McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 13 Aggregate Demand and Aggregate Supply

13-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 25- All Learning Objectives 1.Define the aggregate demand curve  Explain why it slopes downward  Explain why it shifts 2.Define the aggregate supply curve  Explain why it slopes downward  Explain why it shifts 3.Show how aggregate supply and demand determine short-run output and inflation  Show how aggregate demand, aggregate supply, and the long-run aggregate supply curve determine long-run output and inflation

13-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 25- All Learning Objectives 4.Analyze how the economy adjusts to expansionary and recessionary gaps  Relate this to the idea of a self-correcting economy 5.Use the aggregate demand – aggregate supply model to study the sources of inflation in the short run and in the long run

13-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Introduction  The Keynesian model assumes that producers meet demand at preset prices.  Does not explain inflation  Output gaps can cause inflation to increase or decrease  The aggregate demand - aggregate supply model shows both inflation and output  Effective for analyzing macroeconomic policies

13-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Interest in the Keynesian Model – An Example  Components of aggregate spending are C = (Y – T) – 400 r I P = 250 – 600 r G = 300 NX = 20 T = 250  PAE = 1,010 – 1,000 r Y

13-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Planned Aggregate Expenditures  Suppose the real interest rate is 5%, or 0.05  Planned aggregate expenditures becomes PAE = 1,010 – 1,000 (0.05) Y PAE = Y  Short-run equilibrium output is PAE = Y Y = Y 0.2 Y = 960 Y = $4,800

13-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Fed Fights Inflation  Expansionary gap can lead to inflation  Planned spending is greater than potential output  The output level of full employment  Demand for output exceeds normal rate of production  If gap persists, prices will increase  The Fed attempts to close expansionary gaps  Raise real interest rate  Decrease consumption and planned investment  Decrease planned aggregate expenditures  Decrease equilibrium output

13-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Fed Controls the Nominal Interest Rate  Fed policy is stated in terms of interest rates  The tool they use is the supply of money  Initial equilibrium at E  Fed increases the money supply to MS'  New equilibrium at F  Interest rated decrease to i' to convince the market to hold the new, larger amount of money Money (M) MD MS M E i Nominal interest rate (i) F i' M' MS'

13-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Fed Fights Inflation Output (Y) Planned aggregate expenditure (PAE) Y = PAE E Expenditure line (r = 5%) 4,800 An increase in r shifts the expenditure line down and closes the expansionary gap 4,600 Y* Expenditure line (r = 9%) G

13-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Monetary Policy Rule (MPR)  The monetary policy reaction function shows the action a central bank takes in response to changes in the economy  Target inflation rate,  *, is the Fed's long-term goal for inflation  Target real interest rate, r*, is the Fed's long-term goal for the real interest rate  If  >  *, then r > r*  If  <  *, then r < r* Real interest rate set by Fed (r) MPR Inflation (  ) r* Slope = g ** A

13-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation, the Fed, and the AD Curve  A primary objective of the Fed is to maintain a low and stable inflation rate  When inflation increases, the Fed increases the nominal interest rate which, in turn, increases real interest rates  r  C, I P  PAE  Y 

13-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Aggregate Demand Curve  Aggregate demand (AD) curve shows the relationship between short-run equilibrium output, Y, and the rate of inflation,   Holds all other factors constant  AD has a negative slope  When inflation increases, the Fed raises interest rates  Higher r means lower total spending  Along the AD curve, short-run Y equals planned spending Output (Y) AD Inflation (  )

13-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation (  ) Real interest rate (r) r1r1 A 11 MPR Inflation (  ) Output (Y) 11 A Planned Spending (PAE) Output (Y) A Y = PAE PAE (r = r 1 ) Y1Y1 Y1Y1 AD  Initial conditions:  1, r 1, Y 1  One point on AD  Suppose inflation increases to  2  Economy moves to  2, r 2, Y 2  Second point on AD 22 B Y2Y2 PAE (r = r 2 ) r2r2 B 22 B Y2Y2

13-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Shifts in Aggregate Demand Curve  At a given inflation rate, aggregate demand shifts when  Exogenous changes in spending occur  Fed's monetary policy reaction function changes  Exogenous changes in spending are changes other than those caused by changes in output or the real interest rate  Consumer wealth  Business confidence  Foreign demand for US goods Output (Y) AD AD' Inflation (  )

