Frank & Bernanke Ch. 15: Inflation, Aggregate Demand, and Aggregate Supply

Output Gaps and Policies AD > Y* => Expansionary Gap AD Recessionary Gap Policies to eliminate gaps: – Fiscal policies G increase/decrease T increase/decrease – Monetary policies Money supply increase/decrease (r increase/decrease)

Shortcoming of the Keynesian Cross It keeps prices constant. How does one include inflation into the Keynesian cross? Explain what happens to AD at higher levels of inflation and use this new diagram. Include the self-correcting mechanism of the economy by differentiating short run aggregate supply (Keynesian) from the long run aggregate supply (Classical).

Aggregate Demand AD = C + I + G + NX C = C (Y, r) I = I (r) When Y up => C up => AD up When r up => I down, C down => AD down

Why Does Aggregate Demand Fall When Inflation Rises? When  up => Fed Policy Reaction Function raises r => I and C down => AD down – Fed Policy Reaction Function (Example: Taylor rule): r = [(Y*-Y)/Y*] 

Taylor Rule r = 0.01 –0.5 [(Y* - Y)/Y*] π How does the Fed react when inflation rises? How does the Fed react when output gaps appear? What will the real and nominal interest rates be given different values?

Fed Policy Reaction Function  r Zero percent Output Gap Expansionary Gap Recessionary Gap

Why Does Aggregate Demand Fall When Inflation Rises? When  up => wealth held in money form erodes => C down => AD down When  up => MPC falls because the poor are affected more than the rich => multiplier falls => AD flatter When  up => at constant exchange rates our exports become more expensive and our imports become cheaper => NX falls => AD falls

Deriving AD Given C and I, find the AD if Fed has a policy reaction function to determine r for different inflation rates. C = (Y - T) - 300r I = r T = 200; G = 250; NX = 20 r = 

Deriving AD Y = Y r.1Y = r Y = r

π Y

Shifts in AD Changes in autonomous aggregate demand. – Autonomous C – Autonomous I – Taxes – Government purchases – Net exports Changes in Fed’s policy reaction function – Tightening of monetary policy – Easing of monetary policy

Shifting of AD Increase in autonomous spending shifts AD right. Tightening of monetary policy raises r and shifts AD left. Easing of monetary policy lowers r and shifts AD right. Changes in inflation are movements along the AD curve.

Shifting of AD Suppose autonomous consumption increased from 400 to 410 and autonomous investment increased from 300 to 305. At the same time, taxes are increased to 210. What is the new AD? Old AD was Y = 7900 – 11,000r Y = 7960 – 11,000r

Shifting AD

Movement Along AD Any change in the vertical axis shows as a movement along the AD line, just like demand and supply (changes in P). The vertical axis measures the inflation rate. Therefore, any change in the inflation rate is shown as a movement along the AD line.

Why Inflation Rate Doesn’t Change? Inflation has inertia. – Inflationary expectations tend to keep inflation constant. – Contracts include expected inflation. Long term contracts keep inflation constant.

Why Inflation Rate Changes? 1. Output Gap. 1. Expansionary output gaps (Y>Y*) 2. Inflation shock 1. An increase in price of inputs that raise the cost of production for a significant portion of the economy. (Oil; wages for national unions). 3. Shock to potential output 1. Disasters.

Output Gaps and Inflation Expansionary gap (Y > Y*) => Inflation rises. Recessionary gap (Y Inflation falls. No output gap (Y = Y*) => Inflation remains the same.

Inertia and Output Gaps Y* Y LRAS SRAS AD Inflation

Long Run Equilibrium Y* Y LRAS SRAS AD Inflation

Expansionary Gaps How will an expansionary gap look in an AD-AS diagram? How will the economy adjust to the expansionary gap? What will happen to SRAS in the long-run? Keynesian - Classical dilemma.

Expansionary Gap Inflation Y Y* Identify the lines and explain the short and long run changes when there is no government intervention.

Excessive AD Shifts in AD that create expansionary output gaps will raise inflation rate. – G increase: military buildup of 1960s and 1980s. – Inflation rose in the sixties but did not in the eighties. The Fed’s policy stand is the answer.

Inflation Shocks Oil price shock of the seventies pushed the inflation up: SRAS shifts up. If the Fed doesn’t respond recessionary gap will be eliminated in the long run. If the Fed does respond to recession, AD will be shifted to the right but the long run equilibrium will take place at the higher inflation rate.

Inflation Shock Inflation YY*

Shock to Potential Output If a disaster happens or capital becomes obsolete or expensive to use, Y* shifts left. Again, stagflation occurs, just like when inflationary shocks takes place. Long run equilibrium will be at a higher inflation rate and lower Y.

Shock to Potential Output Y Inflation Y*

Lowering Inflation Suppose the country is experiencing double digit inflation. Because of inflationary expectations and contracts, the inflation will remain at that level. However, to eliminate the costs of inflation, the Central Bank embarks in a new monetary policy. Show the short and long run effects.

Lowering Inflation Time GDP Infl’n r Y* Inflation