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ECO102
Macroeconomics
Lecture 7
ECO201
Macroeconomics
1
Chapter 28: Aggregate Supply and the
Equilibrium Price
Level
ECO102 Macroeconomics
The Aggregate Supply Curve
Chapter 28:
Aggregate Supply
and the Equilibrium
Price Level
Bölüm 28: Toplam
Arz ve Denge Fiyat
Seviyesi
!
The Aggregate Supply Curve: A Warning
!
Aggregate Supply in the Short Run
!
Shifts of the Short-Run Aggregate Supply Curve
The Equilibrium Price Level
The Long-Run Aggregate Supply Curve
!
Potential GDP
Monetary and Fiscal Policy Effects
!
Long-Run Aggregate Supply and Policy Effects
Causes of Inflation
!
Demand-Pull Inflation
!
Cost-Push, or Supply-Side, Inflation
!
Expectations and Inflation
!
Money and Inflation
!
Sustained Inflation as a Purely Monetary
Phenomenon
The Behavior of the Central Bank
2
Terms and Concepts
aggregate supply
toplam arz
aggregate supply (AS)
curve
toplam arz (AS) eğrisi
cost-push, or supply-side, maliyet itişli veya arz yanlı
enflasyon
inflation
cost shock, or supply
shock
maliyet şoku veya arz şoku
demand-pull inflation
talep çekişli enflasyon
equilibrium price level
3
inflation targeting
enflasyon hedeflemesi
potential output, or poten- potansiyel çıktı veya potential GDP
siyel GSYİH
stagflation
stagflasyon
4
The Aggregate Supply Curve
aggregate supply
The total supply of all goods and services in an economy.
aggregate supply (AS) curve
A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall
price level.
The aggregate supply curve is not a market supply curve, and it is
not the simple sum of all the individual supply curves in the economy. Because many firms in the economy set prices as well as output, we can say an “aggregate supply curve” is really a “price/
output response” curve under given set of circumstances.
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The Aggregate Supply Curve
Aggregate Supply in the Short Run
In the short run, the aggregate
supply curve (the price/output
response curve) has a positive
slope.
At low levels of aggregate output, the curve is fairly flat.
As the economy approaches capacity, the curve becomes
nearly vertical.
At capacity, Y*, the curve is vertical.
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The Aggregate Supply Curve
Aggregate Supply in the Short Run
Why an Upward Slope?
Wages are a large fraction of total costs and wage changes lag behind
price changes. This gives us an upward sloping short-run AS curve.
Why the Particular Shape?
At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (Y*), the AS
curve is vertical.
At low levels of output, the AS curve is flatter. Small price increases
may be associated with relatively large output responses. We may observe relatively “sticky” wages upward at this point on the AS curve.
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The Aggregate Supply Curve
Shifts of the Short-Run Aggregate Supply Curve
cost shock, or supply shock A change in costs that shifts the
short-run aggregate supply (AS) curve.
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The Equilibrium Price Level
The price level at which the aggregate demand and aggregate supply curves intersect.
At each point along the AD curve,
both the money market and the
goods market are in equilibrium.
Each point on the AS curve represents the price/ output decisions
of all the firms in the economy.
P0 and Y0 correspond to equilibrium in the goods market and the
money market and to a set of
price/output decisions on the part
of all the firms in the economy.
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The Long-Run Aggregate Supply Curve
When the AD curve shifts
from AD0 to AD1, the equilibrium price level initially
rises from P0 to P1 and output rises from Y0 to Y1.
Wages respond in the
longer run, shifting the AS
curve from AS0 to AS1.
If wages fully adjust, output
will be back at Y0.
Y0 is sometimes called potential GDP.
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The Long-Run Aggregate Supply Curve
potential output, or potential GDP
The level of aggregate output that can be sustained in
the long run without inflation.
Short-Run Equilibrium Below Potential Output
Although different economists have different opinions
on how to determine whether an economy is operating
at or above potential output, there is general agreement
that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve)
that can be sustained without inflation.
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Monetary and Fiscal Policy Effects
A Shift of the Aggregate Demand Curve
When the Economy Is on the Nearly Flat
Part of the AS Curve
Aggregate demand can shift to the right
for a number of reasons, including an increase in the money supply, a tax cut, or
an increase in government spending.
If the shift occurs when the economy is on
the nearly flat portion of the AS curve, the
result will be an increase in output with little increase in the price level from point A
to point A.
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Monetary and Fiscal Policy Effects
A Shift of the Aggregate Demand Curve When the Economy Is Operating At or Near
Maximum Capacity
If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output
from point B to point B.
