,  • Holds all other factors constant • AD has a negative slope • When inflation increases, theFed raises interest rates • Higher r means lower total spending • Along the AD curve, short-run Yequals planned spending Inflation () AD Output (Y)

13. Y = PAE MPR B A PAE (r = r1) r2 A r1 PAE (r = r2) Planned Spending (PAE) B Real interest rate (r) 2 1 Y2 Y1 Inflation () Output (Y) • Initial conditions: 1, r1, Y1 • One point on AD • Suppose inflation increases to 2 • Economy moves to 2, r2, Y2 • Second point on AD 2 B Inflation () 1 A AD Output (Y) Y2 Y1

14. Shifts in Aggregate Demand Curve • At a given inflation rate, aggregate demand shifts when • Exogenous changes in spending occur • Fed's monetary policy reaction function changes • Exogenous changes in spending are changes other than those caused by changes in output or the real interest rate • Consumer wealth • Business confidence • Foreign demand for US goods Inflation () AD' AD Output (Y)

15. Exogenous Changes in Spending • Increases in aggregate demand could occur from a boom in the stock market • Consumer wealth increases • Consumption increases at each level of output and real interest rate • PAE curve shifts up • Y increases for each possible level of  • Aggregate demand curve shift right Inflation () AD' AD Output (Y)

16. Fed's MPR Changes • The Fed's monetary policy reaction function ties inflation to real interest rates • Suppose the Fed's targets are 1 and r1 • MPR is shown in the graph • Fed normally follows a stable MPR • Fed can tighten or ease monetary policy • Shifts MPR • Tightening monetary policy lowers the long-run inflation target MPR r1 Real interest rate (r) 1 Inflation ()

17. Tightening Monetary Policy • Tighter monetary policy results in each interest rate, r, being associated with a lower rate of inflation • A leftward shift of the MPR • The economy begins at the original target inflation rate, 1 • MPR shifts to MPR2 • Fed increases interest rate from r1 to r2 MPR2 MPR1 r2 r1 Real interest rate (r) 2 1 Inflation ()

18. Easing Monetary Policy • Easing monetary policy results in each interest rate, r, being associated with a higher rate of inflation • A rightward shift of the MPR • The economy begins at the original target inflation rate, 1 • MPR shifts to MPR3 • Fed decreases interest rate from r1 to r3 MPR1 r1 MPR3 Real interest rate (r) r3 1 3 Inflation ()

19. Shift in Aggregate Demand • MPR shifts up; interest rate increases from r1* to r2* • Higher r decreases PAE and shifts AD to AD' AD AD' MPR' Inflation () r2* MPR B Real interest rate (r) A 1 r1* B A 1* Y2 Y1 Inflation () Output (Y)

20. Inflation and Aggregate Supply • Aggregate supply curve (AS) shows the relationship between the rate of inflation and the short-run equilibrium level of output • Holds all other factors constant • Aggregate supply curve has a positive slope • When output is below potential, actual inflation is above expected inflation • When output is above potential, actual inflation is below expected inflation • Movement along the AS curve is related to inflation inertia and output gaps

21. Inflation Inertia • Inflation will remain have inertia if the economy is operating at Y* • No external shocks to the price level • Three factors that can increase the inflation rate • Output gap ■ Shock to potential output • Inflation shock • In industrial economies, inflation tends to change slowly from year to year for two reasons • Inflation expectations • Long-term wage and price contracts

22. Inflation Expectations • Today's expectations affect tomorrow's inflation • Inflation expectations are built into the pricing in multi-period contracts • The higher the expected rate of inflation, the more nominal wages and the cost of other inputs will increase • With rising input costs, firms increase their prices to cover costs

23. Expected Inflation • Expectations are influenced by recent experience • If inflation is low and stable, people expect that to continue • Volatile inflation leads to volatile expectations • Low and stable inflation creates a virtuous circlethat keeps inflation low • High and stable inflation creates a vicious circle that keeps inflation high

24. The Role of Long-Term Contracts • Long-term contracts reduce the cost of negotiations between buyers and sellers • Cost - Benefit Principle • Labor contracts may be multi-year agreements • Supply agreements, particularly for high cost inputs, extend over several years • Long-term contracts build in wage and price increases that build in current expectations about inflation • In the absence of external shocks, inflation tends to be stable over time • Especially true in industrialized economies

