Transcript Document

Inflation and
Aggregate Supply
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
Inflation and Aggregate Supply
 Where does inflation come from?
– If people, businesses and government demand
more goods, their prices will rise.
– But if firms produce more goods, their prices will
fall.
 Inflation is determined by the interaction of
Aggregate Demand and Aggregate Supply
for goods and services.
Copyright c 2004 by The McGraw-Hill
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Chapter 28: Inflation and
Aggregate Supply
2
The Aggregate Demand Curve
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Aggregate Demand (AD) Curve
– Shows the
relation between
short-run equilibrium output Y
and the rate of inflation, .
– For AD, changes in  cause changes in Y.
Copyright c 2004 by The McGraw-Hill
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Chapter 28: Inflation and
Aggregate Supply
4
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Aggregate Demand (AD) Curve
– The name of the curve reflects the fact that
short-run equilibrium output is determined by,
and equals, total planned spending in the
economy.
– Increases in inflation reduce planned spending
and short-run equilibrium output, so the
aggregate demand curve is downward-sloping.
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Chapter 28: Inflation and
Aggregate Supply
5
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Inflation and the AD Curve
– The Keynesian model assumes output adjusts
to demand at preset prices in the short run.
– Prices do not remain fixed indefinitely: this
means there can be inflation.
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Chapter 28: Inflation and
Aggregate Supply
6
The Aggregate Demand Curve
 The Income-Expenditures Model (chapter 26)
told us that equilibrium output is given by

 1 
Y 
 C  cT  I  G  NX
1 c 

 and that, including the effect of interest rates on
C and I (chapter 27)

