1 Frank & Bernanke 4 th edition, 2009 Ch. 13: Aggregate Demand and Aggregate Supply

2 Aggregate Demand-Aggregate Supply LRAS AS AD Y π Y*

3 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.

4 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.

5 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

6 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

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

8 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)

9 π r (by Fed) π π π Y Y PAE AD DERIVATION OF THE AD CURVE Monetary Policy Rule PAE Fed responds to inflation rate and sets the federal funds interest rate. In the short run nominal and real interest rates remain the same because inflationary expectations haven’t changed. The real interest rate determines the C, I, NX and consequently the PAE. The Keynesian Cross gives us the equilibrium Y. We now have a point on the AD curve because we know the equilibrium Y and the inflation. 45 0

10 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.

11 π r (by Fed) π π π Y Y PAE AD AD’ SHIFTS IN AD IN RESPONSE TO SHIFTS IN PAE: G down What changes make the PAE shift? In the Keynesian Cross diagram, what changes might have happened? If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet? Try your hand at the diagrams when G increases or T decreases. 45 0

12 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’ Inflation 

13 π r (by Fed) π π π Y Y PAE AD AD’ THE IMPACT OF MONETARY POLICY RULE CHANGE ON AD What does it mean to shift MPR up? Follow the resulting changes. Show what happens to AD when the monetary policy becomes expansionary. Monetary policy is more restrictive

14 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*

15 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)

16 π r (by Fed) π π π Y Y PAE AD AD’ INCREASE IN INFLATION Upward movement along AD

17 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

18 A Virtuous Circle

19 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.

20 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

21 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 (D>S for firms) Y > Y*  3. Recessionary gapInflation falls (D<S for firms) Y < Y* 

22 Aggregate Supply Y* π Current inflation (π) is the result of expected inflation plus the inflationary impact of the output gap. If the economy is at Y*, current and expected inflation are the same. If there is an expansionary gap (Y>Y*) inflation increases to π 1. If there is a recessionary gap (Y<Y*) inflation falls to π 2. π2π2 π0π0 π1π1 Y2Y2 Y1Y1

23 AS Shifts AS 0 AS 1 Y* π0π0 π1π1 CHANGE IN INFLATIONARY EXPECTATIONS Expected inflation is higher at Y*. A SUDDEN INFLATION SHOCK A sudden economy-wide cost increase

24 Short-run Equilibrium Inflation equals the value determined by past expectations and output gap (AS) and output equals the level of short-run equilibrium output that is consistent with that inflation rate (AD) Inflation equals the value determined by past expectations and output gap (AS) and output equals the level of short-run equilibrium output that is consistent with that inflation rate (AD) Graphically, short-run equilibrium occurs at the intersection of the AD curve and the AS line Graphically, short-run equilibrium occurs at the intersection of the AD curve and the AS line

25 Equilibrium Output Inflation  Long-run equilibrium AD, AS (  *), LRAS (Y*) will intersect at the same point LRAS Y* AS AD π*π*

26 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 AS line, and the LRAS line all intersect at a single point Graphically, long-run equilibrium occurs when the AD curve, the AS line, and the LRAS line all intersect at a single point

27 Recessionary Gap Output Inflation  LRAS Y* AS AD π0π0 Y0Y0 π*π*

28 Adjustment to Recessionary Gap Y<Y* means firms are selling less than they want to; will start to lower prices. Y<Y* means firms 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.

29 Expansionary Gap Output Inflation  LRAS Y* AS AD π π*π*

30 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.

31 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.

32 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.

33 Sources of Inflation Excessive Aggregate Spending Excessive Aggregate Spending Inflation Shocks Inflation Shocks Shocks to Potential Output Shocks to Potential Output Try to draw each one. Try to draw each one.

34 π r (by Fed) π π π Y Y PAE AD’ AD EXCESSIVE AGGREGATE SPENDING In the Keynesian Cross diagram, what changes might have happened? Military expenditures? If inflation hasn’t changed, and Fed has not changed the r, where do the inflation rate and equilibrium Y meet? 45 0 PAE PAE’

35 Excessive Aggregate Spending Output Inflation  LRAS Y* AS AD π π*π* Show the impact on Fed Policy Rule. What does it mean?

36 Higher Inflation and Fed r π

37 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? What did Germany do during early 1990s? What did Germany do during early 1990s?

38 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

39 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

40 Inflation Shock Output Inflation  LRAS Y* AS AD π*π* AS’ Two Options: Don’t do anything.

41 Inflation Shock Output Inflation  LRAS Y* AS AD π*π* AS’ Two Options: Fed lowers r – easing money supply. AD’

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

43 Shock To Potential Output Output Inflation  LRAS Y* AS AD π*π* Y*’ LRAS’ Loss of capital, loss of labor, sudden abandonment of machinery (capital loss), extended recession (human capital loss).

44 Greenspan Output Inflation  LRAS Y* AS AD π*π*