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Slide 15 - 0
Inflation, Aggregate Demand,
and Aggregate Supply
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 15 - 1
Volcker’s Move
The 1979 inflation rate had reached 13% and
Paul Volcker’s job was to get inflation under
control and restore confidence in
policymaking
Appointed by Carter as the Chairman of the
Fed in Sept. 1979, he sharply reduced the
growth rate of the money supply, causing a
recession
Interest rates would rise and AD would fall
Output and employment would also fall
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 15 - 2
Extending the Basic
Keynesian Model
This chapter extends the basic
Keynesian model to allow for price
changes
We will now use the
aggregate demand-aggregate supply diagram
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Slide 15 - 3
Aggregate Demand AD
Aggregate demand AD curve shows the
relationship between aggregate demand
and inflation
Because short-run equilibrium output equals
aggregate demand, the aggregate demand curve
also shows the relationship between short-run
equilibrium output and inflation
Increases in inflation reduce aggregate demand
and short-run output, so the aggregate demand
curve is downward sloping
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Slide 15 - 4
AD and Inflation (p)
AD determined output in the short run
as Y = AD
AD is positively related to output (Y)
AD is negatively related to the real
interest rate (r)
An increase in the rate of inflation (p)
tends to reduce both aggregate demand
and short-run equilibrium output
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Slide 15 - 5
Fig. 15.1
The Aggregate Demand Curve
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Slide 15 - 6
Low Inflation
The Fed’s goal is to keep inflation low
So that society can avoid the costs of high
inflation
Inflation occurs during an expansionary gap
The Fed can decrease AD to close the
output gap and reduce inflation by
Raising the real interest rate r
Reducing C and I, which reduces AD
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Fig. 15.2
Slide 15 - 7
Numerical Example of an Aggregate Demand
Curve
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Slide 15 - 8
Other Reasons for
Downward Slope of AD
Higher inflation reduces AD
Actions of the Fed (just discussed)
Real value of money
Inflation reduces the purchasing power of
money which reduces spending
Distributional effects
Prices of domestic goods and services sold
abroad
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Slide 15 - 9
Shifts in AD
The AD curve holds all other factors
constant
When these other factors change, the AD
curve shifts
Other factors
Changes in autonomous aggregate
demand
The Fed’s policy reaction function
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Slide 15 - 10
Autonomous Changes
Autonomous aggregate demand
The portion of AD that is determined
outside the model
For example, households desire to
consume more shifts AD right
A decrease in autonomous AD shifts AD
left
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Fig. 15.3
Slide 15 - 11
Effect of an Increase in Autonomous Aggregate
Demand
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Slide 15 - 12
Examples of Autonomous
Changes
C
Autonomous consumption
Consumers become more optimistic and
spend more
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Slide 15 - 13
Examples of Autonomous
Changes
T
Taxes
Cut in taxes increases consumer spending
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Slide 15 - 14
Examples of Autonomous
Changes
I
Autonomous investment
Development of a new cost-saving technology
increases spending by firms buying it
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Slide 15 - 15
Examples of Autonomous
Changes
G
Government purchases
Buying more military hardware
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Slide 15 - 16
Examples of Autonomous
Changes
NX
Net Exports
Increased demand for U.S. products by foreigners
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Slide 15 - 17
Changes in the Fed’s Policy
Reaction Function
The Fed’s policy reaction function
Describes how the Fed sets the real interest rate at
each level of inflation
The Fed may deviate from its policy reaction
function
Tightening money
For a given inflation rate, the Fed increases the real
interest rate
Easing money
For a given inflation rate, the Fed increases the real
interest rate
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Slide 15 - 18
Fig. 15.4
A Tightening of Monetary Policy
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Slide 15 - 19
Shifts vs. Movements Along
Movements along AD
Downward slope of AD shows the inverse
relationship between inflation and aggregate
demand
Changes in the inflation rate
Changes in the real interest rate
Shifts in AD
A factor that changes AD at a given level of
inflation
Autonomous changes in spending
Changes in the Fed’s policy reaction function
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Slide 15 - 20
Inflation Inertia
Inflation inertia
Inflation tends to change relatively slowly as long
as the economy is at full employment and there
are no external shocks to the price level
Three factors that change the inflation rate
Output gap
Inflation shock
Shock to potential output
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Slide 15 - 21
Expectations on Inflation
The public’s inflation expectations
Buyers and sellers take into account their
expectation of inflation when negotiating
many types of contracts
The higher the expectation of inflation the
higher the nominal price negotiated
E.G., higher wages and costs of other inputs
If wages and other costs go upfirms will
have to raise prices
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Slide 15 - 22
Expectations Determine
Reality
