1 Frank & Bernanke 3 rd edition, 2007 Ch. 15: Inflation, Aggregate Supply, and Aggregate Demand

2 Introduction The Keynesian model assumes that producers meet demand at preset prices. The Keynesian model assumes that producers meet demand at preset prices. The shortcoming of their assumption is that it does not explain the behavior of inflation. The shortcoming of their assumption is that it does not explain the behavior of inflation.

3 Introduction The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output. The aggregate demand/aggregate supply model will allow us to see how macroeconomic policy affects inflation and output.

4 The Aggregate Demand Curve Aggregate Demand (AD) Curve Aggregate Demand (AD) Curve Shows the relationship between short-run equilibrium output Y and the rate of inflation,  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 The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy

5 The Aggregate Demand Curve Aggregate Demand (AD) Curve Aggregate Demand (AD) Curve Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward- sloping Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward- sloping

6 The Aggregate Demand Curve Output Y AD Aggregate Demand Curve An increase in  reduces Y (all other factors held constant) Inflation 

7 The Fed and the AD Curve A primary objective of the Fed is to maintain a low and stable inflation rate. A primary objective of the Fed is to maintain a low and stable inflation rate. Inflation is likely to occur when Y > Y*. Inflation is likely to occur when Y > Y*. To control inflation, the Fed must keep Y from exceeding Y*. To control inflation, the Fed must keep Y from exceeding Y*. The Fed should lower the AD curve when Y>Y*. The Fed should lower the AD curve when Y>Y*. The Fed can reduce autonomous expenditure by raising the interest rate. The Fed can reduce autonomous expenditure by raising the interest rate.  increases r increases autonomous spending decreases Y decreases (AD curve)  increases r increases autonomous spending decreases Y decreases (AD curve)

8 The Aggregate Demand Curve and the Monetary Policy Reaction Function Output Y Inflation  Real interest rate set by the Fed, r A A 11 r1r1 11 B B 22 r2r2 22

9 Other Reasons for the Downward Slope of the AD Curve Real value of money Real value of money Distributional effects Distributional effects Uncertainty Uncertainty Prices of domestic goods and services sold abroad Prices of domestic goods and services sold abroad

10 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 

11 Fed Targets Higher r Real interest rate set by Fed, r Output Y Inflation  Fed “tightens” monetary policy – shifting reaction curve The new Fed policy increases r and AD shifts to AD’ Old monetary policy reaction function AD A A r* 1*1* New monetary policy reaction function AD’ B B 2*2*

12 Movements Along the AD Curve  and Y are inversely related  and Y are inversely related Changes in  cause a change in Y or a movement along the AD curve Changes in  cause a change in Y or a movement along the AD curve  increases r increases planned spending decreases Y decreases (stationary monetary policy reaction function)  increases r increases planned spending decreases Y decreases (stationary monetary policy reaction function)

13 Shifts of the AD Curve Any factor that changes Y at a given  shifts the AD curve. Any factor that changes Y at a given  shifts the AD curve. Shifts of the AD curve can be caused by: Shifts of the AD curve can be caused by: Changes in exogenous spending. Changes in exogenous spending. Changes in the Fed’s policy reaction function. Changes in the Fed’s policy reaction function.

14 Inflation and Aggregate Supply Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level. Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level. Inflation Inertia Inflation Inertia In industrial economies (U.S.), inflation tends to change slowly from year to year. In industrial economies (U.S.), inflation tends to change slowly from year to year. The inflation inertia occurs for two reasons: The inflation inertia occurs for two reasons: Inflation expectations Inflation expectations Long-term wage and price contracts Long-term wage and price contracts

15 A Virtuous Circle

16 Long-term Contracts Union wage contracts set wages for several years. Union wage contracts set wages for several years. Contracts setting the price of raw materials and parts for manufacturing firms also cover several years. Contracts setting the price of raw materials and parts for manufacturing firms also cover several years. These long-term contracts reflect the inflation expectations at the time they are signed. These long-term contracts reflect the inflation expectations at the time they are signed.

