7/29/2019 Econ1102 Week 9

1/41

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

7/29/2019 Econ1102 Week 9

2/41

2

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

7/29/2019 Econ1102 Week 9

3/41

3

Planned Aggregate Expenditure

rTYcCC )( rII

P

GG

XNNX

TT NXGICPAE

P

The above model can be simplified to gives the following

equation forPAE

cYrXNGITcCPAE ])([

7/29/2019 Econ1102 Week 9

4/41

4

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

7/29/2019 Econ1102 Week 9

5/41

5

Policy Reaction Function (continued)

r grr

r

0 0.01 0.02 0.03

7/29/2019 Econ1102 Week 9

6/41

6

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

7/29/2019 Econ1102 Week 9

7/41

7

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

7/29/2019 Econ1102 Week 9

8/41

8

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.

7/29/2019 Econ1102 Week 9

9/41

9

AD curve has a negative slope

AD

y Other things equal, an increase in inflation is associated

with a fall in equilibrium output.

7/29/2019 Econ1102 Week 9

10/41

10

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.

7/29/2019 Econ1102 Week 9

11/41

11

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

7/29/2019 Econ1102 Week 9

12/41

12

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?

7/29/2019 Econ1102 Week 9

13/41

13

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.

7/29/2019 Econ1102 Week 9

14/41

14

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.

7/29/2019 Econ1102 Week 9

15/41

15

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

7/29/2019 Econ1102 Week 9

16/41

16

ttt 1

7/29/2019 Econ1102 Week 9

17/41

17

Inflation and the Output Gap

In the longer-term, the output gap matters.

Output Gap Inflation

Expansionary (y>y*) Rising

Contractionary (y

7/29/2019 Econ1102 Week 9

18/41

18

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)

7/29/2019 Econ1102 Week 9

19/41

19

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.

7/29/2019 Econ1102 Week 9

20/41

20

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.

7/29/2019 Econ1102 Week 9

21/41

21

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.

7/29/2019 Econ1102 Week 9

22/41

22

Adjustment to an Expansionary Gap

LRAS

* SRAS

0 SRAS

AD

*

y y y

Inflation rises and output falls, until LR equilibrium

7/29/2019 Econ1102 Week 9

23/41

23

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.

7/29/2019 Econ1102 Week 9

24/41

24

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.

7/29/2019 Econ1102 Week 9

25/41

25

Excessive Aggregate Expenditure (Short-run) LRAS

SRAS

ADAD

*y y

Increase in PAEshifts AD curve to the right andproduces a SR expansionary gap.

7/29/2019 Econ1102 Week 9

26/41

26

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.

7/29/2019 Econ1102 Week 9

27/41

27

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.

7/29/2019 Econ1102 Week 9

28/41

28

Exogenous Policy by RBA

RBA raises r to offset increase

in PAE

AD*

y

7/29/2019 Econ1102 Week 9

29/41

7/29/2019 Econ1102 Week 9

30/41

30

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)

7/29/2019 Econ1102 Week 9

31/41

31

Adverse Inflation Shock

LRAS

SRAS SRAS

AD

y*

y y

Rise in inflation and recessionary gap.

7/29/2019 Econ1102 Week 9

32/41

32

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.

7/29/2019 Econ1102 Week 9

33/41

33

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.

7/29/2019 Econ1102 Week 9

34/41

34

Shock to Potential Output

Fall in Potential Output

LRAS LRAS

SRAS

AD

*

1y *

y y

7/29/2019 Econ1102 Week 9

35/41

35

Shock to Potential Output (Long-Run Adjustment)LRAS

LRAS

SRAS

SRAS

AD*

1y *

y y Permanent fall in output

7/29/2019 Econ1102 Week 9

36/41

36

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

7/29/2019 Econ1102 Week 9

37/41

37

Short-Run Effect: Recessionary Gap

LRAS

10% SRAS

AD

ADy

*y y

7/29/2019 Econ1102 Week 9

38/41

38

Long-Run Effect: Lower inflation, Zero Output Gap

LRAS

10% SRAS

5% SRAS

AD

AD*

y y

7/29/2019 Econ1102 Week 9

39/41

39

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

7/29/2019 Econ1102 Week 9

40/41

40

(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

7/29/2019 Econ1102 Week 9

41/41

41

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?