 1 
Y 
 C  cT  I  G  NX  (a  b)r
1 c 

 This means real interest rates and equilibrium
output are inversely related.
Eq 1
The Aggregate Demand Curve
 Where does r come from?
 It is the real opportunity cost of holding a
real stock of money
– That is, holding an X amount of purchasing
power in the form of money.
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Chapter 28: Inflation and
Aggregate Supply
8
The Aggregate Demand Curve
 People’s Real Money Holdings are.
M
P
 Let’s think in terms of growth rates.
M
– M rises at “the rate of money growth,”
.
M
– P rises at “the rate of inflation”, .
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Chapter 28: Inflation and
Aggregate Supply
10
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Inflation and Real Balances
M
P
M
 If
> , Real Money Holdings rise.
M
– People’s money has more value, so spending
rises.
M
 If  > M , Real Money Holdings fall.
– People’s money has less value, so spending
falls.
Chapter 28: Inflation and
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Aggregate Supply
11
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Inflation reduces the real money supply,
leading to a higher cost of borrowing money.
 As interest rates rise, expenditure falls.
M
 >m
M
M
P
i
I,C
Y
M
 <m
M
M
P
i
I,C
Y
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Chapter 28: Inflation and
Aggregate Supply
14
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Inflation reduces the real money supply,
leading to a higher cost of borrowing money.
 As interest rates rise, expenditure falls.
M
 >m
M
M
P
↓
i↑
I ↓, C ↓
Y↓
M
 <m
M
M
P
↑
i↓
I ↑, C ↑
Y↑
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Chapter 28: Inflation and
Aggregate Supply
15
The Aggregate Demand
Curve
An increase in  reduces Y
(all other factors held constant)
Inflation 
High  means
lower M/P, higher
i,
lower C, I, and Y
Aggregate Demand Curve
Low  means
higher M/P, lower
i,
higher C, I, and
Y
AD
Output Y
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Chapter 28: Inflation and
Aggregate Supply
20
The Aggregate Demand
Curve
Inflation 
An increase in  reduces Y
(all other factors held constant)
Aggregate Demand Curve
AD
Output Y
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Chapter 28: Inflation and
Aggregate Supply
21
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Other Reasons for the Downward Slope of
the AD Curve
– Distributional effects.
 Poorer people are more hurt by inflation (less
financially sophisticated) and they spend more out of
their disposable income.
– Uncertainty.
– Prices of domestic goods and services sold
abroad.
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Chapter 28: Inflation and
Aggregate Supply
22
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Movements Along the AD Curve
–  and Y are inversely related
– Changes in  cause a change in Y
– This means a movement along the AD curve
–  increases r increases planned
spending decreases Y decreases
– Note: the real balances function is unchanged.
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Chapter 28: Inflation and
Aggregate Supply
24
Inflation, Spending, and Output: The
Aggregate Demand Curve
 Shifts of the AD Curve
– Any factor that changes Y at a given  shifts the
AD curve.
– Shifts of the AD curve can be caused by:
 Changes in exogenous spending.
– Higher G or Lower T
– Higher I or Higher C
– Higher NX
 Changes in the Fed’s anti-inflation stance.
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Chapter 28: Inflation and
Aggregate Supply
26
Effect of A Shift In The Fed’s
Policy Reaction Function: A Shift in AD
 Shifts of the AD Curve
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AD’
Inflation 
– In the early 1980s, the
Fed raised interest
rates dramatically,
causing two major
recessions.
– This shifted the AD
curve to the left: Y fell
at any level of .
AD
Output Y
The new Fed policy increases r
and AD shifts to AD’
Chapter 28: Inflation and
Aggregate Supply
27
Effect of An Increase In Exogenous
Spending: A Shift of AD
AD’
Inflation 
AD
Exogenous Spending: spending
unrelated to Y or r
• Fiscal policy turns
expansionary
•Confidence rises
•Foreign demand increases
An increase in exogenous
spending shifts AD to AD’ and
vice versa
Output Y
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Chapter 28: Inflation and
Aggregate Supply
28
The Aggregate Supply Curve
Inflation and
Aggregate Supply
 Inflation will remain roughly constant if the
economy is operating at Y* and there are no
external shocks to the price level.
 We refer to this as “inflation inertia.”
– In physics, inertia refers to the propensity of
bodies to maintain a constant speed once
forces have stopped acting on them.
– Here, we mean that inflation tends to stay
constant unless something happens.
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Chapter 28: Inflation and
Aggregate Supply
37
Inflation and
Aggregate Supply
 Inflation Inertia
– In industrial economies (U.S.), inflation tends to
change slowly from year to year.
– The inflation inertia occurs for two reasons:
 Inflation expectations
 Long-term wage and price contracts
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Chapter 28: Inflation and
Aggregate Supply
38
A Virtuous Circle of Low Inflation and
Low Expected Inflation
If workers expect  = 3%, they will ask for a 3% raise to keep their purchasing
power.
If firms give a 3% wage raise, they will raise their prices by no less than 3% to
keep their profits; but by no more
than 28:
3%Inflation
to stay
Chapter
andcompetitive. So  will be …?
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Aggregate Supply
39
Inflation and
Aggregate Supply
 Long-term Wage and Price Contracts
– Union wage contracts set wages for several
years.
– Contracts setting the price of raw materials and
parts for manufacturing firms also cover several
years.
– These long-term contracts reflect the inflation
expectations at the time they are signed.
– So if unions expected =3% in 2001, their
expectations will affect actual  for years to
come.
Chapter 28: Inflation and
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Aggregate Supply
40
Inflation and
Aggregate Supply
 The Output Gap and Inflation
– Now suppose you are selling all your production
and you are using your resources at normal
rates.
 The output gap is zero.
– You will try to remain competitive: don’t raise
prices too much, not too little. Raise prices as
much as wages and other costs.
– So if everyone else raises prices and costs by
3%, you raise them by 3%.
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Chapter 28: Inflation and
Aggregate Supply
41
Inflation and
Aggregate Supply
 The Output Gap and Inflation
– If everyone else raises prices and costs by 3%,
you raise them by 3%.
– You try to keep your relative price (that is, your
price relative to all other goods) constant.
– This means that if the output gap is zero,
inflation is constant.
 This is what we mean by inflation inertia.
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Chapter 28: Inflation and
Aggregate Supply
42
The Output Gap and Inflation
Relationship of output
to potential output
1. No output gap
Y = Y*
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Behavior of inflation
