11

Frank & BernankeFrank & Bernanke44thth edition, 2009 edition, 2009

Ch. 13: Aggregate Ch. 13: Aggregate Demand and Demand and

Aggregate SupplyAggregate Supply

22

Aggregate Demand-Aggregate Aggregate Demand-Aggregate SupplySupply

LRAS

AS

AD

Y

π

Y*

33

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.

44

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.

55

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

66

The Aggregate Demand CurveThe Aggregate Demand Curve

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

77

The Aggregate Demand CurveThe Aggregate Demand Curve

Output Y

AD

Aggregate Demand Curve

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

Infl

atio

n

88

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)

99

π

r (by Fed)

π

ππ

Y

Y

PAE

AD

DERIVATION OF THE AD CURVE

Monetary Policy Rule

PAE

Fed responds to inflation rate and sets the federal funds interest rate. In the short run nominal and real interest rates remain the same because inflationary expectations haven’t changed. The real interest rate determines the C, I, NX and consequently the PAE. The Keynesian Cross gives us the equilibrium Y. We now have a point on the AD curve because we know the equilibrium Y and the inflation.

450

450

1010

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.

1111

π

r (by Fed)

π

ππ

Y

Y

PAE

ADAD’

SHIFTS IN AD IN RESPONSE TO SHIFTS IN PAE: G down

What changes make the PAE shift?

In the Keynesian Cross diagram, what changes might have happened?

If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet?

Try your hand at the diagrams when G increases or T decreases.

450

450

1212

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’

Infl

atio

n

1313

π

r (by Fed)

π

ππ

Y

Y

PAE

ADAD’

THE IMPACT OF MONETARY POLICY RULE CHANGE ON AD

What does it mean to shift MPR up?

Follow the resulting changes.

Show what happens to AD when the monetary policy becomes expansionary.

Monetary policy is more restrictive

1414

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*

1515

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)

1616

π

r (by Fed)

π

π π

Y

Y

PAE

ADAD’

INCREASE IN INFLATION

Upward movement along AD

1717

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

1818

A Virtuous CircleA Virtuous Circle

1919

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.

2020

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

2121

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 (D>S for firms)

Y > Y*

3. Recessionary gap Inflation falls (D<S for firms)

Y < Y*

2222

Aggregate SupplyAggregate Supply

Y*

πCurrent inflation (π) is the result of expected inflation plus the inflationary impact of the output gap.

If the economy is at Y*, current and expected inflation are the same. If there is an expansionary gap (Y>Y*) inflation increases to π1. If there is a recessionary gap (Y<Y*) inflation falls to π2.π2

π0

π1

Y2 Y1

2323

AS ShiftsAS Shifts

AS0

AS1

Y*

π0

π1

CHANGE IN INFLATIONARY EXPECTATIONSExpected inflation is higher at Y*.

A SUDDEN INFLATION SHOCKA sudden economy-wide cost increase

2424

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

past expectations and output gap (AS) and past expectations and output gap (AS) and output equals the level of short-run output equals the level of short-run equilibrium output that is consistent with equilibrium output that is consistent with that inflation rate (AD)that inflation rate (AD)

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 ASAS line line

2525

EquilibriumEquilibrium

Output

Infl

atio

n Long-run equilibrium

• AD, AS (*), LRAS (Y*) will intersect at the same point

LRAS

Y*

AS

AD

π*

2626

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 ASAS line, and the line, and the LRAS LRAS line all intersect at a single pointline all intersect at a single point

2727

Recessionary GapRecessionary Gap

Output

Infl

atio

n

LRAS

Y*

AS

AD

π0

Y0

π*

2828

Adjustment to Recessionary GapAdjustment to Recessionary Gap Y<Y* means firms are selling less than they Y<Y* means firms are selling less than they

want to; will start to lower prices.want to; will 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.

2929

Expansionary GapExpansionary Gap

Output

Infl

atio

n

LRAS

Y*

AS

AD

π

π*

3030

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.

3131

The Self-Correcting EconomyThe Self-Correcting Economy

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.

3232

The Self-Correcting EconomyThe Self-Correcting Economy

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.

3333

Sources of InflationSources of InflationExcessive Aggregate SpendingExcessive Aggregate Spending Inflation ShocksInflation ShocksShocks to Potential OutputShocks to Potential OutputTry to draw each one.Try to draw each one.

3434

π

r (by Fed)

π

ππ

Y

Y

PAE

AD’AD

EXCESSIVE AGGREGATE SPENDING

In the Keynesian Cross diagram, what changes might have happened? Military expenditures?

If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet?

450

450

PAEPAE’

3535

Excessive Aggregate SpendingExcessive Aggregate Spending

Output

Infl

atio

n

LRAS

Y*

AS

AD

π

π* Show the impact on Fed Policy Rule. What doesit mean?

3636

Higher Inflation and FedHigher Inflation and Fed

r

π

3737

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?

What did Germany do during early 1990s?What did Germany do during early 1990s?

3838

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

3939

Sources of InflationSources of Inflation

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

4040

Inflation ShockInflation Shock

Output

Infl

atio

n

LRAS

Y*

AS

AD

π*

AS’Two Options:Don’t do anything.

4141

Inflation ShockInflation Shock

Output

Infl

atio

n

LRAS

Y*

AS

AD

π*

AS’Two Options:Fed lowers r – easing money supply.

AD’

4242

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?

4343

Shock To Potential OutputShock To Potential Output

Output

Infl

atio

n

LRAS

Y*

AS

AD

π*

Y*’

LRAS’

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

Loss of capital, loss of labor, sudden abandonment of machinery (capital loss), extended recession (human capital loss).

4444

GreenspanGreenspan

Output

Infl

atio

n

LRAS

Y*

AS

AD

π*