aggregate demand and aggregate supply - … slides/lecture 17... · friday 22nd: end of chapter 15...

2013

Aggregate Demand and Aggregate

Supply

Outline

1. Friday 14th : Chapter 16 (AS-AD, demand policies)

2. Monday 18th

Bas Jacobs (45 to 60 minutes interactive lecture on current crisis)

Chapter 17 (debt and stabilization policies)

3. Wednesday 20th : end of Chapter 17 + Chapter 14/15

4. Friday 22nd : end of Chapter 15 + solutions to mock exam

The big picture

Introduction

Short run Medium run Long run

AS-AD in the short run

Aggregate demand and aggregate supply

Output gap

Inflation

AS

AD

Equilibrium on the goods and money market, IS-TR (Chapter 10)

Phillips curve & Okun’s law (Chapter 12)

Introduction

AS-AD in the long run

Output gap

Inflation

LAS

LAD

Introduction

Literature for AS-AD model

Lecture notes + pdf « Notes Chapter 13»

Burda & Wyplosz:

13.3.1 The Fisher equation

13.3.2 The long-run AD curve

13.3.6 Monetary Policy

13.4 – 13.4.3 How to use the AS-AD framework

In the lecture: no international capital markets in this framework (we don’t talk explicitly about exchange rate, but implicitely we assume a flexible exchange rate regime).

Skip the details on the differences between fixed and flexible exchange rate.

Model presented here based on

Mankiw, Macroeconomics, 7th edition of the international edition, Chapter 14, mainly section 14.3 and 14.4

Outline

1. Introduction

2. The Fisher equation

3. Recall: Phillips curve, expectations and aggregate supply

4. Aggregate demand

1. Long run

2. Short run

5. Using the AD-AS framework: Explaining fluctuations

1. Supply shocks

2. Demand shocks

3. Monetary policy

4. The role of Policies

Keeping track of time

We use a dynamic model of aggregate supply and demand.

Therefore: we need to introduce the time dimension

The subscript “t ” denotes the time period, e.g.

Yt = real GDP in period t

Yt -1 = real GDP in period t – 1

Yt +1 = real GDP in period t + 1

We can think of time periods as years, e.g., if t = 2008, then

Yt = Y2008 = real GDP in 2008

Yt -1 = Y2007 = real GDP in 2007

Yt +1 = Y2009 = real GDP in 2009

Introduction

The model’s variables and parameters

Endogenous variables (we see how these evolve over time):

Yt : output

πt: inflation

rt: real interest rate

it: nominal interest rate

: underlying inflation Shows us how last period’s events influences today’s outcome

Exogenous variables (determined outside of our model):

: trend output

: inflation target by CB

Demand shocks: G, T, wealth, consumer confidence…

st : Supply shocks

t~

Y

Introduction

2. … what happens to those?

1. If we change one of these…

The Fisher equation

Central bank sets the nominal interest rate i:

Distinction between nominal and real interest rate

rt : real intrest rate - relevant for spending decisions

it : nominal intrest rate - relevant for money market

: inflation that I expect today will happen between today (year t) and tomorrow (t+1)

Notation: πt : ex-post observed inflation between year t and year t+1

πt-1 : observed inflation between last period (t-1) and today (t)

gapgap bYaii


te

ttt ir

te

t

The Fisher equation

Example:

i= 8%, πte=10%

r=?

r=0,08-0,10= -0,02

Your money will buy 2% fewer goods

Lender: prefers low inflation

Borrower: prefers high inflation

r = only observable ex post

CB fixes the nominal interest rate and long run inflation expectations

ttt ir


Inflation

Unemployment

B

U

Phillips curve:

Short run:

Trade-off between inflation and unemployment possible IF no supply shocks

underlying inflation constant

Un constant.

Long-run:

No trade-off possible between

unemployment and inflation

A

Long run

Short run

Phillips

curves

Phillips curve

1~

2~

tgaptt sbU ~

UUs tttt 0&~

3. Recall: Phillips curve

Underlying inflation

Underlying inflation : expected inflation

Two components

Backward looking component (πt-1)

Forward looking component (long run inflation rate)

For the moment, we assume adaptive expectations.

