Money and Banking Lecture 43

Review of the Previous Lecture Money growth, Inflation and Aggregate Demand Long Run Real Interest Rate Monetary Policy Reaction Curve Aggregate Demand Curve Shifts in Aggregate Demand

The Aggregate Supply Curve The aggregate supply curve tells us where on the aggregate demand curve the economy will end up, explaining the relationship between inflation and real output in the process. The short run aggregate supply curve tells us where the economy will settle at any particular time Long run curve tells us the levels of inflation and output the economy is moving toward.

The Aggregate Supply Curve Inflation persistence. Inflation tends to change slowly; when it is low one year it tends to be low the next year, and when it is high it tends to stay high. This is called inflation persistence If inflation remains steady over shorter periods, while real output adjusts, then the short-run aggregate supply curve must be flat at the current level of inflation

Inflation is persistent for two reasons First, when people expect inflation to continue, they adjust their prices and wages accordingly. When people expect inflation in the near future they raise wages and prices in a way that causes the inflation they expect to occur. Therefore, current inflation is at least partially determined by expected inflation

Inflation is persistent for two reasons Second, not all wage and price decisions are made at the same time. Price and wage adjustments are staggered, and this slows down the adjustment process causing persistence in inflation

The Short-Run Aggregate Supply Curve: The fact that inflation is persistent means that it is fixed in the short run, so the short-run aggregate supply curve is horizontal at the current level of inflation.

The Aggregate Supply Curve

Firms simply do not adjust the rate of their price increases in the short run; instead, they adjust the quantities they produce and sell. Over periods of several years or more, inflation does change, shifting the short-run aggregate supply curve up or down

Shifts in the Short-Run Aggregate Supply Curve There are two reasons why the short run aggregate supply curve can shift Deviations of current output from potential output, causing changes in inflation Changes in external factors driving production costs

Output Gaps When current output equals potential output so that there is no output gap, the short-run aggregate supply curve remains stable But when current output rises above or falls below potential output, so that an output gap develops, inflation will rise or fall.

When current output is below potential output, part of the economy’s capacity is idle, and firms tend to raise their prices and wages less than they did when current output equaled potential output. When current output exceeds potential output, the opposite happens; firms increase their prices and wages more than they would if they were operating at normal levels Thus when current output deviates from potential output, inflation adjusts, and the effect takes time to be felt.

Economists have differing views on how quickly inflation reacts and the short-run aggregate supply curve shifts. Those who believe in flexible prices think it happens quickly, While those who emphasize that many price and wage decisions involve long-term contracts think the adjustment is sluggish.

Inflation Shocks: An inflation shock is a change in the cost of producing output and causes the short-run aggregate supply curve to shift. This can be the result of changes in the cost of raw materials or labor, or (as is most common) a change in the price of energy. A positive inflation shock causes the short-run aggregate supply curve to shift upward, causing inflation to rise

The Long-Run Aggregate Supply Curve In the long run the economy moves to the point where current output equals potential output, while inflation is determined by money growth The long-run aggregate supply curve is vertical at the point where current output equals potential output.

Changes in expected inflation operate like cost shocks, shifting the short-run aggregate supply curve up and down. For the economy to remain in long-run equilibrium, then, in addition to current output equaling potential output, current inflation must equal expected inflation

At any point along the long-run aggregate supply curve, current output equals potential output and current inflation equals expected inflation Potential output is constantly rising as a result of investment and technological improvements (the sources of economic growth), which increase the normal output level. Changes in the economy’s productive capacity will shift the long-run aggregate supply curve; increases will shift it right and decreases will shift it left.