25. The Output Gap and Inflation

26. The Aggregate Supply Curve Current inflation () = expected inflation (e) + inflation from an output gap • If the economy is operating at potential output, then= e = 1 at A • If the economy has an inflationary gap, Y > Y* and 2> e at B • If the economy has an expansionary gap, Y < Y* and 3< e at C • The AS curve slope up AggregateSupply (AS) B Inflation () 2 A 1 C 3 Output (Y) Y* Y2 Y1

27. Shifts in the AS Curve • Two changes can shift the AS curve • Inflation expectations • Inflation shocks • If actual inflation exceeds expectations, expected inflation increases • AS curve shifts to the left • At each level of output, inflation is higher AS2 AS1 2 Inflation () 1 Y* Output (Y)

28. Inflation Shock • An inflation shock is a sudden change in the normal behavior of inflation • A shock is not related to an output gap • A sudden rise in the price of oil increases prices of • Gasoline, diesel fuel, jet fuel, heating oil • Goods made with oil (synthetic rubber, plastics, etc.) • Transportation of most goods • OPEC reduced supplies in 1973; price of oil quadrupled • Food shortages occurred at the same time • Sharp increase in inflation in 1974

29. Inflation Shocks • An adverse inflation shock shifts the aggregate supply curve to the left • Increases inflation at each output level • Oil price increases in 1973 • A favorable inflation shock shifts the aggregate supply curve to the right • Lower inflation at each output level • Oil price decrease in 1986

30. Long-Run Equilibrium • In the long run, • Actual output equals potential output • Actual inflation equals expected inflation • Long-run equilibriumoccurs at the intersection of • Aggregate demand • Aggregate supply and • Long-run aggregate supply Long-Run AggregateSupply (LRAS) AggregateSupply (AS) Inflation () AggregateDemand (AD) Output (Y) Y*

31. Short-Run Equilibrium • Short-run equilibrium occurs when there is either an expansionary gap or a recessionary gap • Intersection of AD and AS curves at a level of output different from Y* • Point A in the graph • Short-run equilibrium is temporary LRAS AS1 Inflation () A 1 AD Y* Y1 Output (Y)

32. An Expansionary Gap • Initial short-run equilibrium at A • AD is stable as long as there is no change in the Fed's monetary policy rule and no exogenous changes in spending • Inflation increases and expected inflation increases • Shifts AS curve to AS2 • Output is at potential, Y* • New expected inflation is 2 LRAS AS2 AS1 2 Inflation () 1 A AD Y* Y1 Output (Y)

33. Adjustment from an Expansionary Gap • When output is above potential output, firms increase prices faster than the expected rate of inflation • Causes inflation to increase above expected level • As inflation rises, the Fed increases interest rates • Consumption and planned investment spending decrease • Planned aggregate expenditures decrease • Output decreases • This process continues until the economy reaches equilibrium at the potential level of output • Actual inflation is higher than initial level of inflation

34. A Recessionary Gap • Initial equilibrium is at B, a recessionary gap • AD curve remains stable unless MPRF changes or exogenous spending changes • With inflation above its expected value, the Fedlowers interest rates • Aggregate supply shiftsto AS2 • The new long-run equilibrium is at potential output and an inflation level of 2 LRAS AS1 AS2 B 1 Inflation () 2 AD Y1 Y* Output (Y)

35. Self-Correcting Economy • In the long-run the economy tends to be self-correcting • Missing from Keynesian model • Concentrates on the short-run; no price adjustments • Given time, output gaps disappear without any changes in monetary or fiscal policy • Whether stabilization policies are needed depends on the speed of the self-correction process • If the economy returns to potential output quickly, stabilization policies may be destabilizing • The greater the gap, the longer the adjustment period

36. Self-Correcting Economy • A slow self-correcting mechanism • Fiscal and monetary policy can help stabilize the economy • A fast self-correcting mechanism • Fiscal and monetary policy are not effective and may destabilize the economy • The speed of correction will depend on • The use of long-term contracts • The efficiency and flexibility of labor markets • Fiscal and monetary policy are most useful when attempting to eliminate large output gaps