Inflation remains unchanged
Chapter 28: Inflation and
Aggregate Supply
43
The Aggregate Demand Aggregate Supply Diagram
The Aggregate Demand - Aggregate
Supply Diagram
 Short-run Aggregate Supply (SRAS)
– A horizontal line showing the current rate of
inflation, as determined by past expectations
and pricing decisions.
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Chapter 28: Inflation and
Aggregate Supply
45
Inflation, 
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Short-run
aggregate
supply, SRAS
Y*
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Chapter 28: Inflation and
Aggregate Supply
Output
46
The Aggregate Demand - Aggregate
Supply Diagram
 Short-run Equilibrium
– Because inflation is inertial, it just is whatever is
consistent with past pricing decisions.
 This inertial  implies a certain level of M/P, which
determines the interest rate and expenditure.
– Output is demand-determined in the short-run.
 Changes in autonomous expenditure change Y.
– Graphically, short-run equilibrium occurs at the
intersection of the AD curve and the SRAS line.
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Chapter 28: Inflation and
Aggregate Supply
48
The Aggregate Demand - Aggregate
Supply Diagram
 Short-run Equilibrium
– A situation in which
Inflation = the value determined by past expectations and
pricing decisions
And
Output = the level of short-run equilibrium output that is
consistent with that inflation rate.
– Short-run equilibrium occurs at the intersection of the
AD curve and the SRAS line.
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Chapter 28: Inflation and
Aggregate Supply
49
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Short-run
aggregate
supply, SRAS
Short-run
equilibrium
•Y: SRAS() = AD
•Given the level of ,
M and G are
relatively low.
•Y < Y* -recessionary gap
Inflation, 
A
Aggregate demand,
AD
Y
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Y*
Chapter 28: Inflation and
Aggregate Supply
Output
50
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Short-run
aggregate
supply, SRAS
Inflation, 
A
Short-run equilibrium
•Y: SRAS() = AD
•Given the level of , M
and G are relatively
high.
•Y > Y* -- expansionary
gap
Aggregate demand,
AD
Y*
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Y
Chapter 28: Inflation and
Aggregate Supply
Output
51
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Short-run
aggregate
supply, SRAS
Inflation, 
A
Short-run
equilibrium
•Y: SRAS() = AD
•Given the level of ,
M and G are just
right.
•Y = Y* -- no gap
Aggregate demand,
AD
Y*
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Chapter 28: Inflation and
Aggregate Supply
Output
52
The Aggregate Demand - Aggregate
Supply Diagram
 This is just the old Keynesian model of
chapter 26.
– In chapter 26, prices were exogenous. Here
inflation is exogenous. (It just “is”).
– Different levels of autonomous expenditure, of
G and T, and of M lead to different levels of Y.
– Output is demand-determined.
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Chapter 28: Inflation and
Aggregate Supply
53
The Aggregate Demand - Aggregate
Supply Diagram
 Output is demand-determined: is this a good
thing or a bad thing?
– It’s good: we, as a society, can choose the level
of output we like.
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Chapter 28: Inflation and
Aggregate Supply
54
The Aggregate Demand - Aggregate
Supply Diagram
 Output is demand-determined: is this a good
thing or a bad thing?
– It’s bad: if we don’t coordinate our decisions
properly, expenditure may be too low, and we
may end up with high unemployment.
– Recessions and over-expansions can happen
(and do happen) all the time. In the short-run,
the economy can’t correct itself.
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Chapter 28: Inflation and
Aggregate Supply
55
Is the economy self-correcting in the
short run?
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images/homeless%2520family%2520big.JPG&imgrefurl=http://bolivia.f
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%3Dactive%26rls%3DGGLD,GGLD:2004-49,GGLD:en
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tory.homeless.jpg
Chapter 28: Inflation and
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Aggregate Supply
Companies,
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g
56
Is the economy self-correcting in the
short run?
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http://interactive.pfaw.org/images/unemployment_line.gif
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Chapter 28: Inflation and
Aggregate Supply
57
Is the economy self-correcting in the
short run?
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Chapter 28: Inflation and
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58
The Adjustment Process to an
Output Gap
Inflation and
Aggregate Supply
 Three factors that can increase the inflation
rate
– Output gap
– Inflation shock
– Shock to potential output
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Chapter 28: Inflation and
Aggregate Supply
60
Inflation and
Aggregate Supply
 The Output Gap and Inflation
– Recessionary Gap:
 If people are unemployed, they reduce their wage
demands.
 Lower wage rises lead to lower inflation.
– This process may take a long time.
 Long-term wage contracts.
 People’s life plans (college, vacations, social status)
around their wages.
– Taking a pay cut or slower wage growth is very traumatic.
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Chapter 28: Inflation and
Aggregate Supply
61
Inflation and
Aggregate Supply
 The Output Gap and Inflation
– Expansionary Gap:
 If people are working overtime too much, they
demand faster raises.
 Higher “wage inflation” leads to higher inflation.
– This process may be very fast.
 People are always happy to take higher wages or to
raise prices.
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Chapter 28: Inflation and
Aggregate Supply
62
The Phillips Curve
Strong
workers
Inflation
=> speeds up
Needs 10 workers:
Unemployment is low
Weak => Inflation
falls
workers
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Chapter 28: Inflation and
Aggregate Supply
Needs 10 workers:
Unemployment is high
63
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
After being laid off from her job as a manager at Ford Motor
Co.'s [Mexican] unit, [Karina] Maldonado searched
unsuccessfully for a job for months before settling on a
position selling cars at a Volkswagen AG dealership. Her
commute is two hours and her pay is half of what she
earned at Ford.
“At first I looked for something close to home and well- paid,”
Maldonado, who ran the auto parts division at Ford's Land
Rover unit in Mexico … . “Then I said I'd take something
anywhere, as long as it was in planning. In the end, I didn't
care as long as it was a job.”
“Mexican Jobless Rate Has Biggest Rise in Almost Decade, Jan. 21, 2004”
(Bloomberg)
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Chapter 28: Inflation and
Aggregate Supply
64
The Output Gap and Inflation
Relationship of output
to potential output
Behavior of inflation
1. No output gap
Y = Y*
Inflation remains unchanged
2. Expansionary gap
Y > Y*
Inflation rises
3. Recessionary gap
Y < Y*
Inflation falls