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Monetary and Fiscal Policy Effects
Long-Run Aggregate Supply and Policy Effects
If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate
output in the long run.
The longer the lag time between wages and output
prices, the greater the potential impact of monetary and
fiscal policy on aggregate output.
Some argue that wages do not fall during slack periods
and that the economy can get “stuck” at an equilibrium
below potential output. In this case, monetary and fiscal
policy would be necessary to restore full employment.
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Causes of Inflation
demand-pull inflation
Inflation that is initiated by an increase in aggregate demand.
If the economy is operating on the steep portion of the
AS curve at the time of the increase in aggregate demand, most of the effect will be an increase in the price
level instead of an increase in output.
If the economy is operating on the flat portion of the AS
curve, most of the effect will be an increase in output instead of an increase in the price level.
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Causes of Inflation
Cost-Push, or Supply-Side, Inflation
An increase in costs shifts
the AS curve to the left.
By assuming the government does not react to
this shift, the AD curve
does not shift, the price
level rises, and output
falls.
stagflation Occurs when output is falling at the same
time that prices are rising.
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Causes of Inflation
Cost-Push, or Supply-Side, Inflation
A cost shock with no change in
monetary or fiscal policy would
shift the aggregate supply curve
from AS0 to AS1, lower output
from Y0 to Y1, and raise the price
level from P0 to P1.
Monetary or fiscal policy could be
changed enough to have the AD
curve shift from AD0 to AD1.
This policy would raise aggregate
output Y again, but it would raise
the price level further, to P2.
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Causes of Inflation
Expectations and Inflation
When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, it may raise its
own price.
The firm’s profit-maximizing optimum price is presumably not too
far from the average of its competitors’ prices.
Expectations can lead to an inertia that makes it difficult to stop an
inflationary spiral. If prices have been rising and if people’s expectations are adaptive, firms may continue raising prices even if demand is slowing or contracting.
Given the importance of expectations in inflation, central banks
aim to keep them low.
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Causes of Inflation
Money and Inflation
Sustained Inflation from an Initial Increase
in G and Ms.
An increase in G with the money supply
constant shifts the AD curve from AD0 to
AD1.
Although not shown in the figure, this leads
to an increase in the interest rate and
crowding out of planned investment.
If the Fed tries to keep the interest rate unchanged by increasing the money supply,
the AD curve will shift farther and farther to
the right.
The result is a sustained inflation, perhaps
even hyperinflation.
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Causes of Inflation
Sustained Inflation as a Purely Monetary Phenomenon
Virtually all economists agree that an increase in the
price level can be caused by anything that causes the
AD curve to shift to the right or the AS curve to shift to
the left.
It is also generally agreed that for a sustained inflation
to occur, the Central Bank must accommodate it.
In this sense, a sustained inflation can be thought of as
a purely monetary phenomenon.
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The Behavior of the Central Bank
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The Behavior of the Central Bank
Targeting the Interest Rate
The actual variable of interest to the Central Bank is
not the money supply, but the interest rate.
In practice, it is the interest rate that directly affects
economic activity, for example, by affecting firms’ decisions about investing.
Targeting the interest rate thus gives the Central Bank
more control over the key variable that matters to the
economy.
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The Behavior of the Central Bank
The CB’s Response to
Low Output/Low Inflation
During periods of low output/low
inflation, the economy is on the
relatively flat portion of the AS
curve.
In this case, the CB is likely to
lower the interest rate (and thus
expand the money supply).
This will shift the AD curve to the
right, from AD0 to AD1, and lead to
an increase in output with very little increase in the price level.
23
The Behavior of the Central Bank
The CB’s Response to
High Output/Low Inflation
During periods of high output/high
inflation, the economy is on the
relatively steep portion of the AS
curve.
In this case, the Fed is likely to increase the interest rate (and thus
contract the money supply).
This will shift the AD curve to the
left, from AD0 to AD1, and lead to a
decrease in the price level with
very little decrease in output.
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The Behavior of the Central Bank
The Fed lowered the short-term interest rate to near zero beginning in 2008 IV.
Since interest rates cannot go below zero, the ability of the
Fed to stimulate the economy when interest rates are zero is
severely limited.
Its main way of stimulating the economy is to lower interest
rates, which stimulates plant and equipment investment as
well as consumption of durable goods and housing investment.
This option is not available when interest rates are near zero.
In this case, stimulus must come primarily from fiscal policy.
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The Behavior of the Central Bank
inflation targeting
When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within
some specified band over some specified horizon.
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