13-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Exogenous Changes in Spending  Increases in aggregate demand could occur from a boom in the stock market  Consumer wealth increases  Consumption increases at each level of output and real interest rate  PAE curve shifts up  Y increases for each possible level of   Aggregate demand curve shift right Output (Y) AD AD' Inflation (  )

13-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Fed's MPR Changes  The Fed's monetary policy reaction function ties inflation to real interest rates  Suppose the Fed's targets are  1 and r 1  MPR is shown in the graph  Fed normally follows a stable MPR  Fed can tighten or ease monetary policy  Shifts MPR  Tightening monetary policy lowers the long-run inflation target Inflation (  ) Real interest rate (r) MPR r1r1 11

13-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Tightening Monetary Policy  Tighter monetary policy results in each interest rate, r, being associated with a lower rate of inflation  A leftward shift of the MPR  The economy begins at the original target inflation rate,  1  MPR shifts to MPR 2  Fed increases interest rate from r 1 to r 2 Inflation (  ) Real interest rate (r) MPR 1 r1r1 11 22 MPR 2 r2r2

13-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Easing Monetary Policy  Easing monetary policy results in each interest rate, r, being associated with a higher rate of inflation  A rightward shift of the MPR  The economy begins at the original target inflation rate,  1  MPR shifts to MPR 3  Fed decreases interest rate from r 1 to r 3 Inflation (  ) Real interest rate (r) MPR 1 r1r1 11 MPR 3 33 r3r3

13-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Shift in Aggregate Demand  MPR shifts up; interest rate increases from r 1 * to r 2 *  Higher r decreases PAE and shifts AD to AD' Real interest rate (r) Inflation (  ) MPR A r1*r1* 1*1* Output (Y) Inflation (  ) AD A 11 r2*r2* MPR' B Y1Y1 AD' B Y2Y2

13-20 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation and Aggregate Supply  Aggregate supply curve (AS) shows the relationship between the rate of inflation and the short-run equilibrium level of output  Holds all other factors constant  Aggregate supply curve has a positive slope  When output is below potential, actual inflation is above expected inflation  When output is above potential, actual inflation is below expected inflation  Movement along the AS curve is related to inflation inertia and output gaps

13-21 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation Inertia  Inflation will remain have inertia if the economy is operating at Y*  No external shocks to the price level  Three factors that can increase the inflation rate  Output gap ■ Shock to potential output  Inflation shock  In industrial economies, inflation tends to change slowly from year to year for two reasons  Inflation expectations  Long-term wage and price contracts

13-22 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Low Inflation Low Expected Inflation Slow Increase in Wages and Production Costs Inflation Expectations  Today's expectations affect tomorrow's inflation  Inflation expectations are built into the pricing in multi-period contracts  The higher the expected rate of inflation, the more nominal wages and the cost of other inputs will increase  With rising input costs, firms increase their prices to cover costs

13-23 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Expected Inflation  Expectations are influenced by recent experience  If inflation is low and stable, people expect that to continue  Volatile inflation leads to volatile expectations  Low and stable inflation creates a virtuous circle that keeps inflation low  High and stable inflation creates a vicious circle that keeps inflation high Low Inflation Low Expected Inflation Slow Increase in Wages and Production Costs

13-24 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Role of Long-Term Contracts  Long-term contracts reduce the cost of negotiations between buyers and sellers  Cost - Benefit Principle  Labor contracts may be multi-year agreements  Supply agreements, particularly for high cost inputs, extend over several years  Long-term contracts build in wage and price increases that build in current expectations about inflation  In the absence of external shocks, inflation tends to be stable over time  Especially true in industrialized economies

13-25 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Output Gap and Inflation Relationship of Output to Potential Output Behavior of Inflation Expansionary gap Y > Y* Inflation increases No output gap Y = Y* Inflation is stable Recessionary gap Y < Y*Inflation decreases