For AS, changes in Y cause changes in .
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Chapter 28: Inflation and
Aggregate Supply
65
Inflation, 
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Y > Y*
Inertial level of
inflation
Y < Y*
Y*
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Chapter 28: Inflation and
Aggregate Supply
Output
66
Inflation and
Aggregate Supply
 The Output Gap and Inflation
– Suppose we start from 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.
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Chapter 28: Inflation and
Aggregate Supply
67
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
 OVER a period of TIME,
if there’s a recession, wages will fall.
– The “speed of adjustment” depends on
 Wage and price contracts
 Cultural norms
 Laws and regulations
 The country’s experience with inflation and
disinflation.
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Chapter 28: Inflation and
Aggregate Supply
68
The Aggregate Demand - Aggregate
Supply Diagram
 In Short-run Equilibrium
– Y may or may not = Y*
 Remember there’s no reason for the economy to be
producing at full employment of resources in the
short run.
– The inflation rate may or may not be stable.
 If Y > Y*, inflation will rise
 If Y < Y*, inflation will fall
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Chapter 28: Inflation and
Aggregate Supply
69
The Aggregate Demand - Aggregate
Supply Diagram
 Short-run Aggregate Supply (SRAS)
– If Y<Y*, SRAS shifts down.
– If Y>Y*, SRAS shifts up.
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Chapter 28: Inflation and
Aggregate Supply
70
Inflation, 
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Short-run
aggregate
supply, SRAS
Y*
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Chapter 28: Inflation and
Aggregate Supply
Output
71
The Aggregate Demand - Aggregate
Supply Diagram
 Long-run Equilibrium
– A situation in which
actual output = potential output
and
the inflation rate is stable.
– Graphically, long-run equilibrium occurs when
the AD curve and the SRAS line intersect at
potential output.
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Chapter 28: Inflation and
Aggregate Supply
72
The Aggregate Demand - Aggregate
Supply Diagram
 Long-run aggregate supply (LRAS)
– A vertical line showing the economy’s potential
output Y*.
– Potential Output is independent of inflation.
 It depends on human capital, physical capital,
technology, laws, etc.
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Chapter 28: Inflation and
Aggregate Supply
73
The Aggregate Demand-Aggregate
Supply (AD-AS) Diagram
Inflation, 
Long-run aggregate supply, LRAS
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Chapter 28: Inflation and
Aggregate Supply
Y*
Output
74
The Aggregate Demand - Aggregate
Supply Diagram
 A Review of the Adjustment Process
– Suppose there is a Recessionary Gap
– Firms that are selling less than they want to will
start to slow down prices.
– Workers whose job is in danger slow down
wage demands.
– As  falls, the real money supply expands,
interest rates fall, and spending increases.
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Chapter 28: Inflation and
Aggregate Supply
76
The Aggregate Demand - Aggregate
Supply Diagram
 A Review of the Adjustment Process
– As Y increases, cyclical unemployment falls
(Okun’s Law).
– Adjustment continues until long-run equilibrium
is reached.
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Chapter 28: Inflation and
Aggregate Supply
77
The Adjustment of Inflation
When A Recessionary Gap Exists
LRAS
Inflation

