Frank & Bernanke 4 th edition, 2009

Frank & Bernanke4th edition, 2009 Ch. 13: Aggregate Demand and Aggregate Supply

Aggregate Demand-Aggregate Supply π LRAS AS AD Y Y*

Introduction • The Keynesian model assumes that producers meet demand at preset prices. • The shortcoming of their assumption is that it does not explain the behavior of inflation.

Introduction • The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output.

The Aggregate Demand Curve • Aggregate Demand (AD) Curve • Shows the relationship between short-run equilibrium output Y and the rate of inflation,  • The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy

The Aggregate Demand Curve • Aggregate Demand (AD) Curve • Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping

An increase in  reduces Y (all other factors held constant) Aggregate Demand Curve AD The Aggregate Demand Curve Inflation  Output Y

The Fed and the AD Curve • A primary objective of the Fed is to maintain a low and stable inflation rate. • Inflation is likely to occur when Y > Y*. • To control inflation, the Fed must keep Y from exceeding Y*. • The Fed should lower the AD curve when Y>Y*. • The Fed can reduce autonomous expenditure by raising the interest rate. •  increases r increases autonomous spending decreases Y decreases (AD curve)

r (by Fed) DERIVATION OF THE AD CURVE Fed responds to inflation rate and sets the federal funds interest rate. In the short run nominal and real interest rates remain the same because inflationary expectations haven’t changed. The real interest rate determines the C, I, NX and consequently the PAE. The Keynesian Cross gives us the equilibrium Y. We now have a point on the AD curve because we know the equilibrium Y and the inflation. Monetary Policy Rule π π π 450 AD π Y 450 PAE PAE Y

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. • Changes in the Fed’s policy reaction function.

SHIFTS IN AD IN RESPONSE TO SHIFTS IN PAE: G down r (by Fed) What changes make the PAE shift? In the Keynesian Cross diagram, what changes might have happened? π π π 450 If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet? AD Try your hand at the diagrams when G increases or T decreases. AD’ π Y 450 PAE Y

Exogenous Spending: spending unrelated to Y or r • Fiscal policy • Technology • Foreign demand AD’ AD An increase in exogenous spending shifts AD to AD’ Increase In Exogenous Spending Inflation  Output Y

THE IMPACT OF MONETARY POLICY RULE CHANGE ON AD r (by Fed) What does it mean to shift MPR up? π Monetary policy is more restrictive π π Follow the resulting changes. AD AD’ π Y Show what happens to AD when the monetary policy becomes expansionary. PAE Y

AD New monetary policy reaction function AD’ Old monetary policy reaction function B A r* B A 2* 1* Fed Targets Higher r Real interest rate set by Fed, r Inflation  Output Y Inflation  Fed “tightens” monetary policy – shifting reaction curve The new Fed policy increases r and AD shifts to AD’

Movements Along the AD Curve •  and Y are inversely related • Changes in  cause a change in Y or a movement along the AD curve •  increases r increasesplanned spending decreases Y decreases (stationary monetary policy reaction function)

INCREASE IN INFLATION r (by Fed) Upward movement along AD π π π AD AD’ π Y PAE Y

Inflation and Aggregate Supply • Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level. • 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

A Virtuous Circle

Long-term 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.

Inflation and Aggregate Supply • Three factors that can increase the inflation rate • Output gap • Inflation shock • Shock to potential output

1. No output gap Inflation remains unchanged Y = Y* 2. Expansionary gap Inflation rises (D>S for firms) Y > Y*  3.Recessionary gap Inflation falls (D<S for firms) Y < Y*  The Output Gap and Inflation Relationship of output to potential output Behavior of inflation

Aggregate Supply Current inflation (π) is the result of expected inflation plus the inflationary impact of the output gap. If the economy is at Y*, current and expected inflation are the same. If there is an expansionary gap (Y>Y*) inflation increases to π1. If there is a recessionary gap (Y<Y*) inflation falls to π2. π π1 π0 π2 Y2 Y* Y1

