Aggregate Supply Aggregate Demand by stw87072



                                                                     What is the difference between rules
             ECON 206                                                          and discretion?
      MACROECONOMIC ANALYSIS                                     • Rules mean set-in-stone reactions: For example, if inflation goes
                                                                     up, the Fed will raise interest rates

                                                                 • Discretion means nothing is set for sure: If the Fed feels that an
                                                                     increase in inflation is OK, maybe because it is caused by more
                                                                       p growth than normal, it might not act
                                                                     rapid g                    ,   g
                   Roumen Vesselinov                             • Rules are clearly easier to implement and understand, and more
                                                                     importantly, rules may also help produce more macroeconomic
                      Chapter # 12a
                                                                 • Why might this happen? People’s expectations are important,
                                                                     and the effectiveness of discretionary policy may be weakened if
                                                                     people expect it — which they should if policymakers use it a lot
                                                                     — so a rule might be better

                                                                 • We’ll discuss this more in the next class

                                                                Let’s imagine that the Fed follows a simple rule
                                                                  between inflation and the real interest rate
           Aggregate Supply &
                                                                 •   Whenever inflation gets too high above some standard
           Aggregate Demand                                          acceptable level, , then the Fed will raise the real interest rate,
                                                                     Rt, above the marginal product of capital,
                                                                 •   The Fed then sets the difference between Rt and        based on
                                                                     the difference between     and :

                                                                 •   This means that if           and inflation is 0.02 or 2% above its
                                                                     long-run acceptable level, then the Fed will raise the real
                Chapter 12 (1 of 2)                                  interest rate by 0.01 or 1% above the marginal product of capital
                                                                 •   Supposing the Fed followed this rule, what does the IS-MP-PC
                                                                     framework, our short-run model, imply about economic activity?

        Our objectives today                                    This monetary policy rule allows us to combine the IS
                                                                 and MP curves into an Aggregate Demand Curve
•   So far, we have thought of monetary policy as a reaction     •   The IS Curve relates short-run output to the difference
    to particular events with the IS-MP-PC model                     between the real interest rate and the marginal product of
                                                                     capital (MPK):
•   Today, we consider systematic use of monetary policy,
    through rules, to stabilize the economy through all kinds
    of events, rather than case-by-case                          •                  yp    y
                                                                     The monetary policy rule relates the difference between the
                                                                     real interest rate and the MPK to the difference between
•   When monetary policy is rule-based, we can view the IS           actual and desired long-run inflation:
    Curve and MP Curve together as Aggregate Demand,
                                                                 •   Combining these together, by substituting for             , gives
•   While the Phillips Curve is Aggregate Supply                     us an equation in output and inflation:

• Why do this? It gets us to output and inflation
    quicker                                                                This is the Aggregate Demand Curve


       The Aggregate Demand Curve relates
           short-run output and inflation                                         What is equilibrium or steady state in this model?
                                                •How does this look?                                                                              •For there to be a steady
                                                                                                                                                  state, inflation must be
                                                •It’s a downward sloping                                                                          steady at:
Inflation, πt                                   line, just like all demand    Inflation, πt
                                                curves! Inflation is like
                                                the price, and short-run                                                                          •Since we know inflation
                                                output the quantity                                                                               is steady, and there are no
                                                                                                                                                  shocks, then we also
                                                •The reason this                                                                                  know from the Aggregate
                                                relationship exists is
                                                because the Fed is
                                                                                                                                         AS       Supply (Phillips) Curve
                                                                                                                                                  that short-run output is
                                                following a monetary                                                                              zero in the steady state:
                                                policy rule:
                                                •When inflation is higher
                                                than normal, the Fed                                                                                                ,
                                                raises interest rates (not
                                                shown) and thus reduces
                                                                                                                                               •So Aggregate Supply and
                                        AD      output                                                                                      AD Demand intersect at this
                                                •Note that   is the                                                                               point
                                                intercept and thus also
                ’   0    Short-run output,      the shock shifting AD                                              0      Short-run output,

What determines the slope of Aggregate Demand?                                     Why have we developed this framework?
                                                •We have two
                                                parameters that multiply
                                                                                     • Aggregate Supply and Aggregate Demand allow us to quickly
                                                                                           ascertain how macroeconomic events will affect output and
Inflation, πt                                   •When         , their                      inflation
                                                product, is large, then
                                                deviations in inflation,πt,          • IS-MP-PC is underneath it all, but sometimes we don’t really care
                                                away from its long-run
                                                level will produce big
                                                                                           about the real interest rate — so it’s like we’re fast-forwarding
                                                swings in short-run                        ahead to the good part
                                                                                     • T review: Why does A
                                                                                       To   i    Wh d     Aggregate D
                                                                                                                 t Demand slope d
                                                                                                                        d l         ?
                                                •That means that an
                                                increase in either one                  •      The Fed raises interest rates when inflation increases, to lower short-run
                                                makes AD flatter                               output and pull inflation back down

