Aggregate Demand, Aggregate Supply, and Inflation in Economics

Chapter 27 Aggregate Demand, Aggregate Supply, and Inflation

@ 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw Hill.Learning Objectives

1. Define the aggregate demand curve, explain why it slopes downward, and explain what may shift it.
2. Define the long-run and short-run aggregate supply curves, explain their orientation, and explain what may shift them. In particular, show how the curves capture the idea of inflation inertia and the link between inflation and the output gap.
3. Analyze how the economy is affected by aggregate spending shocks, inflation shocks, and shocks to potential output.
4. Discuss the short-run and long-run effects of an anti-inflationary monetary policy.

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Inflation, Spending, and Output: The Aggregate Demand Curve

• Aggregate Demand (AD) Curve
  • Shows the relationship between short-run equilibrium output Y and the rate of inflation, It
  • 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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Inflation, The Fed, and Why the AD Curve Slopes Downward

• The Keynesian model assumes output adjusts to demand at preset prices in the short run.
• Prices do not remain fixed indefinitely.
• The Keynesian model does not explain the behavior of inflation.

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Other Reasons Why AD Slopes Downward

• Distributional effects: Inflation hurts people with lower incomes more. These people also spend more of their income, so Y drops when their income does
• Uncertainty: Inflation uncertainty about future prices, so people may be more cautious in spending
• Exports: Inflation Prices of exported goods rises, lowering exports

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The Aggregate Demand Curve

An increase in T reduces Y (all other factors held constant)

Inflation

Aggregate Demand Curve

AD

Output Y

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Inflation, Spending, and Output: The Aggregate Demand Curve

• Movements Along the AD Curve
  • T and Y are inversely related
  • Changes in it cause a change in Y or a movement along the AD curve
  • I increases -> r increases > planned spending decreases > Y decreases

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Factors that Shift the AD Curve

• Shifts of the AD Curve
  • Any factor that changes Y at a given at shifts the AD curve.
  • Shifts of the AD curve can be caused by:
  • Changes in exogenous spending.
  • Changes in the Fed's policy reaction function.

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Effect of An Increase In Exogenous Spending

AD'

AD

Exogenous Spending: spending unrelated to Y or r

• Fiscal policy
• Technology
• Foreign demand

Inflation T

An increase in exogenous spending shifts AD to AD' and vice versa

Output Y

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A Shift in the Fed's Policy Reaction Function

New policy reaction function

Real interest rate set by Fed, r

Old policy reaction function

Inflation Rate

Fed "tightens" monetary policy - shifting reaction curve

AD

AD'

Inflation Rate

Output Y

The new Fed policy increases r and AD shifts to AD'

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Inflation and Aggregate Supply

• Inflation will remain roughly constant, or have inertia, if operating at Y* and there are no external shocks to the price level.
  • 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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Inflation Expectations

• The public must negotiate wages and prices for future sales
• The prices they agree to will be based on their expectations about inflation
• If you think there will be high inflation, you'll agree to much higher prices
• This can lead to actual inflation as prices rise

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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.

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A Virtuous Circle of Low Inflation and Low Expected Inflation

Low inflation

Slow increase in wages and other production costs

1

Low expected inflation

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Inflation and Aggregate Supply

• Three factors that can increase the inflation rate
  • Output gap
  • Inflation shock
  • Shock to potential output

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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

T

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The Aggregate Demand-Aggregate Supply Diagram

• Long-run aggregate supply (LRAS)
  • A vertical line showing the economy's potential output Y*
• 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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The Aggregate Demand-Aggregate Supply Diagram

• Short-run equilibrium
  • A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate
  • Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line

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The Aggregate Demand-Aggregate Supply Diagram

• Long-run equilibrium
  • A situation in which actual output equals potential output and the inflation rate is stable
  • Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point

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The Aggregate Demand-Aggregate Supply (AD-AS) Diagram

Long-run aggregate supply, LRAS

A

Short-run aggregate supply, SRAS

Short-run equilibrium A

• Y: SRAS(IT) = AD
• Y < Y* -- recessionary gap
• T and Y adjust to the gap
• IT decreases & Y increases