AS Shifts CHANGE IN INFLATIONARY EXPECTATIONS Expected inflation is higher at Y*. AS1 A SUDDEN INFLATION SHOCK A sudden economy-wide cost increase AS0 π1 π0 Y*

Short-run Equilibrium • Inflation equals the value determined by past expectations and output gap (AS) and output equals the level of short-run equilibrium output that is consistent with that inflation rate (AD) • Graphically, short-run equilibrium occurs at the intersection of the AD curve and the AS line

Equilibrium LRAS AS • Long-run equilibrium • AD, AS (*), LRAS (Y*) will intersect at the same point π* Inflation  AD Output Y*

Long-run Equilibrium • A situation in which actual output equals potential output and the inflation rate is stable • Graphically, long-run equilibrium occurs when the AD curve, the AS line, and the LRAS line all intersect at a single point

Recessionary Gap LRAS AS Inflation  π0 π* AD Output Y0 Y*

Adjustment to Recessionary Gap • Y<Y* means firms are selling less than they want to; will start to lower prices. • As  falls the Fed lowers r and AD increases. • Falling  reduces uncertainty which also increases AD • As Y increases, cyclical unemployment falls (Okun’s Law) • Adjustment continues until long-run equilibrium is reached.

Expansionary Gap LRAS π* AS π Inflation  AD Output Y*

The Self-Correcting Economy • In the long-run the economy tends to be self-correcting. • The Keynesian model does not include a self-correcting mechanism. • The Keynesian model concentrates on the short-run with no price adjustment. • The self-correcting mechanism concentrates on the long-run with price adjustments.

The 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 Self-Correcting 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.

Sources of Inflation • Excessive Aggregate Spending • Inflation Shocks • Shocks to Potential Output • Try to draw each one.

EXCESSIVE AGGREGATE SPENDING r (by Fed) In the Keynesian Cross diagram, what changes might have happened? Military expenditures? π π π 450 If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet? AD’ AD π Y 450 PAE PAE’ PAE Y

Excessive Aggregate Spending LRAS π* Show the impact on Fed Policy Rule. What does it mean? AS π Inflation  AD Output Y*

Higher Inflation and Fed r π

Sources of Inflation • What Do You Think? • Does the Fed have the power to prevent the increased inflation that is induced by a rise in military spending? • Hint: Can the Fed reduce AD? • What is the cost of avoiding inflation during a military buildup? • What did Germany do during early 1990s?

Sources of Inflation in 1960 • 1959-63 inflation averaged about 1% • By 1970 inflation was 7% • Fiscal policy • Increased spending on Great Society and war on poverty initiatives • Increases in defense spending • 1965 = $50.6 billion or 7.4% of GDP • 1968 = $81.9 billion or 9.4% of GDP • Monetary policy • The Fed did not try to offset the increase in government spending

Sources of Inflation • Inflation Shock • A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap • Inflation Shock -- Examples • OPEC embargo of 1973 • Drop in oil prices in 1986

Inflation Shock Two Options: Don’t do anything. LRAS AS’ AS π* Inflation  AD Output Y*

Inflation Shock Two Options: Fed lowers r – easing money supply. LRAS AS’ AS π* Inflation  AD’ AD Output Y*

U.S. Macroeconomic Data, Annual Averages, 1985-2000 Was Greenspan right in 1996? % Growth in Unemployment Inflation Productivity Years real GDP rate (%) rate (%) growth (%) 1985-1995 2.8 6.3 3.5 1.4 1995-2000 4.1 4.8 2.5 2.5

Shock To Potential Output LRAS’ LRAS Loss of capital, loss of labor, sudden abandonment of machinery (capital loss), extended recession (human capital loss). AS π* Inflation  AD Output Y*’ Y* http://www.npr.org/templates/story/story.php?storyId=101386052

Greenspan LRAS AS π* Inflation  AD Output Y*

Frank & Bernanke 4 th edition, 2009