                                                •   is high if the Fed                  •      So higher inflation is associated with lower output: AD slopes down
                                                raises interest rates a lot             •      Shocks to demand will shift the curve
                                                when inflation rises,
                                                •                                    • And: Why does Aggregate Supply slope up?
                                        AD           is high if investment
                                                declines a lot when                     •      Firms set their prices relative to demand conditions
                                                interest rates rise
                                                                                        •      So higher output is associated with higher inflation: AS slopes up
                    0    Short-run output,                                              •      Shocks to inflation shift the curve

                                                                                   Next: We will use the AS/AD model to
     What about an Aggregate Supply Curve?                                           predict macroeconomic behavior
                                             •It turns out we already
                                             have an Aggregate Supply
                                                                                    • We’ll describe what happens to output and inflation over
Inflation, πt                                                                                 time following macroeconomic events like oil shocks and
                                             •The Phillips Curve tells us                     demand shocks using Aggregate Supply and Aggregate
                                             how firms behave in setting
                                             their prices relative to how

                                             they perceive demand — πt
                                             rises when demand is
                                                                                       •      Shocks will initially shift either AS or AD (or both together)

                                    AS       higher: upward sloping
                                                                                       •      W ’ll pay special attention t A
                                                                                              We’ll            i l tt ti to Aggregate Supply, which will
                                                                                                                                      t S     l hi h ill
                                             •When output is equal to                         move slowly over time to achieve a steady state where
                                             potential,        , and
                                             inflation is equal to what it
                                                                                              inflation is stable and the output gap is zero:
                                             was last period:
                                                                                       •      To see how AS responds, it might help to write it as
                                             •An increase in inflation
                                             means πt–1 becomes                                                                            instead of
                                             πt–1’ > πt–1. Aggregate
                                             Supply must start shifting
                                             upward                                         With ∆πt in the equation, you can see that πt increases when
                    0                                                                                    is positive, so AS must be shifting up
                        Short-run output,


        Ex.#1: Suppose the price of oil spikes up and                                    Let’s review the time path of output and
                produces an inflation shock                                                  inflation after this oil price shock
                                                   •The math of this is that
                                                   the parameter in AS                                                            •Before the oil price
Inflation, πt                                      increases from zero:           Inflation, πt                                   shock hits, inflation is
                                                                                                                                  stable and output is
                                   AS’             •What happens to AS?
                                                                                                                                  growing at potential

                                                   • It shifts upward: at                                                         •When the oil shock hits,
                                                                                                                                  Aggregate Supply shifts
                                                   every level of output,
                                                                                                                                  up, immediately raising
                                           AS      inflation is    higher
                                                   i fl ti i now hi h
                                                                                                                                  inflation and lowering
                                                   •The economy                                                                   short-run output below
    ’                                              immediately jumps to a                                               time, t   potential
                                                   new temporary                  Short-run output,
                                                   equilibrium at a lower                                                         •Since output is below
                                                   level of short-run output                                                      potential, firms set their
                                                   and a higher level of                                                          prices lower, reducing
                                                   inflation                       0                                              inflation; Aggregate
                                             AD •It turns out that’s only                                                         Supply slowly shifts
                                                                                                                                  down, increasing short-
                                                   the short-run effect; what
                                                                                                                                  run output back to zero
                                                   happens next?
                     ’    0   Short-run output,                                                                         time, t

    After the oil shock subsides, inflation expectations
       update slowly, and AS will slowly shift back
                                                    •We can see from the

Inflation, πt
                                                    Aggregate Supply curve
                                                    that inflation stays high
                                                    because it was high last
                                                                                                          Next time
                                   AS’              period, even though the
                                                    shock subsides and
                                           AS’’     decreased output pulls it

                                                                                           • Finishing up Chapter 12
    ’                                             Now higher       Now zero                • Rules versus discretion:        when and how
”                                                   Now negative (lower)                          should authorities act to smooth
                                                    •So next, AS shifts                           temporary fluctuations
                                                    down but not all the way
                                                    •Inflation falls a little
                                             AD     while output increases
                                                    •Another perspective:

                     ’   ”0   Short-run output,

    But we are still not yet back to the steady state, so the
     whole process repeats itself, with AS shifting slowly

                                                    •The same logic applies:
Inflation, πt                                       even with no oil shock
                                                    this period, and with
                                   AS’              output below potential
                                           AS’’     pulling inflation down,
                                                    inflation will still remain
                                                    above its long run level,
                                           AS         ith    d l t
                                                    with gradual steps b k back
                                                    toward steady state

”                                                   •The steps get smaller
                                                    and smaller as the
                                                    economy nears steady
                                                    state ...
                                                    •Sound familiar? This is
                                             AD     like the Solow Model
                                                    •An oil shock takes a
                                                    while to dissipate!
                         ”0   Short-run output,


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