1 Frank & Bernanke 3 rd edition, 2007 Ch. 15: Inflation, Aggregate Supply, and Aggregate Demand

11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 15: Inflation, Aggregate Ch. 15: Inflation, Aggregate Supply, and Aggregate DemandSupply, and Aggregate Demand

22

IntroductionIntroduction

The Keynesian model assumes that The Keynesian model assumes that producers meet demand at preset prices.producers meet demand at preset prices.

The shortcoming of their assumption is The shortcoming of their assumption is that it does not explain the behavior of that it does not explain the behavior of inflation.inflation.

33

IntroductionIntroduction

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

44

The Aggregate Demand CurveThe Aggregate Demand Curve

Aggregate Demand (Aggregate Demand (ADAD) Curve) CurveShows the relationship between short-run Shows the relationship between short-run

equilibrium output equilibrium output Y Y and the rate of inflation, and the rate of inflation, The name of the curve reflects the fact that The name of the curve reflects the fact that

short-run equilibrium output is determined by, short-run equilibrium output is determined by, and equals, total planned spending in the and equals, total planned spending in the economyeconomy

55


Aggregate Demand (Aggregate Demand (ADAD) Curve) Curve Increases in inflation reduce planned Increases in inflation reduce planned

spending and short-run equilibrium output, so spending and short-run equilibrium output, so the aggregate demand curve is downward-the aggregate demand curve is downward-slopingsloping

66


Output Y

AD

Aggregate Demand Curve

An increase in reduces Y(all other factors held constant)

Infl

atio

n

77

The Fed and the The Fed and the ADAD Curve CurveA primary objective of the Fed is to A primary objective of the Fed is to

maintain a low and stable inflation rate.maintain a low and stable inflation rate. Inflation is likely to occur when Inflation is likely to occur when Y > Y*.Y > Y*.To control inflation, the Fed must keep To control inflation, the Fed must keep Y Y from from

exceeding exceeding Y*.Y*.The Fed should lower the AD curve when The Fed should lower the AD curve when

Y>Y*.Y>Y*.The Fed can reduce autonomous expenditure The Fed can reduce autonomous expenditure

by raising the interest rate.by raising the interest rate. increases increases rr increases autonomous spending increases autonomous spending

decreases decreases Y Y decreases (decreases (AD AD curve)curve)

88

The Aggregate Demand Curve and the The Aggregate Demand Curve and the Monetary Policy Reaction FunctionMonetary Policy Reaction Function

Output Y

Infl

atio

n

Inflation

Rea

l in

tere

st r

ate

set

by

the

Fed

, r

A

A

1

r1

1

B

B

2

r2

2

99

Other Reasons for the Downward Other Reasons for the Downward Slope of the Slope of the ADAD Curve Curve

Real value of moneyReal value of moneyDistributional effectsDistributional effectsUncertaintyUncertaintyPrices of domestic goods and Prices of domestic goods and

services sold abroadservices sold abroad

1010

Increase In Exogenous SpendingIncrease In Exogenous Spending

Output Y

ADExogenous Spending: spending unrelated to Y or r•Fiscal policy•Technology•Foreign demand

AD’

An increase in exogenous spending shifts AD to AD’ and vice versaIn

flat

ion

1111

Fed Targets Higher rFed Targets Higher rR

eal i

nte

rest

rat

e se

t b

y F

ed, r

Output YInflation

Infl

atio

n

Fed “tightens” monetary policy – shifting reaction curve

The new Fed policy increases r and AD shifts to AD’

Old monetary policy reaction function

AD

A

Ar*

1*

New monetary policy reaction function AD’

B

B

2*

1212

Movements Along the Movements Along the ADAD Curve Curve

and and YY are inversely related are inversely relatedChanges in Changes in cause a change in cause a change in Y Y or or

a movement along the a movement along the AD AD curvecurve increases increases r r increasesincreases planned planned

spending decreases spending decreases YY decreases decreases (stationary monetary policy reaction (stationary monetary policy reaction function)function)

1313

Shifts of the Shifts of the ADAD Curve Curve

Any factor that changes Any factor that changes YY at a given at a given shifts the shifts the ADAD curve. curve.