17 Inflation and Aggregate Supply Three factors that can increase the inflation rate Three factors that can increase the inflation rate Output gap Output gap Inflation shock Inflation shock Shock to potential output Shock to potential output

18 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* 

19 Aggregate Supply Long-run aggregate supply (LRAS) Long-run aggregate supply (LRAS) A vertical line showing the economy’s potential output Y* A vertical line showing the economy’s potential output Y* Short-run Aggregate Supply (SRAS) Short-run Aggregate Supply (SRAS) A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

20 Short-run Equilibrium Inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate Inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line

21 Equilibrium Output Inflation  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

22 AD LRAS A Y SRAS 1  SRAS 2 SRAS 3 The Adjustment of Inflation When a Recessionary Gap Exists Output Inflation Y* SRAS Final B ’’

23 Long-run Equilibrium A situation in which actual output equals potential output and the inflation rate is stable A situation in which actual output equals potential output and the inflation rate is stable Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point

24 Adjustment to Recessionary Gap Firms that are selling less than they want to will start to lower prices. Firms that are selling less than they want to will start to lower prices. As  falls the Fed lowers r and AD increases. As  falls the Fed lowers r and AD increases. Falling  reduces uncertainty which also increases AD Falling  reduces uncertainty which also increases AD As Y increases, cyclical unemployment falls (Okun’s Law) As Y increases, cyclical unemployment falls (Okun’s Law) Adjustment continues until long-run equilibrium is reached. Adjustment continues until long-run equilibrium is reached.

25 The Adjustment of Inflation When A Expansionary Gap Exists Output Inflation 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 Final SRAS 3 SRAS 2

26 The Self-Correcting Economy In the long-run the economy tends to be self-correcting. In the long-run the economy tends to be self-correcting. The Keynesian model does not include a self-correcting mechanism. The Keynesian model does not include a self-correcting mechanism. The Keynesian model concentrates on the short-run with no price adjustment. The Keynesian model concentrates on the short-run with no price adjustment. The self-correcting mechanism concentrates on the long-run with price adjustments. The self-correcting mechanism concentrates on the long-run with price adjustments.

27 The Self-Correcting Economy A slow self-correcting mechanism A slow self-correcting mechanism Fiscal and monetary policy can help stabilize the economy. Fiscal and monetary policy can help stabilize the economy. A fast self-correcting mechanism A fast self-correcting mechanism Fiscal and monetary policy are not effective and may destabilize the economy. Fiscal and monetary policy are not effective and may destabilize the economy.

28 The Self-Correcting Economy The speed of correction will depend on: The speed of correction will depend on: The use of long-term contracts. The use of long-term contracts. The efficiency and flexibility of labor markets. The efficiency and flexibility of labor markets. Fiscal and monetary policy are most useful when attempting to eliminate large output gaps. Fiscal and monetary policy are most useful when attempting to eliminate large output gaps.

29 Sources of Inflation Excessive Aggregate Spending Excessive Aggregate Spending Inflation Shocks Inflation Shocks Shocks to Potential Output Shocks to Potential Output

30 Military Buildup and Inflation Output Inflation Output Inflation AD LRAS A Y* SRAS LRAS A Y* SRAS   ’’ SRAS Final C  increases shifting SRAS to SRAS Final Long-run equilibrium back to Y* with  * SRAS 3 SRAS 2 Y B AD’ Y B Increase in military spending causes AD to increase Creates an expansionary gap -- Y > Y*

31 Sources of Inflation What Do You Think? What Do You Think? Does the Fed have the power to prevent the increased inflation that is induced by a rise in military spending? Does the Fed have the power to prevent the increased inflation that is induced by a rise in military spending? Hint: Can the Fed reduce AD? Hint: Can the Fed reduce AD? What is the cost of avoiding inflation during a military buildup? What is the cost of avoiding inflation during a military buildup?

