Download Aggregate Supply (AS) Curve

Aggregate Demand Curve – Putting It All Together
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
Aggregate Demand (AD)
curve is downward sloping
G&S
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
Notation: G&S = Final goods and services
 = Inflation rate
i = Nominal interest rate
r = Real interest rate
Real
Nominal
Rate
interest = interest

of
rate
rate
inflation
r
=
i


Question: Why Is the aggregate demand curve downward sloping?
Fed’s Goal: Stabilize the Economy
The Fed does so by using its throttle, the real interest rate.
Taylor Principle: How the Federal Reserve Board (Fed) Stabilizes the Economy
When the inflation rate () increases
the Fed “slows down” the economy
by increasing the real interest rate (r).
Inflation rate () increases

Real interest rate (r) increases

Loans become more costly
When the inflation rate () decreases
the Fed “speeds up” the economy by
decreasing the real interest rate (r).
Taylor principle

Households and firm purchase
fewer goods and services

In the entire economy fewer goods
and services (G&S) purchased

Economy “slows down”
Inflation rate () decreases

Real interest rate (r) decreases

Loans become less costly

Households and firm purchase
more goods and services

In the entire economy more goods
and services (G&S) purchased

Economy “speeds up”
Economy stabilizes
Taylor Principle and the Fed Policy (FP) Curve
Taylor
Principle
When the inflation rate () increases
the Fed “slows down” the economy
by increasing the real interest rate (r).
When the inflation rate () decreases
the Fed “speeds up” the economy by
decreasing 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?
 (%)
FP
The Fed policy (FP) curve is
upward sloping to stabilize
the economy.
r (%)
Deriving the Aggregate Demand (AD) Curve
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
AD
r (%)
Fed increases
Loans
Households
Fewer goods
Inflation
the real
 become  and firms  and services
rate () 
interest rate (r) more costly
purchase less
purchased
increases



Taylor principle
C and I
AD = C + I + G
(FP curve)
decrease
decreases
Question: How does the Fed influence the real interest rate (r)?
G&S
To understand how the Fed affects the real interest rate (r) we study the money market.
Money and Income Differ.
Conceptual Definition of Money: The medium
Operational Definition of Money:
of exchange. The financial assets that you own
M1 = Cash + Checking Deposits
that can be used to purchase goods and services.
M2 = M1 + Savings Deposits
Income: How much you earn over the
i (%)
MS
course of a year.
The demand curve for
Demand Curve for Money (MD): How
money is downward
much money would be demanded if the
sloping
nominal interest rate were ______, given
that everything else relevant to the demand
for money remains the same?
The nominal interest (i) rate rises.

Interest earning assets (CD’s, Treasury bonds,
corporate bonds, etc.) become more attractive
because they are earning more interest.

Individuals seek to hold more interest earning
assets.

To hold more interest earning assets individuals
hold less money.
i*
MD
M
Question: Why is the demand curve for
money (MD) downward sloping?
Question: Why is the supply curve for
money (MS) vertical?
Claim: The Fed controls the
money supply.
Question: How does the Fed control the money supply? Study the banking system
Banking System
Is the bank
Yes Board
Roles
of the“loaned
Federalup?”
Reserve
Liabilities
Assets
Fed MonitorsRequired
Banks
Required
RES
50
DEP
500
=
reserve

Deposits
Fed
Acts
as
the
Bank’s
Bank
reserves
ratio
Vault Cash
30
Fed Uses Its
Policy
Tools
Dep at Fed
20
500
= Monetary
10%

to Control the Money Supply
SEC
60
=
50
Open market operations
BOR
10
LOANS
480
Excess = (Actual)  Required
rate
reservesDiscount
reserves
reserves
Required Reserve Ratio = 10%
Required
reserve
ratio
=
50

50
= 0
Question: Which balance sheet entry constitutes
Open market operation:
money? That is, which entry can we use to
The Fed purchases or sells Treasury
purchase goods and services? Deposits. DEP
bills (T-bills) that have been previously
Increase
the
Decrease
the operations
Question: How do
open market
affect
issued by the U.S. Treasury.
money supply
money supply
the bank’s deposits?
Key Questions
to Pose
Monetary
Policy
i (%)
Decrease
the reservesIncrease
the and a required
MS
MS’
MS’
With actual
of _______
money
supply
money supply
reserve
ratio of _______%,
how many deposits
can banks
be liable for? _______


DEP
decreases
DEP increases
Since
loans and deposits
increase by the same
amount
 when a bank issues
 a new loan and
reserves
are unaffected,
many ____________
MS curve
MShow
curve
loans
_________
shiftscan
leftbanks issue?
shifts
right
M
Open Market Operation: Purchase of $5
Liabilities
Assets
With actual reserves of _______
55
and a
RES
DEP
550 505 500
55 50
10
required reserve ratio of _______%,
Vault Cash
30
how many deposits can banks be liable
Dep at Fed 25 20
550
for? _______
SEC
60
Since loans and deposits increase by the
BOR
10
525 480
same amount when a bank issues a new LOANS
loan and reserves are unaffected, how
Required
Required
more
many ____________
loans should banks
 Deposits
reserves = reserve
ratio
issue? _________
45
T-Bill
=

10%
550
500
= 55
50
Federal Reserve Board
Washington, DC
Kate
Pay to the order of Kate
Janet Yellen
$5
Fed
Bank’s deposits at its
bank, the Fed,
increase by $5.
Kate’s deposits at his
bank increase by $5.
Kate’s
Bank
Open Market Operation: Purchase of $5
Bank deposits increase
by 50 from 500 to 550