Shifts of the Shifts of the AD AD curve can be caused by:curve can be caused by:Changes in exogenous spending.Changes in exogenous spending.Changes in the Fed’s policy reaction function.Changes in the Fed’s policy reaction function.

1414

Inflation and Aggregate SupplyInflation and Aggregate Supply

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

Inflation InertiaInflation Inertia In industrial economies (U.S.), inflation tends In industrial economies (U.S.), inflation tends

to change slowly from year to year.to change slowly from year to year.The The inflation inertiainflation inertia occurs for two reasons: occurs for two reasons:

Inflation expectationsInflation expectationsLong-term wage and price contractsLong-term wage and price contracts

1515

A Virtuous CircleA Virtuous Circle

1616

Long-term ContractsLong-term Contracts

Union wage contracts set wages for Union wage contracts set wages for several years.several years.

Contracts setting the price of raw materials Contracts setting the price of raw materials and parts for manufacturing firms also and parts for manufacturing firms also cover several years.cover several years.

These long-term contracts reflect the These long-term contracts reflect the inflation expectations at the time they are inflation expectations at the time they are signed.signed.

1717

Inflation and Aggregate SupplyInflation and Aggregate Supply

Three factors that can increase the Three factors that can increase the inflation rateinflation rateOutput gapOutput gap Inflation shockInflation shockShock to potential outputShock to potential output

1818

The Output Gap and InflationThe Output Gap and Inflation

Relationship of outputto potential output Behavior of inflation

1. No output gap Inflation remains unchangedY = Y*

2. Expansionary gap Inflation rises

Y > Y*

3. Recessionary gap Inflation falls

Y < Y*

1919

Aggregate SupplyAggregate Supply

Long-run aggregate supply (Long-run aggregate supply (LRASLRAS))A vertical line showing the economy’s A vertical line showing the economy’s

potential output potential output Y*Y*Short-run Aggregate Supply (Short-run Aggregate Supply (SRASSRAS))

A horizontal line showing the current rate of A horizontal line showing the current rate of inflation, as determined by past expectations inflation, as determined by past expectations and pricing decisionsand pricing decisions

2020

Short-run EquilibriumShort-run Equilibrium Inflation equals the value determined by Inflation equals the value determined by

past expectations and pricing decisions past expectations and pricing decisions and output equals the level of short-run and output equals the level of short-run equilibrium output that is consistent with equilibrium output that is consistent with that inflation ratethat inflation rate

Graphically, short-run equilibrium occurs Graphically, short-run equilibrium occurs at the intersection of the at the intersection of the ADAD curve and the curve and the SRASSRAS line line

2121

EquilibriumEquilibrium

Output

Infl

atio

n

Aggregate demand, AD

Long-run aggregate

supply, LRAS

A

Y*Y

Short-run aggregate supply, SRAS

Short-run equilibrium•Y: SRAS() = AD•Y < Y* -- recessionary gap and Y adjust to the gap

decreases & Y increases

Long-run equilibrium• AD, SRAS (*), LRAS (Y*)

will intersect at the same point

2222

AD

LRAS

A

Y

SRAS1SRAS2SRAS3

The Adjustment of Inflation The Adjustment of Inflation When a Recessionary Gap ExistsWhen a Recessionary Gap Exists

Output

Infl

atio

n

Y*

SRASFinal

B’

2323

Long-run EquilibriumLong-run Equilibrium

A situation in which actual output equals A situation in which actual output equals potential output and the inflation rate is potential output and the inflation rate is stablestable

Graphically, long-run equilibrium occurs Graphically, long-run equilibrium occurs when the when the ADAD curve, the curve, the SRASSRAS line, and line, and the the LRAS LRAS line all intersect at a single pointline all intersect at a single point

2424

Adjustment to Recessionary GapAdjustment to Recessionary Gap Firms that are selling less than they want to will Firms that are selling less than they want to will

start to lower prices.start to lower prices. As As falls the Fed lowers falls the Fed lowers rr and and AD AD increases.increases. Falling Falling reduces uncertainty which also reduces uncertainty which also

increases increases ADAD As As YY increases, cyclical unemployment falls increases, cyclical unemployment falls

(Okun’s Law)(Okun’s Law) Adjustment continues until long-run equilibrium Adjustment continues until long-run equilibrium

is reached.is reached.

