Eco106 W8A Aggregate Demand and Supply Case-Fair Ch 12-13

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Eco106 W8AAggregate Demand and SupplyCase-Fair
Ch 12-13

• 1. AD
• 2. AS
• 3. Cost Push vs Demand Pull Inflation
• 4. FRB responses to the economy
• 5. Hyperinflation and Deflation Damage

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AD
LM 3
LM 2
P is the price level as measured by the GDP
deflator. As the price level rises the
real Money supply falls and the Interest rate
rises. (A higher Price level shifts the LM curve
left.) So higher prices have lower Spending and
output. Thats the idea of the AD line.
r
LM 1
IS
Y
P
P3
P2
P1
Y
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Aggregate Supplyand the EquilibriumPrice Level
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The Aggregate Supply Curve
aggregate supply The total supply of all goods
and services in an economy.
The Aggregate Supply Curve A Warning
aggregate supply (AS) curve A graph that shows
the relationship between the aggregate quantity
of output supplied by all firms in an economy and
the overall price level.
An aggregate supply curve in the traditional
sense of the word supply does not exist. What
does exist is what we might call a price/output
response curvea curve that traces out the price
decisions and output decisions of all firms in
the economy under a given set of circumstances.
Important constants are the capacity of the
economy and the international prices it faces,
especially for oil
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The Aggregate Supply Curve in the Short Run
The price level refers to the prices of final
goods the GDP deflator. We assume that wages and
other input prices are constant.
In the short run, the aggregate supply curve (the
price/output response curve) has a positive
slope. At low levels of aggregate output, the
curve is fairly flat. As the economy approaches
capacity, the curve becomes nearly vertical. At
capacity, the curve is vertical.
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The Aggregate Supply Curve
Shifts of the Short-Run Aggregate Supply Curve
cost shock, or supply shock A change in costs
that shifts the short-run aggregate supply (AS)
curve.
? FIGURE 13.2 Shifts of the Short-Run Aggregate
Supply Curve
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The Equilibrium Price Level
equilibrium price level The price level at which
the aggregate demand and aggregate supply curves
intersect.
At each point along the AD curve, both the money
market and the goods market are in equilibrium.
Each point on the AS curve represents the price/
output decisions of all the firms in the economy.
P0 and Y0 correspond to equilibrium in the goods
market and the money market and to a set of
price/output decisions on the part of all the
firms in the economy.
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The Long-Run Aggregate Supply Curve
When the AD curve shifts from AD0 to AD1, the
equilibrium price level initially rises from P0
to P1 and output rises from Y0 to Y1. Wages
respond in the longer run, shifting the AS curve
from AS0 to AS1. If wages fully adjust, output
will be back at Y0. Y0 is sometimes called
potential GDP.
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The Long-Run Aggregate Supply Curve
The Simple Keynesian Aggregate Supply Curve
One view of the aggregate supply curve, the
simple Keynesian view, holds that at any given
moment, the economy has a clearly defined
capacity, or maximum, output.
If expenditure and aggregate demand exceed YF,
there is an inflationary gap and the price level
rises.
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The Long-Run Aggregate Supply Curve
Potential GDP
potential output, or potential GDP The level of
aggregate output that can be sustained in the
long run without inflation.
Short-Run Equilibrium Below Potential Output
Although different economists have different
opinions on how to determine whether an economy
is operating at or above potential output, there
is general agreement that there is a maximum
level of output (below the vertical portion of
the short-run aggregate supply curve) that can be
sustained without inflation.
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Monetary and Fiscal Policy Effects
Aggregate demand can shift to the right for a
number of reasons, including an increase in the
money supply, a tax cut, or an increase in
government spending. If the shift occurs when
the economy is on the nearly flat portion of the
AS curve, the result will be an increase in
output with little increase in the price level
from point A to point A.
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Monetary and Fiscal Policy Effects
If a shift of aggregate demand occurs while the
economy is operating near full capacity, the
result will be an increase in the price level
with little increase in output from point B to
point B.
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Monetary and Fiscal Policy Effects
Long-Run Aggregate Supply and Policy Effects
It is important to realize that if the AS curve
is vertical in the long run, neither monetary
policy nor fiscal policy has any effect on
aggregate output in the long run. The
conclusion that policy has no effect on
aggregate output in the long run is perhaps
startling.
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Causes of Inflation
