Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-1 Chapter 9 The aggregate demand – aggregate supply model

Learning objectives 1.What does an aggregate demand curve show? 2.What implication do the Reserve Bank’s anti-inflation policies have for the slope of the aggregate demand curve? 3.For what reasons might the aggregate demand curve shift? 4.What is meant by the phrase ‘inflation inertia’? 5.How does the output gap affect the rate of inflation? 6.How is the aggregate demand–aggregate supply diagram constructed? 7.In what sense is the economy ‘self-correcting’? 8.What are the sources of inflations? 9.What are the effects on the economy of an inflation shock? 10.Describe how monetary policy can influence the rate of inflation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-2

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-3 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

Aggregate demand The aggregate demand (AD) curve shows the relationship between short-run equilibrium output and the inflation rate,  To incorporate inflation into the model, a longer time frame than the short run is needed, assuming prices did not change when the AD curve changed. Since short-run equilibrium output equals PAE, the AD curve shows the relationship between spending and inflation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-4

Why does aggregate demand slope down? An increase in the rate of inflation tends to reduce equilibrium output. –The AD curve is downward sloping when  is on the y axis and output is on the x axis. When the inflation rate exceeds its targeted level, the Reserve Bank will increase real interest rates, which reduces C and I, and thus, equilibrium output. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-5

Downward-sloping AD curve Reasons for a downward-sloping AD curve: 1.High inflation reduces the purchasing power of financial assets, and this reduction of real wealth at high inflation reduces household spending. 2.High inflation tends to redistribute resources from less well- off households who spend greater proportions of their incomes to better off households, who spend a lesser proportion. 3.High inflation generates uncertainty for households and firms and this makes them more cautious and reduces spending. 4.At constant exchange rates, higher domestic inflation makes exports less competitive, and reduces the level of net exports. Again, this reduces spending at higher levels of inflation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-6

The aggregate demand curve Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-7 Figure 9.1 The aggregate demand curve

Shifts of the aggregate demand curve Downward-sloping AD curve implies a higher level of inflation leads to a lower equilibrium output, ceteris paribus. However, changes can affect planned spending and so equilibrium output at the same inflation can change: 1.exogenous changes in spending 2.exogenous changes in the policy reaction function. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-8

Exogenous changes in spending These are changes in spending caused by factors other than changes in output or interest rates. –For example, the level of government spending, consumer and business confidence, increased business investment, increases in exports, etc. Effects of exogenous changes in spending: –An increase in exogenous spending increases equilibrium output at each level of inflation and the AD curve shifts to the right –A decrease in exogenous spending decreases equilibrium output at each level of inflation and the AD curve shifts to the left. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-9

Exogenous changes in spending (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-10 Figure 9.2 Effect of an increase in exogenous spending

Exogenous changes in the policy reaction function The Reserve Bank usually follows a stable reaction function. If the Reserve Bank decides to change how they want to react to a given level of inflation, they will set a different real interest rate at the same level of inflation as previously. –This shift in the policy reaction function would cause the AD curve to shift as a different equilibrium output would result at each inflation rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-11

Exogenous changes in the policy reaction function (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-12 Figure 9.3 A shift in the Reserve Bank’s policy reaction function

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-13 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

Inflation inertia Inflation in many economies tends to change relatively slowly due to: –the public’s inflation expectations –the existence of long-term wage and price contracts. Wages and the prices of many inputs are usually negotiated for a period of time. –Nominal prices negotiated include the expectations of inflation, and these are usually based on recent inflation experience. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-14

A virtuous circle Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-15 Figure 9.4 A virtuous circle of low inflation and low expected inflation

Inflation inertia: A formal treatment Let be the expected inflation in time t. It depends on the inflation in the previous period: Suppose the expected inflation flows through to wages and other production costs to affect the actual inflation and some random shocks: Inflation inertia can be shown formally as: Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-16

Australia’s inertial inflation rate Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-17 Figure 9.5 Australia’s inertial inflation rate