*
A
SRAS’
SRAS
B
SRAS’
AD
YChapter 28: Inflation
Y* and
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Aggregate Supply
Output
78
The Adjustment of Inflation
When A Expansionary Gap Exists
Inflation
Long-run
aggregate
supply LRAS
B
*
Short-run Eq. Y
•Expansionary gap Y > Y*
•The economy overheats.
• rises, spending falls – Y falls
•Long-run equilibrium at Y*, *
SRAS’
A

SRAS
AD
Output
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Y*
Chapter 28: Inflation and
Aggregate Supply
Y
79
The Self-Correcting Economy
The Neo-Classical Synthesis of
Classical and Keynesian
Economics
The Aggregate Demand - Aggregate
Supply Diagram
 The Self-Correcting Economy
– In the long-run the economy tends to be selfcorrecting.
 The $13.3 trillion question: how long does it take to
get to the long run?
 The LR equilibrium is reached because
– Unemployment weakens workers, so “wage inflation” slows.
– Over-employment strengthens workers, so “wage inflation”
speeds up.
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Chapter 28: Inflation and
Aggregate Supply
81
The Aggregate Demand - Aggregate
Supply Diagram
 The Self-Correcting Economy
– The Keynesian model does not include a selfcorrecting mechanism.
 It applies to the short run.
– The Keynesian model concentrates on the
short-run with no price adjustment.
– The self-correcting mechanism concentrates on
the long-run with price adjustments.
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Chapter 28: Inflation and
Aggregate Supply
82
The Aggregate Demand - Aggregate
Supply Diagram
 The Self-Correcting Economy
– If the self-correcting mechanism is slow
 Active Fiscal and Monetary policy may be needed to
help stabilize the economy.
– If the self-correcting mechanism is fast
 Fiscal and monetary policy are not effective and may
destabilize the economy.
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Chapter 28: Inflation and
Aggregate Supply
83
The Aggregate Demand - Aggregate
Supply Diagram
 The Self-Correcting Economy
– The speed of correction will depend on:
 The use of long-term contracts.
 The efficiency and flexibility of labor markets.
– Fiscal and monetary policy are most useful
when attempting to eliminate large output gaps.
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Chapter 28: Inflation and
Aggregate Supply
84
ACTIVIST Policy when Adjustment is
SLOW
LRAS
SRAS
Inflation

A
A hike in G, a
cut in T, or an
increase in M
shift the AD
curve to the
right and reduce
the output gap.
AD’
AD
Y*
Y
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Output
Chapter 28: Inflation and
Aggregate Supply
What happens
if we do
nothing?
85
ACTIVIST Policy when Adjustment is
A decrease in M,
SLOW
a cut in G, or a
cut in T shift the
AD curve to the
left and reduce
the output gap.
LRAS

SRAS
Inflation
A
AD’
Y*
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Y
Chapter 28: Inflation and
Aggregate Supply
Output
AD
What happens
if we do
nothing?
86
ACTIVIST Policy when Adjustment is
FAST
If the adjustment
LRAS
Inflation

A
B
Y*
Y
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process is faster
than what
policymakers think,
activist
SRAS expansionary
policy may
overshoot its target
because SRAS
SRAS’ shifts quickly.
What happens if we
choose to do
nothing?
AD’
AD
The economy now
has an
expansionary gap
Output
Chapter 28: Inflation and
Aggregate Supply
87
ACTIVIST Policy when Adjustment is
Again, the
FAST
economy adjusts
B
SRAS’
LRAS

SRAS
Inflation
A
faster than
expected and the
economy now has
a recessionary
gap.
AD’
Y*
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Y
Chapter 28: Inflation and
Aggregate Supply
AD
What happens if we
choose to do
Output
nothing?
88
Sources of Inflation
 What Do You Think?
– Is activist fiscal policy a good thing?
 Remember it’s very inflexible: it takes a long time to
act and to take effect.
– Is activist monetary policy a good thing?
 It’s more flexible, quick, and reversible, but it’s still
very imprecise and uncertain.
 Can a government economist really figure out the
actions of millions of people making trillions of
transactions?
 Can they “play it by ear” cutting and raising interest
rates as the economy reacts?
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Chapter 28: Inflation and
Aggregate Supply
89
Sources of Inflation
Fighting Inflation
 Before we talk about where inflation comes
from, let’s talk about what the Fed does to
fight it.
 Obviously, the Fed can’t control Wal-mart’s
pricing decisions and it can’t control the
wages demanded by GM’s workers.
 But it can seriously affect the amount of
unemployment in the economy.
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Chapter 28: Inflation and
Aggregate Supply
91
Fighting Inflation
 If the Fed raises interest rates and slows the
economy down, it will generate
unemployment.
 Higher unemployment makes workers weak
and moderates their wage demands.
– Firms’ costs rise more slowly.
 Desiring to sell products, firms raise prices
more slowly.
– Price inflation falls.
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Chapter 28: Inflation and
Aggregate Supply
92
Anti-Inflation Policy
 Suppose the Public is tired of high inflation.
 The Central Bank may want to have
contractionary monetary policies.
– Lower m, higher interest rates.
 This will lead to a recession for a while, but
then inflation will fall.
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Chapter 28: Inflation and
Aggregate Supply
93
Short-Run Effects of an
Anti-inflationary Monetary Policy
LRAS
B
A
SRAS
•Eq. At A (Y = Y*)
• = 10%
•Fed shifts AD to AD’
•Short run eq. At B
•Y < Y* -- recessionary gap
Inflation
10%
AD
AD’
Y
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Y*
Chapter Output
28: Inflation and
Aggregate Supply
94
Long-Run Effects of an
Anti-inflationary Monetary Policy
LRAS
10%
B
SRAS
Inflation
•Short-run eq. at B
•Recessionary gap -- Y < Y*
• falls to 3% and Y rises to Y*
•Long-run eq. -- lower  @ Y*
C
3%
SRAS’
AD’
Y
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Y*
Chapter Output
28: Inflation and
Aggregate Supply
95
U.S. Macroeconomic
Data, 1978-1985
% Growth in
Years
real GDP
Unemployment
rate (%)
Inflation
rate (%)
Nominal
interest
rate (%)
Real
interest
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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Chapter 28: Inflation and
Aggregate Supply
96
Sources of Inflation
 Suppose autonomous expenditure rises
dramatically.
 We know this will lead to an expansionary
gap.
 If Y > Y*, the SRAS curve will eventually
shift upwards, leading to higher inflation in
the long run.
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Chapter 28: Inflation and
Aggregate Supply
97
War and Military Buildup
As A Source of Inflation
•Increase in military
spending causes AD
to increase
•Creates an
expansionary gap -Y > Y*
Inflation
LRAS