13-26 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Aggregate Supply Curve Current inflation (  ) = expected inflation (  e ) + inflation from an output gap  If the economy is operating at potential output, then  =  e =  1 at A  If the economy has an inflationary gap, Y > Y* and  2 >  e at B  If the economy has an expansionary gap, Y < Y* and  3 <  e at C  The AS curve slope up Inflation (  ) Output (Y) Aggregate Supply (AS) 22 Y1Y1 B Y2Y2 33 C Y* 11 A

13-27 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Shifts in the AS Curve  Two changes can shift the AS curve  Inflation expectations  Inflation shocks  If actual inflation exceeds expectations, expected inflation increases  AS curve shifts to the left  At each level of output, inflation is higher Inflation (  ) Output (Y) AS 1 Y* 11 22 AS 2

13-28 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation Shock  An inflation shock is a sudden change in the normal behavior of inflation  A shock is not related to an output gap  A sudden rise in the price of oil increases prices of  Gasoline, diesel fuel, jet fuel, heating oil  Goods made with oil (synthetic rubber, plastics, etc.)  Transportation of most goods  OPEC reduced supplies in 1973; price of oil quadrupled  Food shortages occurred at the same time  Sharp increase in inflation in 1974

13-29 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation Shocks  An adverse inflation shock shifts the aggregate supply curve to the left  Increases inflation at each output level  Oil price increases in 1973  A favorable inflation shock shifts the aggregate supply curve to the right  Lower inflation at each output level  Oil price decrease in 1986

13-30 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Long-Run Equilibrium  In the long run,  Actual output equals potential output  Actual inflation equals expected inflation  Long-run equilibrium occurs at the intersection of  Aggregate demand  Aggregate supply and  Long-run aggregate supply Inflation (  ) Output (Y) Aggregate Demand (AD) Aggregate Supply (AS) Y* Long-Run Aggregate Supply (LRAS)

13-31 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Short-Run Equilibrium  Short-run equilibrium occurs when there is either an expansionary gap or a recessionary gap  Intersection of AD and AS curves at a level of output different from Y*  Point A in the graph  Short-run equilibrium is temporary Inflation (  ) Output (Y) AD AS 1 Y* LRAS Y1Y1 11 A

13-32 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO An Expansionary Gap  Initial short-run equilibrium at A  AD is stable as long as there is no change in the Fed's monetary policy rule and no exogenous changes in spending  Inflation increases and expected inflation increases  Shifts AS curve to AS 2  Output is at potential, Y*  New expected inflation is  2 Inflation (  ) Output (Y) AD AS 1 Y* LRAS Y1Y1 AS 2 11 A 22

13-33 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Adjustment from an Expansionary Gap  When output is above potential output, firms increase prices faster than the expected rate of inflation  Causes inflation to increase above expected level  As inflation rises, the Fed increases interest rates  Consumption and planned investment spending decrease  Planned aggregate expenditures decrease  Output decreases  This process continues until the economy reaches equilibrium at the potential level of output  Actual inflation is higher than initial level of inflation

13-34 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO A Recessionary Gap  Initial equilibrium is at B, a recessionary gap  AD curve remains stable unless MPRF changes or exogenous spending changes  With inflation above its expected value, the Fed lowers interest rates  Aggregate supply shifts to AS 2  The new long-run equilibrium is at potential output and an inflation level of  2 Inflation (  ) Output (Y) AD AS 1 Y* LRAS Y1Y1 11 B 22 AS 2

13-35 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Self-Correcting Economy  In the long-run the economy tends to be self-correcting  Missing from Keynesian model  Concentrates on the short-run; no price adjustments  Given time, output gaps disappear without any changes in monetary or fiscal policy  Whether stabilization policies are needed depends on the speed of the self-correction process  If the economy returns to potential output quickly, stabilization policies may be destabilizing  The greater the gap, the longer the adjustment period

13-36 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Self-Correcting Economy  A slow self-correcting mechanism  Fiscal and monetary policy can help stabilize the economy  A fast self-correcting mechanism  Fiscal and monetary policy are not effective and may destabilize the economy  The speed of correction will depend on  The use of long-term contracts  The efficiency and flexibility of labor markets  Fiscal and monetary policy are most useful when attempting to eliminate large output gaps

