Transcript Principles of Economics, Case and Fair,9e

PART III THE CORE OF MACROECONOMIC THEORY
Aggregate Supply
and the Equilibrium
Price Level
13
CHAPTER OUTLINE
The Aggregate Supply Curve
The Equilibrium Price Level
The Long-Run Aggregate Supply Curve
Monetary and Fiscal Policy Effects
Causes of Inflation
The Behavior of the Fed
Prepared by:
Fernando & Yvonn Quijano
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Principles of Macroeconomics 9e by Case, Fair and Oster
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
13.1 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 AS curve is more complex than a simple individual or market supply
(SS) curve. The AS curve is not a market supply curve, and it is not the
sum of all the individual supply curves in the economy.
It is thus helpful to think of the AS curve as a “price/output response”
curve, i.e. a curve that traces out the price decisions and output
decisions of all firms in the economy under a given set of circumstances.
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Aggregate Supply in the Short Run
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
The shape of the short-run AS curve (the
price/output response curve) is a source of
much controversy in macroeconomics.
The AS curve has a positive slope because
when aggregate demand , the response
will be an increase in both output (Y) and
price (P).
Many economists believe that at low levels
of aggregate output (firms have excess
capacity), the curve is fairly flat (Y>P).
As the economy approaches capacity, the
curve becomes nearly vertical (P>Y). .
At capacity, the curve is vertical (increases
in demand will be met by raising prices
only).
The flat and steep parts of the AS curve are
due to the difference in the levels of firms’
capacity utilization.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
Shifts of the Short-Run Aggregate Supply Curve
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
13.2 The Equilibrium Price Level
At each point along the AD curve,
both the money market and the goods
market are in equilibrium.
 FIGURE 13.3 The Equilibrium Price
Level
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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13.3 The Long-Run Aggregate Supply Curve
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
 FIGURE 13.4 The Long-Run AS 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 and the long-run AS curve is vertical.
Y0 is sometimes called potential GDP.
If the long-run AS curve is vertical, factors
that shift the AD curve to the right (such
as Ms, G or T) will end up increasing
the price level P only.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
13.4 Monetary and Fiscal Policy Effects
An expansionary policy (such as Ms,
G or T) shifts the AD curve to the
right.
 FIGURE 13.5 A Shift of the
Aggregate Demand Curve When the
Economy Is on the Nearly Flat Part of
the AS Curve
A contractionary policy (such as Ms,
G or T) shifts the AD curve to the
left.
If the economy is on the nearly flat
portion of the AS curve, an
expansionary policy will result in a
small price increase relative to the
output increase (Y > P).
This is when an expansionary policy
works well.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
 FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near
Maximum Capacity
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If the economy
is on the steep
portion of the
AS curve, an
expansionary
policy will result
in a much
higher price
level with little
increase in
output (P >
Y).
This is when an
expansionary
policy does not
work well.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
If the AS curve is vertical in the long
run, neither monetary policy nor fiscal
policy has any effect on Y in the long
run. It will end up increasing the price
level P only.
The conclusion that policy has no
effect on aggregate output in the long
run is perhaps startling.
For this reason, the exact length of the
long run is one of the most pressing
questions in macroeconomics.
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13.5 Causes of Inflation
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
(1) Demand-Pull Inflation
Inflation that is initiated
by an increase in
aggregate demand
(i.e. by a rightward
shift of AD curve).
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
Demand-pull Inflation
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(2) Cost-Push, or Supply-Side, Inflation
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
Inflation caused by an increase in costs
(i.e. by a leftward shift of AS curve).
By assuming the government does not
react to this shift, the AD curve does not
shift.
Cost-Push, or Supply-Side, Inflation
Hence, the price level rises, and output
falls (this is called stagflation, i.e. the
economy is experiencing both a
contraction and inflation simultaneously).
What if the government counteract by
engaging in an expansionary policy?
See next slide
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
If the government counteract
by engaging in an
expansionary policy, the AD
curve will shift to the right
from AD0 to AD1.
