1 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft CASE FAIR OSTER P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N

2 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 13 Aggregate Supply and the Equilibrium Price Level The Aggregate Supply Curve The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve The Equilibrium Price Level The Long-Run Aggregate Supply Curve Potential GDP Monetary and Fiscal Policy Effects Long-Run Aggregate Supply and Policy Effects Causes of Inflation Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon The Behavior of the Fed Targeting the Interest Rate The Fed’s Response to the State of the Economy Fed Behavior Since 1970 Interest Rates Near Zero Inflation Targeting Looking Ahead

4 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 is not a market supply curve, and it is not the simple sum of all the individual supply curves in the economy. Because many firms in the economy set prices as well as output, we can say an “aggregate supply curve” is really 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. The Aggregate Supply Curve The Aggregate Supply Curve: A Warning

5 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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, Y*, the curve is vertical.  FIGURE 13.1 The Short-Run Aggregate Supply Curve The Aggregate Supply Curve Aggregate Supply in the Short Run

6 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The Aggregate Supply Curve Aggregate Supply in the Short Run Why an Upward Slope? Wages are a large fraction of total costs and wage changes lag behind price changes. This gives us an upward sloping short-run AS curve. Why the Particular Shape? At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (Y*), the AS curve is vertical. At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. We may observe relatively “sticky” wages upward at this point on the AS curve.

7 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The Aggregate Supply Curve Shifts of the Short-Run Aggregate Supply Curve

8 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The Equilibrium Price Level

9 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall When the AD curve shifts from AD 0 to AD 1, the equilibrium price level initially rises from P 0 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 The Long-Run Aggregate Supply Curve

10 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The simple “Keynesian” view of the aggregate supply curve 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. E C O N O M I C S I N P R A C T I C E The Simple “Keynesian” Aggregate Supply Curve Despite insights the kinked aggregate supply curve provides, most economists find it unlikely that the whole economy suddenly runs into a capacity “wall” at a specific level of output. As output expands, some firms and industries will hit capacity before others.

11 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. 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. The Long-Run Aggregate Supply Curve Potential GDP Short-Run Equilibrium Below Potential Output

12 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Monetary and Fiscal Policy Effects

13 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Monetary and Fiscal Policy Effects

14 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 longer the lag time between wages and output prices, the greater the potential impact of monetary and fiscal policy on aggregate output. Some argue that wages do not fall during slack periods and that the economy can get “stuck” at an equilibrium below potential output. In this case, monetary and fiscal policy would be necessary to restore full employment. Monetary and Fiscal Policy Effects Long-Run Aggregate Supply and Policy Effects

15 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall demand-pull inflation Inflation that is initiated by an increase in aggregate demand. Causes of Inflation Demand-Pull Inflation If the economy is operating on the steep portion of the AS curve at the time of the increase in aggregate demand, most of the effect will be an increase in the price level instead of an increase in output. If the economy is operating on the flat portion of the AS curve, most of the effect will be an increase in output instead of an increase in the price level.

16 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Causes of Inflation Cost-Push, or Supply-Side, Inflation stagflation Occurs when output is falling at the same time that prices are rising.

17 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Causes of Inflation Cost-Push, or Supply-Side, Inflation

18 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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, it may raise its own price. The firm’s profit-maximizing optimum price is presumably not too far from the average of its competitors’ prices. Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral. If prices have been rising and if people’s expectations are adaptive, firms may continue raising prices even if demand is slowing or contracting. Given the importance of expectations in inflation, central banks aim to keep them low. Causes of Inflation Expectations and Inflation

19 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall E C O N O M I C S I N P R A C T I C E Inflationary Expectations in China Expectations that prices will rise can be self- fulfilling as firms raise prices in expectation that all other prices will rise. This same phenomenon is discussed in the context of China. It is also interesting to note that many people believed the official statistics on inflation understated their own experience. Inflation Perceptions Run High in China The Wall Street Journal

20 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 Causes of Inflation Money and Inflation

21 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. Causes of Inflation Sustained Inflation as a Purely Monetary Phenomenon

22 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE Fed Behavior The Behavior of the Fed

23 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The Behavior of the Fed Targeting the Interest Rate The actual variable of interest to the Fed is not the money supply, but the interest rate. In practice, it is the interest rate that directly affects economic activity, for example, by affecting firms’ decisions about investing. Targeting the interest rate thus gives the Fed more control over the key variable that matters to the economy.

24 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The Behavior of the Fed The Fed’s Response to the State of the Economy

25 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 The Behavior of the Fed The Fed’s Response to the State of the Economy

26 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall E C O N O M I C S I N P R A C T I C E Markets Watch the Fed One measure of how important interest rates are to the health of the economy is the attention paid to Fed actions by the private sector, including prominently the major investment banks. All of the major investment banks employ economists to help them forecast what the Fed will do. These economists have been especially active in the recent period as there has been more uncertainty about whether the Fed might begin to tighten (raise interest rates) as the U.S. economy recovers. J.P. Morgan Pushes Back Rate Hike Forecast to Late 2011 The Wall Street Journal

27 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 III–1991 I, 2001 I– 2001 III, and 2008 I– 2009 II 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–2010 I The Behavior of the Fed Fed Behavior Since 1970

28 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The Behavior of the Fed Interest Rates Near Zero The Fed lowered the short-term interest rate to near zero beginning in 2008 IV. Since interest rates cannot go below zero, the ability of the Fed to stimulate the economy when interest rates are zero is severely limited. Its main way of stimulating the economy is to lower interest rates, which stimulates plant and equipment investment as well as consumption of durable goods and housing investment. This option is not available when interest rates are near zero. In this case, stimulus must come primarily from fiscal policy.

29 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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. The Behavior of the Fed Inflation Targeting Looking Ahead In this chapter, we introduced the aggregate supply curve. By using the aggregate supply and aggregate demand curves, we can determine the equilibrium price level in the economy and understand some causes of inflation. We have still said little about employment, unemployment, and the functioning of the labor market in the macroeconomy. The next chapter will link everything we have done so far to this third major market arena—the labor market—and to the problem of unemployment.

30 of 30 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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 R E V I E W T E R M S A N D C O N C E P T S