Download Aggregate Demand/Aggregate Supply Model

Amherst College
Department of Economics
Economics 111 – Section 3
Fall 2012
Friday, November 30 Lecture: Aggregate Demand/Aggregate Supply Model –
The Dynamics
Review
Aggregate Demand/Aggregate Supply Model
SRAS
Actual Infl
Rate (%)
Equilibrium
Actual Infl Rate
AD
Equilibrium Y
Aggregate Demand
Y (GDP)
Aggregate Supply
Actual Infl
Rate (%)
Actual Infl
Rate (%)
LRAS
SRAS
Expected
Infl Rate
AD
Y (GDP)
AD Curve Questions: How many
final goods and services would be
demanded if the inflation rate
were _____ % given that there are
no demand shocks.
Taylor Principle
Infl Rate Up
↓
Int Rate Up → I Down
↓
AE Down → Y Down
Demand Shock: Anything shifting the
Keynesian AE curve other than the Fed’s
application of the Taylor principle.
AD Curve Summary:
• Downward sloping
• Shifts whenever there is
a demand shock
Y*
Y (GDP)
SRAS Curve Questions: How many
final goods and services would be
produced if the inflation rate
were _____ % given that
• the expected inflation rate is unchanged
and
• there are no supply shocks.
LRAS Curve: Denotes Potential GDP (Y*)
Y* = Potential GDP
= GDP whenever the actual inflation
rate equals the expected inflation rate
SRAS and LRAS
Intersect at the expected inflation rate.
SRAS Curve Summary:
Upward sloping
Shifts whenever
• The expect inflation rate changes
• There is a supply shock
2
Summary: Inflation
Real GDP
Actual < Expected
↓
______ Potential
Actual = Expected
↓
______ Potential
The short run aggregate supply curve (SRAS) is
upward sloping intersecting the long run aggregate
supply curve (LRAS) at the expected inflation rate.
Actual > Expected
↓
______ Potential
SRAS and LRAS Curves
Actual
Infl Rate
LRAS
SRAS
Expected
Infl Rate
Y (GDP)
Y*
Question: When will the short run aggregate supply curve shift?
• A change in the expected inflation rate.
• A supply shock.
For example, what would to Mr. Atkins’ production of apples if a freak storm
damaged his apple orchard and had a similar effect on many other firms in the
economy?
Adaptive Expectations and Short Run Aggregate Supply (SRAS) Curve Dynamics
Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent
past.
“You can fool some of the people all of the time, and all of the people some of the time,
but you cannot fool all of the people all of the time.” Abraham Lincoln (attributed)
Scenario 1: Stable Start Benchmark
Access the following lab by clicking inside the red box:
{LabLink}
Actual Infl
Rate (%)
The following table reports the lab results:
Period
0
1
2
..
.
7
GDP
2000
2000
2000
Investment
100
100
100
Interest
Rate (%)
12.0
12.0
12.0
2000
100
12.0
Actual
Infl Rate (%)
10.0
10.0
10.0
10.0
LRAS
SRAS10
10.0
This represents a stable start because the actual inflation rate
and the expected inflation rate are equal.
In view of adaptive expectations, the expected inflation rate must equal 10 percent.
Consequently, potential GDP must equal 2,000. The following diagram illustrates this
situation:
AD
2,000
Y (GDP)
3
Scenario 2: Actual GDP Greater Than Potential GDP
Click inside the red box to access the next lab:
Actual Infl
Rate (%)
LRAS
{LabLink}
The following table describes the data from Period 0:
Period
0
GDP
2008
Interest
Investment Rate (%)
103
9.9
Actual
Infl Rate (%)
9.3
SRAS0
9.3
AD
We can now illustrate the equilibrium in Period 0:
2,000
Question: What will happen in Period 1?
To answer this question, first ask consider inflationary
expectations:
• The actual inflation rate in Period 0 is 9.3
percent.
• As a consequence of adaptive expectations,
expected inflation in Period 1 should equal
about 9.2 percent.
• Since the short run and long run aggregate
supply curve intersect at the expected inflation
rate, the short run supply curve in Period 1 and
long run aggregate supply curve intersect at 9.3
percent
The short run aggregate supply curve shifts up:
Actual Infl
Rate (%)
GDP
2008
2005
Interest
Investment Rate (%)
103
9.9
102
10.7
Actual
Infl Rate (%)
9.3
9.6
Y (GDP)
LRAS
SRAS1
9.6
SRAS0
9.3
AD
1,992
1,995
In Period 1, GDP decreases and the actual inflation rate increases. The simulation
confirms this:
Period
0
1
2,008
Expected
Infl Rate (%)
9.3
2,000
2,005
2,008
Y (GDP)
4
This process will continue period after period until actual GDP equals potential GDP:
Period
0
1
2
3
..
