Aggregate Demand Supply Part III Equilibrium Equilibrium Aggregate

Aggregate Demand & Supply Part III: Equilibrium

Equilibrium Aggregate Price Level n Putting aggregate D & S together: AS P Pe AD Ye Y

Oil Crisis, 1974 n Arab Boycott leads to 4 X increase in oil prices: AS' AS P 1974 -75 Recession Pe' Pe AD Ye' Ye Y

Fiscal & Monetary Policy - I n G, T, Ms all shift AD to right AS P Pe AD Ye Y AD'

Fiscal & Monetary Policy - II n G, T, Ms all shift AD to left AS P Pe AD AD' Ye Y

Fiscal & Monetary Policy - III n But what are size of effects on prices & output? AS P ? Pe ? Ye AD Y

Size of effects = f(shape of AS) n Where AS is flatter, e. g. , in depression, shifts in AD produce large changes in Y with small changes in P (typical Keynesian result): AS P AD Pe Ye' Ye Y

Size of effects = f(shape of AS) n But where AS is steeper, e. g. , in boom, shifts in AD produce large changes in P with small changes in Y: P AS AD Pe Ye Ye' Y

Keynesian "Gaps" Below Ye aggregate demand could be increased with no upward pressure on prices n Above Ye aggregate demand increases would generate inflation (rising price level) n aggregate demand C, I, G deflationary gap inflationary gap B Y A Y

Keynesian Aggregate Supply n We can translate this into AS - AD terms: P AS Y Ye

Long Run Aggregate Supply - I Long run AS is said to be vertical. Why? n Ans: wages adjust to price changes n LRAS P Pe AD Ye Y

Long Run Aggregate Supply - II n Suppose AD increased by policy, P & Y LRAS SRAS P Pe' Pe AD' AD Ye Ye' Y

Long Run Aggregate Supply - III n But then wages/costs/SRAS adjust to P P LRAS SRAS' SRAS Pe" Pe' Pe AD' AD Ye Ye' Y

"Long Run" AS? Problem: "short run" defined by fixed assets, upper limit to production capacity n "Long Run" defined in micro by all assets can be changed, plant & equipment & productivity can be increased n In micro a given technology may produce an "envelop" of short run cost curves n But in aggregate, technology can change and output can be expanded indefinately! n

Potential GDP? LRAS curve vertical at what is called "potential GDP" n "Potential GDP" = "level of output that can be sustained in the long run without inflation" n But in aggregate, technology can change and output can be expanded indefinitely! n

Inflation We now have model with price level, and hence inflation, explicit n We can use this model to talk about various kinds of inflationary pressures n

Demand Pull Inflation - I n As we approach full employment, increasing demand "pulls" up the price level: P AS AD Pe Ye Ye' Y

At Full Employment n At full employment, increases in AD produces only price increases: P AS Y Ye

Cost Push Inflation - I Increases in costs (wages, oil) shifts AS up, n so P (but note: Y = stagflation) AS' AS P n Pe' Pe AD Ye' Ye Y

Cost Push Inflation - II n But in late 1960 s Y ROSE with wage , how? AS' AS P Pe' Pe AD Ye' Ye Y

Cost Push Inflation - III n Ans: accomodating monetary policy that AD AS' AS P e" Pe' Pe AD' AD Ye' Ye Y

Inflation = Monetary Phenomenon? C&F: "a sustained inflation, whatever the initial cause. . . , is essentially a monetary phenomenon. " (p. 332) n C&F: "can be thought of as a purely monetary phenomenon" (p. 337) n This view is associated with "monetarism" which became popular in 1970 s because it offered a policy alternative: hold down Ms. n

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