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Aggregate Demand & Supply Part III: Equilibrium Equilibrium Aggregate Price Level Putting aggregate D & S together: AS P Pe AD Ye Y Oil Crisis, 1974 Arab Boycott leads to 4X increase in oil prices: AS' AS P 1974-75 Recession Pe' Pe AD Ye' Ye Y Fiscal & Monetary Policy - I G, T, Ms all shift AD to right AS P Pe AD Ye Y AD' Fiscal & Monetary Policy - II G, T, Ms all shift AD to left AS P Pe AD AD' Ye Y Fiscal & Monetary Policy - III But what are size of effects on prices & output? AS P ? Pe AD ? Ye Y Size of effects = f(shape of AS) Where AS is flatter, e.g., in depression, shifts in AD produce large changes in Y with small changes in P (typical Keynesian result): AS P AD Pe Ye' Ye Y Size of effects = f(shape of AS) But where AS is steeper, e.g., in boom, shifts in AD produce large changes in P with small changes in Y: AS P AD Pe Ye Ye' Y Keynesian "Gaps" Below Ye aggregate demand could be increased with no upward pressure on prices Above Ye aggregate demand increases would generate inflation (rising price level) aggregate demand C, I, G deflationary gap inflationary gap B Y A Y Keynesian Aggregate Supply We can translate this into AS - AD terms: P AS Y Ye Long Run Aggregate Supply - I Long run AS is said to be vertical. Why? Ans: wages adjust to price changes LRAS P Pe AD Ye Y Long Run Aggregate Supply - II Suppose AD increased by policy, P & Y LRAS SRAS P Pe' Pe AD' AD Ye Ye' Y Long Run Aggregate Supply - III But then wages/costs/SRAS adjust to P LRAS SRAS' SRAS P Pe" Pe' Pe AD' AD Ye Ye' Y "Long Run" AS? Problem: "short run" defined by fixed assets, upper limit to production capacity "Long Run" defined in micro by all assets can be changed, plant & equipment & productivity can be increased In micro a given technology may produce an "envelop" of short run cost curves But in aggregate, technology can change and output can be expanded indefinately! Potential GDP? LRAS curve vertical at what is called "potential GDP" "Potential GDP" = "level of output that can be sustained in the long run without inflation" But in aggregate, technology can change and output can be expanded indefinitely! Inflation We now have model with price level, and hence inflation, explicit We can use this model to talk about various kinds of inflationary pressures Demand Pull Inflation - I As we approach full employment, increasing demand "pulls" up the price level: AS P AD Pe Ye Ye' Y At Full Employment At full employment, increases in AD produces only price increases: P AS Y Ye Cost Push Inflation - I Increases in costs (wages, oil) shifts AS up, so P (but note: Y = stagflation) AS' AS P Pe' Pe AD Ye' Ye Y Cost Push Inflation - II But in late 1960s Y ROSE with wage , how? AS' AS P Pe' Pe AD Ye' Ye Y Cost Push Inflation - III Ans: accomodating monetary policy that AD AS' AS Pe" Pe' Pe AD' AD Ye' Ye Y Inflation = Monetary Phenomenon? C&F: "a sustained inflation, whatever the initial cause . . ., is essentially a monetary phenomenon." (p. 332) C&F: "can be thought of as a purely monetary phenomenon" (p. 337) This view is associated with "monetarism" which became popular in 1970s because it offered a policy alternative: hold down Ms. --END--