Principles of macroeconomics 10e by case fair oster ch13

Level The Aggregate Supply Curve The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve The Equilibrium Price Level The Lo

Level The Aggregate Supply Curve

The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve

The Equilibrium Price Level The Long-Run Aggregate Supply Curve

Potential GDP

Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects

Causes of Inflation

Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation

Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon

The Behavior of the Fed

The aggregate supply curve is not a market supply curve, and it is not

the simple sum of all the individual supply curves in the economy

Because many firms in the economy set prices as well as output, we can say an “aggregate supply curve” is really a “price/output response”

curve—a curve that traces out the price decisions and output decisions

of all firms in the economy under a given set of circumstances

The Aggregate Supply Curve

The Aggregate Supply Curve: A Warning

In the short run, the

aggregate supply curve (the

price/output response curve)

has a positive slope.

At low levels of aggregate

output, the curve is fairly

flat.

As the economy approaches

capacity, the curve becomes

nearly vertical.

At capacity, Y*, the curve is

vertical.

 FIGURE 13.1 The Short-Run

Aggregate Supply Curve

The Aggregate Supply Curve

Aggregate Supply

in the Short Run

The Aggregate Supply Curve

Aggregate Supply in the Short Run

Why an Upward Slope?

Wages are a large fraction of total costs and wage changes lag behind price changes This gives us an upward sloping

short-run AS curve.

Why the Particular Shape?

At some level the overall economy is using all its capital and all the labor that wants to work at the market wage At this

level (Y*), the AS curve is vertical.

At low levels of output, the AS curve is flatter Small price

increases may be associated with relatively large output responses We may observe relatively “sticky” wages upward

at this point on the AS curve.

run aggregate supply (AS) curve.

The Aggregate Supply Curve

Shifts of the Short-Run

Aggregate Supply Curve

At each point along the AD curve, both the

money market and the goods market are in

equilibrium

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

 FIGURE 13.3 The Equilibrium Price Level

The Equilibrium Price Level

c At points corresponding to high price levels, such as (Y2, P2).

b At every point along the AD curve.

c At points corresponding to high price levels, such as (Y2, P2)

d At points corresponding to low price levels, such as (Y1, P1)

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

Y0 is sometimes called potential GDP.

 FIGURE 13.4 The Long-Run Aggregate Supply

Curve

The Long-Run Aggregate Supply Curve

The simple “Keynesian” view of the aggregate

supply curve holds that at any given moment,

the economy has a clearly defined capacity, or

maximum, output

With planned aggregate expenditure of AE1 and aggregate

demand of AD1, equilibrium output is Y1

A shift of planned aggregate expenditure to AE2,

corresponding to a shift of the AD curve to AD2, causes

output to rise but the price level to remain at P1

If planned aggregate expenditure and aggregate demand

exceed Y F, however, there is an inflationary gap and the

price level rises to P3

E C O N O M I C S I N P R A C T I C E

The Simple “Keynesian” Aggregate Supply Curve

Despite insights the kinked aggregate supply

curve provides, most economists find it unlikely

that the whole economy suddenly runs into a

capacity “wall” at a specific level of output

As output expands, some firms and industries will hit capacity before others

Although different economists have different opinions on how

to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation

The Long-Run Aggregate Supply Curve

Potential GDP

Short-Run Equilibrium Below Potential Output

Aggregate demand can shift to the right for a

number of reasons, including an increase in

the money supply, a tax cut, or an increase in

government spending

If the shift occurs when the economy is on

the nearly flat portion of the AS curve, the

result will be an increase in output with little

increase in the price level from point A to

point A

 FIGURE 13.5 A Shift of the Aggregate Demand

Curve When the Economy Is on the Nearly Flat

Part of the AS Curve

Monetary and Fiscal Policy Effects

It is important to realize that if the AS curve is vertical in the long run,

neither monetary policy nor fiscal policy has any effect on aggregate output in the long run

The longer the lag time between wages and output prices, the greater the potential impact of monetary and fiscal policy on aggregate output

Some argue that wages do not fall during slack periods and that the

economy can get “stuck” at an equilibrium below potential output In this case, monetary and fiscal policy would be necessary to restore full employment

Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects

If the economy is operating on the steep portion of the AS curve at the

time of the increase in aggregate demand, most of the effect will be an increase in the price level instead of an increase in output

If the economy is operating on the flat portion of the AS curve, most of

the effect will be an increase in output instead of an increase in the price level

By assuming the government does not

react to this shift, the AD curve does not

shift, the price level rises, and output falls

 FIGURE 13.7 Cost-Push, or Supply-Side,

Inflation

cost-push, or supply-side, inflation Inflation caused by an increase in costs

Causes of Inflation

Cost-Push, or Supply-Side, Inflation

stagflation Occurs when output is falling at the same time that prices are rising

A cost shock with no change in

monetary or fiscal policy would

shift the aggregate supply curve

from AS0 to AS1, lower output from

Y0 to Y1, and raise the price level

from P0 to P1.