.
11
12
GDP
2008
2005
2004
2003
2000
2000
Interest
Investment Rate (%)
103
9.9
102
10.7
101
11.2
101
11.5
100
100
12.0
12.0
Actual
Infl Rate (%)
9.3
9.6
9.7
9.8
Expected
Infl Rate (%)
9.3
9.6
9.7
10.0
10.0
10.0
10.0
Actual Infl
Rate (%)
LRAS
SRAS12
10.0
SRAS1
9.6
SRAS0
9.3
AD
2,000
2,005
2,008
Scenario 3: Actual GDP Less Than Potential GDP
Click inside the red box to access the next lab:
{LabLink}
Period
0
1
2
3
..
.
11
12
GDP
1992
1995
1996
1998
2000
2000
Interest
Investment Rate (%)
97
14.1
98
13.3
99
12.8
99
12.5
100
100
12.0
12.0
Using the same line of reasoning, actual GDP
gravitates to potential GDP.
Actual
Infl Rate (%)
10.7
10.4
10.3
10.2
Expected
Infl Rate (%)
10.7
10.4
10.3
10.0
10.0
10.0
10.0
Actual Infl
Rate (%)
LRAS
SRAS0
SRAS1
10.7
SRAS12
10.4
10.0
AD
1,992
1,996
2,000
Y (GDP)
Y (GDP)
5
Summary AS Dynamics
GDP < Potential GDP
↓
Actual Infl Rate
GDP = Potential GDP
↓
Actual Infl Rate
GDP > Potential GDP
↓
Actual Infl Rate
Less Than
Expected Infl Rate
↓
SRAS Curve Shifts Down
↓
GDP Increases
Equals
Expected Infl Rate
↓
SRAS Curve Stationary
↓
GDP Unchanged
Greater Than
Expected Infl Rate
↓
SRAS Curve Shifts Up
↓
GDP Decreases
6
Demand Shocks
Demand shocks can be created by both the
• Congress and the President through the use of fiscal policies
o Government purchases of goods and services
o Tax (and transfer) policies
and
• Federal Reserve Board through the use of discretionary monetary policies.
We shall use a simulation to help us illustrate how demand shocks affect the economy. We
use a simulation to illustrate the most straightforward type of demand shock, an increase in
government purchases of goods and services. Access the simulation by clicking within the
red box:
{LabLink}
Period
0
1
2
..
.
7
GDP
2,000
2,000
2,000
Govt
Pur
500
500
500
2,000
500
Actual
Expected
Infl Rate (%) Infl Rate (%)
10.0
10.0
10.0
10.0
10.0
10.0
10.0
We have added a column to the table that does not appear in the lab: Expected Infl Rate (%).
Since the actual inflation rate has remained
Actual Infl
Rate (%)
LRAS
at 10 percent throughout all the periods,
adaptive expectation allows us to concluded
that the expected inflation rate equals 10
percent:
SRAS
Adaptive Expectations: The expected
inflation rate depends on the inflation
rate in the recent past.
Since the actual inflation rate equals the
actual inflation rate, potential GDP must
10.0
equal 2,000.
AD
Potential GDP (Y*): GDP whenever the
actual inflation rate equals the expected
2,000
Y (GDP)
inflation rate.
0
0,1
7
Now, we increase government expenditures by 20 from 500 to 520 in Period 1.
Question: What will happen in Period 1?
In period 1, the aggregate demand curve shifts to the right.
GDP increases from 2,000 to 2,025.
The actual inflation rate increases from 10.0 percent to 11.3 percent.
Question: What will happen in Period 2?
To answer this question, first ask consider inflationary expectations:
• The actual inflation rate in Period 1 is 11.3 percent.
• As a consequence of adaptive expectations, expected inflation in Period 2 should
equal about 11.3 percent.
• Since the short run and long run aggregate supply curve intersect at the expected
inflation rate, the short run supply curve in Period 2 and long run aggregate
supply curve intersect at 11.3 percent
In period 2, the short run aggregate supply curve shifts up.
Question: What will happen in Period 3?
To answer this question, first ask consider inflationary expectations:
• The actual inflation rate in Period 2 is 12.0 percent.
• As a consequence of adaptive expectations, expected inflation in Period 3 should
equal about 12.0 percent.
• Since the short run and long run aggregate supply curve intersect at the expected
inflation rate, the short run supply curve in Period 3 and long run aggregate
supply curve intersect at 12.0 percent
In period 3, the short run aggregate supply curve shifts up.
Period
0
1
2
3
..
.
11
12
GDP
2,000
2,025
2,016
2,010
Govt
Pur
500
520
520
520
2,001
2,000
520
520
Actual
Expected
Infl Rate (%) Infl Rate (%)
10.0
11.3
10.0
12.0
11.3
12.5
12.0
13.3
13.3
13.3
13.3
Actual Infl
Rate (%)
SRAS12
LRAS
SRAS2
13.3
Increase in G
SRAS0,1
12.0
11.3
AD1
10.0
AD0
2,000
2,016
2,025
Y (GDP)
8
Aggregate Demand/Aggregate Supply Dynamics: Importance of the Taylor Principle
Taylor Principle: The Fed’s
monetary policy depends on the
actual inflation rate:
• When the actual inflation
rate increases, the Fed
responds contractionary
monetary policy to increase
the real interest rate.
• On the other hand, when the
inflation rate decreases the
Fed responds with
expansionary monetary
policy to decrease the real
interest rate.
Market for Borrowing and Lending
Real Int
Rate (%)
Investment Component of AE
Real Int
Rate (%)
S
Equ
Int
Rate
Equ
Int
Rate
D
I
Funds ($)
Investment
Keynesian Cross
AE, GDP
GDP = Y
Taylor Factor = 3: 1 Percent Increase in Inflation → 3 Percent
Increase in Real Interest Rate
Actual
Inflation
Rate (%)
Real
Interest
Rate (%)
Invest
Pur
Keynesian
Equilibrium
GDP
9.0
9.0
104.5
2,012.0
10.0
12.0
100.0
2,000.0
11.0
15.0
95.5
1,988.0
AE =
C+I+G+NX
Act Infl = 11%
Act Infl = 9%
Y (GDP)
2,000
Actual Infl
Rate (%)
11.0
10.0
9.0
AD Curve
1998
Period
0
1
2
..
.
9
10
..
.
15
16
GDP
2,000
2,027
2,018
Govt
Pur
500
520
520
Interest
Rate (%)
12.0
16.1
18.8
Invest
Pur
100
96
93
Actual
Infl (%)
10.0
11.1
12.3
2001
2001
520
520
24.1
24.3
87
97
14.0
14.1
2000
2000
520
520
24.5
24.5
86
86
14.2
14.2
2,000
2,012
Y (GDP)
9
Taylor Factor = 6: 1 Percent Increase in Inflation → 6 Percent Increase in Real Interest Rate
Keynesian Cross
Actual
Inflation
Rate (%)
Real
Interest
Rate (%)
Keynesian
Equilibrium
Investment
GDP
9.0
6.0
109.0
2,024.0
10.0
12.0
100.0
2,000.0
11.0
18.0
91.0
1,976.0
AE, GDP
GDP = Y
Act Infl = 11%
AE =
C+I+G+NX
Act Infl = 9%
Y (GDP)
2,000
Actual Infl
Rate (%)
11.0
10.0
AD Curve
9.0
1998
Period
0
GDP
2,000
Govt
Pur
500
Interest
Rate (%)
12.0
Invest
Pur
100
Actual
Infl (%)
10.0
1
2,020
520
18.1
93
11.0
2
..
.
9
2,010
520
21.2
90
11.5
2000
520
24.5
86
12.1
10
..
.
15
2000
520
24.5
86
12.1
2000
520
24.5
86
12.1
16
2000
520
24.5
86
12.1
2,000
2,012
Y (GDP)
10
Summary
Govt
Period Pur
0
500
Taylor Factor = 3
Interest Invest
Actual
GDP Rate (%)
Pur
Infl (%)
2,000
12.0
100
10.0
GDP
2,000
Taylor Factor = 6
Interest Invest
Rate (%)
Pur
12.0
100
Actual
Infl (%)
10.0
1
520
2,027
16.1
96
11.4
2,020
18.1
93
11.0
2
..
.
9
529
2,018
18.8
93
12.3
2,010
21.2
90
11.5
520
2,001
24.1
87
14.0
2,000
24.5
86
12.1
10
..
.
15
520
2,001
24.3
87
14.1
2,000
24.5
86
12.1
520
2,000
24.5
86
14.2
16
520
2,000
24.5
86
14.2
Justifying the Taylor Principle
Taylor Factor = 0: 1 Percent Increase in Inflation → 0 Percent Increase in Real Interest Rate
Period
0
GDP
2,000
Govt
Pur
500
Interest
Rate (%)
12.0
Invest
Pur
100
Actual
Infl (%)
10.0
1
2,040
520
12.0
100
12.0
2
..
.
2,040
520
12.0
100
14.0
9
2,040
520
12.0
100
28.0
10
2,040
520
12.0
100
30.0