1. Aggregate Demand & Supply Part III: Equilibrium

2. Equilibrium Aggregate Price Level n Putting aggregate D & S together: AS P Y AD PePe YeYe

3. Oil Crisis, 1974 n Arab Boycott leads to 4X increase in oil prices: AS P Y AD PePe YeYe P e' Y e' AS' 1974-75 Recession

4. Fiscal & Monetary Policy - I  G,  T,  Ms all shift AD to right  G,  T,  Ms all shift AD to right AS P Y AD PePe YeYe AD'

5. Fiscal & Monetary Policy - II  G,  T,  Ms all shift AD to left  G,  T,  Ms all shift AD to left AS P Y AD' PePe YeYe AD

6. Fiscal & Monetary Policy - III n But what are size of effects on prices & output? AS P Y AD PePe YeYe ? ?

7. Size of effects = f(shape of AS) n Where AS is flatter, e.g., in depression, shifts in AD produce large changes in Y with small changes in P (typical Keynesian result): AS P Y AD YeYe PePe Y e'

8. Size of effects = f(shape of AS) n But where AS is steeper, e.g., in boom, shifts in AD produce large changes in P with small changes in Y: AS P Y AD YeYe PePe Y e'

9. Keynesian "Gaps" n Below Y e aggregate demand could be increased with no upward pressure on prices n Above Y e aggregate demand increases would generate inflation (rising price level) Y C, I, G AB inflationary gap deflationary gap Y fe aggregate demand

10. Keynesian Aggregate Supply n We can translate this into AS - AD terms: YeYe AS Y P

11. Long Run Aggregate Supply - I n Long run AS is said to be vertical. Why? n Ans: wages adjust to price changes LRAS P Y AD PePe YeYe

12. Long Run Aggregate Supply - II Suppose AD increased by policy, P  & Y  Suppose AD increased by policy, P  & Y  LRAS P Y AD PePe YeYe SRAS AD' Y e' P e'

13. Long Run Aggregate Supply - III But then wages/costs/SRAS adjust to P  But then wages/costs/SRAS adjust to P  LRAS P Y AD PePe YeYe SRAS AD' Y e' P e' SRAS' P e"

14. "Long Run" AS? n Problem: "short run" defined by fixed assets, upper limit to production capacity n "Long Run" defined in micro by all assets can be changed, plant & equipment & productivity can be increased n In micro a given technology may produce an "envelop" of short run cost curves n But in aggregate, technology can change and output can be expanded indefinately!

15. Potential GDP? n LRAS curve vertical at what is called "potential GDP" n "Potential GDP" = "level of output that can be sustained in the long run without inflation" n But in aggregate, technology can change and output can be expanded indefinitely!

16. Inflation n We now have model with price level, and hence inflation, explicit n We can use this model to talk about various kinds of inflationary pressures

17. Demand Pull Inflation - I n As we approach full employment, increasing demand "pulls" up the price level: AS P Y AD YeYe PePe Y e'

18. At Full Employment n At full employment, increases in AD produces only price increases: YeYe AS Y P

19. Cost Push Inflation - I n Increases in costs (wages, oil) shifts AS up, so P  (but note: Y  = stagflation) so P  (but note: Y  = stagflation) AS P Y AD PePe YeYe P e' Y e' AS'

20. Cost Push Inflation - II But in late 1960s Y ROSE with wage , how? But in late 1960s Y ROSE with wage , how? AS P Y AD PePe YeYe P e' Y e' AS'

21. Cost Push Inflation - III Ans: accomodating monetary policy that  AD Ans: accomodating monetary policy that  AD AS Pe"Pe" Y AD PePe YeYe P e' Y e' AS' AD'

22. Inflation = Monetary Phenomenon? n C&F: "a sustained inflation, whatever the initial cause..., is essentially a monetary phenomenon." (p. 332) n C&F: "can be thought of as a purely monetary phenomenon" (p. 337) n This view is associated with "monetarism" which became popular in 1970s because it offered a policy alternative: hold down Ms.

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