Inflation Rate

Long-run equilibrium B

• AD, SRAS (*), LRAS (Y*)

  will intersect at the same point

Aggregate demand, AD

Y

Y*

Output

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The Aggregate Demand-Aggregate Supply (AD-AS) Diagram

• A Review of the Adjustment Process to a Recessionary Gap
  • Firms that are selling less than they want to will start to lower prices.
  • As a falls the Fed lowers r and AD increases.
  • Falling T reduces uncertainty which also increases AD
  • As Y increases, cyclical unemployment falls (Okun's law)
  • Adjustment continues until long-run equilibrium is reached.

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The Adjustment of Inflation When a Recessionary Gap Exists

LRAS

A

SRAS

-

Inflation Rate

*

SRAS'

T

Long-run equilibrium B

• AD, SRAS ( ** ), LRAS (Y*)

  will intersect at the same point

AD

Y

Y*

Output

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The Adjustment of Inflation When an Expansionary Gap Exists

Long-run aggregate supply

LRAS

Short-run Eq. Y

• Expansionary gap Y > Y*
• T rises, AD falls - Y falls
• Long-run equilibrium at Y*, **

B

SRAS'

A

SRAS

T

AD

Output

Y*

Y

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The Self-Correcting Economy

• In the long-run the economy tends to be self-correcting.
• The Keynesian model does not include a self-correcting mechanism.

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The Self-Correcting Economy

• 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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The Self-Correcting Economy

• A slow self-correcting mechanism
  • Fiscal and monetary policy can help stabilize the economy
• A fast self-correcting mechanism
  • Fiscal and monetary policy are not effective and may destabilize the economy.

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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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War and Military Buildup As A Source of Inflation

Military spending increase > AD increase > Expansionary gap (Y > Y*) > It increases > SRAS shifts to SRAS' > Long-run equilibrium Y* and It*

LRAS

LRAS

C

SRAS'

π'

Inflation Rate

T

Inflation Rate

T

A

AD'

AD

Y*

Y

Output

Output

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B

SRAS

B

SRAS

A

AD'

Y*

Y

How Did Inflation Get Started in the 1960s?

• In 1959-63 inflation averaged about 1%
• By 1970 inflation was 6%
• Fiscal Policy
  • Increases in defense spending
  • 1962-65 = $70 billion
  • 1968 = $100 billion
• Monetary Policy
  • The Fed did not try to offset the increase in government spending

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Inflation Shocks

• Inflation Shock
  • A sudden change in the normal behavior of inflation, unrelated to the nation's output gap
• Inflation Shock: Examples
  • OPEC embargo of 1973
  • Drop in oil prices in 1986

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The Effects of An Adverse Inflation Shock

LRAS

• Equilibrium @ A: Y* = Y
• Inflation shock, I increases to T ' (SRAS')
• Short-run eq. At B, Y < Y *; recessionary gap and higher inflation (stagflation)
• No policy -- Tt falls; long-run eq. at A
• With policy -- AD shifts to AD'; Y = Y *; It rises to Tt *

B

C

SRAS'

Inflation Rate

’

A

SRAS

T

AD'

AD

Y'

Y*

Output

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Shocks to Potential Output

• 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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The Effects of a Shock To Potential Output

LRAS'

LRAS

B

• Equilibrium at A -- Y* = Y
• Y* falls to Y*'
• Y > Y* -- expansionary gap
• T increases -- SRAS rises to SRAS'
• Equilibrium at B
• Y = Y*'
• T increased to TT

  ‘

• Decline in output is permanent

SRAS'

Inflation Rate

’

A

SRAS

T

AD

Y **

y*

Output

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U.S. Macroeconomic Data, Annual Averages, 1985-2000

Years

% Growth in real GDP

Unemployment rate (%)

Inflation rate (%)

Productivity growth (%)

1985-1995

3.0

6.3

3.5

1.4

1995-2000

4.3

4.6

2.5

2.4

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