Output gaps and inflation Although inflation shows inertia, it does change, and a key factor is the output gap. In the short run, we have seen that firms expand their production to meet the demand at the pre-existing prices: we call this short-run equilibrium output Y. If Y = the economy’s long run productive output: that is, potential output Y*, then there is no output gap. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-18

Y = Y* : No output gap If Y = Y*, there is no incentive for the firm to increase their price relative to the prices of other goods and services. The inflation rate will tend to remain the same. There is no reason why that should be zero: expectations of future inflation are likely to stay the same as the current level of inflation, all else being equal. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-19

Y > Y* : Expansionary output gap If Y > Y*, most firms’ sales exceed their normal production rates, and firms are likely to increase their price relative to the prices of other goods and services. To do so, they will increase their prices by more than their costs increase. If all firms behave like this, the inflation rate will tend to increase. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-20

Y < Y* : Recessionary output gap If Y < Y*, most firms’ sales are less than their normal production rates, and firms have an incentive to decrease their relative price to sell more. To do so, they will increase their prices by less than their costs increase. If all firms behave like this, the inflation rate will tend to decrease. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-21

Output gap and inflation The following equation incorporates the notion that output gaps change inflation: Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-22 Output gapBehaviour of inflation No output gapInflation remains unchanged Expansionary gapInflation rises Recessionary gapInflation falls

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-23 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

The aggregate demand–aggregate supply diagram The AD–AS diagram shows the adjustment of inflation in response to an output gap in a diagram: –With π the vertical axis and real output, Y, on the horizontal axis –The potential output for the economy, or LRAS, is a vertical line –The short-run aggregate supply, or SRAS, is a horizontal line –The AD curve is downward sloping Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-24

The AD–AS diagram Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-25 Figure 9.6 The aggregate demand–aggregate supply (AD–AS ) diagram

AD–AS and a recessionary gap Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-26 Figure 9.7 The adjustment of inflation when a recessionary gap exists

AD–AS and an expansionary gap Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-27 Figure 9.8 The adjustment of inflation when an expansionary gap exists

Self-correcting economy In the long run: –The economy self corrects in such a way that eliminates output gaps without the need of change to the monetary or fiscal policy, beyond the RBA’s policy reaction function. If so, why do we still observe aggressive monetary and fiscal policies to stabilise output? –The speed of the adjustment, i.e. the larger the initial output gap the longer the adjustment time. Stabilisation policies are useful for large output gaps and the slow speed of adjustment. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-28

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-29 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

Sources of inflation What can cause inflation to change to cause output gaps initially? –Excessive spending –Inflation shocks –Shocks to potential output Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-30

Excessive spending Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-31 Figure 9.9 War and military build-up as a source of inflation

Inflation shocks Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-32 Figure 9.10 The effects of an adverse inflation shock

Shocks to potential output Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-33 Figure 9.11 The effects of a shock to potential output

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-34 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

The effects of anti-inflationary monetary policy Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-35 Figure 9.15 Short-run and long-run effects of an anti-inflationary monetary policy

Example: The global financial crisis and inflation Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-36 Figure 9.16 The global financial crisis led to recession in many countries and a fall in inflation, consistent with the predictions of the aggregate demand–aggregate supply model

Inflation targeting Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-37 Figure 9.20 A rightward shift in the AD curve creates an expansionary output gap

Inflation targeting (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-38 Figure 9.22 Monetary policy is tightened to maintain the inflation target

Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-39 Chapter organisation 9.1Inflation, spending and output: aggregate demand curve 9.2Inflation and supply decisions 9.3Aggregate demand–aggregate supply diagram 9.4Sources of inflation 9.5Controlling inflation Summary

The AD–AS diagram has 3 components: a horizontal SRAS curve, a vertical LRAS curve and a downward- sloping AD curve. Short-run equilibrium occurs at the point where the AD curve intersects the SRAS curve. Long-run equilibrium occurs at the point where the AD curve intersects the LRAS curve. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-40

Summary The economy has the tendency to correct itself back to its long-run equilibrium. The AD–AS diagram showcases the dilemma facing the Reserve Bank: the trade-off between inflation and output. Disinflation has serious consequences on the economy in the long run. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 9-41