 FIGURE 13.8 Cost Shocks Are Bad
News for Policy Makers
This policy would raise
aggregate output Y again, but
it would raise the price level
further, to P2.
Either the government
intervene or not, cost shocks
are bad news for policy
makers.
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(3) Expectations and Inflation
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
If a firm expects that its competitors will raise their prices, in anticipation, it
may raise its own price.
If firms increase their prices because of a change in inflationary expectations,
the result is a leftward shift of the AS curve.
Given the importance of expectations in inflation, the central banks of many
countries survey consumers about their expectations. One of the aims of the
central banks is to try to keep these expectations low.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
(4) Sustained Inflation
An increase in G with the money supply
constant shifts the AD curve from AD0 to
AD1, and results in a higher price level at
P1.
 FIGURE 13.9 Sustained Inflation
From an Initial Increase in G and Fed
Accommodation
A higher price will shift the Md curve to
the right, and hence  interest rate, which
then crowds out I.
If the Fed tries to keep the interest rate
unchanged (and hence eliminates the
crowding out effect) by increasing Ms, the
AD curve will shift farther and farther to
the right.
The result is a sustained inflation
(inflation that persists over a long period of
time), perhaps even hyperinflation (very
rapid increases in the overall price level).
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
13.6 The Behavior of the Fed In Practice
 FIGURE 13.10 Fed Behavior
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Controlling money supply or the interest rate?
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
When the Fed  Ms, the interest rate falls.
If the Fed wants to achieve a particular value of the money supply, it must
accept whatever interest rate value is implied by this choice.
Conversely, if the Fed wants to achieve a particular value of the interest
rate, it must accept whatever money supply value is implied by this. For
instance, if the Fed wants to lower interest rate by 1% to 5%, it must keep
increasing money supply until the interest rate value of 5% is reached.
In practice, the Fed controls the interest rate rather than the money
supply. And the targeted interest rate depends on the state of the economy.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
The State of the Economy and the Fed’s Interest Rate Decision
During periods of low output/ low
inflation, the economy is on the
relatively flat portion of the AS curve. In
this case, the Fed is likely to lower the
interest rate (by expanding Ms).
 FIGURE 13.11 The Fed’s Response to Low
Output/Low Inflation
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.
Y > P
For instance, in the U.S., inflation
was a concern in early 2008, but
lower output was more of a concern.
The Fed thus responded by lowering
interest rates.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
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 (by
contracting Ms).
 FIGURE 13.12 The Fed’s Response
to High Output/High Inflation
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.
P > Y
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
How about during periods of stagflation, i.e. the economy is experiencing both a
contraction (low output) and inflation simultaneously?
If the Fed lowers interest rate, Y will , but so will the inflation rate (which is already
too high)
 Solving output at the expense of inflation.
If the Fed increases the interest rate, P will , but so will the output (which is already
too low)
 Solving inflation at the expense of output
So, there is a trade-off here, and the decision depends on how the Fed weights
output relative to inflation.
If Fed dislikes high inflation more than low output, it will increase the interest rate.
If Fed dislikes low output more than high inflation, it will lower the interest rate.
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Fed Behavior Since 1970
CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
 FIGURE 13.13 Output, Inflation, and the Interest Rate 1970 I–2007 IV
The Fed generally had high interest rates in the 1970s and early 1980s as it fought inflation. Since 1983,
inflation has been low by historical standards, and the Fed focused in this period on trying to smooth
fluctuations in output.
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CHAPTER 13 Aggregate Supply and the Equilibrium Price Level
Inflation Targeting
A monetary authority chooses its interest rate values with the aim of
keeping the inflation rate within some specified band over some
specified horizon.
Some central banks in the world are primarily inflation targeters (for
example, the European Central Bank), whereas others are not (for
example, the Fed).
In the case of inflation targeting, the central banks put all the weight on
inflation (and none on output). So, the interest rate decision is aimed at
solving inflation problem.
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