A low rate of expected inflation tends to lead
to a low rate of actual inflation
A high rate of expected inflation tends to lead
to a high rate of actual inflation
Long-term wage and price contracts build in
wage and price increases that depend on
inflation expectations
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Slide 15 - 23
Fig. 15.5
A Virtuous Circle of Low Inflation
and Low Expected Inflation
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Slide 15 - 24
Output Gap and Inflation
Output gap
The difference between potential output
Y* and actual output Y
Y* - Y
In the short run
Y may equal Y*
Y may differ from Y*
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Slide 15 - 25
No Output Gap
No output gap
Y = Y*
Actual output equals potential output
Firms are satisfied
Sales equal normal production rates
No incentive to change their prices relative to
other prices
Inflation rate tends to remain the same
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Slide 15 - 26
Expansionary Gap
Expansionary output gap
Y > Y*
Actual output is greater than potential output
Firms are over-utilizing resources
Sales exceed normal production rates
Incentive to increase their prices more than
the increase in their costs
Inflation rate tends to increase
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Slide 15 - 27
Recessionary Gap
Recessionary output gap
Y < Y*
Actual output is less than potential output
Firms are under-utilizing resources
Sales are less than normal production rates
Incentive to decrease their relative prices so
they can sell more
Inflation rate tends to decrease
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Slide 15 - 28
AD-AS Diagram
Long-run aggregate supply (LRAS) line
A vertical line showing the economy’s
potential output Y*
Short-run aggregate supply (SRAS) line
A horizontal line showing the current rate
of inflation, as determined by past
expectations and pricing decisions
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Slide 15 - 29
Fig. 15.6
The Aggregate Demand-Aggregate Supply
(AD-AS) diagram
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Slide 15 - 30
SR Equilibrium
Short-run equilibrium
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, it occurs at the intersection of
the AD curve and the SRAS curve
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Slide 15 - 31
Inflation and Recovery from
a Recessionary Gap
An economy experiencing a recessionary gap
Will eliminate the gap
Firms not selling as much as they want to will
Slow the rate at which they increase their prices
This will cause the inflation rate to fall
As inflation falls output rises and unemployment
falls, and the Fed lowers the real interest rate
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Fig. 15.7
Slide 15 - 32
The Adjustment of Inflation When a
Recessionary Gap Exists
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Slide 15 - 33
LR Equilibrium
LR equilibrium
Actual output equals potential output and
the inflation rate is stable
Y = Y*
Graphically, it is where the AD curve, the
SRAS line, and the LRAS line all intersect
at a single point
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Slide 15 - 34
Inflation and Recovery from
an Expansionary Gap
An economy experiencing an expansionary
gap will eliminate the gap
Firms experience high demand will
Increase prices more than costs
This will cause the inflation rate to rise
As inflation rises output falls and unemployment
rises, and the Fed raises the real interest rate
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Fig. 15.8
Slide 15 - 35
The Adjustment of Inflation When an
Expansionary Gap Exists
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Slide 15 - 36
Fig. 15.9
War and Military Buildup as a
Source of Inflation
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Slide 15 - 37
Self-Correcting Economy
The economy tends to be self-correcting
Given enough time, output gaps tend to disappear
without changes in monetary or fiscal policy
The result contrasts with the basic Keynesian
model
Basic Keynesian model focuses on the short run
when prices do not adjust and ignores the longrun adjustment period
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Slide 15 - 38
Timing
If self-correction is slow
Then active use of monetary and fiscal policy can
help to stabilize output
If self-correction is rapid
Then active stabilization polices are probably not
justified
Problems of policymaking: lags and uncertainties
Large gaps will take longer to fix themselves
Greater justification for policy intervention
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Slide 15 - 39
Sources of Inflation
Excessive AD
Too much spending chasing too few goods
Inflation shocks
A sudden change in the normal behavior
of inflation, unrelated to the nation’s
output gap
Favorable or unfavorable
1973 oil shock was unfavorable
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Slide 15 - 40
Fig. 15.10
The Effects of an Adverse Inflation
Shock
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Slide 15 - 41
Sources of Inflation
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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Slide 15 - 42
Fig. 15.11
The Effects of a Shock to Potential
Output
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Slide 15 - 43
Controlling Inflation
What should policymakers do if
inflation is too high?
Inflation can be slowed by policies that
reduce aggregate demand
The short-run costs involve lost output
and increased unemployment
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Slide 15 - 44
Fig. 15.12
The Short-Run and Long-Run Effects of
a Monetary Tightening
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Slide 15 - 45
Disinflation
Disinflation
A substantial reduction in the rate of
inflation
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