MBMC Inflation and Aggregate Supply Principles of Macroeconomics, by Ben Bernanke & Robert Frank, 2 nd Ed, 2004

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Inflation and Aggregate Supply

Inflation and Aggregate Supply

Principles of Macroeconomics,

by Ben Bernanke & Robert Frank,

2nd Ed, 2004.

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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Inflation, the Fed, and the AD CurveThe (simple) Keynesian model assumes

output adjusts to demand at preset prices in the short run.

Prices do not remain fixed indefinitely.The (simple) 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*

(Y* = Potential Output).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 Curve (independent of Fed Policy)Real Balance Effect (stored money wealth)Distributional 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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A Virtuous Circle of Low Inflation and Low Expected Inflation


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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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Inflation andAggregate Supply

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 (AD-AS) Diagram

Output

No

min

al in

tere

st r

ate

i

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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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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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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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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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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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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Sources of Inflation

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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MBMC Inflation and Aggregate Supply Principles of Macroeconomics, by Ben Bernanke & Robert Frank, 2 nd Ed, 2004