CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 25 PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 25

13 PART III THE CORE OF MACROECONOMIC THEORY © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster Aggregate Supply and the Equilibrium Price Level Fernando & Yvonn Quijano Prepared by:

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of The Aggregate Supply CurveThe Aggregate Supply Curve: A WarningAggregate Supply in the Short RunShifts of the Short-Run Aggregate Supply CurveThe Equilibrium Price LevelThe Long-Run Aggregate Supply CurvePotential GDPMonetary and FiscalPolicy EffectsLong-Run Aggregate Supply and Policy EffectsCauses of InflationDemand-Pull InflationCost-Push, or Supply-Side, InflationExpectations and InflationMoney and InflationSustained Inflation as a Purely Monetary Phenomenon The Behavior of the FedControlling the Interest RateThe Fed’s Response to the State of the Economy Fed Behavior Since 1970Inflation TargetingLooking Ahead CHAPTER OUTLINE Aggregate Supply and the Equilibrium Price Level 13 PART III THE CORE OF MACROECONOMIC THEORY

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of 25 The Aggregate Supply Curve aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. The Aggregate Supply Curve: A Warning An “aggregate supply curve” in the traditional sense of the word supply does not exist. What does exist is what we might call a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy under a given set of circumstances.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of 25 The Aggregate Supply Curve Aggregate Supply in the Short Run In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical.  FIGURE 13.1 The Short-Run Aggregate Supply Curve

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of 25 The Aggregate Supply Curve Shifts of the Short-Run Aggregate Supply Curve cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.  FIGURE 13.2 Shifts of the Short-Run Aggregate Supply Curve

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of 25 The Equilibrium Price Level equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect. At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/ output decisions of all the firms in the economy. P 0 and Y 0 correspond to equilibrium in the goods market and the money market and to a set of price/output decisions on the part of all the firms in the economy.  FIGURE 13.3 The Equilibrium Price Level

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of 25 The Long-Run Aggregate Supply Curve When the AD curve shifts from AD 0 to AD 1, the equilibrium price level initially rises from P0 to P 1 and output rises from Y 0 to Y 1. Wages respond in the longer run, shifting the AS curve from AS 0 to AS 1. If wages fully adjust, output will be back at Y 0. Y 0 is sometimes called potential GDP.  FIGURE 13.4 The Long-Run Aggregate Supply Curve

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of 25 The Long-Run Aggregate Supply Curve The Simple “Keynesian”Aggregate SupplyCurve One view of the aggregate supply curve, the simple “Keynesian” view, holds that at any given moment, the economy has a clearly defined capacity, or maximum, output. With planned aggregate expenditure of AE 1 and aggregate demand of AD 1, equilibrium output is Y 1. A shift of planned aggregate expenditure to AE 2, corresponding to a shift of the AD curve to AD 2, causes output to rise but the price level to remain at P 1. If planned aggregate expenditure and aggregate demand exceed Y F, however, there is an inflationary gap and the price level rises to P 3.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of 25 The Long-Run Aggregate Supply Curve Potential GDP potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. Short-Run Equilibrium Below Potential Output Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of 25 Monetary and Fiscal Policy Effects Aggregate demand can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A’.  FIGURE 13.5 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of 25 Monetary and Fiscal Policy Effects If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B’.  FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near Maximum Capacity

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of 25 Monetary and Fiscal Policy Effects Long-Run Aggregate Supply and Policy Effects It is important to realize that if the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run. The conclusion that policy has no effect on aggregate output in the long run is perhaps startling.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of 25 Causes of Inflation Demand-Pull Inflation demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of 25 Causes of Inflation Cost-Push, or Supply-Side, Inflation An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls.  FIGURE 13.7 Cost-Push, or Supply- Side, Inflation cost-push, or supply-side, inflation Inflation caused by an increase in costs.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of 25 Causes of Inflation Cost-Push, or Supply-Side, Inflation A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS 0 to AS 1, lower output from Y 0 to Y 1, and raise the price level from P 0 to P 1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD 0 to AD 1. This policy would raise aggregate output Y again, but it would raise the price level further, to P 2.  FIGURE 13.8 Cost Shocks Are Bad News for Policy Makers stagflation Occurs when output is falling at the same time that prices are rising.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of 25 Causes of Inflation Expectations and Inflation When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, in anticipation, it may raise its own price. Given the importance of expectations in inflation, the central banks of many countries survey consumers about their expectations.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of 25 Causes of Inflation Money and Inflation An increase in G with the money supply constant shifts the AD curve from AD 0 to AD 1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps even hyperinflation.  FIGURE 13.9 Sustained Inflation From an Initial Increase in G and Fed Accommodation

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of 25 Causes of Inflation Sustained Inflation as a Purely Monetary Phenomenon Virtually all economists agree that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left. It is also generally agreed that for a sustained inflation to occur, the Fed must accommodate it. In this sense, a sustained inflation can be thought of as a purely monetary phenomenon.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of 25 The Behavior of the Fed  FIGURE Fed Behavior

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of 25 The Behavior of the Fed Controlling the Interest Rate The buying and selling of government securities by the Fed has two effects at the same time: It changes the money supply, and it changes the interest rate. How much the interest rate changes depends on the shape of the money demand curve. The steeper the money demand curve, the larger the change in the interest rate for a given size change in government securities. If the Fed wants to achieve a particular value of the money supply, it must accept whatever interest rate value is implied by this choice. Conversely, if the Fed wants to achieve a particular value of the interest rate, it must accept whatever money supply value is implied by this.

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 25 The Behavior of the Fed The Fed’s Response to the State of the Economy During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Fed is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD 0 to AD 1, and lead to an increase in output with very little increase in the price level.  FIGURE The Fed’s Response to Low Output/Low Inflation

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of 25 The Behavior of the Fed The Fed’s Response to the State of the Economy During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Fed is likely to increase the interest rate (and thus contract the money supply). This will shift the AD curve to the left, from AD 0 to AD 1, and lead to a decrease in the price level with very little decrease in output.  FIGURE The Fed’s Response to High Output/High Inflation

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of 25 The Behavior of the Fed Fed Behavior Since 1970 The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid 1980s on. It aggressively lowered interest rates in the 1990 IV–1991 I and 2001 I–2001 III recessions. Output is the percentage deviation of real GDP from its trend. Inflation is the 4-quarter average of the percentage change in the GDP deflator. The interest rate is the 3- month Treasury bill rate.  FIGURE Output, Inflation, and the Interest Rate 1970 I–2007 IV

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of 25 The Behavior of the Fed Inflation Targeting inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. Rising Food PricesWorry Central BanksAround the World Food Prices Worry Central Bankers Wall Street Journal

CHAPTER 13 Aggregate Supply and the Equilibrium Price Level © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 25 aggregate supply aggregate supply (AS) curve cost-push, or supply-side, inflation cost shock, or supply shock demand-pull inflation equilibrium price level inflation targeting potential output, or potential GDP stagflation REVIEW TERMS AND CONCEPTS