MBMC Inflation and Aggregate Supply Principles of Macroeconomics, by Ben Bernanke & Robert Frank, 2 nd Ed, 2004.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 2 Inflation, Spending, and Output: The Aggregate Demand Curve Aggregate Demand (AD) Curve Shows the relationship between short-run equilibrium output Y and the rate of inflation,  The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 3 Inflation, Spending, and Output: The Aggregate Demand Curve Inflation, the Fed, and the AD Curve The (simple) Keynesian model assumes output adjusts to demand at preset prices in the short run. Prices do not remain fixed indefinitely. The (simple) Keynesian model does not explain the behavior of inflation.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 4 The Aggregate Demand Curve Output Y AD Aggregate Demand Curve An increase in  reduces Y (all other factors held constant) Inflation 

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 5 Inflation, Spending, and Output: The Aggregate Demand Curve Inflation, the Fed, and the AD Curve A primary objective of the Fed is to maintain a low and stable inflation rate. Inflation is likely to occur when Y > Y* (Y* = Potential Output). To control inflation, the Fed must keep Y from exceeding Y*

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 6 Inflation, Spending, and Output: The Aggregate Demand Curve Inflation, the Fed, and the AD Curve The Fed can reduce autonomous expenditure by raising the interest rate.  increases => r increases => autonomous spending decreases => Y decreases (AD curve)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 7 Inflation, Spending, and Output: The Aggregate Demand Curve Other Reasons for the Downward Slope of the AD Curve (independent of Fed Policy) Real Balance Effect (stored money wealth) Distributional effects Uncertainty Prices of domestic goods and services sold abroad

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 8 Effect of An Increase In Exogenous Spending Output Y AD Exogenous Spending: spending unrelated to Y or r Fiscal policy Technology Foreign demand AD’ An increase in exogenous spending shifts AD to AD’ and vice versa Inflation 

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 9 A Shift In The Fed’s Policy Reaction Function Real interest rate set by Fed, r Output Y Inflation  New policy reaction function Fed “tightens” monetary policy – shifting reaction curve Old policy reaction function AD AD’ The new Fed policy increases r and AD shifts to AD’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 10 A Virtuous Circle of Low Inflation and Low Expected Inflation

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 11 The Output Gap and Inflation Relationship of output to potential outputBehavior of inflation 1. No output gapInflation remains unchanged Y = Y* 2. Expansionary gapInflation rises Y > Y*  3. Recessionary gapInflation falls Y < Y* 

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 12 Inflation and Aggregate Supply The Output Gap and Inflation If Y* = Y  An increase in exogenous spending creates and expansionary gap (Y > Y*) – inflation increases  A decrease in exogenous spending creates a recessionary gap (Y < Y*) and inflation decreases

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 13 Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram Long-run aggregate supply (LRAS)  A vertical line showing the economy’s potential output Y*

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 14 Inflation and Aggregate Supply The Aggregate Demand—Aggregate Supply Diagram Short-run Aggregate Supply (SRAS)  A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 15 The Aggregate Demand-Aggregate Supply (AD-AS) Diagram Output Nominal interest rate i Aggregate demand, AD Long-run aggregate supply, LRAS A Y*Y Short-run aggregate supply, SRAS Short-run equilibrium Y: SRAS(  ) = AD Y < Y* -- recessionary gap  and Y adjust to the gap  decreases & Y increases Long-run equilibrium AD, SRAS (  *), LRAS (Y*) will intersect at the same point

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 16 Inflation and Aggregate Supply A Review of the Adjustment Process to a Recessionary Gap Firms that are selling less than they want to will start to lower prices. As  falls the Fed lowers r and AD increases. Falling  reduces uncertainty which also increases AD

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 17 The Adjustment of Inflation When A Recessionary Gap Exists Output Inflation AD LRAS A Y SRAS  Y* SRAS’ B **

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 18 The Adjustment of Inflation When A Expansionary Gap Exists Output Inflation Long-run aggregate supply LRAS A AD Y*Y SRAS  B Short-run Eq. Y Expansionary gap Y > Y*  rises, AD falls – Y falls Long-run equilibrium at Y*,  * ** SRAS’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 19 War and Military Buildup As A Source of Inflation Output Inflation Output Inflation Y B AD’ Y B Increase in military spending causes AD to increase Creates an expansionary gap -- Y > Y* AD LRAS A Y* SRAS LRAS A Y* SRAS   ’’ SRAS’ C  increases shifting SRAS to SRAS’ Long-run equilibrium back to Y* with  *

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 20 The Effects of An Adverse Inflation Shock Output Inflation AD’ C No policy --  falls; long-run eq. at A With policy--AD shifts to AD’; Y = Y*;  rises to  * AD LRAS A Y*Y* SRAS A--Y* = Y  Y’ B SRAS’ Inflation shock,  increases to  ‘ (SRAS’) Short-run eq. At B, Y < Y*; recessionary gap and higher inflation (stagflation) ’’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 21 The Effects of a Shock To Potential Output Output Inflation AD LRAS A Y*Y* SRAS Equilibrium at A -- Y* = Y  Y*’ B SRAS’ LRAS’ Y* falls to Y*’ Y > Y* -- expansionary gap  increases--SRAS rises to SRAS’ Equilibrium at B Y = Y*’  increased to  ‘ Decline in output is permanent ’’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 22 Sources of Inflation Shocks to Potential Output Aggregate supply shock  Inflation shocks oStagflation oTemporary reduction in output

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 23 Sources of Inflation Shocks to Potential Output Aggregate supply shock  Potential output shocks oStagflation oPermanent reduction in output

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 24 Sources of Inflation Economic Naturalist Why was the United States able to experience rapid growth and low inflation in the latter part of the 1990s?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 25 U.S. Macroeconomic Data, Annual Averages, % Growth inUnemploymentInflationProductivity Yearsreal GDPrate (%)rate (%)growth (%)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 26 Economic Naturalist Output Inflation AD Equilibrium at B -- Y*’ = Y Y*’ B SRAS’ LRAS’ ’’ LRAS A Y*Y* SRAS  Productivity increases Y*’ shifts to Y* Recessionary gap -- Y*’ < Y*  falls to  Equilibrium at A Lower inflation; higher output

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 27 AD LRAS A Y*Y* SRAS 10% Eq. At A (Y = Y*)  = 10% Short-Run Effects of an Anti-inflationary Monetary Policy Output Inflation Y B AD’ Fed shifts AD to AD’ Short run eq. At B Y < Y* -- recessionary gap Long run correction occurs

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 28 Long-Run Effects of an Anti-inflationary Monetary Policy Output Y*Y* Inflation LRAS C Y SRAS B AD’ 10% Short-run eq. at B Recessionary gap -- Y < Y* SRAS’ 3%  falls to 3% and Y rises to Y* Long-run eq. -- lower Y*

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 15: Inflation and Aggregate Supply Slide 29 U.S. Macroeconomic Data, NominalReal % Growth inUnemploymentInflationinterestinterest Yearsreal GDPrate (%)rate (%)rate (%)rate (%)

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