Frank & BernankeFrank & Bernanke

Ch. 15: Inflation, Aggregate Demand, and Aggregate Supply

Output Gaps and PoliciesOutput Gaps and PoliciesAD > Y* => Expansionary GapAD < Y* => Recessionary GapPolicies to eliminate gaps:

– Fiscal policies G increase/decrease T increase/decrease

– Monetary policies Money supply increase/decrease (r increase/decrease)

Shortcoming of the Keynesian Shortcoming of the Keynesian CrossCrossIt keeps prices constant.

How does one include inflation into the Keynesian cross?

Explain what happens to AD at higher levels of inflation and use this new diagram.

Include the self-correcting mechanism of the economy by differentiating short run aggregate supply (Keynesian) from the long run aggregate supply (Classical).

Aggregate DemandAggregate Demand

AD = C + I + G + NXC = C (Y, r)I = I (r)When Y up => C up => AD upWhen r up => I down, C down => AD

down

Why Does Aggregate Demand Why Does Aggregate Demand Fall When Inflation Rises?Fall When Inflation Rises?

When up => Fed Policy Reaction Function raises r => I and C down => AD down– Fed Policy Reaction Function (Example: Taylor

rule): r = 0.01 - 0.5[(Y*-Y)/Y*] + 0.5

Taylor RuleTaylor Ruler = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π

How does the Fed react when inflation rises?

How does the Fed react when output gaps appear?

What will the real and nominal interest rates be givendifferent values?

Fed Policy Reaction FunctionFed Policy Reaction Function

r

Zero percent Output Gap

Expansionary Gap

Recessionary Gap

Why Does Aggregate Demand Why Does Aggregate Demand Fall When Inflation Rises?Fall When Inflation Rises?

When up => wealth held in money form erodes => C down => AD down

When up => MPC falls because the poor are affected more than the rich => multiplier falls => AD flatter

When up => at constant exchange rates our exports become more expensive and our imports become cheaper => NX falls => AD falls

Deriving ADDeriving ADGiven C and I, find the AD if Fed has a

policy reaction function to determine r for different inflation rates.

C = 400 + .9 (Y - T) - 300rI = 300 - 800rT = 200; G = 250; NX = 20r = 0.01 + 0.5

Deriving ADDeriving AD

r Y0.02 0.02 76800.04 0.03 75700.06 0.04 7460

Y = 790 + .9Y - 1100r.1Y = 790 - 1100rY = 7900 - 11000r

π

Y

Shifts in ADShifts in ADChanges in autonomous aggregate demand.

– Autonomous C– Autonomous I– Taxes– Government purchases– Net exports

Changes in Fed’s policy reaction function– Tightening of monetary policy– Easing of monetary policy

Shifting of ADShifting of ADIncrease in autonomous spending shifts AD

right.Tightening of monetary policy raises r and

shifts AD left.Easing of monetary policy lowers r and

shifts AD right.Changes in inflation are movements along

the AD curve.

Shifting of ADShifting of ADSuppose autonomous consumption

increased from 400 to 410 and autonomous investment increased from 300 to 305.

At the same time, taxes are increased to 210.

What is the new AD?Old AD was Y = 7900 – 11,000rY = 7960 – 11,000r

Shifting ADShifting AD

r Y Y'0.02 7680 77400.03 7570 76300.04 7460 7520

Movement Along ADMovement Along ADAny change in the vertical axis shows as a

movement along the AD line, just like demand and supply (changes in P).

The vertical axis measures the inflation rate.Therefore, any change in the inflation rate

is shown as a movement along the AD line.

Why Inflation Rate Doesn’t Why Inflation Rate Doesn’t Change?Change?

Inflation has inertia.– Inflationary expectations tend to keep inflation

constant.– Contracts include expected inflation.

Long term contracts keep inflation constant.

Why Inflation Rate Changes?Why Inflation Rate Changes?1. Output Gap.

1. Expansionary output gaps (Y>Y*)

2. Inflation shock1. An increase in price of inputs that raise the

cost of production for a significant portion of the economy. (Oil; wages for national unions).

3. Shock to potential output1. Disasters.

Output Gaps and InflationOutput Gaps and Inflation

Expansionary gap (Y > Y*) => Inflation rises.

Recessionary gap (Y < Y*) => Inflation falls.

No output gap (Y = Y*) => Inflation remains the same.

Inertia and Output GapsInertia and Output Gaps

Y*Y

LRAS

SRAS

AD

Inflation

Long Run EquilibriumLong Run Equilibrium

Y*Y

LRAS

SRAS

AD

Inflation

Expansionary GapsExpansionary GapsHow will an expansionary gap look in an

AD-AS diagram?How will the economy adjust to the

expansionary gap?What will happen to SRAS in the long-run?Keynesian - Classical dilemma.

Expansionary GapExpansionary GapInflation

YY*

Identify the lines and explain the short and long run changeswhen there is no government intervention.

Excessive ADExcessive ADShifts in AD that create expansionary

output gaps will raise inflation rate.– G increase: military buildup of 1960s and

1980s.– Inflation rose in the sixties but did not in the

eighties. The Fed’s policy stand is the answer.

Inflation ShocksInflation ShocksOil price shock of the seventies pushed the

inflation up: SRAS shifts up.If the Fed doesn’t respond recessionary gap

will be eliminated in the long run.If the Fed does respond to recession, AD

will be shifted to the right but the long run equilibrium will take place at the higher inflation rate.

Inflation ShockInflation ShockInflation

YY*

Shock to Potential OutputShock to Potential OutputIf a disaster happens or capital becomes

obsolete or expensive to use, Y* shifts left.Again, stagflation occurs, just like when

inflationary shocks takes place.Long run equilibrium will be at a higher

inflation rate and lower Y.

Shock to Potential OutputShock to Potential Output

Y

Inflation

Y*

Lowering InflationLowering InflationSuppose the country is experiencing double

digit inflation.Because of inflationary expectations and

contracts, the inflation will remain at that level.

However, to eliminate the costs of inflation, the Central Bank embarks in a new monetary policy.

Show the short and long run effects.

Lowering InflationLowering Inflation

Time

GDP

Infl’n

rY*

Inflation