Long Run Aggregate Demand & Supply Lecture 20 Dr. Jennifer P. Wissink ©2015 Jennifer P. Wissink, all rights reserved. April 8, 2015

i>clicker question If you were POTUS and you wanted expansionary policy to work really well (i.e., have the greatest multiplier impact), where would you hope AD currently intersects SR-AS? A. In the horizontal part. B. In the intermediate part. C. In the vertical part. D. Doesn’t matter.

Monetary &/or Fiscal Policy When SR-AS is Rather Flat u Expansionary Policy –Monetary OR Fiscal –Suppose we are on the “flatter” part of SR-AS. –AD shifts out (to the right). –Policy works well when the economy is on the flatter portion of the SR-AS curve, causing little change in PL relative to the output increase. –Note: assuming no shift in SR-AS for now.

u Expansionary Policy –Monetary OR Fiscal –Suppose we start out on the “steeper” part of SR-AS. –AD shifts out. –When the economy is operating near capacity, an increase in AD will result in an increase in the price level, PL, with little increase in output. –Note: still assuming no shift in SR-AS. Monetary &/or Fiscal Policy When SR-AS is Rather Steep

The Response of Input Prices to Changes in the Overall Price Level u If the price-level increase were assumed to be fully anticipated, then wage rates and all other prices would be predicted to increase at exactly the same rate as the overall price level ... –But many argue that this is simply not the observed case. u So... there must be a lag between changes in input prices and changes in output prices, otherwise the SR-AS (the SR price/output response) curve would be vertical. u So... we operate with the idea that enough input prices tend to lag changes in output prices to make it so we talk about SR-AS & LR-AS.

u We distinguish between the –short run AS curve (SR-AS) –long run AS curve (LR-AS) u SR-AS is positively sloped and… –tends to start out rather flat/horizontal at low levels of Y –then has a section that’s positively sloped –then tends to get very steep/vertical as we approach Y-capacity (which is different than Y potential /Y FE ) –will shift with cost/supply shocks (see chart again, the one with the pics) u LR-AS is vertical. –This is because eventually all prices adjust, including input prices. –Typically we assume the LR-AS is vertical at Y potential /Y FE. –Y potential /Y FE is the level of income/output where there is no inflation. –If Y>Y FE then you’ll get rising price/wage levels and a shift in the SR-AS back to LR-AS, but now at a higher price level. –If Y<Y FE then you’ll get falling price/wage levels and a shift in the SR-AS back to LR-AS, but now at a lower price level. SR-AS versus LR-AS

AD, LR-AS and SR-AS Curves u Recall: Some/enough input costs lag behind price-level changes in the short run, resulting in an upward-sloping SR-AS curve. u In the long run, costs and the price level move in tandem, so once costs finally “catch up” and adjust, the LR-AS curve is vertical at what we will call Y Potential or Y FE = Yo

Consider An Increase in AD

u Output can be temporarily pushed above Y Potential by higher aggregate demand. u The aggregate price level rises – we see inflation. u We move up/along the SR-AS as price levels rise, and some wages rise. (Note: other input prices and wages have not fully adjusted yet.)

u When Y is pushed above Y Potential, there is upward pressure on costs, and this causes the SR-AS curve to shift to the left (a negative cost or supply shock) u Costs ultimately increase by the same percentage as the price level, and the quantity supplied ends up back at Y 0 = Y Potential. u There is a higher price level in the economy but now the inflation is over. Consider An Increase in AD

u If AS (Long run) is vertical, then neither monetary policy nor fiscal policy has any long run effect on aggregate output. u In the long run, the multiplier effect of a change in M S, government spending or taxes on aggregate output is zero. u So is the AS (Long run) vertical? u Can policy (and what type of policy then?) change where AS (Long run) is? BAD NEWS? AD, SR-AS, LR-AS and Monetary and Fiscal Policy: Long Run Impact

Inflation Concepts Review u Inflation is an increase in the overall price level. u Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time. u Hyperinflation is a period of very rapid increases in the price level. u Stagflation occurs when output is falling at the same time that prices are rising.

TWO Major Types of Inflation u Demand-pull inflation is inflation initiated by an increase in AD (a shift rightward of AD). u Cost-push, or supply-side, inflation is inflation (  stagflation) caused by an increase in costs generating a decrease (a shift leftward) in SR-AS.

Cost-Push Inflation & Stagflation Leading to Demand Pull Inflation u Recall Stagflation... occurs when output is falling at the same time that prices are rising. u Suppose for example: –we’re at Yo and then... –oil prices increase –AS shifts left and we get higher prices and less output. –So suppose we react and use expansionary monetary or fiscal policy. –But that increases prices even more!

Cost-Push Inflation & Stagflation Leading to Demand Pull Inflation u Recall Stagflation... occurs when output is falling at the same time that prices are rising. u Suppose for example: –we’re at Yo and then... –oil prices increase –AS shifts left and we get higher prices and less output. –So suppose we react and use expansionary monetary or fiscal policy. –But that increases prices even more!

Another Source of Inflation: Expectations u If every firm expects every other firm to raise prices by 10%, every firm will raise prices by about 10%. This is how expectations can get “built into the system.” u In terms of the AD/AS diagram, an increase in inflationary expectations shifts the SR-AS curve to the left. u Works like a negative cost shock. u Called expectational inflation. u Turns out to be “self-fulfilling.” u Note: Something had to “start” it, like expansionary monetary or fiscal policy. –  Expectational inflation can only sustain an ongoing inflation (which typically starts with some increase in AD) u Related to an idea of “inertial inflation” when inflation continues on its own inertia when the original reason has ceased.

Money Supply and Inflation u It is often said that, “You can’t have a sustained inflation (or worse yet a hyperinflation) without monetary support.” WHY? HOW’s THAT WORK? u Consider an increase in G with the FED keeping the money supply constant. –AD curve shifts right. –When M D depends on Y & PL, this leads to an increase in M D and therefore an increase in the interest rate and crowding out of planned investment, so AD shifts back a little leftward. –Also once wages and other input prices catch up, SR-AS will shift left, too. –This will all stop at a higher price level and back on LR-AS. –END OF STORY. Inflation is over....

Money Supply and Inflation u BUT... u If the monetary guys decide to increase the money supply to decrease the interest rate to undo some of the crowding out effect... u...then we kind of start the whole thing over again with a rightward shift in AD. u The result is a sustained inflation, perhaps hyperinflation. u So if the Fed holds fast on the money supply, the inflation will eventually end on its own. u Albeit at a stable HIGHER overall price level.