MBMC Inflation and Aggregate Supply. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate

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Inflation and Aggregate Supply

Inflation and Aggregate Supply

Chapter 15: Inflation and Aggregate Supply Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Inflation, Spending, and Output: The Aggregate Demand Curve

Aggregate Demand (AD) CurveShows the relationship between short-run

equilibrium output Y and the rate of inflation,

The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy


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Aggregate Demand (AD) CurveIncreases in inflation reduce planned

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


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Inflation, the Fed, and the AD CurveThe Keynesian model assumes output

adjusts to demand at preset prices in the short run.

Prices do not remain fixed indefinitely.The Keynesian model does not explain the

behavior of inflation.


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The Aggregate Demand Curve

Output Y

AD

Aggregate Demand Curve

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

Infl

atio

n


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Inflation, the Fed, and the AD CurveA primary objective of the Fed is to

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

from exceeding Y*.


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Inflation, the Fed, and the AD CurveThe Fed can reduce autonomous

expenditure by raising the interest rate. increases r increases autonomous

spending decreases Y decreases (AD curve)


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Other Reasons for the Downward Slope of the AD CurveReal value of moneyDistributional effectsUncertaintyPrices of domestic goods and services sold

abroad


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Effect of An Increase 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


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A Shift In The Fed’s Policy Reaction FunctionR

eal i

nte

rest

rat

e se

t b

y F

ed, r

Output YInflation

Infl

atio

n

New policy reaction function

Fed “tightens” monetary policy – shifting reaction curve

Old policy reaction function

AD

AD’

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


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Movements Along the AD Curve and Y are inversely relatedChanges in cause a change in Y or a

movement along the AD curve increases r increases planned

spending decreases Y decreases


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Shifts of the AD CurveAny factor that changes Y at a given

shifts the AD curve.Shifts of the AD curve can be caused by:

Changes in exogenous spending.Changes in the Fed’s policy reaction function.


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Inflation andAggregate Supply

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


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Three factors that can increase the inflation rateOutput gapInflation shockShock to potential output


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Inflation InertiaIn industrial economies (U.S.), inflation

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

Inflation expectationsLong-term wage and price contracts


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A Virtuous Circle of Low Inflation and Low Expected Inflation


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Long-term Wage and Price ContractsUnion wage contracts set wages for

several years.Contracts setting the price of raw materials

and parts for manufacturing firms also cover several years.

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


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The 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*


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The Output Gap and InflationIf Y* = Y

An increase in exogenous spending creates and expansionary gap (Y > Y*) – inflation increases

A decrease in exogenous spending creates a recessionary gap (Y < Y*) and inflation decreases


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The Aggregate Demand—Aggregate Supply DiagramLong-run aggregate supply (LRAS)

A vertical line showing the economy’s potential output Y*


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The Aggregate Demand—Aggregate Supply DiagramShort-run Aggregate Supply (SRAS)

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


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The Aggregate Demand—Aggregate Supply DiagramShort-run Equilibrium

A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate

Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line


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The Aggregate Demand-Aggregate Supply (AD-AS) Diagram

Output

Infl

atio

n π

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


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The Aggregate Demand—Aggregate Supply DiagramLong-run Equilibrium

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

Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point


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A Review of the Adjustment Process to a Recessionary GapFirms that are selling less than they want

to will start to lower prices.As falls the Fed lowers r and AD

increases.Falling reduces uncertainty which also

increases AD


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A Review of the Adjustment Process to a Recessionary GapAs Y increases, cyclical unemployment

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

equilibrium is reached.


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The Adjustment of Inflation When A Recessionary Gap Exists

Output

Infl

atio

n

AD

LRAS

A

Y

SRAS

Y*

SRAS’B

*


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The Adjustment of Inflation When A Expansionary Gap Exists

Output

Infl

atio

nLong-run aggregate

supply LRAS

A

AD

Y* Y

SRAS

B

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

* SRAS’


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The Self-Correcting EconomyIn the long-run the economy tends to be

self-correcting.The Keynesian model does not include a

self-correcting mechanism.


