©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 23: Aggregate Demand and Aggregate Supply

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Define the aggregate demand curve, explain why it slopes downward and explain why it shifts 2.Define the aggregate supply curve, explain why it slopes downward and explain why it shifts 3.Show how the aggregate demand curve and the aggregate supply curve determine the short-run equilibrium levels of output and inflation, and show how the aggregate demand curve, the aggregate supply curve, and the long-run aggregate supply curve determine the long-run equilibrium levels of output and inflation

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Learning Objectives 4.Analyze how the economy adjusts to expansionary and recessionary gaps and 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

©2012 The McGraw-Hill Companies, All Rights Reserved 4 The Aggregate Demand (AD) and Aggregate Supply (AS) Model: A Brief Overview Shows how output and inflation are determined simultaneously  Short run and long run analysis  Current situation and future changes Inflation and output on the axes Changes in inflation lead to changes in spending on AD AS shows output gaps affect inflation LRAS shows Y* Inflation (  ) Output (Y) Aggregate Demand (AD) Aggregate Supply (AS) Y* Long-Run Aggregate Supply (LRAS)

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Inflation, Spending, And Output: The Aggregate Demand Curve 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

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Inflation, The Central Bank, And The AD Curve A primary objective of the central bank is to maintain a low and stable inflation rate  Inflation is likely to occur when Y > Y*  To control inflation, the central bank must keep Y from exceeding Y* When inflation increases, the central bank increases the nominal interest rate which, in turn, increases real interest rates  r  C, I P  PAE  Y 

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Inflation, The Central Bank, And The AD Curve The central bank also responds to a recessionary gap  Inflation is likely to decrease when Y < Y* When inflation decreases,  The central bank decreases the nominal interest rate  real interest rates decrease and  Aggregate spending increases  r  C, I P  PAE  Y 

©2012 The McGraw-Hill Companies, All Rights Reserved 8 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 central bank raises interest rates  Higher r means lower total spending Along the AD curve, short-run Y equals planned spending Output (Y) AD Inflation (  )

©2012 The McGraw-Hill Companies, All Rights Reserved 9 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

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Shifts in Aggregate Demand Curve At a given inflation rate, aggregate demand shifts when  Exogenous changes in spending occur  Central bank'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 local goods Output (Y) AD AD' Inflation (  )

©2012 The McGraw-Hill Companies, All Rights Reserved 11 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 (  )

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Tightening and Easing Monetary Policy The central bank's monetary policy reaction function ties inflation to real interest rates  Suppose the central bank's targets are  1 and r 1  MPR is shown in the graph Central bank normally follows a stable MPR  Central bank 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

©2012 The McGraw-Hill Companies, All Rights Reserved 13 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  Central bank increases interest rate from r 1 to r 2 Inflation (  ) Real interest rate (r) MPR 1 r1r1 11 22 MPR 2 r2r2

©2012 The McGraw-Hill Companies, All Rights Reserved 14 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  Central bank decreases interest rate from r 1 to r 3 Inflation (  ) Real interest rate (r) MPR 1 r1r1 11 MPR 3 33 r3r3

©2012 The McGraw-Hill Companies, All Rights Reserved 15 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

©2012 The McGraw-Hill Companies, All Rights Reserved 16 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

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Inflation Inertia, Output Gaps, And The AS Curve 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

©2012 The McGraw-Hill Companies, All Rights Reserved 18 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

©2012 The McGraw-Hill Companies, All Rights Reserved 19 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

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Long-term Wage and Price 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

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Output Gaps 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

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Deriving the AS Curve: Graphical Analysis 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

©2012 The McGraw-Hill Companies, All Rights Reserved 23 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

©2012 The McGraw-Hill Companies, All Rights Reserved 24 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

©2012 The McGraw-Hill Companies, All Rights Reserved 25 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

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Aggregate Demand – Aggregate Supply Analysis 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)

©2012 The McGraw-Hill Companies, All Rights Reserved 27 Aggregate Demand – Aggregate Supply Analysis 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

©2012 The McGraw-Hill Companies, All Rights Reserved 28 An Expansionary Gap Initial short-run equilibrium at A  AD is stable as long as there is no change in the central bank'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

©2012 The McGraw-Hill Companies, All Rights Reserved 29 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 central bank 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

©2012 The McGraw-Hill Companies, All Rights Reserved 30 A Recessionary Gap Initial equilibrium is at B, a recessionary gap  AD curve remains stable unless MPR changes or exogenous spending changes With inflation above its expected value, the central bank 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

©2012 The McGraw-Hill Companies, All Rights Reserved 31 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

©2012 The McGraw-Hill Companies, All Rights Reserved 32 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

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Sources of Inflation: Excessive Aggregate Spending 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 central bank 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

©2012 The McGraw-Hill Companies, All Rights Reserved 34 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 has decreased, some component of aggregate spending has also decreased  As inflation rose, the central bank increased the real interest rate  Investment spending declined, crowded out by government spending

©2012 The McGraw-Hill Companies, All Rights Reserved 35 The War and the Central Bank The central bank can prevent the increased inflation from the rise in military spending  The central bank 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

©2012 The McGraw-Hill Companies, All Rights Reserved 36 The Effects of an Adverse Inflation Shock Persistent inflation may be caused by an adverse oil shock  Aggregate supply decreases, creating a recessionary gap, resulting in stagflation, that is higher inflation and a recessionary gap

©2012 The McGraw-Hill Companies, All Rights Reserved 37 The Effects of an Adverse Inflation Shock Adverse oil shocks 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

©2012 The McGraw-Hill Companies, All Rights Reserved 38 The Effects of an Adverse Inflation Shock 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

©2012 The McGraw-Hill Companies, All Rights Reserved 39 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