B
SRAS
A
AD’
AD
Y*
Y
Output
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Chapter 28: Inflation and
Aggregate Supply
98
War and Military Buildup
As A Source of Inflation
•SRAS shifts to
SRAS’
•Long-run
equilibrium back to
Y* with  *
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LRAS

SRAS’
C
’
Inflation
•Because the
economy is
overheated, 
increases
B
SRAS
A
AD’
Y*
Y
Output
Chapter 28: Inflation and
Aggregate Supply
99
Sources of Inflation
 Does the Fed have the power to prevent the
increased inflation that is induced by a rise
in military spending?
– Hint: Can the Fed reduce AD?
 What is the cost of avoiding inflation during
a military buildup?
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Chapter 28: Inflation and
Aggregate Supply
100
War and Military Buildup
As A Source of Inflation
•The CB could
counteract the
expansionary fiscal
policy with
contractionary
monetary policy.
•This avoids high
inflation.
Inflation
LRAS

B
SRAS
A
AD’
AD
Y*
Y
Output
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Chapter 28: Inflation and
Aggregate Supply
101
Sources of Inflation
 Economic Naturalist
– How did inflation get started in the United States
in the 1960s?
 1959-63 inflation averaged about 1%
 By 1970 inflation was 7%
 Fiscal policy
– Increases in defense spending
 1965 = $50.6 billion or 7.4% of GDP
 1968 = $81.9 billion or 9.4% of GDP
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Chapter 28: Inflation and
Aggregate Supply
102
Sources of Inflation
 Economic Naturalist
– How did inflation get started in the United States
in the 1960s?
 Fiscal policy
– Increased spending on Great Society and war on poverty
initiatives
 Monetary policy
– The Fed did not try to offset the increase in government
spending
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Chapter 28: Inflation and
Aggregate Supply
103
Sources of Inflation
 Source of Inflation: Inflation Shock
– A sudden (and temporary) change in the normal
behavior of inflation, unrelated to the nation’s
output gap.
 OPEC embargo of 1973
 Drop in oil prices in 1986
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Chapter 28: Inflation and
Aggregate Supply
104
The Effects of An
Adverse Inflation Shock
• Equilibrium @ A--Y* = Y
LRAS • Inflation shock,  increases to  ’
Inflation
(SRAS’)
• Short-run eq. At B, Y < Y*; recessionary
gap and higher inflation (stagflation)
’
B
SRAS’
A

SRAS
AD
Y’
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Y*
Output
Chapter
28: Inflation and
Aggregate Supply
105
The Effects of An
Adverse Inflation Shock
LRAS
• Equilibrium @ A--Y* = Y
• Inflation shock,  increases to  ‘ (SRAS’)
• Short-run eq. At B, Y < Y*; recessionary gap
and higher inflation (stagflation)
Inflation
•No policy --  falls; long-run eq. at A
’
B
SRAS’
A