2525

The Adjustment of Inflation The Adjustment of Inflation When A Expansionary Gap ExistsWhen A Expansionary Gap Exists

Output

Infl

atio

nLRAS

A

AD

Y* Y

SRAS

B

Short-run Eq. Y•Expansionary gap Y > Y* rises, AD falls – Y falls•Long-run equilibrium at Y*, *

’ SRASFinal

SRAS3SRAS2

2626

The Self-Correcting EconomyThe Self-Correcting Economy

In the long-run the economy tends to be In the long-run the economy tends to be self-correcting.self-correcting.

The Keynesian model does not include a The Keynesian model does not include a self-correcting mechanism.self-correcting mechanism.

The Keynesian model concentrates on the The Keynesian model concentrates on the short-run with no price adjustment.short-run with no price adjustment.

The self-correcting mechanism The self-correcting mechanism concentrates on the long-run with price concentrates on the long-run with price adjustments.adjustments.

2727


A slow self-correcting mechanismA slow self-correcting mechanismFiscal and monetary policy can help stabilize Fiscal and monetary policy can help stabilize

the economy.the economy.A fast self-correcting mechanismA fast self-correcting mechanism

Fiscal and monetary policy are not effective Fiscal and monetary policy are not effective and may destabilize the economy.and may destabilize the economy.

2828


The speed of correction will depend on:The speed of correction will depend on:The use of long-term contracts.The use of long-term contracts.The efficiency and flexibility of labor markets.The efficiency and flexibility of labor markets.

Fiscal and monetary policy are most useful Fiscal and monetary policy are most useful when attempting to eliminate large output when attempting to eliminate large output gaps.gaps.

2929

Sources of InflationSources of InflationExcessive Aggregate SpendingExcessive Aggregate Spending Inflation ShocksInflation ShocksShocks to Potential OutputShocks to Potential Output

3030

Military Buildup and InflationMilitary Buildup and Inflation

Output

Infl

atio

n

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

LRAS

A

Y*

SRAS

’ SRASFinal

C

increases shifting SRAS to SRASFinal

•Long-run equilibrium back to Y* with *

SRAS3

SRAS2

Y

B

AD’

Y

B

AD’

•Increase in military spending causes AD to increase•Creates an expansionary gap -- Y > Y*

3131

Sources of InflationSources of Inflation

What Do You Think?What Do You Think?Does the Fed have the power to prevent the Does the Fed have the power to prevent the

increased inflation that is induced by a rise in increased inflation that is induced by a rise in military spending?military spending?Hint: Can the Fed reduce Hint: Can the Fed reduce ADAD??

What is the cost of avoiding inflation during a What is the cost of avoiding inflation during a military buildup?military buildup?

3232

Sources of Inflation in 1960Sources of Inflation in 1960 1959-63 inflation averaged about 1%1959-63 inflation averaged about 1% By 1970 inflation was 7%By 1970 inflation was 7% Fiscal policyFiscal policy

Increased spending on Great Society and war on Increased spending on Great Society and war on poverty initiativespoverty initiatives

Increases in defense spendingIncreases in defense spending 1965 = $50.6 billion or 7.4% of GDP1965 = $50.6 billion or 7.4% of GDP 1968 = $81.9 billion or 9.4% of GDP1968 = $81.9 billion or 9.4% of GDP

