Chapter 23: Aggregate Demand and Aggregate Supply

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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 2 2012 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
4.Analyze how the economy adjusts to expansionary and recessionary gaps and relate this to the idea of a selfcorrecting economy 5. Use the aggregate demand aggregate supply model to study the sources of inflation in the short run and in the long run
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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 ()

Long-Run Aggregate Supply (LRAS) Aggregate Supply (AS) Aggregate Demand (AD)

Y* Output (Y)
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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

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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, IP PAE Y

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Inflation, The Central Bank, And The AD Curve

The central bank also responds to a recessionary gap
Inflation The

is likely to decrease when Y < Y*

When inflation decreases,

central bank decreases the nominal interest rate real interest rates decrease and Aggregate spending increases

C, IP

PAE

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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

Inflation () 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

AD
Output (Y)

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Real interest rate (r)

Planned Spending (PAE)

r2 r1

B A

MPR

Y = PAE

A
B

PAE (r = r1) PAE (r = r2)

2 Inflation ()

Y2

Y1

Output (Y)

Inflation ()

Initial conditions: 1, r1, Y1 One point on AD

Suppose inflation increases to 2 Economy moves to 2, r2, Y2 Second point on AD

B A

1
Y2

AD
Y1 Output (Y)
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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

Consumer wealth Business confidence Foreign demand for local goods

Inflation ()

Exogenous changes in spending are changes other than those caused by changes in output or the real interest rate

AD' AD
Output (Y)
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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

Inflation ()

increases for each possible level of Aggregate demand curve shift right

AD' AD
Output (Y)
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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 r1

MPR is shown in the graph

Central bank normally follows a stable MPR

Central

Shifts MPR

Tightening

monetary policy lowers the long-run inflation target

Real interest rate (r)

bank can tighten or ease monetary policy

MPR

r1

Inflation ()
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Tightening Monetary Policy

Tighter monetary policy results in each interest rate, r, being associated with a lower rate of inflation
Real interest rate (r)

leftward shift of the MPR

MPR2
r2 r1 MPR1

The economy begins at the original target inflation rate, 1

MPR

2 shifts to MPR2 Central bank increases 2012 The McGraw-Hill Companies, interest rate from r1 to r2 All Rights Reserved

Inflation ()
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Easing Monetary Policy

Easing monetary policy results in each interest rate, r, being associated with a higher rate of inflation
A

The economy begins at the original target inflation rate, 1

MPR

Real interest rate (r)

rightward shift of the MPR

MPR1

r1 r3

MPR3

shifts to MPR3 Central bank decreases interest rate from r1 to r3

Inflation ()
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Shift in Aggregate Demand

MPR shifts up; interest rate increases from r1* to r2*
Higher

r decreases PAE and shifts AD to AD'

Inflation () AD AD'

Real interest rate (r)

MPR' r2 * r1 * B A MPR

A
B

1* Inflation ()
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Y2

Y1

Output (Y)
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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

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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 output Inflation shock

Shock

to potential

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

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Inflation Expectations
Today's expectations affect tomorrow's inflation
Inflation

expectations are built into the pricing in multi-period contracts

Low Inflation

Increase The higher the expected Slow in Wages and rate of inflation, the more Production Costs nominal wages and the cost of other inputs will increase

With

rising input costs, firms increase their prices to cover costs

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Low Expected Inflation

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Expected Inflation
Expectations are influenced by recent experience
If

Low and stable inflation creates a virtuous circle that keeps inflation low High and stable inflation creates a vicious circle that keeps inflation high

inflation is low and stable, people expect that to continue Slow Increase Volatile inflation leads Low in Wages and to volatile expectations Production Inflation
Costs

Low Expected Inflation

19

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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

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Output Gaps and Inflation

Relationship of Output to Potential Output Expansionary gap Y > Y* No output gap Y = Y* Recessionary gap Y < Y*