Monetary or fiscal policy could be

changed enough to have the AD

curve shift from AD0 to AD1

This policy would raise aggregate

output Y again, but it would raise

the price level further, to P2

 FIGURE 13.8 Cost Shocks Are Bad

News for Policy Makers

Causes of Inflation

Cost-Push, or Supply-Side, Inflation

When firms are making their price/output decisions, their expectations

of future prices may affect their current decisions If a firm expects that its competitors will raise their prices, it may raise its own price

The firm’s profit-maximizing optimum price is presumably not too far

from the average of its competitors’ prices

Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral If prices have been rising and if people’s

expectations are adaptive, firms may continue raising prices even if

demand is slowing or contracting

Given the importance of expectations in inflation, central banks aim to keep them low

Causes of Inflation

Expectations and Inflation

Inflationary Expectations in China

Expectations that prices

will rise can be

self-fulfilling as firms raise

prices in expectation that

all other prices will rise

This same phenomenon

is discussed in the

context of China

It is also interesting to

note that many people

believed the official

statistics on inflation

understated their own experience

An increase in G with the money supply

constant shifts the AD curve from AD0

to AD1

Although not shown in the figure, this

leads to an increase in the interest rate

and crowding out of planned

investment

If the Fed tries to keep the interest rate

unchanged by increasing the money

supply, the AD curve will shift farther

and farther to the right

The result is a sustained inflation,

perhaps even hyperinflation.

 FIGURE 13.9 Sustained Inflation from an

Initial Increase in G and Fed

Accommodation

Causes of Inflation

Money and Inflation

Which of the following scenarios leads to hyperinflation?

economy is on the flat portion of the AS curve.

economy is on the steep part of the AS curve.

itself on the flat portion of the AS curve.

itself on the steep portion of the AS curve.

Which of the following scenarios leads to hyperinflation?

economy is on the flat portion of the AS curve.

b Fed accommodation of expansionary fiscal policy, while

the economy is on the steep part of the AS curve.

itself on the flat portion of the AS curve.

itself on the steep portion of the AS curve.

Virtually all economists agree that an increase in the price level can be

caused by anything that causes the AD curve to shift to the right or the

AS curve to shift to the left

It is also generally agreed that for a sustained inflation to occur, the

Fed must accommodate it

In this sense, a sustained inflation can be thought of as a purely monetary phenomenon

Causes of Inflation

Sustained Inflation as a Purely Monetary Phenomenon

Sustained inflation is:

firms

d Entirely the fault of contractionary fiscal policy during periods

of economic recession

Sustained inflation is:

a A purely monetary phenomenon.

firms

d Entirely the fault of contractionary fiscal policy during periods

of economic recession

 FIGURE 13.10 Fed Behavior

The Behavior of the Fed

The Behavior of the Fed

Targeting the Interest Rate

The actual variable of interest to the Fed is not the money supply, but the interest rate

In practice, it is the interest rate that directly affects economic activity, for example, by affecting firms’ decisions about investing

Targeting the interest rate thus gives the Fed more control over the key variable that matters to the economy

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 (and thus expand the

money supply)

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

 FIGURE 13.11 The Fed’s Response to Low

Output/Low Inflation

The Behavior of the Fed

The Fed’s Response to the State of the Economy

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 (and thus

contract the money supply).

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.

 FIGURE 13.12 The Fed’s Response to

High Output/High Inflation

The Behavior of the Fed

The Fed’s Response to the State of the Economy

Markets Watch the Fed

One measure of how important

interest rates are to the health of

the economy is the attention paid

to Fed actions by the private

sector, including prominently the

major investment banks

All of the major investment banks

employ economists to help them

forecast what the Fed will do

These economists have been

especially active in the recent

period as there has been more

uncertainty about whether the

Fed might begin to tighten (raise interest rates) as the U.S economy recovers

J.P Morgan Pushes Back Rate Hike Forecast to Late 2011

The Wall Street Journal

The Fed generally had

high interest rates in the

two inflationary periods

and low interest rates

from the mid 1980s on

The Behavior of the Fed

Interest Rates Near Zero

The Fed lowered the short-term interest rate to near zero beginning in

consumption of durable goods and housing investment

This option is not available when interest rates are near zero In this case, stimulus must come primarily from fiscal policy

The Behavior of the Fed

Inflation Targeting

Looking Ahead

In this chapter, we introduced the aggregate supply curve

By using the aggregate supply and aggregate demand curves, we can

determine the equilibrium price level in the economy and understand some

causes of inflation

We have still said little about employment, unemployment, and the functioning

demand-pull inflationequilibrium price levelinflation targeting

potential output, or potential GDP

stagflation

R E V I E W T E R M S A N D C O N C E P T S