Outline Chapter 12 – Aggregate Supply, Aggregate Demand and Inflation Section 1 – Inflation and Aggregate Demand Equilibrium Section 2 – Capacity and Aggregate Supply Response Section 3 – Putting ASR/ADE Model to Work

Inflation and AD Equilibrium Remember: simple macroeconomic model, fiscal policy and monetary policy = demand side Problem of inflation? We used to depict the relationship btw income and AD or output. If output is above FE level, threat of rising inflation. Need to show the relationship btw AD and inflation: ADE – Aggregate Demand Equilibrium combination of AD equilibrium points consistent with various levels of inflation.

Inflation and AD Equilibrium Two more assumptions to incorporate inflation 1)CB would intend to stabilize output – to prevent “overheating” or “slump” 2)In LR, CB would intend to stabilize prices – to prevent inflation Reaction Rule: If CB sees the inflation rate rising… … it moves to raise interest rates r0r0 r1r1 π1π1 π0π0 B A

Inflation and AD Equilibrium If CB observes that the inflation rate is on the rise (due to economic expansion – “overheating”), CB will use contractionary MP to cool down the economy by raising i. If CB observes that the inflation rate is falling (due to economic contraction – “slump”), CB will use expansionary MP to avoid recession by lowering i. CB sees inflation rising Raises iII is discouraged AD falls Equilibrium GDP falls CB sees inflation falling Lowers iII is encouraged AD risesEquilibrium GDP rises

Inflation and AD Equilibrium Because CB reacts to the changes in inflation rate, “cooling down” if inflation is rising and stimulating if inflation is falling, there is an inverse relationship between output (AD) and the inflation rate. Output (Y ) If inflation rises… …the CB takes action to “cool off” the economy Y1Y1 Y0Y0 A B Inflation rate (π ) π1π1 π0π0

Inflation and AD Equilibrium Shifts of ADE Curve – Fiscal Policy or Spending Expansionary fiscal policy : G ↑ or T↓ Increase in consumer confidence : C ↑, II ↑ Net exports increase: X↑ or M↓ All happen at the existing level of inflation and i. Output (Y ) Inflation rate (π ) ADE 1 ADE 0

Inflation and AD Equilibrium Shifts of ADE Curve – CB inflation targets, more active form of monetary policy Inflation targeting: contractionary policy when inflation is rising and expansionary vice versa. Output (Y ) Inflation rate (π ) 5% target 10% target ADE 1 ADE 0

Capacity and ASR Increases in AD => FE level. What happens if output even exceeds FE level? capacity constraint Aggregate Supply Response – combinations of output and inflation under capacity constraints Output (Y ) Inflation rate (π ) Maximum Capacity Recession Wage-Price Spiral Y*

Capacity and ASR maximum capacity output – the level of output to be produced by utilizing all resources available in the economy wage-price spiral – high demand for L and other resources creates upward pressure on wages, which in turn leads to upward pressure on prices etc.; steep rise in inflation direct wage and price controls set by gov. Y * : range of full employment output Below this level, economy is in recession and no tendency for inflation to rise or fall

Capacity and ASR Supply shock – changes in the productive capacity of the economy; can be beneficial; increases in labour productivity Moving ASR to right and downward Right – expansion in the capacity Down – decreases in price levels Inflation rate (π ) ASR 1 ASR 0 Expansion of Maximum Capacity Output (Y )

Putting ADE and ASR Together 1.Fiscal and Monetary Policies affect output and inflation -Contractionary policies tend towards lower output, inflation falls but persistent recession -Expansionary policies tend towards higher output, inflation rises, “overheating” 2.Supply shocks may have significant effects (adverse vs. beneficial) 3.Investor and consumer confidence + expectations have effects on output and inflation

Putting ADE and ASR Together E 0 : SR equilibrium Spending not enough to keep economy in FE. Unemployment – need to make expansionary policies to shift ADE ASR Y* Recession ADE E0E0 Inflation rate (π ) Output (Y )

Inflation rate (π ) ASR 0 Y* ADE 0 ADE 1 E0E0 E1E1 ASR 1 Putting ADE and ASR Together Remember –stagflation of 1970s (hi inflation, low output) Background – contractionary fiscal policy (ADE 0 to ADE 1 ), “too little too late”, inflationary expectations did not cool down – “toothpaste”

Putting ADE and ASR Together Oil price shock – adverse supply shock of early 1970s, start from recession, both capacity shrinks and ASR shifts up in SR. In MR, prices stop rising and deeper recession, ASR shifts down Inflation rate (π ) ASR 0 ASR 1 ADE E1E1 E0E0 Lower Capacity Output (Y ) ASR 0 ASR 1 ADE E1E1 E0E0

Putting ADE and ASR Together Tight monetary policy – lower target inflation rate; ADE shifts down in SR – at a cost of hi UN and deeper recession! In MR, expectations are revised, ASR shifts down, ADE falls due to tight MP Output (Y ) Inflation rate (π ) ASR Y* Recession ADE 0 ADE 1 E0E0 E1E1 ASR 0 Recession ADE 0 E0E0 E1E1 ASR 1 ADE 1 Y* Output