Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation, Aggregate Demand, and Aggregate Supply

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Volcker’s Move  The 1979 inflation rate had reached 13% and Paul Volcker’s job was to get inflation under control and restore confidence in policymaking  Appointed by Carter as the Chairman of the Fed in Sept. 1979, he sharply reduced the growth rate of the money supply, causing a recession  Interest rates would rise and AD would fall  Output and employment would also fall

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Extending the Basic Keynesian Model  This chapter extends the basic Keynesian model to allow for price changes  We will now use the aggregate demand-aggregate supply diagram

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Aggregate Demand AD  Aggregate demand AD curve shows the relationship between aggregate demand and inflation  Because short-run equilibrium output equals aggregate demand, the aggregate demand curve also shows the relationship between short-run equilibrium output and inflation  Increases in inflation reduce aggregate demand and short-run output, so the aggregate demand curve is downward sloping

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD and Inflation (   AD determined output in the short run as Y = AD  AD is positively related to output (Y)  AD is negatively related to the real interest rate (r)  An increase in the rate of inflation (  ) tends to reduce both aggregate demand and short-run equilibrium output

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Aggregate Demand Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Low Inflation  The Fed’s goal is to keep inflation low  So that society can avoid the costs of high inflation  Inflation occurs during an expansion- ary gap  The Fed can decrease AD to close the output gap and reduce inflation by  Raising the real interest rate r  Reducing C and I, which reduces AD

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Numerical Example of an Aggregate Demand Curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Other Reasons for Downward Slope of AD  Higher inflation reduces AD  Actions of the Fed (just discussed)  Real value of money  Inflation reduces the purchasing power of money which reduces spending  Distributional effects  Prices of domestic goods and services sold abroad

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Shifts in AD  The AD curve holds all other factors constant  When these other factors change, the AD curve shifts  Other factors  Changes in autonomous aggregate demand  The Fed’s policy reaction function

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Autonomous Changes  Autonomous aggregate demand  The portion of AD that is determined outside the model  For example, households desire to consume more shifts AD right  A decrease in autonomous AD shifts AD left

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Effect of an Increase in Autonomous Aggregate Demand

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Examples of Autonomous Changes  Autonomous consumption  Consumers become more optimistic and spend more

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Examples of Autonomous Changes  Taxes  Cut in taxes increases consumer spending

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Examples of Autonomous Changes  Autonomous investment  Development of a new cost-saving technology increases spending by firms buying it

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Examples of Autonomous Changes  Government purchases  Buying more military hardware

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Examples of Autonomous Changes  Net Exports  Increased demand for U.S. products by foreigners

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Changes in the Fed’s Policy Reaction Function  The Fed’s policy reaction function  Describes how the Fed sets the real interest rate at each level of inflation  The Fed may deviate from its policy reaction function  Tightening money  For a given inflation rate, the Fed increases the real interest rate  Easing money  For a given inflation rate, the Fed increases the real interest rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Tightening of Monetary Policy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Shifts vs. Movements Along  Movements along AD  Downward slope of AD shows the inverse relationship between inflation and aggregate demand  Changes in the inflation rate  Changes in the real interest rate  Shifts in AD  A factor that changes AD at a given level of inflation  Autonomous changes in spending  Changes in the Fed’s policy reaction function

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation Inertia  Inflation inertia  Inflation tends to change relatively slowly as long as the economy is at full employment and there are no external shocks to the price level  Three factors that change the inflation rate  Output gap  Inflation shock  Shock to potential output

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Expectations on Inflation  The public’s inflation expectations  Buyers and sellers take into account their expectation of inflation when negotiating many types of contracts  The higher the expectation of inflation the higher the nominal price negotiated  E.G., higher wages and costs of other inputs  If wages and other costs go upfirms will have to raise prices

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Expectations Determine Reality  A low rate of expected inflation tends to lead to a low rate of actual inflation  A high rate of expected inflation tends to lead to a high rate of actual inflation  Long-term wage and price contracts build in wage and price increases that depend on inflation expectations

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Virtuous Circle of Low Inflation and Low Expected Inflation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Output Gap and Inflation  Output gap  The difference between potential output Y* and actual output Y  Y* - Y  In the short run  Y may equal Y*  Y may differ from Y*

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide No Output Gap  No output gap  Y = Y*  Actual output equals potential output  Firms are satisfied  Sales equal normal production rates  No incentive to change their prices relative to other prices  Inflation rate tends to remain the same

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Expansionary Gap  Expansionary output gap  Y > Y*  Actual output is greater than potential output  Firms are over-utilizing resources  Sales exceed normal production rates  Incentive to increase their prices more than the increase in their costs  Inflation rate tends to increase

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Recessionary Gap  Recessionary output gap  Y < Y*  Actual output is less than potential output  Firms are under-utilizing resources  Sales are less than normal production rates  Incentive to decrease their relative prices so they can sell more  Inflation rate tends to decrease

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide AD-AS Diagram  Long-run aggregate supply (LRAS) line  A vertical line showing the economy’s potential output Y*  Short-run aggregate supply (SRAS) line  A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Aggregate Demand-Aggregate Supply (AD-AS) diagram

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide SR Equilibrium  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  Graphically, it occurs at the intersection of the AD curve and the SRAS curve

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation and Recovery from a Recessionary Gap  An economy experiencing a recessionary gap  Will eliminate the gap  Firms not selling as much as they want to will  Slow the rate at which they increase their prices  This will cause the inflation rate to fall  As inflation falls output rises and unemployment falls, and the Fed lowers the real interest rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Adjustment of Inflation When a Recessionary Gap Exists

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide LR Equilibrium  LR equilibrium  Actual output equals potential output and the inflation rate is stable  Y = Y*  Graphically, it is where the AD curve, the SRAS line, and the LRAS line all intersect at a single point

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation and Recovery from an Expansionary Gap  An economy experiencing an expansionary gap will eliminate the gap  Firms experience high demand will  Increase prices more than costs  This will cause the inflation rate to rise  As inflation rises output falls and unemployment rises, and the Fed raises the real interest rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Adjustment of Inflation When an Expansionary Gap Exists

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig War and Military Buildup as a Source of Inflation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Self-Correcting Economy  The economy tends to be self-correcting  Given enough time, output gaps tend to disappear without changes in monetary or fiscal policy  The result contrasts with the basic Keynesian model  Basic Keynesian model focuses on the short run when prices do not adjust and ignores the long- run adjustment period

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Timing  If self-correction is slow  Then active use of monetary and fiscal policy can help to stabilize output  If self-correction is rapid  Then active stabilization polices are probably not justified  Problems of policymaking: lags and uncertainties  Large gaps will take longer to fix themselves  Greater justification for policy intervention

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Sources of Inflation  Excessive AD  Too much spending chasing too few goods  Inflation shocks  A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap  Favorable or unfavorable  1973 oil shock was unfavorable

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Effects of an Adverse Inflation Shock

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Sources of Inflation  Shocks to potential output  Aggregate supply shock  Either an inflation shock or a shock to potential output  Adverse aggregate supply shocks of both types reduce output and increase inflation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Effects of a Shock to Potential Output

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Controlling Inflation  What should policymakers do if inflation is too high?  Inflation can be slowed by policies that reduce aggregate demand  The short-run costs involve lost output and increased unemployment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Short-Run and Long-Run Effects of a Monetary Tightening

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Disinflation  Disinflation  A substantial reduction in the rate of inflation