5.9 financial markets and central bank online test
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L14ECON3507.pptxOutput, Inflation, and Monetary Policy
Chapter 21
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Learning Objectives
Last week :
Describe the determinants of output and inflation in the long run.
Show the role of monetary policy in the dynamic aggregate demand curve.
This week
Characterize the aggregate supply in the short run and the long run.
Explain short-run and long-run equilibrium using the dynamic aggregate demand and aggregate supply curves.
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Aggregate Supply
The aggregate supply (AS) curve tells us where along the dynamic aggregate demand curve the economy ends up.
When combined with the dynamic aggregate demand curve, the short-run AS curve tells us where the economy settles at any particular time.
The long-run AS curve together with dynamic aggregate demand, tells us the levels of inflation and the quantity of output that the economy is moving toward in the long term.
21-3
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Short-Run Aggregate Supply
The short-run AS curve is the upward-sloping relationship between current inflation and the quantity of output.
In the short term, production costs don’t change much, so when product prices rise, firms increase supply in order to take advantage.
In the short run, higher inflation elicits more aggregate output supplied by the firms that produce it.
21-4
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Short-Run Aggregate Supply
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Shifts in the Short-Run Aggregate Supply Curve
When production costs change, the short-run AS curve shifts.
Changes in expectations of future inflation.
Factors that drive production costs up or down.
21-6
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Shifts in the Short Run Aggregate Supply Curve
Changes in inflation expectations are analogous to changes in production costs.
An increase in expected inflation increases production costs lowering production at every level of current inflation.
This shifts the short-run AS curve to the left.
Changes in the prices of raw materials, as well as other external factors that change production cists, shift the short-run AS curve:
An increase in the price of oil, increase in labor prices from higher payroll taxes, increased health care costs, etc.
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Shifts in the Short Run Aggregate Supply Curve
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The Long-Run Aggregate Supply Curve
In the long-run,
Current output must equal potential output
Inflation must be determined by monetary policy
In the long run, output and inflation are unrelated and the long-run aggregate supply curve (LRAS) is vertical at the point where current output equals potential output.
21-9
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The Long-Run Aggregate Supply Curve
When current inflation deviates from expected inflation, expected inflation will change.
For the economy to be in long-run equilibrium, current inflation must equal expected inflation
At any point along the LRAS curve, current output equals potential output and current inflation equals expected inflation.
21-10
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Long-Run Aggregate Supply
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Aggregate Supply: Summary
21-12
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Equilibrium and the Determination of Output and Inflation
Short Run Equilibrium
SR equilibrium is determined by the intersection of:
The dynamic aggregate demand curve (AD) and
The short-run aggregate supply curve (SRAS).
21-13
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Adjustment to Long-Run Equilibrium
Expansionary output gaps push current inflation above expected inflation
This shifts the SRAS curve to the left.
This continues until current and expected inflation are equal .
Recessionary output gaps depress current inflation below expected inflation
This shifts the SRAS curve to the right.
This continues until current output returns to potential.
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Adjustment to Long-Run Equilibrium
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Current inflation is greater than expected inflation so inflation rises
SRAS shifts left until current inflation and expected inflation are equal.
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Adjustment to Long-Run Equilibrium
21-16
Current inflation is less than expected inflation so expected inflation falls.
SRAS shifts right until current inflation and expected inflation are equal.
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Adjustment to Long-Run Equilibrium
This example has several important implications.
The economy has a self-correcting mechanism.
The fact that inflation changes whenever there is an output gap reinforces our conclusion that in the long run output returns to potential output.
Long run equilibrium is the point at which the economy comes to rest.
21-17
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Adjustment to Long-Run Equilibrium
There are three conditions for long run equilibrium:
Current inflation equals expected inflation: = e.
Current output equals potential output:
Y = YP.
Current inflation is steady and equal to target inflation: = T
21-18
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The Sources of Fluctuations in Output and Inflation
While shifts in the dynamic AD curve or the SRAS curve can have the same effect on inflation, they have opposite effects on output.
Shifts in AD cause output and inflation to rise and fall together, moving in the same direction.
Shifts in the SRAS curve move output and inflation in opposite directions, one rises when the other one falls.
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The Sources of Fluctuations in Output and Inflation
Inflation in the long run will only change if policymakers have changed their inflation target.
In the short run fluctuations can come from
Increases in the components of AE that are not sensitive to real interest rate (shift of AD),
A permanent easing of monetary policy (shift of monetary policy reaction curve,) or
Increases in the costs of production (shift of SRAS).
21-20
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The Sources of Fluctuations in Output and Inflation
In the short run, fluctuations in output can come from:
A decline in aggregate expenditure,
A shift to the left in monetary policy reaction curve
Increases in either production costs or inflation expectations drive output down
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What Causes Recessions?
If demand shifts were the cause of recessions, we should see inflation decline when output falls.
If production cost increases were the source, then we should see inflation rise as the economy weakens.
21-22
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What Causes Recessions?
Inflation fell in 7 of the past 9 recessions.
The only one where inflation rose was in 1973-1975 when oil prices tripled, driving up production costs.
It appears that three-quarters of the recessions listed can be traced to shifts in AD.
21-23
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What Causes Recessions?
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What Causes Recessions?
Shortly before each recession starts, the interest rate tends to rise.
This suggests that the Fed policy is at least partly to blame of the business cycle downturns over the past 50 years.
They have done this to bring down inflation.
The only thing the Fed could do was to raise interest rates triggering a recession.
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What Causes Recessions?
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