Early 1980s Review: Aggregate Demand/Aggregate Supply Model AD Question: How many final goods and services would be purchased if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%) AS Question: How many final goods and services would be produced if the inflation rate () were _______ percent, given that all other factors relevant to supply remained the same? AS Aggregate Demand (AD) curve is downward sloping AD Aggregate Supply (AS) curve is upward sloping G&S Equilibrium Goods and services (G&S) purchased Goods and services (G&S) produced =  AD  AS =  C + I + G  GDP =

Changes in the expected inflation rate (E) Shifts in the Aggregate Demand (AD) Curve Fiscal Policy: President and Congress Government Purchases Taxes Increase Decrease Increase Decrease  Expansionary  Contractionary  Contractionary  Expansionary  AD curve shifts right  AD curve shifts left  AD curve shifts left  AD curve shifts right Long Run Aggregate Supply (LRAS) Curve Vertical: A placeholder for potential GDP, GDPP. Intersects the AS curve at the expected inflation rate, E. AS Shifts in the Aggregate Supply (AS) Curve  (%) LRAS Supply Shocks AS Positive Shock Negative Shock AS  AS curve shifts right  AS curve shifts left E E Changes in the expected inflation rate (E) E Increase in E Decrease in E  AS curve shifts up  AS curve shifts down G&S GDPP

Expected inflation rate decreases Reagan Tax Cut Unemp Real Actual Infl Expected Infl Govt Real Interest Year Rate (%) GDP  Rate (%) Purch 1980   9.0 1981 7.6 6,610 9.3 1,630 4.8 1982 9.7 6,485 6.2 1,660 1983 9.6 6,785 3.9 1,720 8.1 1984 7.5 7,275 3.5 1,785 9.2 9.0 9.3 6.2 3.9  (%) 1983-1984 1982-1983 1981-1982 AS Curve Adaptive Expectations: The expected inflation rate depends on the actual inflation rate in the recent past. AS1981,82 Expected inflation rate decreases Expected inflation rate about the same Expected inflation rate decreases AS1983 10.0 1981  AS curve shifts down  AS curve stationary  AS curve shifts down 8.0 1982 6.0 AS1984 4.0 1983 1984 AS and LRAS curves intersect at the expected inflation rate. 2.0 GDP 6,500 6,750 7,000 7,250 7,500

Puzzle: What are we missing? Unemp Real Actual Infl Expected Infl Govt Real Interest Year Rate (%) GDP  Rate (%) Purch 1980   9.0 1981 7.6 6,610 9.3 1,630 4.8 1982 9.7 6,485 6.2 1,660 1983 9.6 6,785 3.9 1,720 8.1 1984 7.5 7,275 3.5 1,785 9.2 9.0 9.3 6.2 3.9 AD Curve Fiscal Policy: President and Congress Government Purchases Taxes  (%) AD1981 Increase Decrease AS1981,82  Expansionary  Expansionary 10.0 1981  AD curve shifts right  AD curve shifts right 8.0 1982 6.0 Reagan Tax Cut In August 1981, the President and Congress enacted a 25 percent reduction phased in over the next three years: Question: Did the aggregate demand (AD) curve have to shift? 4.0 2.0 5 percent in 1982 Answer: Yes, to the left. Puzzle: What are we missing? 10 percent in 1983 GDP 10 percent in 1984 6,500 6,750

Monetary Policy: Federal Reserve Board (Fed) FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%)  (%) Aggregate demand (AD) curve is downward sloping as a consequence of the Taylor principle. Taylor Principle FP AD r (%) G&S Inflation rate () increases Real interest rate (r) increases Loans become more costly Households and firms purchase less Fewer goods and services purchased      Taylor principle (FP curve)  C and I decrease  AD = C + I + G decreases Taylor Principle is reactive. The Fed is reacting to a change in the inflation rate.

At a given inflation rate () Autonomous Monetary Policy: Shift of the Fed Policy (FP) curve – A Proactive Fed Autonomous Contractionary Monetary Policy Autonomous Expansionary Monetary Policy  Fed becomes tougher on inflation  Fed becomes easier on inflation  Fed shifts the FP curve right  Fed shifts the FP curve right  At a given inflation rate (), the Fed increases the real interest rate (r).  At a given inflation rate (), the Fed decreases the real interest rate (r). FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%)  (%) FP curve shifts right  AD curve shifts left FP FP  Contractionary At a given inflation rate ()  Lab 10.1 AD AD r (%) G&S Fed increases the real interest rate (r) Loans become more costly Households and firms purchase less Fewer goods and services purchased Aggregate demand (AD) curve shifts left    

Actual Infl Real Interest Year Rate (%) The Fed and Autonomous Monetary Policies Question: Did the Fed pursue autonomous monetary policies in the early 1980s?   Actual Infl Real Interest Year Rate (%) 1981 9.3% 4.8% 1982 6.2% 7.6% 1983 3.9% 8.1% 1984 3.5% 9.2% The FP curve shifted right  The Fed pursued an autonomous contractionary monetary policy  The Fed shifted the AD curve left.  (%) Question: When the FP curve shifts right, what happens to the AD curve? FP1981 FP1982 10.0 FP1983 Answer: The AD curve shifts left. 1981 8.0 FP1984 1982 6.0 Taylor Principle: The Fed policy (FP) curve is upward sloping. 1983 4.0 1984 2.0 r (%) 4.0 6.0 8.0 10.0

Real Actual Infl Govt Year GDP Rate (%) Purch Reagan Tax Cut Revisted 1981-1982 1983-1984 1982-1983 Real Actual Infl Govt Year GDP  Rate (%) Purch 1980   9.0 1981 6,610 9.3 1,630 1982 6,485 6.2 1,660 1983 6,785 3.9 1,720 1984 7,275 3.5 1,785 Fiscal Policy Fiscal Policy Fiscal Policy Autonomous Monetary Policy Autonomous Monetary Policy Autonomous Monetary Policy  Expansionary  Expansionary  Expansionary  Contractionary  Contractionary  Contractionary       In net, AD curve shifts right. Fiscal policy dominates. In net, AD curve shifts left. Monetary policy dominates. In net, AD curve shifts right. Fiscal policy dominates.  (%) AD1981 AS1981,82 10.0 1981 Reagan Tax Cut AS1983 1982: 5 percent AS1984 1983: 10 percent 8.0 1984: 10 percent 1982 6.0 4.0 1983 1984 2.0 AD1983 AD1984 AD1982 G&S 6,500 6,750 7,000 7,250 7,500

Summary: Fiscal and Monetary Policies Fiscal Policy: Congress and the President Autonomous Monetary Policy: The Fed Expansionary Contractionary Expansionary Contractionary G Up T Down G Down T Up Open Market Purchase Open Market Sale FP Curve FP Shifts Left FP Shifts Right FP Stationary AD Curve AD Shifts Right AD Shifts Left AD Shifts Right AD Shifts Left FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%)  (%) FP FP FP AD AD AD r (%) G&S