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Inflation and Aggregate Supply

Inflation and Aggregate Supply. Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University. Inflation and Aggregate Supply. Where does inflation come from? If people, businesses and government demand more goods, their prices will rise.

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Inflation and Aggregate Supply

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  1. Inflation and Aggregate Supply Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

  2. Inflation and Aggregate Supply • Where does inflation come from? • If people, businesses and government demand more goods, their prices will rise. • But if firms produce more goods, their prices will fall. • Inflation is determined by the interaction of Aggregate Demand and Aggregate Supply for goods and services. Chapter 28: Inflation and Aggregate Supply

  3. The Aggregate Demand Curve

  4. Inflation, Spending, and Output: The Aggregate Demand Curve • Aggregate Demand (AD) Curve • Shows therelation betweenshort-run equilibrium output Y and the rate of inflation, . • For AD, changes in p cause changes in Y. Chapter 28: Inflation and Aggregate Supply

  5. Inflation, Spending, and Output: The Aggregate Demand Curve • Aggregate Demand (AD) Curve • The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy. • Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping. Chapter 28: Inflation and Aggregate Supply

  6. Inflation, Spending, and Output: The Aggregate Demand Curve • Inflation and the AD Curve • The Keynesian model assumes output adjusts to demand at preset prices in the short run. • Prices do not remain fixed indefinitely: this means there can be inflation. Chapter 28: Inflation and Aggregate Supply

  7. The Aggregate Demand Curve • The Income-Expenditures Model (chapter 26) told us that equilibrium output is given by • and that, including the effect of interest rates on C and I (chapter 27) • This means real interest rates and equilibrium output are inversely related. Eq 1

  8. The Aggregate Demand Curve • Where does r come from? • It is the real opportunity cost of holding a real stock of money • That is, holding an X amount of purchasing power in the form of money. Chapter 28: Inflation and Aggregate Supply

  9. The Aggregate Demand Curve • People’s Real Money Holdings are. • Let’s think in terms of growth rates. • M rises at “the rate of money growth,” . • P rises at “the rate of inflation”, p. Chapter 28: Inflation and Aggregate Supply

  10. Inflation, Spending, and Output: The Aggregate Demand Curve • Inflation and Real Balances • If > p, Real Money Holdings rise. • People’s money has more value, so spending rises. • If p > , Real Money Holdings fall. • People’s money has less value, so spending falls. Chapter 28: Inflation and Aggregate Supply

  11. Inflation, Spending, and Output: The Aggregate Demand Curve • Inflation reduces the real money supply, leading to a higher cost of borrowing money. • As interest rates rise, expenditure falls. Chapter 28: Inflation and Aggregate Supply

  12. Inflation, Spending, and Output: The Aggregate Demand Curve • Inflation reduces the real money supply, leading to a higher cost of borrowing money. • As interest rates rise, expenditure falls. Chapter 28: Inflation and Aggregate Supply

  13. High p means lower M/P, higher i, lower C, I, and Y An increase in  reduces Y (all other factors held constant) Aggregate Demand Curve Low p means higher M/P, lower i, higher C, I, and Y AD The Aggregate Demand Curve Inflation  Output Y Chapter 28: Inflation and Aggregate Supply

  14. An increase in  reduces Y (all other factors held constant) Aggregate Demand Curve AD The Aggregate Demand Curve Inflation  Output Y Chapter 28: Inflation and Aggregate Supply

  15. Inflation, Spending, and Output: The Aggregate Demand Curve • Other Reasons for the Downward Slope of the AD Curve • Distributional effects. • Poorer people are more hurt by inflation (less financially sophisticated) and they spend more out of their disposable income. • Uncertainty. • Prices of domestic goods and services sold abroad. Chapter 28: Inflation and Aggregate Supply

  16. Inflation, Spending, and Output: The Aggregate Demand Curve • Movements Along the AD Curve •  and Y are inversely related • Changes in  cause a change in Y • This means a movement along the AD curve •  increases r increasesplannedspending decreases Y decreases • Note: the real balances function is unchanged. Chapter 28: Inflation and Aggregate Supply

  17. Inflation, Spending, and Output: The Aggregate Demand Curve • Shifts of the AD Curve • Any factor that changes Y at a given  shifts the AD curve. • Shifts of the AD curve can be caused by: • Changes in exogenous spending. • Higher G or Lower T • Higher I or Higher C • Higher NX • Changes in the Fed’s anti-inflation stance. Chapter 28: Inflation and Aggregate Supply

  18. AD’ The new Fed policy increases r and AD shifts to AD’ Effect of A Shift In The Fed’s Policy Reaction Function: A Shift in AD • Shifts of the AD Curve • In the early 1980s, the Fed raised interest rates dramatically, causing two major recessions. • This shifted the AD curve to the left: Y fell at any level of p. AD Inflation  Output Y Chapter 28: Inflation and Aggregate Supply