13-37 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Excessive Aggregate Spending Causes Inflation  Wars can trigger an inflationary gap  Economy starts in long-run equilibrium,  1 and Y*  Wartime government spending shifts AD to AD 2  Expansionary gap opens  Short-run equilibrium at  2 and Y 2  If AD stays at AD 2 and the Fed does not change monetary policy, inflation is higher than expected  AS shifts to AS 2 Inflation (  ) Output (Y) AD 1 AS 1 Y* LRAS 11 AD 2 22 AS 2 33 Y2Y2

13-38 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Wartime Spending  The increased output created by the shift in aggregate demand is temporary  Economy returns to its potential output at Y* but at a higher inflation rate  Since Y had decreased, some component of aggregate spending has also decreased  As inflation rose, the Fed increased the real interest rate  Investment spending declined, crowded out by government spending

13-39 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The War and the Fed  The Fed can to prevent the increased inflation from the rise in military spending  The Fed aggressively tightens money during the military buildup  Real interest rates increase  Consumption and planned investment decrease to offset the increase in spending for the war  Lowers current and future standards of living  Planned spending is stable  No expansionary gap occurs

13-40 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO US Inflation, 1960s  inflation averaged about 1%  By 1970 inflation was 6%  Inflation resulted from  Increases in government spending  Vietnam war caused defense spending to increase to 9.4% of GDP by 1968 and stay high  Great Society and War on Poverty programs  Failure of the Fed to contain inflation  Did not want to contribute to political turmoil  During the Reagan military buildup, the Fed successfully contained inflation

13-41 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation in the 1970s  Inflation continued to rise in the 1970s  With inflation staying above 4% in 1971, Nixon imposed wage and price controls on August 15, 1971  From 6.2% in 1973 to nearly 11% in 1974  Inflation decreased 1974 – 1978, but increased again  11.4% in 1979 and 13.5% in 1980  Persistent inflation was caused by an adverse oil shock  Aggregate supply decreased, creating a recessionary gap  Stagflation, higher inflation and a recessionary gap, resulted

13-42 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation in the 1970s  Adverse oil shock and stagflation are policy challenges  Government can keeps policies constant  Inflation will eventually decrease  Aggregate supply curve shifts right  Recessionary gap closes  However, economy has a prolonged recession while adjustment occurs  If the government attacks the recessionary gap with added government spending and loosening monetary policy, inflation increases  Higher and higher inflation rates resulted

13-43 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Inflation in the 1970s  Initial equilibrium is at  1 and Y*, potential output  Oil shock reduces aggregate supply to AS 2  Short-term equilibrium is a recessionary gap at  2 and Y 2  Government can increase AD to AD 2 to address recessionary gap  Raises inflation to  3  Government can keep policies constant and let the economy adjust back to AS 1 with  1 and Y* Inflation (  ) Output (Y) AD 1 AS 1 Y* LRAS AS 2 11 AD 2 33 Y2Y2 22

13-44 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Shocks to Potential Output  Oil shocks may lead to lower potential output  Compounds the inflationary effects of the shock  Suppose long-run equilibrium is at Y 1 and  1  Potential output falls to Y 2 and LRAS shifts to LRAS 2  Expansionary gap at Y 1,  1 leads to lower output and higher inflation  Aggregate supply shock is either an inflation shock or a shock to potential output Output (Y) Inflation (  ) AD LRAS 1 Y1Y1 Y2Y2 LRAS 2 11 22

13-45 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Greenspan, 1996  The situation  With low unemployment, price and wage inflation were lower than previously at full employment  Inflationary pressures debatable  Rapid economic growth  Corporate profits were strong  Productivity was increasing  Greenspan believed the economy could continue to grow without increasing inflation  Fed did not increase interest rates

13-46 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Interpreting Macroeconomic Data  Productivity figures were hard to interpret  Business leaders reported productivity gains  Productivity gains did not appear in the government statistics  Service industries showed small or even negative growth in productivity  Large investment in technology was at odds with the data  Greenspan believed the productivity gains were real  Increased potential output s economy could grow without inflation

13-47 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Growth in the 1990s  Compared to 1985 – 1995 period, the last five years of the decade showed higher growth  Unemployment and inflation were lower  A positive shock to potential output causes the long-run aggregate supply curve to shift to the right  Downward pressure on inflation Years Real GDP Growth (%) Unemployment Rate (%) Inflation Rate (%) Productivity Growth (%)