Chapter 23: Aggregate Demand and Aggregate Supply

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Chapter 23: Aggregate Demand

and Aggregate Supply


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Learning Objectives

1.Define the aggregate demand curve, explain why it slopes downward and explain why it shifts

2.Define the aggregate supply curve, explain why it slopes downward and explain why it shifts

3.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


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Learning Objectives

4.Analyze how the economy adjusts to expansionary and recessionary gaps and relate this to the idea of a self-correcting economy

5.Use the aggregate demand – aggregate supply model to study the sources of inflation in the short run and in the long run


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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*

Inflati

on

()

Output (Y)

AggregateDemand (AD)

Aggregate

Supply (AS)

Y*

Long-Run Aggregate

Supply (LRAS)


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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


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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


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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


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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, the

central bank raises interest rates Higher r means lower total

spending Along the AD curve, short-run Y

equals planned spendingOutput (Y)

ADInflati

on

()


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Inflation ()

Real in

tere

st r

ate

(r

)

r1

A

1

MPR

Inflati

on

()

Output (Y)

1 APla

nn

ed S

pend

ing

(PA

E)

Output (Y)

A

Y = PAE

PAE (r = r1)

Y1

Y1

AD

Initial conditions: 1, r1, Y1

One point on AD

Suppose inflation increases to 2

Economy moves to 2, r2, Y2

Second point on AD

2B

Y2

PAE (r = r2)

r2

B

2

B

Y2


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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 goodsOutput (Y)

ADAD'

Inflati

on ()


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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

Output (Y)

ADAD'

Inflati

on ()


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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

Inflation ()

Real in

tere

st r

ate

(r

)

MPR

r1

1


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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

Inflation ()

Real in

tere

st r

ate

(r

)

MPR1

r1

12

MPR2

r2


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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

MPRThe economy begins at

the original target inflation rate, 1 MPR shifts to MPR3 Central bank decreases interest rate from r1 to r3 Inflation ()

Real in

tere

st r

ate

(r

)

MPR1

r1

1

MPR3

3

r3


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Shift in Aggregate Demand

MPR shifts up; interest rate increases from r1* to r2* Higher r decreases PAE and shifts AD to AD'

Real in

tere

st r

ate

(r)

Inflation ()

MPR

Ar1*

1*

Output (Y)

Inflati

on () AD

A1

r2*

MPR'

B

Y1

AD'

B

Y2


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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 inflationMovement along the AS curve is related to

inflation inertia and output gaps


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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


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Inflation Expectations

Today's expectations affect tomorrow's inflation Inflation expectations are built into the

pricing in multi-period contractsThe 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


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Expected Inflation

Expectations are influenced by recent experience If inflation is low and stable, people expect

that to continue Volatile inflation leads

to volatile expectationsLow and stable inflation

creates a virtuous circlethat keeps inflation low

High and stable inflation creates a vicious circle that keeps inflation high


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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 yearsLong-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


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Output Gaps and Inflation

Relationship of Output

to Potential OutputBehavior of Inflation

Expansionary gapY > Y*

Inflation increases

No output gapY = Y*

Inflation is stable

Recessionary gapY < Y* Inflation decreases


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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 CThe AS curve slope up

Inflati

on

()

Output (Y)

Aggregate

Supply (AS)2

Y1

B

Y2

3C

Y*

1A


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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

Inflati

on

(

)

Output (Y)

AS1

Y*

1

2

AS2


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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


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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


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Aggregate Demand – Aggregate Supply Analysis

In the long run, Actual output equals

potential output Actual inflation equals

expected inflationLong-run

equilibrium occurs at the intersection of Aggregate demand Aggregate supply and Long-run aggregate

supply

Inflati

on

()

Output (Y)

AggregateDemand (AD)

Aggregate

Supply (AS)

Y*

Long-Run Aggregate

Supply (LRAS)


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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 graphShort-run equilibrium is

temporary

Inflati

on

()

Output (Y)

AD

AS1

Y*

LRAS

Y1

1

A


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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

Inflati

on

()

Output (Y)

AD

AS1

Y*

LRAS

Y1

AS2

1A

2


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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


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A Recessionary Gap

Initial equilibrium is at B, a recessionary gap AD curve remains stable unless MPR changes or

exogenous spending changesWith 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

Inflati

on

()

Output (Y)

AD

AS1

Y*

LRAS

Y1

1

B

2

AS2


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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


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Self-Correcting Economy

A slow self-correcting mechanism Fiscal and monetary policy can help

stabilize the economyA 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


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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

Inflati

on

()

Output (Y)

AD1

AS1

Y*

LRAS

1

AD2

2

AS2

3

Y2


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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


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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


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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


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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


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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*

Inflati

on

()

Output (Y)

AD1

AS1

Y*

LRAS AS2

1

AD2

3

Y2

2


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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 Y2

and 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

Output (Y)

Inflati

on ()

AD

LRAS1

Y1Y2

LRAS2

1

2

Chapter 23: Aggregate Demand and Aggregate Supply

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Transcript of Chapter 23: Aggregate Demand and Aggregate Supply