  19. Exogenous Spending: spending unrelated to Y or r • Fiscal policy turns expansionary • Confidence rises • Foreign demand increases AD’ AD An increase in exogenous spending shifts AD to AD’ and vice versa Effect of An Increase In Exogenous Spending: A Shift of AD Inflation  Output Y Chapter 28: Inflation and Aggregate Supply

  20. The Aggregate Supply Curve

  21. Inflation andAggregate Supply • Inflation will remain roughly constant if the economy is operating at Y* and there are no external shocks to the price level. • We refer to this as “inflation inertia.” • In physics, inertia refers to the propensity of bodies to maintain a constant speed once forces have stopped acting on them. • Here, we mean that inflation tends to stay constant unless something happens. Chapter 28: Inflation and Aggregate Supply

  22. Inflation andAggregate Supply • Inflation Inertia • In industrial economies (U.S.), inflation tends to change slowly from year to year. • The inflation inertia occurs for two reasons: • Inflation expectations • Long-term wage and price contracts Chapter 28: Inflation and Aggregate Supply

  23. A Virtuous Circle of Low Inflation and Low Expected Inflation If workers expect p = 3%, they will ask for a 3% raise to keep their purchasing power. If firms give a 3% wage raise, they will raise their prices by no less than 3% to keep their profits; but by no more than 3% to stay competitive. So p will be …? Chapter 28: Inflation and Aggregate Supply

  24. Inflation andAggregate Supply • Long-term Wage and Price Contracts • Union wage contracts set wages for several years. • Contracts setting the price of raw materials and parts for manufacturing firms also cover several years. • These long-term contracts reflect the inflation expectations at the time they are signed. • So if unions expected p=3% in 2001, their expectations will affect actual p for years to come. Chapter 28: Inflation and Aggregate Supply

  25. Inflation andAggregate Supply • The Output Gap and Inflation • Now suppose you are selling all your production and you are using your resources at normal rates. • The output gap is zero. • You will try to remain competitive: don’t raise prices too much, not too little. Raise prices as much as wages and other costs. • So if everyone else raises prices and costs by 3%, you raise them by 3%. Chapter 28: Inflation and Aggregate Supply

  26. Inflation andAggregate Supply • The Output Gap and Inflation • If everyone else raises prices and costs by 3%, you raise them by 3%. • You try to keep your relative price (that is, your price relative to all other goods) constant. • This means that if the output gap is zero,inflation is constant. • This is what we mean by inflation inertia. Chapter 28: Inflation and Aggregate Supply

  27. The Output Gap and Inflation Relationship of output to potential output Behavior of inflation 1. No output gap Inflation remains unchanged Y = Y* Chapter 28: Inflation and Aggregate Supply

  28. The Aggregate Demand - Aggregate Supply Diagram

  29. The Aggregate Demand - Aggregate Supply Diagram • Short-run Aggregate Supply (SRAS) • A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions. Chapter 28: Inflation and Aggregate Supply

  30. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Short-run aggregate supply, SRAS Inflation, p Y* Output Chapter 28: Inflation and Aggregate Supply

  31. The Aggregate Demand - Aggregate Supply Diagram • Short-run Equilibrium • Because inflation is inertial, it just is whatever is consistent with past pricing decisions. • This inertial p implies a certain level of M/P, which determines the interest rate and expenditure. • Output is demand-determined in the short-run. • Changes in autonomous expenditure change Y. • Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line. Chapter 28: Inflation and Aggregate Supply

  32. The Aggregate Demand - Aggregate Supply Diagram • Short-run Equilibrium • A situation in which Inflation = the value determined by past expectations and pricing decisions And Output = the level of short-run equilibrium output that is consistent with that inflation rate. • Short-run equilibrium occurs at the intersection of the AD curve and the SRAS line. Chapter 28: Inflation and Aggregate Supply

  33. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Short-run aggregate supply, SRAS A • Short-run equilibrium • Y: SRAS() = AD • Given the level of p, M and G are relatively low. • Y < Y* -- recessionary gap Inflation, p Aggregate demand, AD Y Y* Output Chapter 28: Inflation and Aggregate Supply

  34. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Short-run aggregate supply, SRAS A • Short-run equilibrium • Y: SRAS() = AD • Given the level of p, M and G are relatively high. • Y > Y* -- expansionary gap Inflation, p Aggregate demand, AD Y* Y Output Chapter 28: Inflation and Aggregate Supply

  35. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Short-run aggregate supply, SRAS A • Short-run equilibrium • Y: SRAS() = AD • Given the level of p, M and G are just right. • Y = Y* -- no gap Inflation, p Aggregate demand, AD Y* Output Chapter 28: Inflation and Aggregate Supply

  36. The Aggregate Demand - Aggregate Supply Diagram • This is just the old Keynesian model of chapter 26. • In chapter 26, prices were exogenous. Here inflation is exogenous. (It just “is”). • Different levels of autonomous expenditure, of G and T, and of M lead to different levels of Y. • Output is demand-determined. Chapter 28: Inflation and Aggregate Supply

