econ1102 week 9
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Week 9
Aggregate Demand and Aggregate Supply
Reference: Bernanke, Olekalns and Frank - Chapter 9
Key Issues
Aggregate Demand (AD) CurveSlope and Shifts in the AD CurveInflation: Inertia and the Output Gap
Aggregate Supply (AS) CurveAD-AS ModelApplications
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The Aggregate Demand (AD) Curve
In the previous Lecture we developed the following two
models:
A PAEcurve that depended on the real interest rate
Apolicy reaction function for the RBA, in which thereal interest rate responded to the inflation rate
These two equations can be combined to produce arelationship between output and inflation, that is called
the Aggregate Demand curve
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Planned Aggregate Expenditure
rTYcCC )( rII
P
GG
XNNX
TT NXGICPAE
P
The above model can be simplified to gives the following
equation forPAE
cYrXNGITcCPAE ])([
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Policy Reaction Function
We assume that the policy reaction function of the RBA
can be represented by the following equation:grr r and g are positive constants chosen by the RBA
g indicates by how many percentage points the RBAraises the real interest rate in response to a given rise
in inflation
rindicates the value of the real interest rate wheninflation is zero
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Policy Reaction Function (continued)
r grr
r
0 0.01 0.02 0.03
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Deriving the AD Curve
cYrXNGITcCPAE ])([
For a given real interest rate, we can use the equilibrium
condition
Y = PAE
to solve for equilibrium output:
cYrXNGITcCY ])([
])([1
1rXNGITcC
cY
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AD Curve
Now use the RBAs policy reaction function,
grr to substitute for the real interest rate
])([1
1rXNGITcC
cY
)])(([1
1 grXNGITcC
cY
])()([1
1 grXNGITcCc
Y
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Slope of the AD Curve
We can simplify the AD curve
])()([1
1 grXNGITcC
cY
as
c
gY
1
)(constant
The model implies a negative relationship betweenequilibrium output and the rate of inflation.
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AD curve has a negative slope
AD
y Other things equal, an increase in inflation is associated
with a fall in equilibrium output.
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Why Does AD Curve Slope Downwards?
Model explains negative slope as reflecting the behaviour
of the central bank.
When inflation is high, the RBA will raise the real
interest rate. The increase in rreduces consumption and
investment (i.e. PAE) and this produces a fall inequilibrium output.
Other reasons not explicitly included in the modelinclude: wealth, distributional and uncertainty effects.
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Shifts in the AD Curve
])()([1
1 grXNGITcC
cY
2 main factors
1. Exogenous changes in spending: XNGITC ,,,,
Fiscal policy or private spending
2. Exogenous change in the RBAs policy reaction
function: r
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Exogenous Increase in Spending
AD
AD
y
eg1. Due to increasing future uncertainty in the economy, businesses
reduce spending on new capital?
eg2. The government reduces income taxes?
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Exogenous Shift in Policy Reaction Function
r
ADAD
y
Increase in r produces an upward shift in the policyreaction function (tighter monetary policy) and leads to
an inward shift in the AD curve.
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Inflation and Aggregate Supply (AS)
The AD curve contains two endogenous variables
Output andInflation
To solve for these two variables we need to develop a
model for aggregate supply.
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Inflation Inertia
In the short-run we assume that inflation is sticky or
inertial.
In the absence of any large shocks, the rate of inflation
tends to change relatively slowly from year to year.
Reflects the influence of:
Inflation expectationsLong-term nominal wage and price contracts
Eg. http://www.hr.unsw.edu.au/services/salaries/gensal38.html
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ttt 1
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Inflation and the Output Gap
In the longer-term, the output gap matters.
Output Gap Inflation
Expansionary (y>y*) Rising
Contractionary (y
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Aggregate Supply: Short-Run and Long-Run
LRAS
0 SRAS
*y y
LRAS = Long-run aggregate supply (at potential output)SRAS = Short-run aggregate supply (or short run inertial
inflation line)
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AD-AS: Short-Run Equilibrium LRAS
0 SRAS
AD
y *
y y
SR Equilibrium is where AD curve cuts SRAS.Inflation rate is determined by past expectations and
pricing decisions. The output gap is negative.
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AD-AS: Adjustment to Long-Run Equilibrium LRAS
0 SRAS
AD
y *
y y
The existence of a short-run contractionary gap putsdownward pressure on the inflation rate. SRAS curve
begins to shift downwards and output gap closes.
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AD-AS: Long-Run Equilibrium LRAS
0 SRAS* SRAS
AD
y *
y y
Eventually, the fall in inflation leads to the elimination of
the recessionary gap and economy is in LR equilibrium.
