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Understanding Aggregate Demand and Supply: Adverse Supply Shocks and Monetary Policy Effects

This chapter explores the concepts of aggregate demand and supply, focusing on the implications of adverse supply shocks. It discusses how these shocks lower both the natural level of output (Nbar) and equilibrium levels, leading to inflationary pressures. The chapter analyzes the IS-LM model shifts resulting from monetary expansion, price adjustments, and the self-correcting nature of economies. It contrasts the views of classical and Keynesian economists on price level adjustments and monetary neutrality, illustrating the short-term and long-term effects of monetary policies.

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Understanding Aggregate Demand and Supply: Adverse Supply Shocks and Monetary Policy Effects

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  1. CHAPTER 9 Aggregate Demand and Aggregate Supply

  2. Adverse supply shock Adverse supply shock  lower Nbar at labor market equilibrium  lower Ybar. FE shifts to the left. (FE2) IS-LM intersection is now on the right side of FE line  aggregate demand > aggregate output produced at full employment. Prices will rise  reduces M/P  LM shifts to the left. (LM2) New equilibrium at F.

  3. Monetary Expansion Effect 1: ↑Ms shifts LM to the right. (LM2) IS-LM intersection is now on the right side of FE line  aggregate demand > aggregate output produced at full employment. Price adjustment: IS-LM left of FE  price ↑ IS-LM right of FE  price↓

  4. Monetary Expansion Effect 2: Prices will rise  reduces M/P  LM shifts back to the left. (LM1) Equilibrium returns to E. The inflation rate rises temporarily, not permanently. There is a temporary burst of inflation as the price level moves to a higher level.

  5. Price adjustment and the self-correcting economy How rapidly does the economy reach general equilibrium? Classical economists see rapid adjustment of the price level. So the economy returns quickly to full employment after a shock. If firms change prices instead of output in response to a change in demand, the adjustment process is almost immediate. Keynesian economists see slow adjustment of the price level It may be several years before prices and wages adjust fully. When not in general equilibrium, output is determined by aggregate demand at the intersection of the IS and LM curves, and the labor market is not in equilibrium.

  6. Monetary neutrality What are the effects of monetary policy on the economy? Money is neutral if a change in the nominal money supply changes the price level proportionately but has no effect on real variables. The classical view is that a monetary expansion affects prices quickly with at most a transitory effect on real variables. Keynesians think the economy may spend a long time in disequilibrium, so a monetary expansion increases output and employment and causes the real interest rate to fall. Keynesians believe in monetary neutrality in the long run but not the short run, while classicals believe it holds even in the relatively short run.

  7. End of Lecture 3 Week 7 • Adverse supply shock • Monetary expansion • Price adjustment and self-correcting economy • Monetary neutrality

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