  37. The Aggregate Demand - Aggregate Supply Diagram • Output is demand-determined: is this a good thing or a bad thing? • It’s good: we, as a society, can choose the level of output we like. Chapter 28: Inflation and Aggregate Supply

  38. The Aggregate Demand - Aggregate Supply Diagram • Output is demand-determined: is this a good thing or a bad thing? • It’s bad: if we don’t coordinate our decisions properly, expenditure may be too low, and we may end up with high unemployment. • Recessions and over-expansions can happen (and do happen) all the time. In the short-run, the economy can’t correct itself. Chapter 28: Inflation and Aggregate Supply

  39. Is the economy self-correcting in the short run? http://images.google.com/imgres?imgurl=http://bolivia.freeservers.com/images/homeless%2520family%2520big.JPG&imgrefurl=http://bolivia.freeservers.com/photo3.html&h=552&w=792&sz=87&tbnid=V_qPf5Im_18J:&tbnh=98&tbnw=142&hl=en&start=1&prev=/images%3Fq%3Dhomeless%2Bfamily%26svnum%3D10%26hl%3Den%26lr%3D%26safe%3Dactive%26rls%3DGGLD,GGLD:2004-49,GGLD:en http://archives.cnn.com/2001/WORLD/europe/08/28/britain.homeless/story.homeless.jpg http://www.iamaw.org/publications/imail/photos/unemployment_line2.jpg Chapter 28: Inflation and Aggregate Supply

  40. Is the economy self-correcting in the short run? http://img.radio.cz/pictures/socialni/homeless/hlavak_bezdomovec2x.jpg http://www.perfecteconomy.com/img-great-depression---unemployed-chicagoans---x350-j3.jpg http://rafah.virtualactivism.net/photos/homel4.jpg http://interactive.pfaw.org/images/unemployment_line.gif Chapter 28: Inflation and Aggregate Supply

  41. Is the economy self-correcting in the short run? http://www.timeismoney.ca/images/pic-overworked.jpg http://www.stress-akut.de/images/overworked.jpg http://web.fvdes.com/teacher_resources/Web_Eval_TL/Graphics/overworked.jpg http://equinox.unr.edu/homepage/jacque/Midas/overworked.jpg http://www.jeugfokus.org.za/Pictures/Pret/OverWorked%20mouse.jpg Chapter 28: Inflation and Aggregate Supply

  42. The Adjustment Process to an Output Gap

  43. Inflation andAggregate Supply • Three factors that can increase the inflation rate • Output gap • Inflation shock • Shock to potential output Chapter 28: Inflation and Aggregate Supply

  44. Inflation andAggregate Supply • The Output Gap and Inflation • Recessionary Gap: • If people are unemployed, they reduce their wage demands. • Lower wage rises lead to lower inflation. • This process may take a long time. • Long-term wage contracts. • People’s life plans (college, vacations, social status) around their wages. • Taking a pay cut or slower wage growth is very traumatic. Chapter 28: Inflation and Aggregate Supply

  45. Inflation andAggregate Supply • The Output Gap and Inflation • Expansionary Gap: • If people are working overtime too much, they demand faster raises. • Higher “wage inflation” leads to higher inflation. • This process may be very fast. • People are always happy to take higher wages or to raise prices. Chapter 28: Inflation and Aggregate Supply

  46. The Phillips Curve Strong workers Inflation speeds up => Needs 10 workers: Unemployment is low Inflation falls Weak workers => Needs 10 workers: Unemployment is high Chapter 28: Inflation and Aggregate Supply

  47. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram After being laid off from her job as a manager at Ford Motor Co.'s [Mexican] unit, [Karina] Maldonado searched unsuccessfully for a job for months before settling on a position selling cars at a Volkswagen AG dealership. Her commute is two hours and her pay is half of what she earned at Ford. “At first I looked for something close to home and well- paid,” Maldonado, who ran the auto parts division at Ford's Land Rover unit in Mexico … . “Then I said I'd take something anywhere, as long as it was in planning. In the end, I didn't care as long as it was a job.” “Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 21, 2004” (Bloomberg) Chapter 28: Inflation and Aggregate Supply

  48. 1. No output gap Inflation remains unchanged Y = Y* 2. Expansionary gap Inflation rises Y > Y*  3.Recessionary gap Inflation falls Y < Y*  The Output Gap and Inflation Relationship of output to potential output Behavior of inflation For AS, changes in Y cause changes in p. Chapter 28: Inflation and Aggregate Supply

  49. The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Y > Y* Inertial level of inflation Inflation, p Y < Y* Y* Output Chapter 28: Inflation and Aggregate Supply

  50. Inflation andAggregate Supply • The Output Gap and Inflation • Suppose we start from Y = Y* • An increase in exogenous spending creates and expansionary gap (Y > Y*) – inflation increases. • A decrease in exogenous spending creates a recessionary gap (Y < Y*) and inflation decreases. Chapter 28: Inflation and Aggregate Supply

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