Chapter 13 Aggregate Demand and Inflation

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Chapter 13Aggregate Demand and Inflation
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Real Interest Rates and Aggregate Expenditures

• When the real interest rate rises, aggregate
  expenditures fall for two reasons.
• Investment, I, falls when the real interest rate
  rises because higher borrowing costs reduce the
  profitability of some investment projects.
• Consumption, C, falls because higher interest
  rates on loans cause households to cut back on
  purchases of new housing and durable goods.

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Equilibrium (a)

• The real interest rate adjusts to bring S I in
  the capital market.
• Fluctuations in output cause national saving to
  change.
• Saving depends on disposable income.
• If Y lt Yf, savings fall and the real interest
  rate rises.
• If Y gt Yf, savings rise and the real interest
  rate falls.
• When output changes, profits change and so does
  investment demand.
• If Y lt Yf output and profits are low.
• Investment demand fallsthe investment curve
  shifts left
• Since the savings curve and the investment curve
  both shift left the real interest rate may rise
  or fall.

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Equilibrium When Output Falls Below Y f (a)

• The Fed monitors aggregate demand relative to
  full-employment output, Y f.
• When Y lt Y f, savings fall and the saving
  function shifts to the left.
• The real interest rate rises.
• When output falls profits fall.
• Investment demand shifts to the left.
• The real interest rate may rise or fall.

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Equilibrium When Output Falls Below Y f (b)
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Unemployment and Inflation

• When unemployment falls, the labor market
  tightens.
• Wage growth increases.
• Price growth so inflation increases
• When unemployment rises there is slack in the
  labor market.
• Wage growth slows.
• Price growth is slow so inflation falls.

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The Fed's Policy Rule

• The Feds policy rule
• How much the Fed should raise the real interest
  rate in response to an increase in inflation
• How much the Fed should reduce the real interest
  rate in response to a reduction in inflation
• When the real interest rate rises, consumption
  and investment fall, so AE falls.
• Output and employment fall, and unemployment
  rises.
• When inflation falls, the Fed reduces the real
  interest rate.
• This stimulates investment and consumption.
• AE, output, and employment rise

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The Fed's Policy Rule When Inflation Rises

• Suppose inflation rises.
• The Feds policy rule indicates how much the Fed
  should increase the real interest rate.
• When the real interest rate rises, investment and
  consumption fall, so AE falls.
• Output and employment fall, and unemployment
  rises.
• The rise in unemployment slows down wage growth
  and price growth or inflation.

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The Fed's Policy Rule When Inflation Falls

• When inflation falls, the Feds policy rule
  indicates how much the Fed should reduce the real
  interest rate.
• A reduction the real interest rate stimulates
  investment and consumption.
• AE, output, and employment rise and unemployment
  falls
• The fall in unemployment increases wage growth
  and inflation increases.

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Change in the Fed's Policy Rule

• The Fed changes its policy rule if the Fed sets a
  different real interest rate than its policy rule
  would prescribe even though inflation has not
  changed.
• Example
• In 1997 the Fed reduced real interest rates even
  though U.S. inflation was constant.
• Wanted to increase U.S. demand for goods from
  Southeast Asia and weaken the dollar to help
  Asian countries in the throes of a financial
  crisis

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Equilibrium Output and the ADI Curve

• ADI has a negative slope due to the negative
  relationship between inflation and the level of
  output.
• When inflation rises the Fed implements its
  policy rule and real interest rates rise.
• Investment and consumption fall, AE falls and in
  equilibrium output falls

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Equilibrium Output and the ADI Curve
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The Federal Funds Rate

• The interest rate in the federal funds rate is a
  nominal interest rate.
• i r ?, where i the nominal fed funds rate,
  r the real interest rate and ? is inflation
• The Feds policy rule when ? ? the real interest
  rate must rise
• This implies that i must increase by more than
  inflation.
• ?i ?r ??
• If ?? 5, then for ?r 1, ?i 6 which is
  greater than the increase in inflation.

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What Determines the Slope of the ADI Curve?

• How much the Fed changes real interest rates in
  response to a change in inflation
• How responsive consumption and investment are to
  changes in the real interest rate
• The ADI curve is flat when a small increase in
  inflation leads to large changes in output.
• The Fed changes the real interest rate
  aggressively when inflation changes.
• Or when C and I are sensitive to interest rates
• The ADI curve is steep when a large increase in
  inflation leads to a small change in output.
• The Fed changes the real interest rate less
  aggressively when inflation changes.
• Or when C and I are insensitive to interest rates

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Slope of ADI
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Other Factors that Determine the Slope of the ADI
Curve

• When inflation rises U.S. exports are more
  expensive to foreigners.
• So exports fall, reducing AE and output
• When inflation rises real wealth, Wealth/P, may
  fall.
• This makes households and firms poorer so they
  may cut back on consumption and investment,
  reducing AE and output.
• When inflation rises wage growth may not
  initially match the growth of prices.
• Workers are poorer and may cut back on
  consumption, reducing AE and output.

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What Can Shift the ADI Curve?

• A shift of the ADI curve occurs when there is a
  change in fiscal policy or monetary policy at a
  given rate of inflation.
• An increase in government spending or a tax cut,
  expansionary fiscal policy, shifts the ADI curve
  rightward.
• There is a movement along the ADI curve when the
  Fed responds to inflation by raising interest
  rates which results in lower output.