Monetary policyMonetary policy The Fed did not try to offset the increase in government The Fed did not try to offset the increase in government

spendingspending

3333


Inflation ShockInflation ShockA sudden change in the normal behavior of A sudden change in the normal behavior of

inflation, unrelated to the nation’s output gapinflation, unrelated to the nation’s output gap Inflation Shock -- ExamplesInflation Shock -- Examples

OPEC embargo of 1973OPEC embargo of 1973Drop in oil prices in 1986Drop in oil prices in 1986

3434

Adverse Inflation ShockAdverse Inflation Shock

Output

Infl

atio

n

AD’

C

• No policy -- falls; long-run eq. at A• With policy--AD shifts to AD’; Y = Y*; rises

to *

AD

LRAS

A

Y*

SRAS

• Equilibrium @ A--Y* = Y

Y’

BSRAS’

• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap

and higher inflation (stagflation)

’

3535


What is the macroeconomic policy dilemma What is the macroeconomic policy dilemma created by an inflation shock? (stagflation)?created by an inflation shock? (stagflation)?

Sustained inflation is possible only if monetary Sustained inflation is possible only if monetary policy is sufficiently expansionary.policy is sufficiently expansionary.

3636

Shock To Potential OutputShock To Potential Output

Output

Infl

atio

n

AD

LRAS

A

Y*

SRAS

•Equilibrium at A -- Y* = Y

Y*’

BSRAS’

LRAS’ •Y* falls to Y*’•Y > Y* -- expansionary gap increases--SRAS rises to SRAS’•Equilibrium at B

•Y = Y*’ increased to ‘ •Decline in output is permanent

’

http://www.npr.org/templates/story/story.php?storyId=101386052

3737

Aggregate Supply ShockAggregate Supply Shock

Either an inflation shock or a shock to Either an inflation shock or a shock to potential outputpotential output

Adverse aggregate supply shocks of both Adverse aggregate supply shocks of both types reduce output and increase inflationtypes reduce output and increase inflation

Inflation shocksInflation shocksStagflationStagflationTemporary reduction in outputTemporary reduction in output

3838

U.S. Macroeconomic Data, U.S. Macroeconomic Data, Annual Averages, 1985-2000Annual Averages, 1985-2000

% Growth in Unemployment Inflation ProductivityYears 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

Was Greenspan right in 1996?

3939

GreenspanGreenspan

Output

Infl

atio

n

AD

•Equilibrium at B -- Y*’ = Y

Y*’

BSRAS’

LRAS

’

LRAS’

A

Y*

SRAS

•Productivity increases•Y*’ shifts to Y*•Recessionary gap -- Y*’ < Y* falls to •Equilibrium at A•Lower inflation; higher output

4040

Fiscal Policy and the Supply SideFiscal Policy and the Supply Side

Supply-side PolicySupply-side PolicyA policy that affects potential outputA policy that affects potential outputExamplesExamples

Roads and highwaysRoads and highwaysAirportsAirportsSchoolsSchoolsGovernment tax and transfer programsGovernment tax and transfer programs

4141


Marginal Tax RateMarginal Tax RateThe amount by which taxes rise when before-The amount by which taxes rise when before-

tax income rises by one dollartax income rises by one dollarAverage Tax RateAverage Tax Rate

Total taxes divided by total before-tax incomeTotal taxes divided by total before-tax income

4242

The Potential Effects of Tax Rate The Potential Effects of Tax Rate Reductions on Both AD and ASReductions on Both AD and AS

Output

Infl

atio

n

Y*

LRAS

AD

AD’

LRAS’

Y*’

4343


Effect on Supply of LaborEffect on Supply of LaborLower rates may give people an incentive to Lower rates may give people an incentive to

seek further education and engage in seek further education and engage in entrepreneurial activity.entrepreneurial activity.

Lower rates may give workers an incentive to Lower rates may give workers an incentive to work less.work less.

Married women are more responsive to tax Married women are more responsive to tax changes than men.changes than men.

