978-1259285295 Chapter 21 Lecture Note Part 2

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III. Aggregate Supply

A. Short-Run Aggregate Supply

1. The short-run aggregate supply curve is the upward-sloping relationship between

current inflation and the quantity of output.

2. In the short run the prices of factors used as inputs are sticky; that is, they are slow to

adjust.

3. This means that in the short run production costs do not change much, and so when

prices rise firms produce more in order to take advantage of the situation and increase

their profits.

B. Shifts in the Short-Run Aggregate Supply Curve

1. When production costs change the short-run aggregate supply curve shifts. This can

happen as a result of deviations of current output from potential output, changes in

expectations of future inflation, and factors that drive production costs up or down.

2. Output Gaps:

a. When current output equals potential output so that there is no output gap, the

short-run aggregate supply curve remains stable.

b. But when current output rises above or falls below potential output, so that an

output gap develops, inflation will rise or fall.

c. When current output is below potential output (creating a recessionary output

gap), part of the economy’s capacity is idle, and firms tend to raise their prices

and wages less than they did when current output equaled potential output.

d. When current output exceeds potential output (creating an expansionary output

gap), the opposite happens; firms increase their prices and wages more than they

would if they were operating at normal levels.

e. Thus when current output deviates from potential output, inflation adjusts.

3. Changes in expectations about future inflation:

a. Workers and firms care about real wages and real product prices. Inflation erodes

real wages and prices; therefore everyone is concerned about inflation.

b. The higher expected inflation is, the more nominal wages and nominal prices will

rise.

c. As a result, changes in inflation expectations are analogous to changes in

production costs.

4. Change in the prices of raw materials:

a. A common example is a change in the price of energy; increases can cause the

short-run aggregate supply curve to shift to the left.

C. The Long-Run Aggregate Supply Curve

1. In the long run the economy moves to the point where current output equals potential

output, while inflation is determined by money growth.

2. The long-run aggregate supply curve is vertical at the point where current output

equals potential output.

3. The short-run aggregate supply curve shifts both when current output deviates from

potential output and when expected inflation deviates from current inflation.

4. For the economy to remain in long-run equilibrium, then, in addition to current output

equaling potential output, current inflation must equal expected inflation.

5. At any point along the long-run aggregate supply curve, current output equals

potential output and current inflation equals expected inflation.

IV. Equilibrium and the Determination of Output and Inflation

A. Short-Run Equilibrium

1. Short-run equilibrium is determined by the intersection of the dynamic aggregate

demand curve with the short-run aggregate supply curve.

2. That intersection determines current output and inflation.

3. Changes in inflation and output arise from shifts in either supply, demand, or both.

B. Adjustment to Long-Run Equilibrium

1. When current output exceeds potential, the resulting expansionary gap exerts upward

pressure on production costs, shifting the short-run aggregate supply curve to the left,

a process that continues until current output returns to potential output; at this point

inflation and output stop changing.

2. If current output is lower than potential output, the resulting recessionary gap places

downward pressure on production costs, causing the short-run aggregate supply curve

to shift to the right, and once again the process continues until current output returns

to potential. At this point, output and inflation are steady.

3. This shows that the economy has a self-correcting mechanism. When output moves

away from its long-run level, inflation moves away from the central bank’s target and

policymakers respond by changing the real interest rate. This moves the economy

along the dynamic aggregate demand curve until it returns to its long-run equilibrium.

4. The fact that inflation changes whenever there is an output gap reinforces our

conclusion that in the long run output returns to potential output.

5. In long-run equilibrium, current output equals potential output, current inflation is

steady and equal to target inflation, and current inflation equals expected inflation.

C. The Sources of Fluctuations in Output and Inflation

1. Output and inflation movements can arise from either demand or supply shifts.

2. Shifts in the dynamic aggregate demand curve cause inflation and output to rise and

fall together, while shifts in short-run aggregate supply move output and inflation in

opposite directions.

3. Inflation goes up in the short run when either the dynamic aggregate demand curve

shifts to the right or the short-run aggregate supply curve shifts to the left.

4. The dynamic aggregate demand curve shifts to the right when there is an increase in

the components of aggregate expenditure that are not sensitive to the real interest rate

(higher government expenditure, business optimism, or consumer confidence) or an

easing of monetary policy.

5. A leftward shift in the short-run aggregate supply curve comes from increase in the

costs of production, like an increase in oil prices or inflation expectations.

