Transcript Inflation

Eco106 W8A
Aggregate Demand and Supply
Case-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
AD
LM #3
LM #2
P is the price level as measured
by the GDP deflator.
r
LM #1
IS
Y
P
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.
That’s the idea of the AD line.
P3
P2
P1
Y
PART III THE CORE OF MACROECONOMIC THEORY
Aggregate Supply
and the Equilibrium
Price Level
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
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Principles of Macroeconomics 9e by Case, Fair and Oster
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”
curve—a 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
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little increase in output from point B to point B’.
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 Fed’s Response to the State of the Economy
FIGURE 13.11 The
Fed’s 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 Fed’s Response to the State of the Economy
FIGURE 13.12 The
Fed’s 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.
• The FRB seeks to stay very far away from
the Hyper inflations and Deflations that
have occurred in the past.
• In the early 1900’s Europe experienced
crippling inflation and then deflation, an
experience that left an enduring mark on
Keynes.
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
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