4444

Hours Worked per Person and Hours Worked per Person and Marginal Tax Rates, 1993-1996Marginal Tax Rates, 1993-1996

Hours worked per person per yearCountry relative to the U.S. (U.S. = 100) Marginal tax rate

Japan 104 37%

United States 100 40

United Kingdom 88 44

Canada 88 52

Germany 75 59

France 68 59

Italy 64 64

4545

Output Gaps and PoliciesOutput Gaps and Policies

AD > Y* => Expansionary GapAD > Y* => Expansionary GapAD < Y* => Recessionary GapAD < Y* => Recessionary GapPolicies to eliminate gaps:Policies to eliminate gaps:

Fiscal policiesFiscal policiesG increase/decreaseG increase/decreaseT increase/decreaseT increase/decrease

Monetary policiesMonetary policiesMoney supply increase/decrease (r Money supply increase/decrease (r

increase/decrease)increase/decrease)

4646

Shortcoming of the Keynesian CrossShortcoming of the Keynesian Cross

It keeps prices constant.It keeps prices constant.How does one include inflation into the How does one include inflation into the

Keynesian cross?Keynesian cross?Explain what happens to AD at higher Explain what happens to AD at higher

levels of inflation and use this new diagram.levels of inflation and use this new diagram. Include the self-correcting mechanism of Include the self-correcting mechanism of

the economy by differentiating short run the economy by differentiating short run aggregate supply (Keynesian) from the long aggregate supply (Keynesian) from the long run aggregate supply (Classical).run aggregate supply (Classical).

4747

Why Does Aggregate Demand Why Does Aggregate Demand Fall When Inflation Rises?Fall When Inflation Rises?

When When up => Fed Policy Reaction up => Fed Policy Reaction Function raises r => I and C down => AD Function raises r => I and C down => AD downdownFed Policy Reaction Function (Example: Fed Policy Reaction Function (Example:

Taylor rule): r = 0.01 - 0.5[(Y*-Y)/Y*] + 0.5Taylor rule): r = 0.01 - 0.5[(Y*-Y)/Y*] + 0.5

4848

Why Does Aggregate Demand Why Does Aggregate Demand Fall When Inflation Rises?Fall When Inflation Rises?

When When up => wealth held in money form up => wealth held in money form erodes => C down => AD downerodes => C down => AD down

When When up => MPC falls because the poor up => MPC falls because the poor are affected more than the rich => multiplier are affected more than the rich => multiplier falls => AD flatterfalls => AD flatter

When When up => at constant exchange rates up => at constant exchange rates our exports become more expensive and our our exports become more expensive and our imports become cheaper => NX falls => AD imports become cheaper => NX falls => AD fallsfalls

4949

Shifts in ADShifts in AD

Changes in autonomous aggregate demand.Changes in autonomous aggregate demand.Autonomous CAutonomous CAutonomous IAutonomous ITaxesTaxesGovernment purchasesGovernment purchasesNet exportsNet exports

Changes in Fed’s policy reaction functionChanges in Fed’s policy reaction functionTightening of monetary policyTightening of monetary policyEasing of monetary policyEasing of monetary policy

5050

Shifting of ADShifting of AD

Increase in autonomous spending shifts Increase in autonomous spending shifts AD right.AD right.

Tightening of monetary policy raises r Tightening of monetary policy raises r and shifts AD left.and shifts AD left.

Easing of monetary policy lowers r and Easing of monetary policy lowers r and shifts AD right.shifts AD right.

Changes in inflation are movements Changes in inflation are movements along the AD curve.along the AD curve.

5151

Movement Along ADMovement Along AD

Any change in the vertical axis shows Any change in the vertical axis shows as a movement along the AD line, just as a movement along the AD line, just like demand and supply (changes in P).like demand and supply (changes in P).

The vertical axis measures the inflation The vertical axis measures the inflation rate.rate.

Therefore, any change in the inflation Therefore, any change in the inflation rate is shown as a movement along the rate is shown as a movement along the AD line.AD line.

