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Frank & Bernanke
Ch. 15: Inflation, Aggregate Demand,
and Aggregate Supply
Output Gaps and Policies

AD > Y* => Expansionary Gap
 AD < Y* => Recessionary Gap
 Policies to eliminate gaps:
– Fiscal policies
 G increase/decrease
 T increase/decrease
– Monetary policies
 Money supply increase/decrease (r increase/decrease)
Shortcoming of the Keynesian
Cross
 It keeps prices constant.

How does one include inflation into the
Keynesian cross?
 Explain what happens to AD at higher
levels of inflation and use this new diagram.
 Include the self-correcting mechanism of
the economy by differentiating short run
aggregate supply (Keynesian) from the long
run aggregate supply (Classical).
Aggregate Demand

AD = C + I + G + NX
 C = C (Y, r)
 I = I (r)
 When Y up => C up => AD up
 When r up => I down, C down => AD down
Why Does Aggregate Demand
Fall When Inflation Rises?

When p up => Fed Policy Reaction Function
raises r => I and C down => AD down
– Fed Policy Reaction Function (Example: Taylor
rule): r = 0.01 - 0.5[(Y*-Y)/Y*] + 0.5p
Taylor Rule
r = 0.01 –0.5 [(Y* - Y)/Y*] + 0.5 π
How does the Fed react when inflation rises?
How does the Fed react when output gaps appear?
What will the real and nominal interest rates be given
different values?
Fed Policy Reaction Function
p
Zero percent Output Gap
Recessionary Gap
Expansionary Gap
r
Why Does Aggregate Demand
Fall When Inflation Rises?
When p up => wealth held in money form
erodes => C down => AD down
 When p up => MPC falls because the poor are
affected more than the rich => multiplier falls
=> AD flatter
 When p up => at constant exchange rates our
exports become more expensive and our imports
become cheaper => NX falls => AD falls

Deriving AD

Given C and I, find the AD if Fed has a
policy reaction function to determine r for
different inflation rates.
 C = 400 + .9 (Y - T) - 300r
 I = 300 - 800r
 T = 200; G = 250; NX = 20
 r = 0.01 + 0.5p
Deriving AD
p
r
0.02
0.04
0.06
Y = 790 + .9Y - 1100r
.1Y = 790 - 1100r
Y = 7900 - 11000r
0.02
0.03
0.04
Y
7680
7570
7460
π
Y
Shifts in AD

Changes in autonomous aggregate demand.
–
–
–
–
–

Autonomous C
Autonomous I
Taxes
Government purchases
Net exports
Changes in Fed’s policy reaction function
– Tightening of monetary policy
– Easing of monetary policy
Shifting of AD

Increase in autonomous spending shifts AD
right.
 Tightening of monetary policy raises r and
shifts AD left.
 Easing of monetary policy lowers r and
shifts AD right.
 Changes in inflation are movements along
the AD curve.
Shifting of AD

Suppose autonomous consumption
increased from 400 to 410 and autonomous
investment increased from 300 to 305.
 At the same time, taxes are increased to
210.
 What is the new AD?
 Old AD was Y = 7900 – 11,000r
 Y = 7960 – 11,000r
Shifting AD
r
0.02
0.03
0.04
Y
7680
7570
7460
Y'
7740
7630
7520
Movement Along AD

Any change in the vertical axis shows as a
movement along the AD line, just like
demand and supply (changes in P).
 The vertical axis measures the inflation rate.
 Therefore, any change in the inflation rate is
shown as a movement along the AD line.
Why Inflation Rate Doesn’t
Change?

Inflation has inertia.
– Inflationary expectations tend to keep inflation
constant.
– Contracts include expected inflation.

Long term contracts keep inflation constant.
Why Inflation Rate Changes?
1.
Output Gap.
1. Expansionary output gaps (Y>Y*)
2.
Inflation shock
1. An increase in price of inputs that raise the
cost of production for a significant portion of
the economy. (Oil; wages for national
unions).
3.
Shock to potential output
1. Disasters.
Output Gaps and Inflation

Expansionary gap (Y > Y*) => Inflation
rises.
 Recessionary gap (Y < Y*) => Inflation
falls.
 No output gap (Y = Y*) => Inflation
remains the same.
Inertia and Output Gaps
Inflation
LRAS
SRAS
AD
Y
Y*
Long Run Equilibrium
Inflation
LRAS
SRAS
AD
Y
Y*
Expansionary Gaps

How will an expansionary gap look in an
AD-AS diagram?
 How will the economy adjust to the
expansionary gap?
 What will happen to SRAS in the long-run?
 Keynesian - Classical dilemma.
Expansionary Gap
Inflation
Y*
Y
Identify the lines and explain the short and long run changes
when there is no government intervention.
Excessive AD

Shifts in AD that create expansionary output
gaps will raise inflation rate.
– G increase: military buildup of 1960s and
1980s.
– Inflation rose in the sixties but did not in the
eighties.

The Fed’s policy stand is the answer.
Inflation Shocks

Oil price shock of the seventies pushed the
inflation up: SRAS shifts up.
 If the Fed doesn’t respond recessionary gap
will be eliminated in the long run.
 If the Fed does respond to recession, AD
will be shifted to the right but the long run
equilibrium will take place at the higher
inflation rate.
Inflation Shock
Inflation
Y*
Y
Shock to Potential Output

If a disaster happens or capital becomes
obsolete or expensive to use, Y* shifts left.
 Again, stagflation occurs, just like when
inflationary shocks takes place.
 Long run equilibrium will be at a higher
inflation rate and lower Y.
Shock to Potential Output
Inflation
Y*
Y
Lowering Inflation

Suppose the country is experiencing double
digit inflation.
 Because of inflationary expectations and
contracts, the inflation will remain at that
level.
 However, to eliminate the costs of inflation,
the Central Bank embarks in a new
monetary policy.
 Show the short and long run effects.
Lowering Inflation
GDP
Inflation
Infl’n
Y*
r
Time