Adaptive expectations: focus on backward looking component Realistic when π relatively stable

Later & Chapter 16: Incorporate again the forward looking component: Inflation target fixed

by the central bank

~

1~

t

e

ttt


From the Phillips curve to aggregate supply

Infla

tio

n

Output

Aggregate supply

Inflation

Unemployment

(a) Phillips curve

U

Y

Output

Unem

plo

ym

ent

Y

U

(b) Okun‘s law

saYgap ~

sbUgap ~

gapgap hYU


Aggregate supply curve

describes, for each given level of inflation, π, the quantity of output firms are willing to supply, Y

Medium run: upward sloping,

long run: vertical

Derived from the Phillips curve: Inflation unemployment

Aggregate supply curve

tgaptt saY ~

Inflation

Output Y

A B

Long run AS

Short

run AS 1

~

2~

Shift of AS (and Phillips) curve:

• Change in underlying inflation

• Supply shock, s ≠0

• (Change in natural U or natural Y)

3. Recall: Philips curve

Aggregate demand

Aggregate demand curve

all the combinations of output and inflation such that

the market for goods is in equilibrium (IS)

the money market is in equilibrium (TR )

To draw the aggregate demand curve:

How does the equilibrium on the goods and money markets change when prices change?

1. Long run AD curve

2. Short run AD curve

Here: closed or big and open economy (!!DIFFERENT from Ch. 13 of Burda & Wyplosz!!) we do not worry about the exchange rate here

Framework here: based on Mankiw, Macroeconomics, 7th edition of the international edition, Chapter 14

4. Aggregate demand

The model’s long run equilibrium

We know (from the LAS curve) that in the long run

Intersection of LAS and LAD curve: Long run equilibrium of the economy

What determines inflation in the long run?

CB fixes the inflation target and thus long run inflation

It follows:

Real economy gives natural level of real interest rate:

t tY Y

ri

tt ~

tt~

rrt

4.1 Aggregate demand – Long run

The aggregate demand curve in the long run

LAD = target

inflation frate

Central bank chooses a target for the long run inflation Inflation independent from output

Inflation

Output gap

ribYaii gapgap where, :ruleTaylor

4.1 Aggregate demand – Long run

Deriving the short run AD curve:

How does a change in prices affect the equilibrium in the IS-TR model?

Taylor rule:

Interest rate responds not only to changes in Y but also to changes in π ECB: a = 1.5 i ↑ if πgap >0. (note: i increases by more than πgap !)

r increases also (i – π = r)

When inflation changes shift of TR curve If inflation raises, for every level of output, the interest rate will be

higher, so the TR curve shifts up

Aggregate demand curve in the short run

gapgap bYaii

4.2 Aggregate demand – Short run

Taylor rule and inflation

How does the CB change i when inflation increases?

gapgap bYaii

)( gapbYaii

gapbYaππaii

This constant term will change, when π changes

when i

TR

i

Y gap

TR‘

i

0


Rate

of in

flation

Output gap

Inte

rest

rate

Output gap

A

A

Drawing the short run AD curve

At point A:

TR

0

0

gap

We start

from long-run

equilibrium,

where

0

and .

Y

Along TR is

held constant

at .

iiY Y and

i


AD

A ́

Rate

of in

flation

Output gap

Inte

rest

rate

Output gap

TR ́

A

A ́

A

TR

With π : TR TR’.

IS

0

0

Drawing the short run AD curve 4.2 Aggregate demand – Short run

gapgap bYaii

Question:

Why is r automatically

here, after the ECB

increases i according to

the Taylor rule (a = 1.5)?

Nominal and real interest rate Investment, Y

AD slopes downward: When inflation rises, the central bank raises the (real) interest rate, reducing the demand for goods & services.

Ygap

π

AD curve shifts in response to changes in • the inflation target (↑ shifts AD to the right) • demand shocks (ε = changes in G, T, wealth, …) (↑ in demand shift to the right)

ADt

AD determined by changes in the IS-TR equilibrium due to change in inflation

The short run AD curve

BAYgap )(


AS-AD In

flation

0

AS

AD

LAD

LAS

Output gap


Simulation of economic fluctuations Now that we have built our AS-AD model, we can see how

fluctuations emerge.