Behavior of Inflation
Inflation increases Inflation is stable

Inflation decreases

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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 Aggregate Supply (AS) If the economy has an B inflationary gap, Y > Y* and 2 > e at B A If the economy has an expansionary gap, Y < Y* 3 C and 3 < e at C Y2 Y* Y1 Output (Y) The AS curve slope up
Inflation ()
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Shifts in the AS Curve

Two changes can shift the AS curve
Inflation

expectations Inflation shocks

Inflation ()

If actual inflation exceeds expectations, expected inflation increases

AS curve shifts to the left At each level of output, inflation is higher

AS2

2 1

AS1

Y*

Output (Y)
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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 2012 The McGraw-Hill Companies, All Rights Sharp increase in inflation in Reserved 1974

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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

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Aggregate Demand Aggregate Supply Analysis

In the long run,
Actual

output equals potential output Actual inflation equals expected inflation

Inflation ()

Long-run equilibrium occurs at the intersection of

Aggregate

Long-Run Aggregate Supply (LRAS)

Aggregate Supply (AS) Aggregate Demand (AD)

demand Aggregate supply and Long-run aggregate supply

Y* Output (Y)
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Aggregate Demand Aggregate Supply Analysis Short-run equilibrium occurs when there is either an expansionary gap or a recessionary gap
Intersection

LRAS

of AD and AS curves at a level of output different from Y* Point A in the graph

Inflation ()

AS1

A
AD

Short-run equilibrium is temporary

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Y* Y1

Output (Y)
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An Expansionary Gap
Initial short-run equilibrium at A
AD

Inflation ()

is stable as long as there is no change in the central bank's monetary policy rule and no exogenous changes in spending

LRAS AS2 AS1

Inflation increases and expected inflation increases

Shifts

2 1

A AD

AS curve to AS2 Output is at potential, Y* New expected inflation 2012 The McGraw-Hill Companies, All Rights Reserved is

Y* Y1

Output (Y)
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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 29

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A Recessionary Gap
Initial equilibrium is at B, a recessionary gap
AD

curve remains stable unless MPR changes or exogenous spending changes

LRAS AS1 AS2

Inflation ()

With inflation above its expected value, the central bank lowers interest rates
Aggregate

supply shifts

The new long-run equilibrium is at potential output and an inflation level of 2

to AS2

1 2

AD

Y1 Y*

Output (Y)
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Self-Correcting Economy
In the long-run the economy tends to be selfcorrecting

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 2012 greater the gap, the longer the adjustment The McGraw-Hill Companies, All Rights Reserved

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Self-Correcting Economy
A slow self-correcting mechanism
Fiscal

and monetary policy can help stabilize the economy and monetary policy are not effective and may destabilize the economy

A fast self-correcting mechanism

Fiscal

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
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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 AD2

Expansionary gap opens Short-run equilibrium at 2 and Y2
LRAS

If

AD stays at AD2 and the central bank does not change monetary policy, inflation is higher than expected AS shifts to AS2

Inflation ()

3 2
1

AS2 AS1

AD2 AD1

Y* Y2

Output (Y)
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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
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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
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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

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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

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The Effects of an Adverse Inflation Shock

Initial equilibrium is at 1 and Y*, potential output Oil shock reduces aggregate supply to AS2

Inflation ()

Government can increase AD to AD2 to address recessionary gap

Short-term equilibrium is a recessionary gap at 2 and Y2

LRAS

Government can keep policies constant and let the economy adjust back to AS1 with 1 and Y*

Raises inflation to 3

3 2 1

AS2

AS1

AD2

AD1

Y2 Y*

Output (Y)
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Shocks to Potential Output

Oil shocks may lead to lower potential output
Compounds

the inflationary effects of the shock

LRAS2 LRAS1

Potential

output falls to Y2 and LRAS shifts to LRAS2 Expansionary gap at Y1, 1 leads to lower output and higher inflation

Inflation ()

Suppose long-run equilibrium is at Y1 and 1

2 1
AD

Y Aggregate supply shock is either an inflation shock or a shock to potential output

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Y1

Output (Y)

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