SRAS
AD
Y’
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Y*
Output
Chapter
28: Inflation and
Aggregate Supply
106
Sources of Inflation
 In the “no policy” scenario, the economy
went back to full employment and to the old
level of inflation eventually.
 But, in the meanwhile, it suffered high levels
of unemployment (and it’s hard to find a
reason why this is ok).
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Chapter 28: Inflation and
Aggregate Supply
107
Sources of Inflation
 Suppose that instead monetary policy turns
expansionary.
– Faced with a positive output gap (a recession),
the Fed increases M.
– Higher M/P  lower interest rates  higher C
and I  higher output.
– AD shifts right.
– Short-run equilibrium (AD and SRAS intersect)
and long-run equilibrium (Y=Y*) coincide at a
higher level of inflation.
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Chapter 28: Inflation and
Aggregate Supply
108
The Effects of An
Adverse Inflation Shock
Inflation
LRAS
’
B
• Equilibrium @ A--Y* = Y
• Inflation shock,  increases to  ‘ (SRAS’)
• Short-run eq. At B, Y < Y*; recessionary gap
and higher inflation (stagflation)
• With policy--AD shifts to AD’; Y =
Y*;  rises to  ’
C
SRAS’
A

SRAS
AD’
AD
Y’
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Y*
Output
Chapter
28: Inflation and
Aggregate Supply
109
Sources of Inflation
 The oil shock changed inflation temporarily.
 Inflation only persists if monetary policy is
sufficiently expansionary.
– We express this by saying that monetary policy
is “accomodating”, that is, it goes along with
shocks to the economy so to eliminate output
gaps, at the expense of higher inflation.
– But inflation has costs: uncertainty, difficulty in
planning, etc.
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Chapter 28: Inflation and
Aggregate Supply
110
A Shock To Potential Output
 Now, suppose potential output falls:
– A macroeconomic change (such as higher oil
prices) causes a change in the behavior of firms
so that they accumulate less capital.
 Potential output can also rise
– Improvements in technology, human capital,
physical capital, etc.
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Chapter 28: Inflation and
Aggregate Supply
111
The Effects of a
Shock To Potential Output
Inflation
LRAS’
’
LRAS
B
•Equilibrium at A -- Y* = Y
•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
SRAS’
A

SRAS
AD
Y*’
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Y*
Output
Chapter
28: Inflation and
Aggregate Supply
112
Sources of Inflation
 Aggregate Supply Shock
– Either an inflation shock or a shock to potential
output
– Adverse aggregate supply shocks of both types
reduce output and increase inflation
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Chapter 28: Inflation and
Aggregate Supply
113
Sources of Inflation
 Shocks to Potential Output
– Aggregate supply shock
 Inflation shocks
– Stagflation and Temporary reduction in output
– “New Economy” and Temporary increase in output
 Potential output shocks
– Stagflation and Permanent reduction in output
– “New Economy” and Permanent increase in output
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Chapter 28: Inflation and
Aggregate Supply
114
U.S. Macroeconomic Data,
Annual Averages, 1985-2000
Years
% Growth in Unemployment Inflation
real GDP
rate (%)
rate (%)
Productivity
growth (%)
1985-1995
2.8
6.3
3.5
1.4
1995-2000
4.0
4.6
2.4
2.5
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Chapter 28: Inflation and
Aggregate Supply
116
Economic Naturalist
Inflation
LRAS’
’
LRAS
•Equilibrium at B -- Y*’ = Y
•Productivity increases
•Y*’ shifts to Y*
•Recessionary gap -- Y*’ < Y*
• falls to 
•Equilibrium at A
•Lower inflation; higher output
B
SRAS’
A

