Aggregate Demand & SupplyPart III: Equilibrium

Aggregate Demand & SupplyPart III: Equilibrium

Equilibrium Aggregate Price Level

Equilibrium Aggregate Price Level

Putting aggregate D & S together:Putting aggregate D & S together:

ASP

Y

AD

Pe

Ye

Oil Crisis, 1974Oil Crisis, 1974 Arab Boycott leads to 4X increase in oil prices:Arab Boycott leads to 4X increase in oil prices:

ASP

Y

AD

Pe

Ye

Pe'

Ye'

AS'

1974-75Recession

Fiscal & Monetary Policy - IFiscal & Monetary Policy - I

G, G, T, T, Ms all shift AD to rightMs all shift AD to right

ASP

Y

AD

Pe

Ye

AD'

Fiscal & Monetary Policy - IIFiscal & Monetary Policy - II

G, G, T, T, Ms all shift AD to leftMs all shift AD to left

ASP

Y

AD'

Pe

Ye

AD

Fiscal & Monetary Policy - IIIFiscal & Monetary Policy - III

But what are size of effects on prices & output?But what are size of effects on prices & output?

ASP

Y

AD

Pe

Ye

?

?

Size of effects = f(shape of AS)Size of effects = f(shape of AS) Where AS is Where AS is flatterflatter, e.g., in depression, shifts in AD , e.g., in depression, shifts in AD

produce large changes in Y with small changes in P produce large changes in Y with small changes in P (typical Keynesian result):(typical Keynesian result):

ASP

Y

AD

Ye

Pe

Ye'

Size of effects = f(shape of AS)Size of effects = f(shape of AS) But where AS is steeper, e.g., in boom, shifts in AD But where AS is steeper, e.g., in boom, shifts in AD

produce large changes in P with small changes in Y:produce large changes in P with small changes in Y:

ASP

Y

AD

Ye

Pe

Ye'

Keynesian "Gaps"Keynesian "Gaps" Below YBelow Yee aggregate demand could be increased with no upward aggregate demand could be increased with no upward

pressure on pricespressure on prices Above YAbove Yee aggregate demand increases would generate inflation aggregate demand increases would generate inflation

(rising price level)(rising price level)

Y

C, I, G

AB

inflationarygap

deflationarygap

Yfe

aggregate demand

Keynesian Aggregate SupplyKeynesian Aggregate Supply

We can translate this into AS - AD terms:We can translate this into AS - AD terms:

Ye

AS

Y

P

Long Run Aggregate Supply - ILong Run Aggregate Supply - I Long run AS is said to be vertical. Why?Long run AS is said to be vertical. Why? Ans: wages adjust to price changesAns: wages adjust to price changes

LRAS

P

Y

AD

Pe

Ye

Long Run Aggregate Supply - IILong Run Aggregate Supply - II Suppose AD increased by policy, PSuppose AD increased by policy, P & Y & Y

LRAS

P

Y

AD

Pe

Ye

SRAS

AD'

Ye'

Pe'

Long Run Aggregate Supply - IIILong Run Aggregate Supply - III But then wages/costs/SRAS adjust to PBut then wages/costs/SRAS adjust to P

LRAS

P

Y

AD

Pe

Ye

SRAS

AD'

Ye'

Pe'

SRAS'

Pe"

"Long Run" AS?"Long Run" AS?

Problem: "short run" defined by fixed assets, Problem: "short run" defined by fixed assets, upper limit to production capacityupper limit to production capacity

"Long Run" defined in micro by all assets can "Long Run" defined in micro by all assets can be changed, plant & equipment & productivity be changed, plant & equipment & productivity can be increased can be increased

In micro a given technology may produce an In micro a given technology may produce an "envelop" of short run cost curves"envelop" of short run cost curves

But in aggregate, technology can change and But in aggregate, technology can change and output can be expanded indefinately!output can be expanded indefinately!

Potential GDP?Potential GDP?

LRAS curve vertical at what is called LRAS curve vertical at what is called "potential GDP""potential GDP"

"Potential GDP" = "level of output that can be "Potential GDP" = "level of output that can be sustained in the long run without inflation"sustained in the long run without inflation"

But in aggregate, technology can change and But in aggregate, technology can change and output can be expanded indefinitely!output can be expanded indefinitely!

InflationInflation

We now have model with price level, and hence We now have model with price level, and hence inflation, explicitinflation, explicit

We can use this model to talk about various We can use this model to talk about various kinds of inflationary pressureskinds of inflationary pressures

Demand Pull Inflation - IDemand Pull Inflation - I As we approach full employment, increasing demand As we approach full employment, increasing demand

"pulls" up the price level:"pulls" up the price level:

ASP

Y

AD

Ye

Pe

Ye'

At Full EmploymentAt Full Employment

At full employment, increases in AD produces At full employment, increases in AD produces onlyonly price increases: price increases:

Ye

AS

Y

P

Cost Push Inflation - ICost Push Inflation - I Increases in costs (wages, oil) shifts AS up, Increases in costs (wages, oil) shifts AS up, so Pso P (but note: Y (but note: Y = stagflation) = stagflation)

ASP

Y

AD

Pe

Ye

Pe'

Ye'

AS'

Cost Push Inflation - IICost Push Inflation - II But in late 1960s Y ROSE with wageBut in late 1960s Y ROSE with wage , how? , how?

ASP

Y

AD

Pe

Ye

Pe'

Ye'

AS'

Cost Push Inflation - IIICost Push Inflation - III Ans: accomodating monetary policy that Ans: accomodating monetary policy that ADAD

ASPe"

Y

AD

Pe

Ye

Pe'

Ye'

AS'

AD'

Inflation = Monetary Phenomenon?

Inflation = Monetary Phenomenon?

C&F: "a sustained inflation, whatever the C&F: "a sustained inflation, whatever the initial cause . . ., is essentially a monetary initial cause . . ., is essentially a monetary phenomenon." (p. 332)phenomenon." (p. 332)

C&F: "can be thought of as a purely monetary C&F: "can be thought of as a purely monetary phenomenon" (p. 337)phenomenon" (p. 337)

This view is associated with "monetarism" This view is associated with "monetarism" which became popular in 1970s because it which became popular in 1970s because it offered a policy alternative: hold down Ms.offered a policy alternative: hold down Ms.

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