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How does the Fed Shift the ADI Curve?

• The Fed shifts the ADI curve if it changes its
  policy rule.
• Suppose the Fed decides to lower the real
  interest rate even though inflation is constant
  this is a change in the Feds policy rule.
• The ADI curve shifts right.
• Lower interest rates increase investment and
  consumption, increasing AE and output at the
  constant inflation rate.

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The Feds Response to the Asian Financial Crisis
Shifted the ADI Curve

• In 1998 the Fed was worried about the spread of
  the Asian financial crisis.
• It cut the real interest rate even though U.S.
  inflation was constant.
• This increased investment, consumption, and
  increased imports from countries in Southeast
  Asia that were in the throes of a financial
  crisis.

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Other Factors that Shift the ADI Curve

• A change or shock to consumption or investment
  will shift the ADI curve.
• The stock market boom of the 1990s increased
  consumption and shifted the ADI curve to the
  right for any level of inflation.
• An increase in perceived risks will reduce
  investment and shift the ADI curve to the left
  for any given level of inflation.
• Changes in fiscal policy, the tax and spending
  policies of the government, will shift the ADI
  curve.

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The Short Run and the Long Run

• In the long run, wages and prices adjust to clear
  the labor market.
• There is no cyclical unemployment.
• Output is at the full-employment level Yf.
• In the long run the economy returns to Yf with
  any level of inflation either low or high.
• Yf is independent of inflation.

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Recession Caused by a Shift in ADI (a)
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Recession Caused by a Shift in ADI (b)

• ADI shifts left due to an increase in perceived
  risk which reduces I and C.
• Y lt Yf and unemployment rises with new
  equilibrium at E1.
• Inflation starts to fall, (IA shifts down)
  because of loose labor markets.
• In response to falling inflation the Fed
  implements its policy rule
• The Fed acts to reduce interest rates which, in
  turn, increases I and C.
• After the adjustment full-employment is restored
  at E2.

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Recession Caused by a Shift in ADI (c)

• Note that the Fed could change its policy rule
  and lower the real interest rate before inflation
  starts to fall.
• This would shift the ADI curve back to its
  original position at E0, maintaining the original
  inflation.

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An Expansionary Shift in the ADI Curve (a)

• Expansionary government policy ? the ADI curve
  shifts right.

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Fiscal Policy Shifts the ADI Curve

• When G increases or T falls AE increases as do
  employment and output
• Y gt Yf for a given level of inflation and ADI
  shifts right
• Tight labor markets result in higher wage
  inflation and price inflation so the IA curve
  shifts up.
• As inflation rises, the Fed implements its policy
  rule it raises real interest rates.
• I and C fall as does AE so output returns to full
  employment Yf.

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Example of Fiscal Policy Shifting the ADI Curve
the 1960s (a)

• Kennedy tax cut in 1963 unemployment of 5.3 was
  seen as too high
• In 1964 taxes were cut, C increased, and demand
  and output increased.
• In 1965 unemployment was 4.4, however by the
  late 1960s inflation was 5.7 and unemployment
  was back above 5.5.

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Example of Fiscal Policy Shifting the ADI Curve
the 1960s (b)
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Changes in Energy Prices

• With the oil price shocks of the 1970s, the IA
  curve shifted up.
• Inflation rose and output fell below potential, Y
  lt Yf, so unemployment rose.
• As inflation increased, the Fed increased real
  interest rates, so C and I fell, and Y fell the
  economy moved into recession with higher
  unemployment.
• This was a move along the ADI curve as the IA
  curve shifted upward.

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Changes in Energy Prices (b)
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Volcker Dis-Inflation of the 1980s (a)

• In 1978 the economy was at full-employment with
  unemployment at 5.8, but inflation was high,
  over 8.
• In 1980 Fed Chair Paul Volcker changed the Feds
  policy rule and aggressively increased interest
  rates (when inflation was nearly 10).
• This caused output to fall well below potential
  but eventually brought inflation under control so
  that in 1983 inflation was just 3.2.

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Volcker Dis-Inflation of the 1980s (b)
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Volcker Dis-Inflation of the 1980s (c)
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Using the ADI Curve

• In 1960s G rose due to Vietnam War shifted ADI
  right
• In late 1970s and early 1980s the Fed changed its
  policy rule and aggressively increased the real
  interest rate to reduce high U.S. inflation
  shifted ADI left
• In 1990 when Iraq invaded Kuwait, consumption
  fell shifted ADI left
• In late 1990s the stock market boom and
  associated wealth effects increased consumption
  so the ADI curve shifted right
• In late 1990s increases in the labor productivity
  due to new information technologies increased
  business investment in these products shifted
  ADI right and shifted Yf right as well

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Increase in Potential GDP in 1990s Due to New
Information Technologies

• New information technology improves labor
  productivity.
• Yf may also increase due to increased labor
  market participation rate by women.
• Shifts Yf rightward as the same level of
  employment produces more output.
• Puts downward pressure on inflation
• The IA curve shifts downward.
• Moves along the ADI curvehigher output and lower
  inflation

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The Impact of an Increase in Potential GDP
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The Boom of the 1990s
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Fed Policy in 2000

• In 2000 the Fed feared inflation was reviving.
• Possible if the ADI curve shifts right
• To cut off inflation at the pass, a preemptive
  strike, the Fed raised the real interest rate,
  which shifts the ADI left.