5252

Why Inflation Rate Doesn’t Why Inflation Rate Doesn’t Change?Change?

Inflation has inertia.Inflation has inertia. Inflationary expectations tend to keep inflation Inflationary expectations tend to keep inflation

constant.constant.Contracts include expected inflation.Contracts include expected inflation.

Long term contracts keep inflation Long term contracts keep inflation constant.constant.

5353

Why Inflation Rate Changes?Why Inflation Rate Changes?

1.1. Output Gap.Output Gap.1.1. Expansionary output gaps (Y>Y*)Expansionary output gaps (Y>Y*)

2.2. Inflation shockInflation shock1.1. An increase in price of inputs that raise An increase in price of inputs that raise

the cost of production for a significant the cost of production for a significant portion of the economy. (Oil; wages for portion of the economy. (Oil; wages for national unions).national unions).

3.3. Shock to potential outputShock to potential output1.1. Disasters.Disasters.

5454

Expansionary GapsExpansionary Gaps

How will an expansionary gap look in an How will an expansionary gap look in an AD-AS diagram?AD-AS diagram?

How will the economy adjust to the How will the economy adjust to the expansionary gap?expansionary gap?

What will happen to SRAS in the long-What will happen to SRAS in the long-run?run?

Keynesian - Classical dilemma.Keynesian - Classical dilemma.

5555

Excessive ADExcessive AD

Shifts in AD that create expansionary Shifts in AD that create expansionary output gaps will raise inflation rate.output gaps will raise inflation rate.G increase: military buildup of 1960s and G increase: military buildup of 1960s and

1980s.1980s. Inflation rose in the sixties but did not in the Inflation rose in the sixties but did not in the

eighties.eighties.The Fed’s policy stand is the answer.The Fed’s policy stand is the answer.

5656

Inflation ShocksInflation Shocks

Oil price shock of the seventies pushed Oil price shock of the seventies pushed the inflation up: SRAS shifts up.the inflation up: SRAS shifts up.

If the Fed doesn’t respond recessionary If the Fed doesn’t respond recessionary gap will be eliminated in the long run.gap will be eliminated in the long run.

If the Fed does respond to recession, If the Fed does respond to recession, AD will be shifted to the right but the AD will be shifted to the right but the long run equilibrium will take place at long run equilibrium will take place at the higher inflation rate.the higher inflation rate.

5757

Shock to Potential OutputShock to Potential Output

If a disaster happens or capital If a disaster happens or capital becomes obsolete or expensive to use, becomes obsolete or expensive to use, Y* shifts left.Y* shifts left.

Again, stagflation occurs, just like when Again, stagflation occurs, just like when inflationary shocks takes place.inflationary shocks takes place.

Long run equilibrium will be at a higher Long run equilibrium will be at a higher inflation rate and lower Y.inflation rate and lower Y.

5858

Lowering InflationLowering Inflation

Suppose the country is experiencing Suppose the country is experiencing double digit inflation.double digit inflation.

Because of inflationary expectations Because of inflationary expectations and contracts, the inflation will remain at and contracts, the inflation will remain at that level.that level.

However, to eliminate the costs of However, to eliminate the costs of inflation, the Central Bank embarks in a inflation, the Central Bank embarks in a new monetary policy.new monetary policy.

Show the short and long run effects.Show the short and long run effects.

5959

Lowering InflationLowering Inflation

Time

GDP

Infl’n

rY*

Inflation

6060

Can Fiscal Stimulus WorkCan Fiscal Stimulus Work

http://www.economy.com/mark-zandi/docuhttp://www.economy.com/mark-zandi/documents/assissing-the-impact-of-the-fiscal-stiments/assissing-the-impact-of-the-fiscal-stimulus.pdfmulus.pdf

BarroBarro note note

Documents

1 Frank & Bernanke 3 rd edition, 2007 Ch. 15: Inflation, Aggregate Supply, and Aggregate Demand