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Adjustment to an Expansionary Gap
LRAS
* SRAS
0 SRAS
AD
*
y y y
Inflation rises and output falls, until LR equilibrium
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Is Economy Self-Correcting?
AD-AS model suggests that while the economy may
experience recessionary and inflationary output gaps in
the short-run; it will, in the long-run, return to a position
where*
yy .
What is the justification for active stabilisation policy
using monetary and fiscal policy?
One answer is that the speed at which economy returns tolong-run equilibrium may be unacceptably slow.
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Applications of the AD-AS Model
Shocks to AD Curve
])()([1
1 grXNGITcC
cY
Exogenous changes in consumption, investment,government spending or net exports will all produce
shifts in the AD curve.
If the economy is already at potential output, positive
shocks to AD will be inflationary.
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Excessive Aggregate Expenditure (Short-run) LRAS
SRAS
ADAD
*y y
Increase in PAEshifts AD curve to the right andproduces a SR expansionary gap.
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Excessive Aggregate Expenditure (Long-run) LRAS
SRAS
SRAS
AD
*y y
Expansionary gap increases the inflation rate and SRAS
shifts upward. In the LR*
yy , but higher inflation.
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Could the RBA have prevented the Rise in Inflation?
Yes (potentially).
By increasing r and shifting its policy reaction function
upwards. This will move AD curve to the left and offset
positive spending shock.
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Exogenous Policy by RBA
RBA raises r to offset increase
in PAE
AD*
y
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Inflation Shocks
A sudden change in the rate of inflation that is unrelated
to the output gap.
Shock that shifts the SRAS curve, but does not affect the
level of potential output and hence shift the LRAS curve
Examples
Large increases in economy-wide wagesLarge commodity or energy price shocksLarge falls in manufactured goods prices (China)
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Adverse Inflation Shock
LRAS
SRAS SRAS
AD
y*
y y
Rise in inflation and recessionary gap.
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RBA takes no Deliberate Monetary Policy Actions LRAS
SRAS SRAS
AD
y*
y y
Recessionary gap will eventually lead to a fall in inflationand economy will move back along AD curve to its
initial equilibrium.
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RBA Eases Monetary Policy to Offset Recessionary Gap LRAS
SRAS SRAS
AD
AD
y*
y y
RBA shifts its policy reaction function downwards andthis shifts AD curve to the right. Recessionary gap is
eliminated, but at the cost of a higher rate of inflation.
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Shock to Potential Output
Fall in Potential Output
LRAS LRAS
SRAS
AD
*
1y *
y y
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Shock to Potential Output (Long-Run Adjustment)LRAS
LRAS
SRAS
SRAS
AD*
1y *
y y Permanent fall in output
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Controlling Inflation
Disinflation: process whereby use tight monetary policy
to reduce the rate of inflation in an economy.
Examples:
Volker disinflation in the US in early 1980sDisinflation in Australia in early 1990s
Year 1987 1988 1989 1990 1991 1992 1993 8.5 7.3 7.5 7.3 3.2 1.0 1.8
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Short-Run Effect: Recessionary Gap
LRAS
10% SRAS
AD
ADy
*y y
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Long-Run Effect: Lower inflation, Zero Output Gap
LRAS
10% SRAS
5% SRAS
AD
AD*
y y
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Summary
In the short-run disinflation can be costly in terms of
lost output.
Once a country has attained a low inflation rate, it may
introduce institutional arrangements to help ensure the
low rate is sustained.
Example: Inflation Targets
Help to anchor peoples inflation expectations
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(Some potential MCQ)
Suppose the aggregate demand curve in an economy is Y = 10 000 10 000,current inflation () equals 0.05 (5%), and potential output (Y*) equals 9500. If,starting from long-run equilibrium, an inflation shock raises inflation to 0.07, in theshort run, output will equal ____ and, in the long run, output will equal _____.A. 9300; 9300B. 9300; 9500C. 9500; 5500D. 9500; 9300
If the aggregate demand curve in an economy is Y = 20 000 20 000p, currentinflation (p) equals 0.06 (6%), and potential output (Y*) equals 19 200, then, inthe short run, equilibrium output equals ____ and, in the long run, the inflationrate equals ___ %.
A. 19 200; 4B. 19 200; 6C. 18 800; 4D. 18 800; 6
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After this class you should be able to answer thefollowing questions:
1.What is meant by the target rate of inflation?
2.Why does the AD curve slope downwards?3.How is the AD curve derived?4.What factors cause the AD curve to shift, and how are these different
from those that lead to a movement along the AD curve?
5.What is meant by inflation inertia?
6.How does inflation respond to the output gap?7.How is the AD/AS diagram derived?8.What are the various sources of inflation?9.How can the AD/AS diagram be used to explain developments in the
Australian economy from the 1970s onwards?
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