mbmc inflation and aggregate supply principles of macroeconomics, by ben bernanke & robert...
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MB MC
Inflation and Aggregate Supply
Inflation and Aggregate Supply
Principles of Macroeconomics,
by Ben Bernanke & Robert Frank,
2nd Ed, 2004.
Chapter 15: Inflation and Aggregate Supply Slide 2
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation, Spending, and Output: The Aggregate Demand Curve
Aggregate Demand (AD) CurveShows the relationship between short-run
equilibrium output Y and the rate of inflation,
The name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy
Chapter 15: Inflation and Aggregate Supply Slide 3
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation, Spending, and Output: The Aggregate Demand Curve
Inflation, the Fed, and the AD CurveThe (simple) Keynesian model assumes
output adjusts to demand at preset prices in the short run.
Prices do not remain fixed indefinitely.The (simple) Keynesian model does not
explain the behavior of inflation.
Chapter 15: Inflation and Aggregate Supply Slide 4
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Aggregate Demand Curve
Output Y
AD
Aggregate Demand Curve
An increase in reduces Y(all other factors held constant)
Infl
atio
n
Chapter 15: Inflation and Aggregate Supply Slide 5
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation, Spending, and Output: The Aggregate Demand Curve
Inflation, the Fed, and the AD CurveA primary objective of the Fed is to
maintain a low and stable inflation rate.Inflation is likely to occur when Y > Y*
(Y* = Potential Output).To control inflation, the Fed must keep Y
from exceeding Y*
Chapter 15: Inflation and Aggregate Supply Slide 6
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation, Spending, and Output: The Aggregate Demand Curve
Inflation, the Fed, and the AD CurveThe Fed can reduce autonomous
expenditure by raising the interest rate.
increases => r increases => autonomous spending decreases => Y decreases (AD curve)
Chapter 15: Inflation and Aggregate Supply Slide 7
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation, Spending, and Output: The Aggregate Demand Curve
Other Reasons for the Downward Slope of the AD Curve (independent of Fed Policy)Real Balance Effect (stored money wealth)Distributional effectsUncertaintyPrices of domestic goods and services sold
abroad
Chapter 15: Inflation and Aggregate Supply Slide 8
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Effect of An Increase In Exogenous Spending
Output Y
ADExogenous Spending: spending unrelated to Y or r• Fiscal policy•Technology•Foreign demand
AD’
An increase in exogenous spending shifts AD to AD’ and vice versaIn
flat
ion
Chapter 15: Inflation and Aggregate Supply Slide 9
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
A Shift In The Fed’s Policy Reaction FunctionR
eal i
nte
rest
rat
e se
t b
y F
ed, r
Output YInflation
Infl
atio
n
New policy reaction function
Fed “tightens” monetary policy – shifting reaction curve
Old policy reaction function
AD
AD’
The new Fed policy increases r and AD shifts to AD’
Chapter 15: Inflation and Aggregate Supply Slide 10
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
A Virtuous Circle of Low Inflation and Low Expected Inflation
Chapter 15: Inflation and Aggregate Supply Slide 11
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Output Gap and Inflation
Relationship of outputto potential output Behavior of inflation
1. No output gap Inflation remains unchangedY = Y*
2. Expansionary gap Inflation rises
Y > Y*
3. Recessionary gap Inflation falls
Y < Y*
Chapter 15: Inflation and Aggregate Supply Slide 12
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation andAggregate Supply
The Output Gap and InflationIf Y* = Y
An increase in exogenous spending creates and expansionary gap (Y > Y*) – inflation increases
A decrease in exogenous spending creates a recessionary gap (Y < Y*) and inflation decreases
Chapter 15: Inflation and Aggregate Supply Slide 13
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramLong-run aggregate supply (LRAS)
A vertical line showing the economy’s potential output Y*
Chapter 15: Inflation and Aggregate Supply Slide 14
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation andAggregate Supply
The Aggregate Demand—Aggregate Supply DiagramShort-run Aggregate Supply (SRAS)
A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions
Chapter 15: Inflation and Aggregate Supply Slide 15
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Aggregate Demand-Aggregate Supply (AD-AS) Diagram
Output
No
min
al in
tere
st r
ate
i
Aggregate demand, AD
Long-run aggregate
supply, LRAS
A
Y*Y
Short-run aggregate supply, SRAS
Short-run equilibrium•Y: SRAS() = AD•Y < Y* -- recessionary gap and Y adjust to the gap