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The Self-Correcting EconomyThe Keynesian model concentrates on the

short-run with no price adjustment.The self-correcting mechanism

concentrates on the long-run with price adjustments.


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The Self-Correcting EconomyA slow self-correcting mechanism

Fiscal and monetary policy can help stabilize the economy.

A fast self-correcting mechanismFiscal and monetary policy are not effective

and may destabilize the economy.


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The Self-Correcting EconomyThe 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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War and Military Buildup As A Source of Inflation

Output

Infl

atio

n

Output

Infl

atio

n

Y

B

AD’

Y

B

AD’

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

AD

LRAS

A

Y*

SRAS

LRAS

A

Y*

SRAS

’SRAS’C

increases shifting SRAS to SRAS’•Long-run equilibrium back to Y* with *


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Sources of Inflation

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

the increased inflation that is induced by a rise in military spending?

Hint: Can the Fed reduce AD?


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What Do You Think?What is the cost of avoiding inflation during

a military buildup?


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Economic NaturalistHow did inflation get started in the United

States in the 1960s?1959-63 inflation averaged about 1%By 1970 inflation was 7%


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States in the 1960s?Fiscal policy

o Increases in defense spending» 1965 = $50.6 billion or 7.4% of GDP» 1968 = $81.9 billion or 9.4% of GDP


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States in the 1960s?Fiscal policy

o Increased spending on Great Society and war on poverty initiatives

Monetary policyo The Fed did not try to offset the increase in

government spending


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Inflation ShockA sudden change in the normal behavior of

inflation, unrelated to the nation’s output gap


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Inflation Shock -- ExamplesOPEC embargo of 1973Drop in oil prices in 1986


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Economic NaturalistWhy did inflation escalate in the United

States in the 1970s?


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The Effects of An Adverse 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)

’


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ObservationSustained inflation is possible only if

monetary policy is sufficiently expansionary.


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The Effects of a Shock 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

’


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Aggregate Supply ShockEither an inflation shock or a shock to

potential outputAdverse aggregate supply shocks of both

types reduce output and increase inflation


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Shocks to Potential OutputAggregate supply shock

Inflation shockso Stagflationo Temporary reduction in output


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Shocks to Potential OutputAggregate supply shock

Potential output shockso Stagflationo Permanent reduction in output


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Economic NaturalistWhy was the United States able to

experience rapid growth and low inflation in the latter part of the 1990s?


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U.S. Macroeconomic Data, Annual 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 4.0 4.6 2.4 2.5


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Economic Naturalist

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


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AD

LRAS

A

Y*

SRAS10%•Eq. At A (Y = Y*) = 10%

Short-Run Effects of an Anti-inflationary Monetary Policy

Output

Infl

atio

n

Y

B

AD’

•Fed shifts AD to AD’•Short run eq. At B•Y < Y* -- recessionary gap•Long run correction occurs


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Long-Run Effects of an Anti-inflationary Monetary Policy

Output

Y*

Infl

atio

nLRAS

C

Y

SRASB

AD’

10%

•Short-run eq. at B•Recessionary gap -- Y < Y*

SRAS’3%

falls to 3% and Y rises to Y*•Long-run eq. -- lower prices @ Y*


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U.S. MacroeconomicData, 1978-1985

Nominal Real% Growth in Unemployment Inflation interest interest

Years real GDP rate (%) rate (%) rate (%) rate (%)

1978 5.5 6.1 7.6 8.3 0.7

1979 3.2 5.8 11.4 9.7 -1.7

1980 -0.2 7.1 13.5 11.6 -1.9

1981 2.5 7.6 10.3 14.4 4.1

1982 -2.0 9.7 6.2 12.9 6.7

1983 4.3 9.6 3.2 10.5 7.3

1984 7.3 7.5 4.3 11.9 7.6

1985 3.8 7.2 3.6 9.6 6.0


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Economic NaturalistCan inflation be too low?

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MBMC Inflation and Aggregate Supply. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate