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Early 1980s
Review: Aggregate Demand/Aggregate Supply Model
AD Question: How many
final goods and services
would be purchased if the
inflation rate () were
_______ percent, given that
all other factors relevant to
demand remained the same?
 (%)
AS
AD
G&S
Aggregate Demand (AD)
curve is downward sloping
AS Question: How many
final goods and services
would be produced if the
inflation rate () were
_______ percent, given that
all other factors relevant to
supply remained the same?
Aggregate Supply (AS)
curve is upward sloping
Equilibrium
Goods and services
(G&S) purchased

AD

C + I + G
=
=
=
Goods and services
(G&S) produced

AS

GDP
Shifts in the Aggregate Demand (AD) Curve
Fiscal Policy: President and Congress
Government Purchases
Decrease
Increase


Contractionary
Expansionary


AD curve shifts left
AD curve shifts right
Long Run Aggregate Supply (LRAS) Curve
Taxes
Increase
Decrease

Contractionary

AD curve shifts left

Expansionary

AD curve shifts right
Vertical: A placeholder for potential GDP, GDPP.
Intersects the AS curve at the expected inflation rate, E.
Shifts in the Aggregate Supply (AS) Curve
Supply Shocks
Negative Shock
Positive Shock


AS curve shifts left
AS curve shifts right
Changes in the expected inflation rate (E)
Decrease in E
Increase in E

AS curve shifts up

AS curve shifts down
 (%)
LRAS
AS
AS
AS
E
E
E
GDPP
G&S
Reagan Tax Cut
Unemp
Year Rate (%)
1980
1981
7.6
1982
9.7
1983
9.6
1984
7.5
Real
GDP
Actual Infl
Rate (%)
9.0
9.3
6.2
3.9
3.5
6,610
6,485
6,785
7,275
Expected Infl
Rate (%)
Govt
Purch
Real Interest
Rate (%)
9.0
9.3
6.2
3.9
1,630
1,660
1,720
1,785
4.8
7.6
8.1
9.2
 (%)
Adaptive
Expectations:
The expected
inflation rate
depends on the
actual inflation
rate in the
recent past.
AS1981,82
10.0
1981
1981-1982
1982-1983
1983-1984
AS1983
Expected inflation
raterate
about
decreases
the same

AS curve
shifts
stationary
down
8.0
6.0
1982
AS1984
4.0
AS and LRAS
curves intersect
at the expected
inflation rate.
AS Curve
1983
1984
2.0
GDP
6,500
6,750
7,000
7,250
7,500
Year
1980
1981
1982
1983
1984
Unemp
Rate (%)
Real
GDP
7.6
9.7
9.6
7.5
6,610
6,485
6,785
7,275
Actual Infl
Rate (%)
9.0
9.3
6.2
3.9
3.5
Fiscal Policy: President and Congress
Government Purchases
Taxes
Increase
Decrease


Expansionary
Expansionary


AD curve shifts
AD curve shifts
right
right
Expected Infl
Rate (%)
Govt
Purch
Real Interest
Rate (%)
9.0
9.3
6.2
3.9
1,630
1,660
1,720
1,785
4.8
7.6
8.1
9.2
AD Curve
 (%)
AS1981,82
10.0
5 percent in 1982
10 percent in 1983
10 percent in 1984
1981
8.0
6.0
Reagan Tax Cut
In August 1981, the President and Congress
enacted a 25 percent reduction phased in
over the next three years:
AD1981
1982
Question: Did the
aggregate demand (AD)
curve have to shift?
4.0
2.0
Puzzle: What
are we missing?
Answer: Yes, to the left.
6,500
6,750
GDP
Monetary Policy: Federal Reserve Board (Fed)
FP Question: What would the
AD Question: How many final goods
real interest rate (r) equal, if the
and services would be purchased, if the
inflation rate () were _______
inflation rate () were _______ percent,
percent, given that the Fed does
given that all other factors relevant to
not change its inflation policy?
demand remained the same?
 (%)
 (%)
Aggregate demand (AD)
Taylor
curve is downward sloping
Principle
FP
as a consequence of the
Taylor principle.
AD
G&S
r (%)
Inflation
rate ()
increases
Real interest
Loans
Households
Fewer goods
rate (r)  become  and firms  and services

increases
more costly
purchase less
purchased

Taylor principle
(FP curve)
Taylor Principle is reactive.

C and I
decrease

AD = C + I + G
decreases
The Fed is reacting to a change in the inflation rate.
Autonomous Monetary Policy: Shift of the Fed Policy (FP) curve – A Proactive Fed
Autonomous Expansionary Monetary Policy
Autonomous Contractionary Monetary Policy

Fed becomes tougher on inflation

Fed shifts the FP curve right

At a given inflation rate (),
the Fed increases the real interest rate (r).

Fed becomes easier on inflation

Fed shifts the FP curve right

At a given inflation rate (),
the Fed decreases the real interest rate (r).
FP Question: What would the real
interest rate (r) equal, if the inflation rate
() were _______ percent, given that the
Fed does not change its inflation policy?
AD Question: How many final goods and
services would be purchased, if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
 (%)
 (%)
FP
FP curve shifts right

AD curve shifts left

Contractionary
 Lab 10.1
AD
FP
At a given
inflation
rate ()
AD
G&S
r (%)
Fed increases
Loans
Households
Fewer goods
Aggregate
the real
 become more  and firms  and services  demand (AD)
interest rate (r)
costly
purchase less
purchased
curve shifts left
The Fed and Autonomous Monetary Policies
Question: Did the Fed pursue autonomous monetary policies in the early 1980s?
Actual Infl
Rate (%)
9.3%
6.2%
3.9%
3.5%
Year
1981
1982
1983
1984
Real Interest
Rate (%)
4.8%
7.6%
8.1%
9.2%
The FP curve shifted right

The Fed pursued an autonomous
contractionary monetary policy

The Fed shifted the AD curve left.
 (%)
FP1981
FP1982
FP1983
10.0
1981
8.0
FP1984
1982
Question: When the FP
curve shifts right, what
happens to the AD curve?
Answer: The AD curve
shifts left.
6.0
1983
4.0
Taylor Principle:
The Fed policy (FP) curve
is upward sloping.
1984
2.0
4.0
6.0
8.0
10.0
r (%)
Reagan Tax Cut Revisted
Real Actual Infl
Year
GDP
Rate (%)
1980
9.0
1981
6,610
9.3
1982
6,485
6.2
1983
6,785
3.9
1984
7,275
3.5
Govt
Purch
Fiscal
Policy
1983-1984
1981-1982
1982-1983
Autonomous
Monetary Policy

Expansionary
1,630
1,660
1,720
1,785

Contractionary
In
Innet,
net,AD
ADcurve
curveshifts
shiftsright.
left.
Monetary
Fiscal policy
policy
dominates.
dominates.
 (%)
AD1981 AS1981,82
Reagan Tax Cut 10.0
1982: 5 percent
1983: 10 percent 8.0
1984: 10 percent
6.0
1981
AS1983
AS1984
1982
4.0
1983
2.0
AD1982
6,500
6,750
1984
AD1983
7,000
AD1984
7,250
7,500
G&S
Summary: Fiscal and Monetary Policies
Fiscal Policy:
Congress and the President
Expansionary
Contractionary
G
Up
FP
Curve
AD
Curve
T
Down
G
Down
T
Up
FP Stationary
AD Shifts
Right
AD Shifts
Left
FP Question: What would the real interest
 (%) rate (r) equal, if the inflation rate () were
_______ percent, given that the Fed does not
change its inflation policy?
FP
FP
Autonomous Monetary Policy:
The Fed
Contractionary
Expansionary
Open Market
Open Market
Purchase
Sale
FP Shifts
Left
FP Shifts
Right
AD Shifts
Right
AD Shifts
Left
AD Question: How many final goods and
 (%) services would be purchased, if the inflation
rate () were _______ percent, given that all
other factors relevant to demand remained
the same?
FP
AD
AD
r (%)
AD
G&S