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Chapter 23: Aggregate Demand and Aggregate Supply

Chapter 23: Aggregate Demand and Aggregate Supply. Learning Objectives. Define the aggregate demand curve, explain why it slopes downward and explain why it shifts Define the aggregate supply curve, explain why it slopes downward and explain why it shifts

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Chapter 23: Aggregate Demand and Aggregate Supply

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  1. Chapter 23: Aggregate Demand and Aggregate Supply

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

  3. Learning Objectives • Analyze how the economy adjusts to expansionary and recessionary gaps and 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. The Aggregate Demand (AD) and Aggregate Supply (AS) Model: A Brief Overview • Shows how output and inflation are determined simultaneously • Short run and long run analysis • Current situation and future changes • Inflation and output on theaxes • Changes in inflation lead tochanges in spending on AD • AS shows output gaps affect inflation • LRAS shows Y* Long-Run AggregateSupply (LRAS) AggregateSupply (AS) Inflation () AggregateDemand (AD) Output (Y) Y*

  5. Inflation, Spending, And Output: The Aggregate Demand Curve • 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

  6. Inflation, The Central Bank, And The AD Curve • A primary objective of the central bank is to maintain a low and stable inflation rate • Inflation is likely to occur when Y > Y* • To control inflation, the central bank must keep Y from exceeding Y* • When inflation increases, the central bank increases the nominal interest rate which, in turn, increases real interest rates

  7. Inflation, The Central Bank, And The AD Curve • The central bank also responds to a recessionary gap • Inflation is likely to decrease when Y < Y* • When inflation decreases, • The central bank decreases the nominal interest rate • real interest rates decrease and • Aggregate spending increases

  8. The Aggregate Demand Curve • Aggregate demand (AD) curveshows 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, thecentral bank raises interest rates • Higher r means lower total spending • Along the AD curve, short-run Yequals planned spending Inflation () AD Output (Y)

  9. 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

  10. Shifts in Aggregate Demand Curve • At a given inflation rate, aggregate demand shifts when • Exogenous changes in spending occur • Central bank'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 local goods Inflation () AD' AD Output (Y)

  11. 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)

  12. Tightening and Easing Monetary Policy • The central bank's monetary policy reaction function ties inflation to real interest rates • Suppose the central bank's targets are 1 and r1 • MPR is shown in the graph • Central bank normally follows a stable MPR • Central bank 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 ()

  13. 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 • Central bank increases interest rate from r1 to r2 MPR2 MPR1 r2 r1 Real interest rate (r) 2 1 Inflation ()

  14. 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 • Central bank decreases interest rate from r1 to r3 MPR1 r1 MPR3 Real interest rate (r) r3 1 3 Inflation ()

  15. 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)

  16. 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

  17. Inflation Inertia, Output Gaps, And The AS Curve • 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

  18. 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

  19. 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

  20. Long-term Wage and Price 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

  21. Output Gaps and Inflation

  22. Deriving the AS Curve: Graphical Analysis 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

  23. 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)

  24. 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

  25. 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

  26. Aggregate Demand – Aggregate Supply Analysis • 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*

  27. Aggregate Demand – Aggregate Supply Analysis • 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)

  28. An Expansionary Gap • Initial short-run equilibrium at A • AD is stable as long as there is no change in the central bank'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)

  29. 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 central bank 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

  30. A Recessionary Gap • Initial equilibrium is at B, a recessionary gap • AD curve remains stable unless MPR changes or exogenous spending changes • With inflation above its expected value, the central bank lowers 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)

  31. 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

  32. 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

  33. Sources of Inflation: Excessive Aggregate Spending • 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 central bank 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)

  34. 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 has decreased, some component of aggregate spending has also decreased • As inflation rose, the central bank increased the real interest rate • Investment spending declined, crowded out by government spending

  35. The War and the Central Bank • The central bank can prevent the increased inflation from the rise in military spending • The central bank 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

  36. The Effects of an Adverse Inflation Shock • Persistent inflation may be caused by an adverse oil shock • Aggregate supply decreases, creating a recessionary gap, resulting in stagflation, that is higher inflation and a recessionary gap

  37. The Effects of an Adverse Inflation Shock • Adverse oil shocks 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

  38. The Effects of an Adverse Inflation Shock • 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)

  39. 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)

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