32 Sources of Inflation in inflation averaged about 1% inflation averaged about 1% By 1970 inflation was 7% By 1970 inflation was 7% Fiscal policy Fiscal policy Increased spending on Great Society and war on poverty initiatives Increased spending on Great Society and war on poverty initiatives Increases in defense spending Increases in defense spending 1965 = $50.6 billion or 7.4% of GDP 1965 = $50.6 billion or 7.4% of GDP 1968 = $81.9 billion or 9.4% of GDP 1968 = $81.9 billion or 9.4% of GDP Monetary policy Monetary policy The Fed did not try to offset the increase in government spending The Fed did not try to offset the increase in government spending

33 Sources of Inflation Inflation Shock Inflation Shock A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap Inflation Shock -- Examples Inflation Shock -- Examples OPEC embargo of 1973 OPEC embargo of 1973 Drop in oil prices in 1986 Drop in oil prices in 1986

34 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) ’’

35 Sources of Inflation What is the macroeconomic policy dilemma created by an inflation shock? (stagflation)? What is the macroeconomic policy dilemma created by an inflation shock? (stagflation)? Sustained inflation is possible only if monetary policy is sufficiently expansionary. Sustained inflation is possible only if monetary policy is sufficiently expansionary.

36 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 ’’

37 Aggregate Supply Shock Either an inflation shock or a shock to potential output Either an inflation shock or a shock to potential output Adverse aggregate supply shocks of both types reduce output and increase inflation Adverse aggregate supply shocks of both types reduce output and increase inflation Inflation shocks Inflation shocks Stagflation Stagflation Temporary reduction in output Temporary reduction in output

38 U.S. Macroeconomic Data, Annual Averages, % Growth inUnemploymentInflationProductivity Yearsreal GDPrate (%)rate (%)growth (%) Was Greenspan right in 1996?

39 Greenspan 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

40 Fiscal Policy and the Supply Side Supply-side Policy Supply-side Policy A policy that affects potential output A policy that affects potential output Examples Examples Roads and highways Roads and highways Airports Airports Schools Schools Government tax and transfer programs Government tax and transfer programs

41 Fiscal Policy and the Supply Side Marginal Tax Rate Marginal Tax Rate The amount by which taxes rise when before- tax income rises by one dollar The amount by which taxes rise when before- tax income rises by one dollar Average Tax Rate Average Tax Rate Total taxes divided by total before-tax income Total taxes divided by total before-tax income

42 The Potential Effects of Tax Rate Reductions on Both AD and AS Output Inflation Y* LRAS AD AD’ LRAS’ Y *’

43 Fiscal Policy and the Supply Side Effect on Supply of Labor Effect on Supply of Labor Lower rates may give people an incentive to seek further education and engage in entrepreneurial activity. Lower rates may give people an incentive to seek further education and engage in entrepreneurial activity. Lower rates may give workers an incentive to work less. Lower rates may give workers an incentive to work less. Married women are more responsive to tax changes than men. Married women are more responsive to tax changes than men.

44 Hours Worked per Person and Marginal Tax Rates, Hours worked per person per year Countryrelative to the U.S. (U.S. = 100)Marginal tax rate Japan10437% United States10040 United Kingdom8844 Canada8852 Germany7559 France6859 Italy6464

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

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

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

48 Why Does Aggregate Demand Fall When Inflation Rises? When  up => wealth held in money form erodes => C down => AD down 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 => 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 When  up => at constant exchange rates our exports become more expensive and our imports become cheaper => NX falls => AD falls

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

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

51 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). 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. The vertical axis measures the inflation rate. Therefore, any change in the inflation rate is shown as a movement along the AD line. Therefore, any change in the inflation rate is shown as a movement along the AD line.

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

53 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.

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

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

56 Inflation Shocks Oil price shock of the seventies pushed the inflation up: SRAS shifts up. 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 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. 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.

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

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

59 Lowering Inflation Time GDP Infl’n r Y* Inflation

60 Can Fiscal Stimulus Work zandi/documents/assissing-the-impact-of- the-fiscal-stimulus.pdf zandi/documents/assissing-the-impact-of- the-fiscal-stimulus.pdf zandi/documents/assissing-the-impact-of- the-fiscal-stimulus.pdf zandi/documents/assissing-the-impact-of- the-fiscal-stimulus.pdf Barro note Barro note Barro note Barro note