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Chapter 23: Aggregate Demand and Aggregate Supply. Learning Objectives. Define the aggregate demand curve, explain why it slopes downward and explain why it shifts Define the aggregate supply curve, explain why it slopes downward and explain why it shifts - PowerPoint PPT Presentation
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©2012 The McGraw-Hill Companies, All Rights Reserved
1
Chapter 23: Aggregate Demand
and Aggregate Supply
©2012 The McGraw-Hill Companies, All Rights Reserved
2
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
©2012 The McGraw-Hill Companies, All Rights Reserved
3
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
©2012 The McGraw-Hill Companies, All Rights Reserved
4
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)
©2012 The McGraw-Hill Companies, All Rights Reserved
5
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
©2012 The McGraw-Hill Companies, All Rights Reserved
6
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
©2012 The McGraw-Hill Companies, All Rights Reserved
7
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
©2012 The McGraw-Hill Companies, All Rights Reserved
8
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
()
©2012 The McGraw-Hill Companies, All Rights Reserved
9
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
©2012 The McGraw-Hill Companies, All Rights Reserved
10
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 ()
©2012 The McGraw-Hill Companies, All Rights Reserved
11
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 ()
©2012 The McGraw-Hill Companies, All Rights Reserved
12
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
©2012 The McGraw-Hill Companies, All Rights Reserved
13
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
©2012 The McGraw-Hill Companies, All Rights Reserved
14
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
©2012 The McGraw-Hill Companies, All Rights Reserved
15
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
©2012 The McGraw-Hill Companies, All Rights Reserved
16
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
©2012 The McGraw-Hill Companies, All Rights Reserved
17
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
©2012 The McGraw-Hill Companies, All Rights Reserved
18
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
©2012 The McGraw-Hill Companies, All Rights Reserved
19
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
©2012 The McGraw-Hill Companies, All Rights Reserved
20
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
©2012 The McGraw-Hill Companies, All Rights Reserved
21
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
©2012 The McGraw-Hill Companies, All Rights Reserved
22
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
©2012 The McGraw-Hill Companies, All Rights Reserved
23
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
©2012 The McGraw-Hill Companies, All Rights Reserved
24
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
©2012 The McGraw-Hill Companies, All Rights Reserved
25
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
©2012 The McGraw-Hill Companies, All Rights Reserved
26
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)
©2012 The McGraw-Hill Companies, All Rights Reserved
27
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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28
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
©2012 The McGraw-Hill Companies, All Rights Reserved
29
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
©2012 The McGraw-Hill Companies, All Rights Reserved
30
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
©2012 The McGraw-Hill Companies, All Rights Reserved
31
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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32
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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33
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
©2012 The McGraw-Hill Companies, All Rights Reserved
34
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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35
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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36
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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The Effects of an Adverse Inflation Shock
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
©2012 The McGraw-Hill Companies, All Rights Reserved
38
The Effects of an Adverse Inflation Shock
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
©2012 The McGraw-Hill Companies, All Rights Reserved
39
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