Demand-Pull Inflation
demand-pull inflation Inflation that is
initiated by an increase in aggregate demand.
AS
P
AD
AD
Y
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Causes of Inflation
Cost-Push, or Supply-Side, Inflation
cost-push, or supply-side, inflation Inflation
caused by an increase in costs.
An increase in costs shifts the AS curve to the
left. By assuming the government does not react
to this shift, the AD curve does not shift, the
price level rises, and output falls.
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Causes of Inflation
Expectations and Inflation
When firms are making their price/output
decisions, their expectations of future prices
may affect their current decisions. If a firm
expects that its competitors will raise their
prices, in anticipation, it may raise its own
price. Given the importance of expectations in
inflation, the central banks of many countries
survey consumers about their expectations.
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Fiscal an Monetary Overexpansion Causes Inflation
An increase in G with the money supply constant
shifts the AD curve from AD0 to AD1. Although not
shown in the figure, this leads to an increase in
the interest rate and crowding out of planned
investment. If the Fed tries to keep the
interest rate unchanged by increasing the money
supply, the AD curve will shift farther and
farther to the right. The result is a sustained
inflation, perhaps even hyperinflation.
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Causes of Inflation
Sustained Inflation as a Purely Monetary
Phenomenon
Virtually all economists agree that an increase
in the price level can be caused by anything that
causes the AD curve to shift to the right or the
AS curve to shift to the left. It is also
generally agreed that for a sustained inflation
to occur, the Fed must accommodate it. In this
sense, a sustained inflation can be thought of as
a purely monetary phenomenon.
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The Behavior of the Fed
? FIGURE 13.10 Fed Behavior
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The Behavior of the Fed
Controlling the Interest Rate
The buying and selling of government securities
by the Fed has two effects at the same time It
changes the money supply, and it changes the
interest rate. How much the interest rate
changes depends on the shape of the money demand
curve. The steeper the money demand curve, the
larger the change in the interest rate for a
given size change in government securities. If
the Fed wants to achieve a particular value of
the money supply, it must accept whatever
interest rate value is implied by this choice.
Conversely, if the Fed wants to achieve a
particular value of the interest rate, it must
accept whatever money supply value is implied by
this.
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The Behavior of the Fed
The Feds Response to the State of the Economy
? FIGURE 13.11 The Feds Response to Low
Output/Low Inflation
During periods of low output/low inflation, the
economy is on the relatively flat portion of the
AS curve. In this case, the Fed is likely to
lower the interest rate (and thus expand the
money supply). This will shift the AD curve to
the right, from AD0 to AD1, and lead to an
increase in output with very little increase in
the price level.
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The Behavior of the Fed
The Feds Response to the State of the Economy
? FIGURE 13.12 The Feds Response to High
Output/High Inflation
During periods of high output/high inflation, the
economy is on the relatively steep portion of the
AS curve. In this case, the Fed is likely to
increase the interest rate (and thus contract the
money supply). This will shift the AD curve to
the left, from AD0 to AD1, and lead to a decrease
in the price level with very little decrease in
output.
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• Krugman on Babysitting the Economy
• Considers a famous case of babysitting credits in
  a local economy and the difficulties that arise
  when there are EITHER too FEW credits (money) in
  circulation or too MANY.

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• The FRB seeks to stay very far away from the
  Hyper inflations and Deflations that have
  occurred in the past.
• In the early 1900s Europe experienced crippling
  inflation and then deflation, an experience that
  left an enduring mark on Keynes.

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Keynes on Evils of Inflation
Tract on Monetary Reform 1923-24 p2.
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UK Inflation-Deflation
Inflation to 1920, deflation there after. Alters
the distribution between the Investing
Class, Business Class, and Earning
Class. Inflation or taxation by currency
depreciation Investing Class Looses 80 of the
value of its gov bonds, 1914-1920 This did not
help business even though real interest rate was
lower (Tract on Monetary Reform p.24) Deflation
or even fear of it reduces employment.
(p36-37) So Keynes objective was price
stability. Book is a plea to focus on internal
stability rather than external gold-standard
stability.
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Germany's 1923 hyperinflation

• Commanding Heights Germany's 1923 hyperinflation
  on PBS