37. Excessive Aggregate Spending Causes Inflation • Wars can trigger an inflationary gap • Economy starts in long-run equilibrium, 1 and Y* • Wartime government spending shifts AD to AD2 • Expansionary gap opens • Short-run equilibrium at 2 and Y2 • If AD stays at AD2 and the Fed does not change monetary policy, inflation is higher than expected • AS shifts to AS2 LRAS AS2 3 AS1 2 Inflation () 1 AD2 AD1 Y* Y2 Output (Y)

38. Wartime Spending • The increased output created by the shift in aggregate demand is temporary • Economy returns to its potential output at Y* but at a higher inflation rate • Since Y had decreased, some component of aggregate spending has also decreased • As inflation rose, the Fed increased the real interest rate • Investment spending declined, crowded out by government spending

39. The War and the Fed • The Fed can to prevent the increased inflation from the rise in military spending • The Fed aggressively tightens money during the military buildup • Real interest rates increase • Consumption and planned investment decrease to offset the increase in spending for the war • Lowers current and future standards of living • Planned spending is stable • No expansionary gap occurs

40. US Inflation, 1960s • 1959-63 inflation averaged about 1% • By 1970 inflation was 6% • Inflation resulted from • Increases in government spending • Vietnam war caused defense spending to increase to 9.4% of GDP by 1968 and stay high • Great Society and War on Poverty programs • Failure of the Fed to contain inflation • Did not want to contribute to political turmoil • During the Reagan military buildup, the Fed successfully contained inflation

41. Inflation in the 1970s • Inflation continued to rise in the 1970s • With inflation staying above 4% in 1971, Nixon imposed wage and price controls on August 15, 1971 • From 6.2% in 1973 to nearly 11% in 1974 • Inflation decreased 1974 – 1978, but increased again • 11.4% in 1979 and 13.5% in 1980 • Persistent inflation was caused by an adverse oil shock • Aggregate supply decreased, creating a recessionary gap • Stagflation, higher inflation and a recessionary gap, resulted

42. Inflation in the 1970s • Adverse oil shock and stagflation are policy challenges • Government can keeps policies constant • Inflation will eventually decrease • Aggregate supply curve shifts right • Recessionary gap closes • However, economy has a prolonged recession while adjustment occurs • If the government attacks the recessionary gap with added government spending and loosening monetary policy, inflation increases • Higher and higher inflation rates resulted

43. Inflation in the 1970s • Initial equilibrium is at 1 and Y*, potential output • Oil shock reduces aggregate supply to AS2 • Short-term equilibrium is a recessionary gap at 2 and Y2 • Government can increase AD to AD2 to address recessionary gap • Raises inflation to 3 • Government can keep policies constant and let the economy adjust back to AS1 with1 and Y* LRAS AS2 3 AS1 2 Inflation () 1 AD2 AD1 Y* Y2 Output (Y)

44. Shocks to Potential Output • Oil shocks may lead to lower potential output • Compounds the inflationary effects of the shock • Suppose long-run equilibriumis at Y1 and 1 • Potential output falls to Y2and LRAS shifts to LRAS2 • Expansionary gap at Y1, 1 leads to lower output and higher inflation • Aggregate supply shock is either an inflation shock or a shock to potential output LRAS2 LRAS1 2 Inflation () 1 AD Y2 Y1 Output (Y)

45. Greenspan, 1996 • The situation • With low unemployment, price and wage inflation were lower than previously at full employment • Inflationary pressures debatable • Rapid economic growth • Corporate profits were strong • Productivity was increasing • Greenspan believed the economy could continue to grow without increasing inflation • Fed did not increase interest rates

46. Interpreting Macroeconomic Data • Productivity figures were hard to interpret • Business leaders reported productivity gains • Productivity gains did not appear in the government statistics • Service industries showed small or even negative growth in productivity • Large investment in technology was at odds with the data • Greenspan believed the productivity gains were real • Increased potential output s economy could grow without inflation

47. Growth in the 1990s • Compared to 1985 – 1995 period, the last five years of the decade showed higher growth • Unemployment and inflation were lower • A positive shock to potential output causes the long-run aggregate supply curve to shift to the right • Downward pressure on inflation