Price Equilibrium

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2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster

PowerPoint Lectures for

Principles ofMacroeconomics, 9e

By

Karl E. Case,Ray C. Fair &Sharon M. Oster


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2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster

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PART III THE CORE OF MACROECONOMIC THEORY

Aggregate Supplyand the Equilibrium

Price Level

Fernando & Yvonn Quijano

Prepared by:


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11The Aggregate Supply CurveThe Aggregate Supply Curve: A WarningAggregate Supply in the Short RunShifts of the Short-Run Aggregate Supply Curve

The Equilibrium Price Level

The Long-Run Aggregate Supply CurvePotential GDP

Monetary and FiscalPolicy EffectsLong-Run Aggregate Supply and Policy Effects

Causes of InflationDemand-Pull InflationCost-Push, or Supply-Side, InflationExpectations and InflationMoney and InflationSustained Inflation as a Purely Monetary Phen

The Behavior of the FedControlling the Interest RateThe Feds Response to the State of the

EconomyFed Behavior Since 1970Inflation Targeting

Looking Ahead

CHAPTER OUTLINE

Aggregate Supplyand the Equilibrium

Price Level

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PART III THE CORE OF MACROECONOMIC THEORY


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The Aggregate Supply Curve

aggregate supply The total supply of all goodsand services in an economy.

aggregate supply (AS) curve A graph thatshows the relationship between the aggregatequantity of output supplied by all firms in aneconomy and the overall price level.

The Aggregate Supply Curve: A Warning

An aggregate supply curve in the traditional senseof the word supplydoes not exist. What does existis what we might call a price/output responsecurvea curve that traces out the price decisionsand output decisions of all firms in the economyunder a given set of circumstances.


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Aggregate Supply in the Short Run

In the short run, the aggregate supplycurve (the price/output responsecurve) has a positive slope.At low levels of aggregate output, thecurve is fairly flat.As the economy approaches capacity,the curve becomes nearly vertical.At capacity, the curve is vertical.

FIGURE 13.1 The Short-RunAggregate Supply Curve


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Shifts of the Short-Run Aggregate Supply Curve

cost shock, orsupply shock A change in coststhat shifts the short-run aggregate supply (AS)curve.

FIGURE 13.2 Shifts of the Short-Run Aggregate Supply Curve


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The Equilibrium Price Level

equilibrium price level The price level at which

the aggregate demand and aggregate supplycurves intersect.

At each point along theAD curve, boththe money market and the goodsmarket are in equilibrium. Each pointon theAScurve represents the price/output decisions of all the firms in theeconomy.P0 and Y0correspond to equilibrium in

the goods market and the moneymarket and to a set of price/outputdecisions on the part of all the firms inthe economy.

FIGURE 13.3 The Equilibrium PriceLevel


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The Long-Run Aggregate Supply Curve

When the AD curve shifts fromAD0 to

AD1, the equilibrium price level initially

rises from P0to P1 and output rises

from Y0 to Y1.

Wages respond in the longer run,shifting theAScurve fromAS0 toAS1.

If wages fully adjust, output will beback at Y0. Y0 is sometimes called

potential GDP.

FIGURE 13.4 The Long-RunAggregate Supply Curve


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e Simple Keynesian Aggregate Supply Curve

Oneviewoftheaggregatesupplycurve,thesimpleKeynesianview,holdsthatatanygivenmoment,theeconomyhasaclearlydefinedcapacity,or

maximum,output.

With planned aggregate expenditure ofAE1and aggregate demand ofAD1, equilibrium

output is Y1.

A shift of planned aggregate expenditure toAE2, corresponding to a shift of the AD curve

toAD2, causes output to rise but the price

level to remain at P1.

If planned aggregate expenditure andaggregate demand exceed YF, however,

there is an inflationary gap and the price level

rises to P3.


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Potential GDP

potential output, orpotential GDP The level ofaggregate output that can be sustained in the longrun without inflation.

Short-Run Equilibrium Below Potential Output

Although different economists have differentopinions on how to determine whether aneconomy is operating at or above potential output,there is general agreement that there is amaximum level of output (below the vertical portion

of the short-run aggregate supply curve) that canbe sustained without inflation.


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Monetary and Fiscal Policy Effects

If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will bean increase in the price level with little increase in output from point B to point B.

FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or NearMaximum Capacity


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Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects

It is important to realize that if theAScurve isvertical in the long run, neither monetary policy norfiscal policy has any effect on aggregate output inthe long run.

The conclusion that policy has no effect onaggregate output in the long run is perhapsstartling.


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Causes of Inflation

Demand-Pull Inflation

demand-pull inflation Inflation that is initiated byan increase in aggregate demand.


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Causes of Inflation

Cost-Push, or Supply-Side, Inflation

An increase in costs shifts theAScurve to the left.By assuming the government does notreact to this shift, theAD curve doesnot shift, the price level rises, andoutput falls.

FIGURE 13.7 Cost-Push, orSupply-Side, Inflation

cost-push, orsupply-side, inflation Inflationcaused by an increase in costs.


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Causes of Inflation

Money and Inflation

An increase in G with the moneysupply constant shifts theAD curvefromAD0 to AD1. Although not

shown in the figure, this leads to an

increase in the interest rate andcrowding out of plannedinvestment.If the Fed tries to keep the interestrate unchanged by increasing themoney supply, theAD curve willshift farther and farther to the right.The result is a sustained inflation,perhaps even hyperinflation.

FIGURE 13.9 Sustained InflationFrom an Initial Increase in Gand FedAccommodation


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Causes of Inflation

Sustained Inflation as a Purely Monetary Phenomenon

Virtually all economists agree that an increase inthe price level can be caused by anything thatcauses theAD curve to shift to the right or theAScurve 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 thoughtof as a purely monetary phenomenon.


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The Behavior of the Fed

FIGURE 13.10 Fed Behavior


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The Feds Response to the State of the Economy

During periods of high output/highinflation, the economy is on therelatively steep portion of theAScurve. In this case, the Fed is likelyto increase the interest rate (and

thus contract the money supply).This will shift theAD curve to theleft, fromAD0 to AD1, and lead to a

decrease in the price level withvery little decrease in output.

FIGURE 13.12 The FedsResponse to High Output/High Inflation


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Inflation Targeting

inflation targeting When a monetary authoritychooses its interest rate values with the aim ofkeeping the inflation rate within some specifiedband over some specified horizon.

Food Prices Worry Central Banks Around the World

FoodPricesWorryCentralBankers

WallStreetJournal

REVIEW TERMS AND CONCEPTS


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aggregate supplyaggregate supply (AS) curve

cost-push, or supply-side, inflation

cost shock, or supply shock

demand-pull inflation

equilibrium price level

inflation targeting

potential output, or potential GDP

stagflation

REVIEW TERMS AND CONCEPTS

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Price Equilibrium