decreases & Y increases
Long-run equilibrium• AD, SRAS (*), LRAS (Y*)
will intersect at the same point
Chapter 15: Inflation and Aggregate Supply Slide 16
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Inflation andAggregate Supply
A Review of the Adjustment Process to a Recessionary GapFirms that are selling less than they want
to will start to lower prices.As falls the Fed lowers r and AD
increases.Falling reduces uncertainty which also
increases AD
Chapter 15: Inflation and Aggregate Supply Slide 17
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Adjustment of Inflation When A Recessionary Gap Exists
Output
Infl
atio
n
AD
LRAS
A
Y
SRAS
Y*
SRAS’B
*
Chapter 15: Inflation and Aggregate Supply Slide 18
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Adjustment of Inflation When A Expansionary Gap Exists
Output
Infl
atio
nLong-run aggregate
supply LRAS
A
AD
Y* Y
SRAS
B
Short-run Eq. Y•Expansionary gap Y > Y* rises, AD falls – Y falls•Long-run equilibrium at Y*, *
* SRAS’
Chapter 15: Inflation and Aggregate Supply Slide 19
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
War and Military Buildup As A Source of Inflation
Output
Infl
atio
n
Output
Infl
atio
n
Y
B
AD’
Y
B
AD’
•Increase in military spending causes AD to increase•Creates an expansionary gap -- Y > Y*
AD
LRAS
A
Y*
SRAS
LRAS
A
Y*
SRAS
’SRAS’C
increases shifting SRAS to SRAS’•Long-run equilibrium back to Y* with *
Chapter 15: Inflation and Aggregate Supply Slide 20
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Effects of An Adverse Inflation Shock
Output
Infl
atio
n
AD’
C
• No policy -- falls; long-run eq. at A• With policy--AD shifts to AD’; Y = Y*; rises
to *
AD
LRAS
A
Y*
SRAS
• Equilibrium @ A--Y* = Y
Y’
BSRAS’
• Inflation shock, increases to ‘ (SRAS’)• Short-run eq. At B, Y < Y*; recessionary gap
and higher inflation (stagflation)
’
Chapter 15: Inflation and Aggregate Supply Slide 21
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Effects of a Shock To Potential Output
Output
Infl
atio
n
AD
LRAS
A
Y*
SRAS
•Equilibrium at A -- Y* = Y
Y*’
BSRAS’
LRAS’ •Y* falls to Y*’•Y > Y* -- expansionary gap increases--SRAS rises to SRAS’•Equilibrium at B
•Y = Y*’ increased to ‘ •Decline in output is permanent
’
Chapter 15: Inflation and Aggregate Supply Slide 22
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Sources of Inflation
Shocks to Potential OutputAggregate supply shock
Inflation shockso Stagflationo Temporary reduction in output
Chapter 15: Inflation and Aggregate Supply Slide 23
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Sources of Inflation
Shocks to Potential OutputAggregate supply shock
Potential output shockso Stagflationo Permanent reduction in output
Chapter 15: Inflation and Aggregate Supply Slide 24
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Sources of Inflation
Economic NaturalistWhy was the United States able to
experience rapid growth and low inflation in the latter part of the 1990s?
Chapter 15: Inflation and Aggregate Supply Slide 25
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
U.S. Macroeconomic Data, Annual Averages, 1985-2000
% Growth in Unemployment Inflation ProductivityYears real GDP rate (%) rate (%) growth (%)
1985-1995 2.8 6.3 3.5 1.4
1995-2000 4.0 4.6 2.4 2.5
Chapter 15: Inflation and Aggregate Supply Slide 26
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Economic Naturalist
Output
Infl
atio
n
AD
•Equilibrium at B -- Y*’ = Y
Y*’
BSRAS’
LRAS’
’
LRAS
A
Y*
SRAS
•Productivity increases•Y*’ shifts to Y*•Recessionary gap -- Y*’ < Y* falls to •Equilibrium at A
•Lower inflation; higher output
Chapter 15: Inflation and Aggregate Supply Slide 27
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
AD
LRAS
A
Y*
SRAS10%•Eq. At A (Y = Y*) = 10%
Short-Run Effects of an Anti-inflationary Monetary Policy
Output
Infl
atio
n
Y
B
AD’
•Fed shifts AD to AD’•Short run eq. At B•Y < Y* -- recessionary gap•Long run correction occurs
Chapter 15: Inflation and Aggregate Supply Slide 28
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Long-Run Effects of an Anti-inflationary Monetary Policy
Output
Y*
Infl
atio
nLRAS
C
Y
SRASB
AD’
10%
•Short-run eq. at B•Recessionary gap -- Y < Y*
SRAS’3%
falls to 3% and Y rises to Y*•Long-run eq. -- lower prices @ Y*
Chapter 15: Inflation and Aggregate Supply Slide 29
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
U.S. MacroeconomicData, 1978-1985
Nominal Real% Growth in Unemployment Inflation interest interest
Years real GDP rate (%) rate (%) rate (%) rate (%)
1978 5.5 6.1 7.6 8.3 0.7
1979 3.2 5.8 11.4 9.7 -1.7
1980 -0.2 7.1 13.5 11.6 -1.9
1981 2.5 7.6 10.3 14.4 4.1
1982 -2.0 9.7 6.2 12.9 6.7
1983 4.3 9.6 3.2 10.5 7.3
1984 7.3 7.5 4.3 11.9 7.6
1985 3.8 7.2 3.6 9.6 6.0
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