Transcript Aggregate S&D

Aggregate Demand & Supply
Part III: Equilibrium
Equilibrium Aggregate Price
Level

Putting aggregate D & S together:
AS
P
Pe
AD
Ye
Y
Oil Crisis, 1974

Arab Boycott leads to 4X increase in oil prices:
AS'
AS
P
1974-75
Recession
Pe'
Pe
AD
Ye'
Ye
Y
Fiscal & Monetary Policy - I

 G, T, Ms all shift AD to right
AS
P
Pe
AD
Ye
Y
AD'
Fiscal & Monetary Policy - II

 G, T, Ms all shift AD to left
AS
P
Pe
AD
AD'
Ye
Y
Fiscal & Monetary Policy - III

But what are size of effects on prices & output?
AS
P
?
Pe
AD
?
Ye
Y
Size of effects = f(shape of AS)

Where AS is flatter, e.g., in depression, shifts in AD
produce large changes in Y with small changes in P
(typical Keynesian result):
AS
P
AD
Pe
Ye'
Ye
Y
Size of effects = f(shape of AS)

But where AS is steeper, e.g., in boom, shifts in AD
produce large changes in P with small changes in Y:
AS
P
AD
Pe
Ye Ye'
Y
Keynesian "Gaps"


Below Ye aggregate demand could be increased with no upward
pressure on prices
Above Ye aggregate demand increases would generate inflation
(rising price level)
aggregate
demand
C, I, G
deflationary
gap
inflationary
gap
B
Y
A
Y
Keynesian Aggregate Supply

We can translate this into AS - AD terms:
P
AS
Y
Ye
Long Run Aggregate Supply - I

Long run AS is said to be vertical. Why?
 Ans: wages adjust to price changes
LRAS
P
Pe
AD
Ye
Y
Long Run Aggregate Supply - II

Suppose AD increased by policy, P & Y
LRAS
SRAS
P
Pe'
Pe
AD'
AD
Ye Ye'
Y
Long Run Aggregate Supply - III

But then wages/costs/SRAS adjust to P
LRAS
SRAS'
SRAS
P
Pe"
Pe'
Pe
AD'
AD
Ye Ye'
Y
"Long Run" AS?

Problem: "short run" defined by fixed assets,
upper limit to production capacity
 "Long Run" defined in micro by all assets can
be changed, plant & equipment & productivity
can be increased
 In micro a given technology may produce an
"envelop" of short run cost curves
 But in aggregate, technology can change and
output can be expanded indefinately!
Potential GDP?

LRAS curve vertical at what is called
"potential GDP"
 "Potential GDP" = "level of output that can be
sustained in the long run without inflation"
 But in aggregate, technology can change and
output can be expanded indefinitely!
Inflation

We now have model with price level, and hence
inflation, explicit
 We can use this model to talk about various
kinds of inflationary pressures
Demand Pull Inflation - I

As we approach full employment, increasing demand
"pulls" up the price level:
AS
P
AD
Pe
Ye Ye'
Y
At Full Employment

At full employment, increases in AD produces only price increases:
P
AS
Y
Ye
Cost Push Inflation - I


Increases in costs (wages, oil) shifts AS up,
so P (but note: Y  = stagflation)
AS'
AS
P
Pe'
Pe
AD
Ye'
Ye
Y
Cost Push Inflation - II

But in late 1960s Y ROSE with wage , how?
AS'
AS
P
Pe'
Pe
AD
Ye'
Ye
Y
Cost Push Inflation - III

Ans: accomodating monetary policy that AD
AS'
AS
Pe"
Pe'
Pe
AD'
AD
Ye'
Ye
Y
Inflation = Monetary
Phenomenon?

C&F: "a sustained inflation, whatever the
initial cause . . ., is essentially a monetary
phenomenon." (p. 332)
 C&F: "can be thought of as a purely monetary
phenomenon" (p. 337)
 This view is associated with "monetarism"
which became popular in 1970s because it
offered a policy alternative: hold down Ms.
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