Eco106 W8A Aggregate Demand and Supply Case-Fair Ch AD 2. AS 3. Cost Push vs Demand Pull Inflation 4. FRB responses to the economy 5. Hyperinflation and Deflation Damage

AD Y Y P r IS LM #1 LM #2 LM #3 P1 P2 P3 P is the price level as measured by the GDP deflator. As the price level rises the real Money supply falls and the Interest rate rises. (A higher Price level shifts the LM curve left.) So higher prices have lower Spending and output. That’s the idea of the AD line.

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

4 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. Important constants are: the capacity of the economy and the international prices it faces, especially for oil

5 of 25 The Aggregate Supply Curve 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. The price level refers to the prices of final goods: the GDP deflator. We assume that wages and other input prices are constant.

6 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

7 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.

8 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.

9 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. If expenditure and aggregate demand exceed Y F, there is an inflationary gap and the price level rises.

10 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.

11 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’.

12 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’.

13 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.

14 of 25 Causes of Inflation Demand-Pull Inflation demand-pull inflation: Inflation that is initiated by an increase in aggregate demand. Y P AS AD AD’

15 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. cost-push, or supply-side, inflation Inflation caused by an increase in costs.

16 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.

17 of 25 Fiscal an Monetary Overexpansion Causes 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.

18 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.

19 of 25 The Behavior of the Fed  FIGURE Fed Behavior

20 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.

21 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

22 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

Krugman on Babysitting the Economy Considers a famous case of babysitting credits in a local economy and the difficulties that arise when there are EITHER too FEW credits (money) in circulation or too MANY.

The FRB seeks to stay very far away from the Hyper inflations and Deflations that have occurred in the past. In the early 1900’s Europe experienced crippling inflation and then deflation, an experience that left an enduring mark on Keynes.

25 Keynes on Evils of Inflation Tract on Monetary Reform p2.

26 Inflation to 1920, deflation there after. Alters the distribution between the Investing Class, Business Class, and Earning Class. Inflation or taxation by currency depreciation: Investing Class Looses 80% of the value of its gov bonds, This did not help business even though real interest rate was lower: (Tract on Monetary Reform p.24) Deflation or even fear of it reduces employment. (p36-37) So Keynes’ objective was price stability. Book is a plea to focus on internal stability rather than external gold-standard stability. UK Inflation-Deflation

27 Germany's 1923 hyperinflation Commanding Heights: Germany's 1923 hyperinflation | on PBSCommanding Heights: Germany's 1923 hyperinflation | on PBS