Transcript Principles of Economics, Case and Fair,9e

Lecture 9
Aggregate Supply and the Equilibrium Price Level
The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning
Aggregate Supply in the Short Run
Shifts of the Short-Run Aggregate Supply Curve
The Equilibrium Price Level
The Long-Run Aggregate Supply Curve
Potential GDP
Monetary and Fiscal Policy Effects
Long-Run Aggregate Supply and Policy Effects
Causes of Inflation
Demand-Pull Inflation
Cost-Push, or Supply-Side, Inflation
Expectations and Inflation
Money and Inflation
Sustained Inflation as a Purely Monetary Phenomenon
The Behavior of the Fed
Controlling the Interest Rate
The Fed’s Response to the State of the
Economy
Fed Behavior Since 1970
Inflation Targeting
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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” curve—a curve that traces out the price
decisions and output decisions of all firms in the
economy under a given set of circumstances.
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The Aggregate Supply Curve
Aggregate Supply in the Short Run
 FIGURE 13.1 The Short-Run
Aggregate Supply Curve
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.
 FIGURE 13.3 The Equilibrium Price
Level
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
 FIGURE 13.4 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.
With planned aggregate expenditure of AE1
and aggregate demand of AD1, equilibrium
output is Y1.
A shift of planned aggregate expenditure to
AE2, corresponding to a shift of the AD curve
to AD2, causes output to rise but the price
level to remain at P1.
If planned aggregate expenditure and
aggregate demand exceed YF, however,
there is an inflationary gap and the price level
rises to P3.
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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
 FIGURE 13.5 A Shift of the
Aggregate Demand Curve When the
Economy Is on the Nearly Flat Part of
the AS Curve
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
 FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near
Maximum Capacity
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.
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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.
 FIGURE 13.7 Cost-Push, or SupplySide, Inflation
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
Cost-Push, or Supply-Side, Inflation
stagflation Occurs when output is falling at the
same time that prices are rising.
 FIGURE 13.8 Cost Shocks Are Bad
News for Policy Makers
A cost shock with no change in
monetary or fiscal policy would shift
the aggregate supply curve from AS0
to AS1, lower output from Y0 to Y1, and
raise the price level from P0 to P1.
Monetary or fiscal policy could be
changed enough to have the AD curve
shift from AD0 to AD1.
This policy would raise aggregate
output Y again, but it would raise the
price level further, to P2.
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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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Causes of Inflation
Money and Inflation
 FIGURE 13.9 Sustained Inflation
From an initial Increase in G and
Central Bank’s Accommodation
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 Central Bank 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 Central Bank 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 Behavior of
Central Bank
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The Behavior of the Fed
Controlling the Interest Rate
The buying and selling of government securities by
the Central Bank 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 Central Bank 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 Central Bank 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 Central Bank’s Response to the State of the Economy
 FIGURE 13.11 The Central Bank’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 Central
Bank 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 Central Bank’s Response to the State of the Economy
 FIGURE 13.12 The Central Bank’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 Central
Bank 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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The Behavior of the Fed
Inflation Targeting
inflation targeting When a monetary authority
chooses its interest rate values with the aim of
keeping the inflation rate within some specified
band over some specified horizon.
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REVIEW TERMS AND CONCEPTS
aggregate supply
aggregate supply (AS) curve
cost-push, or supply-side, inflation
cost shock, or supply shock
demand-pull inflation
equilibrium price level
inflation targeting
potential output, or potential GDP
stagflation
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