Money supply (MS)
curve shifts right

Nominal interest rate
falls
Liabilities
Assets
RES
55 50
Vault Cash
30
Dep at Fed 25 20
SEC
60
DEP
550 500
LOANS
BOR
10
525 480
i (%)
MS
MS’
 Lab 5.2
5.0
3.8
MD
500
550
M
Open Market Operation: Sale of $5
With actual reserves of _______
45 and a
10
required reserve ratio of _______%,
how many deposits can banks be liable
for? _______
450
Liabilities
Assets
45 50
RES
Vault Cash
30
Dep at Fed 15 20
SEC
60
DEP
435 480
BOR
Since loans and deposits increase by the
same amount when a bank issues a new LOANS
loan and reserves are unaffected, how
fewer
many ____________
loans should banks
45
issue? _________
450 495 500
10
Required = Required
reserve  Deposits
reserves
ratio
T-Bill
=

10%
450
500
== 45
50
Kate
Amherst, MA
Kate
Pay to the order of the Fed
Kate
$5
Fed
Bank’s deposits at its
bank, the Fed,
decrease by $5.
Kate’s deposits at her
bank decrease by $5.
Kate’s
Bank
Aside: Would reducing loans
create a disruption at the bank?
Open Market Operation: Sale of $5
Bank deposits decrease
by 50 from 500 to 450

Money supply (MS)
curve shifts left

Nominal interest rate
rises
 Lab 5.3
Liabilities
Assets
RES
45 50
Vault Cash
30
Dep at Fed 15 20
SEC
60
DEP
450 500
435 480
BOR
10
LOANS
i (%)
MS’
MS
6.3
5.0
MD
450
500
M
Aggregate Supply Curves
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
Aggregate Demand (AD)
curve is downward sloping
G&S
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
Question: Why is the aggregate supply (AS) curve upward sloping?
Preview: The Aggregate Supply Curves
Long Run Aggregate Supply (LRAS) Curve
Vertical
Placeholder for potential GDP (GDPP)
 (%)
LRAS
AS
We will shortly explain precisely
what we mean by potential GDP.
Aggregate Supply (AS) Curve
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?
E
GDPP
Claims: The AS curve
Is upward sloping.
Intersects the LRAS curve at the expected
inflation rate, E.
G&S
Expected Inflation Rate
Question: Why is the expected inflation rate important?
Answer: Wages are typically set for a specified time in the future.
Workers base their wage demands
Employers base the wage concessions they
on the rate of inflation
are willing to make on the rate of inflation
they expect in the future.
they expect in the future.
Wage increases are based on the expected inflation rate.
Affects
Affect
Expected
wages in the
 firm costs in the
inflation 
upcoming year
upcoming year
rate
Simplifying Assumptions
Firm Costs: Firms incur only labor costs
Stable Start: For many, many years: GDP = 2,000
Annual
Increase = 2.0%
in Prices

Actual
Inflation = 2.0%
Rate ()

Expected
Inflation = 2.0%
Rate (E)
Annual
Increase = 2.0%
in Wages

Increase
in Firm
Costs
= 2.0%
Potential GDP (GDPP): The value of GDP
whenever the actual inflation rate () equals
the expected inflation rate (E)
Potential GDP (GDPP) = 2,000
Aggregate Supply Curves
Atkins’ Apple Orchard
Anything special about Mr. Atkins orchard? No.
Anything special about
No.
apple production?
MCCurrent
MCPrevious
MRCurrent
PCurrent = 102
2.0%
MRPrevious
PPrevious = 100
Mr. Atkins’
apple production
unchanged.
2.0%
50
SRAS Curve Questions: How many
LRAS curve is a place  (%)
final goods and services would be
mark for potential
produced if the inflation rate were
GDP (GDPP)
_____
2.0 % given that all other factors
relevant to supply remained the
same?
Wages and hence E =2.0
firm costs
increase by 2.0%
Generalization: Whenever the actual inflation rate ()
equals the expected inflation rate (E), final goods and
services produced equals potential GDP (GDPP)
Q (bushels)
LRAS
GDPP = 2,000
G&S
Aggregate Supply Curves
Atkins’ Apple Orchard
MCCurrent
Anything special about Mr. Atkins
orchard or apple production? No.
MCPrevious
PCurrent = 103
MRCurrent
3.0%
MRPrevious
PPrevious = 100
Mr. Atkins’
apple production
increases.
2.0%
50
SRAS Curve Questions: How many
LRAS curve is a place  (%)
final goods and services would be
mark for potential
produced if the inflation rate were
GDP (GDPP)
_____
3.0 % given that all other factors
3.0
relevant to supply remained the same?
Wages and hence E =2.0
firm costs
increase by 2.0%
Generalization: Whenever the actual inflation rate () is
greater than the expected inflation rate (E), final goods and
services produced is greater than potential GDP (GDPP)
Q (bushels)
LRAS
G&S
GDPP
= 2,000
Aggregate Supply Curves
Atkins’ Apple Orchard
MCCurrent
Anything special about Mr. Atkins
orchard or apple production? No.
PCurrent = 101
MCPrevious
1.0%
MRCurrent
MRPrevious
2.0%
Mr. Atkins’
apple production
decreases.
PPrevious = 100
50
SRAS Curve Questions: How many
LRAS curve is a place  (%)
final goods and services would be
mark for potential
produced if the inflation rate were
P)
GDP
(GDP
1.0 % given that all other factors
_____
3.0
relevant to supply remained the same?
Q (bushels)
LRAS
AS
Wages and hence E =2.0
firm costs
increase by 2.0%
1.0
Generalization: Whenever the actual inflation rate () is
less than the expected inflation rate (E), final goods and
services produced is less than potential GDP (GDPP)
G&S
GDPP = 2,000