What are the effects? 1. Supply shock

2. Demand shock

3. Change in monetary policy

4. Contractionary versus expansionary policies

Here we make the assumption of adaptive expectations:

We always start from the LR equilibrium: The only disturbance to the economy is in year t. We then see how the economy adjusts over the years to this disturbance via changes in the interest rate and inflation expectations.

1

~ t

tt

e

t


Period t – 1: initial equilibrium at point A

Period t: Supply shock (s > 0) AS shifts upward, π rises CB responds to

higher π by raising the (real) interest rate, output falls.

Point B

πt – 1

Yt –1

π

ASt -1

Y

AD

A

ASt

Yt

B πt

An adverse supply shock

Y gap

tgaptt saY ~

5.1 AD-AS framework: Supply shock

πt – 1

Yt –1

Period t + 1: Supply shock is over (s = 0) but AS does not return to its initial position due to higher inflation expectations.

Period t + 2: As πt , underlying inflation AS shifts downward Y rises.

π

ASt -1

Y

AD

A

ASt

Yt

B πt

ASt +1

C

ASt +2

D

Yt + 2

πt + 2

This process continues until output returns to its natural rate. LR equilibrium at point A.


Y gap

tgaptt saY ~

1

~ tt


tY

t

A one-period

supply shock

affects output

for many

periods.



t

tBecause

inflation

expectations

adjust only

slowly, actual

inflation

remains high

for many

periods.



tr

The real

interest rate

takes many

periods to

return to its

natural rate.

ti



Period t – 1: at point A

πt – 1

π

ASt -1,t

Y

ADt ,t+1,…,t+4

ADt -1

Yt –1

A

ASt + 1

C

Yt

B πt

Period t: Positive demand shock until t = 4 (ε > 0) AD shifts to the right Y and π .

Period t + 1: Higher inflation in t raises inflation expectations for t + 1 AS shifts up. Y and π even more

Positive demand disturbance

Y gap

5.2 AD-AS framework: Demand shock

πt – 1

π

ASt -1,t

Y

ADt ,t+1,…,t+4

ADt -1

Yt –1

A

ASt + 1

C

ASt +2

D

ASt +3

E

ASt +4

F

Yt

B πt

Periods t + 2 to t + 4 : Higher inflation in previous period raises inflation expectations AS curve continues to shift up. Y and π


Y gap


πt – 1

π

ASfinal

Y

ADt ,t+1,…,t+4

ADt -1, t+5

ASt +5

Yfinal

A

Yt

B πt

Yt + 5

G πt + 5

Period t + 5: AS is higher due to higher π in preceding period, but demand shock ends AD returns to its initial position. Equilibrium in t+5 at point G.

Periods t + 6 and higher: AS gradually shifts down as π and fall, the economy gradually recovers until reaching again LR equilibrium at A.


~

Y gap

F πt + 4

ASt +4


tY

t

The demand

shock raises

output for

five periods.

When the

shock ends,

output falls

below its

natural level,

and recovers

gradually.



t

t

The

demand

shock causes

inflation

to rise.

When the

shock ends,

inflation

gradually

falls toward

its initial

level.



tr

The demand

shock raises the

real interest rate.

After the shock

ends, the real

interest

rate falls and

approaches its

initial level.


ti


Conclusion:

A fiscal policy (or any other demand disturbance) can only increase output temporarily

Economy will always come back to it’s natural output level Either: AD curve shifts back (e.g. fiscal policy not sustainable) back

to natural level of Y (Option 1)

Or: change in underlying inflation leads to upward shift of AS-curve decrease in output and increase in inflation back to natural level of Y (but with higher inflation in the long run, i.e. CB accepts higher π in the long run = higher inflation target) (Option 2)

The role of demand policies

Increasing government expenditure has only an effect on output in the short run, NO impact in the long run


πt – 1

π

ASt -1,t

Y

ADt ,t+1,…,t+4

ADt -1, t+5

Yt –1

A

ASt + 1

ASt +n

Yt

B πt


Y gap

Option 2: AS shifts to new long run equilibrium (point Z). Here CB accepts higher inflation target (LAD shifts up to point Z)

Option 1: AD curve shifts back to initial long run equilibrium in point A (has to be the case when CB doesn’t change the inflation target)

Z

Yfinal

Which option occurs? Depends on CB!