SRAS
AD
Y*’
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Y*
Output
Chapter
28: Inflation and
Aggregate Supply
117
Sources of Inflation
 Economic Naturalist
– Can inflation be too low?
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Chapter 28: Inflation and
Aggregate Supply
118
The Phillips Curve
The Phillips Curve
 Fiscal or monetary policy can increase
output above Y* temporarily, in the short run.
– Inflation might rise slightly, so there’s a shortrun output-inflation trade-off.
 But in the long run, Y goes back to Y*, but at
higher inflation.
– Inflation rises but output doesn’t, so there’s no
long-run output-inflation trade-off.
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Chapter 28: Inflation and
Aggregate Supply
120
The Phillips Curve (1954-1968)
Inflation
rate
1968
1956
4
3
1966
1967
1957
1955
1964
1965
1959
1954
2
1
0
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4
1960
1963
1962
5
Chapter 28: Inflation and
Aggregate Supply
6
1958
1961
Unemployment
rate
123
The Breakdown of the Short-Run
Phillips Curve
 In the early 1970s, the relationship between
inflation and unemployment began to break
down.
 Unemployment was high, but so was
inflation.
– This phenomenon was termed stagflation.
 Stagflation – the combination of high and
accelerating inflation and high
unemployment.
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Chapter 28: Inflation and
Aggregate Supply
126
The Phillips Curve ??
(1969-1981)
Inflation
rate
1981
1974
8
1979
6
1978
1971
1970
4
1980
1977
1973
1969
1975
1976
1972
2
0
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4
5
6
Chapter 28: Inflation and
Aggregate Supply
7
Unemployment
rate
127
The Long-Run and Short-Run
Phillips Curves
 The solution is to look at the relation
between changes in inflation and the
unemployment rate.
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Chapter 28: Inflation and
Aggregate Supply
134
The Long-Run and Short-Run
Phillips Curves
Change in Inflation
versus Unemployment
in the United States,
1970-2000
Since 1970, there has
been a negative
relation between the
unemployment rate
and the change in the
inflation rate in the
United States.
 The line that best fits the scatter of points for the
period 1970-2000 is:
π- π
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= 6% - 1.0ut
Chapter 28: Inflation and
t
t- 1
Aggregate Supply
135
The Long-Run and Short-Run
Phillips Curves
 Nowadays, governments aren’t playing a
Phillips Curve game.
 In the 1970s, it became very clear that
inflation is costly and pointless.
 Most Central Banks are in favor of low-andstable inflation.
 The (modified) Phillips curve is still valid,
and changes in  are due to exogenous
shocks.
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Chapter 28: Inflation and
Aggregate Supply
137
What have we learned today?
 The Aggregate Demand curve is a negative
relation between inflation and output.
– Higher inflation reduces the real money supply,
which raises interest rates, makes investment
more expensive, and reduces output.
– This is a movement along the AD curve.
 The AD shifts right with expansionary Fiscal
policy (higher G, lower T) or expansionary
Monetary policy (higher M).
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Chapter 28: Inflation and
Aggregate Supply
143
What have we learned today?
 The Short-Run Aggregate Supply curve is
horizontal in (Y, ) space.
– In the short run, inflation is constant (“inertial”),
so changes in output don’t change .
 The SRAS shifts if there is an output gap.
– If Y<Y*, SRAS shifts down.
– If Y>Y*, SRAS shifts up.
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Chapter 28: Inflation and
Aggregate Supply
144
What have we learned today?
 Short-run equilibrium output takes place
where AD and SRAS intersect.
– Because inflation is inertial, it just is.
– This inertial  implies a certain level of M/P,
which determines the interest rate and
expenditure.
– Output is demand-determined in the short-run.
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Chapter 28: Inflation and
Aggregate Supply
145
What have we learned today?
 In the long run, Y = Y*
– If Y > Y* in the short run, inflation rises. This
reduces M/P, raises interest rates, lowers
expenditure, and makes Y fall until Y = Y*.
– If Y < Y*, the recession causes wages to fall,
leading to lower inflation, etc., until Y rises to Y*.
– In the long-run, output is supply-determined.
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Chapter 28: Inflation and
Aggregate Supply
146
What have we learned today?
 In the long run, the economy is selfcorrecting.
– Overly expansionary monetary or fiscal policy
can expand Y for a while, but will only lead to
more inflation in the long run.
 Remember “inflation is a monetary phenomenon,
always and everywhere”?
– Recessions and depressions cure themselves
because workers accept lower wages.
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Chapter 28: Inflation and
Aggregate Supply
147
What have we learned today?
 In the long run, the economy is selfcorrecting.
– Activist policy only makes sense if the
economy’s self-correcting mechanism is very
slow.
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Chapter 28: Inflation and
Aggregate Supply
148
What have we learned today?
 The Fed can fight inflation by creating
recessions in the short-run.
– It can also fight deflation –falling prices – (or
uncomfortably low inflation) by cutting interest
rates.
 Supply-side shocks such as oil shocks or
shocks to productivity can generate
temporary or permanent changes in inflation
and output.
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Chapter 28: Inflation and
Aggregate Supply
149
What have we learned today?
 The Phillips Curve is a negative relation
between unemployment and inflation.
– Unexpected rises in inflation make workers
cheaper to hire, lowering inflation.
– The government took advantage of it in the
1960s, which led to its disappearance.
 It is now a negative relation between the
change in inflation and the unemployment
rate.
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Chapter 28: Inflation and
Aggregate Supply
150