What is the speed the speed of adjustment? This depends on inflation expectations of individuals. (Details Ch. 16)

5.3 AD-AS framework: Monetary policy

A Shift in Monetary Policy

Inflation

Output gap

Inte

rest

rate

Output gap

TR

LAD‘

IS

C

A

0

LAS AS

AD

Long run: lower inflation target no effect on output

LAD

2

1A

CB changes the inflation target and

follows a more restrictive

monetary policy



Inflation

Output gap

Inte

rest

rate

Output gap

TR

LAD‘

B

0

LAS AS

AD‘

AD

IS

Short run: monetary policy has an impact on Y and π

2

LAD 1B

A

TR ́

A

With inflation target : TR TR’.

Shift in TR : AD AD’

( Y )

On TR’: actual inflation above its new target level i and r investment , Y

BA Ygap )(


Period t – 1: target inflation rate = 2%, initial equilibrium: point A

πt – 1 = 2%

Yt –1

Period t: CB lowers inflation target to = 1%, raises i and r to reduce π. AD shifts left Y and π . New eq. : point B

Y gap

π

ASt -1, t

Y

ADt – 1

A

ADt, t + 1,…

Yt

πt B

Z πfinal = 1%

,

Yfinal



πt – 1 = 2%

Yt –1

π

ASt -1, t

Y

ADt – 1

A

ADt, t + 1,…

ASfinal

Yt

πt B

ASt +1

C

Subsequent periods: This process continues until output returns to its natural rate and inflation reaches its new target.

Z πfinal = 1%

,

Yfinal

A Shift in Monetary Policy Period t + 1: The fall in πt reduces inflation expectations because AS shifts down Y , π

~t ~

Y gap


Response to a reduction in target inflation

tY

Reducing

causes

output to fall

below its

natural level

for a while.

Output

recovers

gradually.

t


t

Because

expectations

adjust slowly,

it takes many

periods for

inflation to

reach the new

target.

t

Response to a reduction in target inflation 5.3 AD-AS framework: Monetary policy

tr

To reduce

inflation,

the CB raises i

and r to reduce

aggregate

demand

new eq in IS-

TR.

r gradually

returns to its

natural rate.

t

Response to a reduction in target inflation 5.3 AD-AS framework: Monetary policy

ti

CB raises i in t.

As inflation

falls, the

nominal rate

falls too.

ri

π r i

Response to a reduction in target inflation

t


So far:

Central bank only follows its predetermined Taylor Rule (except in case of shift in monetary policy)

Government is not intervening to reduce the initial shock.

Now:

What can policy makers do in case of a negative demand or supply shock? Fiscal policy

Monetary policy

Expansionary Contractionary

Role of expectations: importance of forward looking component of underlying inflation

Supply shock & demand policies 5.4 Policy responses to shocks

LAD

AS ́LAS

AS

AD

Inflation

0

B

Stagflation results: both unemployment and inflation increase.

Output gap

A

Adverse supply shock

If s >0 Shift in the AS curve:

saYgap ~

5.4 Policy responses to shocks

Supply shock & demand policies

Suppose we try to fight resulting unemployment with expansionary demand policies...

AD ́

AS ́LAS

LAD

AD

Inflation

0

B

C

We successfully fight unemployment, but at a cost of increased inflation in the long-run.

New equilibrium at C.

Output gap

A


... or we try to fight the inflationary impact of the adverse supply shock through a contractionary policy.

LAD

AD´́

AS ́LAS

AD

AS

Inflation

0

B

D

We successfully fight π but at a cost of increased unemployment (via point D) until we return to the long-run equilibrium at A.

Output gap

A


Third option: Central bank announces credibly that inflation will be at its target level.

LAD

AS ́LAS

AD

AS

Inflation

0

B

If people expect inflation to be at its target level, AS curve shifts back to its original position.

We return directly to the long-run equilibrium at A.

Output gap

A


AD ́

LAS

AD

AS

Inflatio

n

0

A

B

Output gap

Adverse demand shock

An adverse demand shock brings the economy from point A to point B…


AD ́

LAS

AD

AS

Inflation

0

A

B

Output gap

Adverse demand shock

AD policy change to offset demand shock

Here: To go back to point A: Expansionary fiscal or expansionary monetary policy


aggregate demand and aggregate supply - … slides/lecture 17... · friday 22nd: end of chapter 15...

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