6. Output drops when either the dynamic aggregate demand curve or the short-run

aggregate supply curve shift to the left. The leftward shift in the dynamic aggregate

demand curve could be caused by a decline in aggregate expenditure or a tightening

of monetary policy, which raises the possibility that policymakers might cause

recessions.

D. What Causes Recessions?

1. To tell if a recession was caused by a decrease in aggregate demand or a decrease in

short-run aggregate supply, we can examine what happens to inflation during the

recession.

2. It appears that three-quarters of the recessions in the past half century can be traced to

shifts in the dynamic aggregate demand curve.

3. To find out what caused the shifts in the dynamic aggregate demand curve we can

examine the behavior of interest rates.

4. The data suggest that shortly before each recession starts the interest rate tends to rise.

Terms Introduced in Chapter 21

consumption

dynamic aggregate demand curve

expansionary output gap

government purchases

investment

long-run aggregate supply curve (LRAS)

long-run real interest rate

monetary policy reaction curve

net exports

output gap

potential output

recessionary output gap

short-run aggregate supply curve (SRAS)

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Real GDP GDPC1

Potential real GDP GDPPOT

Consumer price index less food and energy CPILFESL

Federal funds rate FEDFUNDS

U.S. 10‐year Treasury yield GS10

U.S. 3‐month Treasury bill rate TB3MS

One‐year inflation expectations (Michigan survey) MICH

Real personal consumption expenditures PCECC96

Real gross private domestic investment GPDIC96

Real net exports of goods and services NETEXC

Real government outlays GCEC96

NBER recession dates (0=expansion, 1=recession) USREC

Lessons of Chapter 21

1. In the long run

A. Current output equals potential output, which is the level of output the economy produces

when its resources are used at normal rates.

B. Inflation equals money growth minus growth in potential output.

2. The dynamic aggregate demand curve is a downward-sloping relationship between inflation

and the quantity of output demanded by those who use it:

A. Aggregate expenditure = Consumption + Investment + Government purchases + Net

exports.

i. Aggregate expenditure falls when the interest rate rises.

ii. The long-run real interest rate equates aggregate expenditure with potential

output.

B. Monetary policy is described by an upward-sloping monetary policy reaction curve.

i. When policymakers change the nominal interest rate, they change the real interest

rate as well, because inflation usually doesn’t change quickly.

ii. Policymakers react to increases in inflation by increasing the real interest rate (as

the Taylor Rule indicates).

iii. The monetary policy reaction curve is set so that the real interest rate equals the

long-run real interest rate when inflation equals the central bank’s target.

iv. The monetary policy reaction curve shifts when either the inflation target changes

or the long-run real interest rate changes.

C. Movements along the dynamic aggregate demand curve occur when monetary

policymakers react to changes in inflation by adjusting the real interest rate.

D. The dynamic aggregate demand curve shifts when

i. An increase in consumer confidence, business optimism, government purchases,

or net exports shifts the dynamic aggregate demand curve to the right.

ii. The monetary policy reaction curve shifts to the right, shifting the dynamic

aggregate demand curve to the right.

3. The aggregate supply curve tells us the amount of output producers are willing to supply at

given levels of inflation.

A. The short-run aggregate supply curve slopes up because, in the short run, costs of

production adjust more slowly than the output prices.

B. Production cost changes shift the short-run aggregate supply curve. These occur when

i. There is a recessionary or expansionary gap.

ii. Expectations about future inflation change.

iii. Raw material prices, such as the cost of energy, change.

C. The long-run aggregate supply curve is vertical at potential output.

i. Along the long-run aggregate supply curve, expected inflation equals current

inflation.

ii. The long-run aggregate supply curve shifts when the amounts of capital and labor

used in the economy change or productivity changes.

iii. The short-run aggregate supply curve intersects the long-run aggregate supply

curve at the point where inflation equals expected inflation.

4. Equilibrium output and inflation are determined by the intersection of the dynamic aggregate

demand curve and either the short-run or long-run aggregate supply curve.

A. The short-run equilibrium point is located where the dynamic aggregate demand curve

intersects the short-run aggregate supply curve.

B. The long-run equilibrium point is located where the dynamic aggregate demand curve

intersects the long-run aggregate supply curve. At that point, current output equals

potential output and inflation equals the inflation target, which equals expected inflation.

C. Fluctuations in output and inflation come from either

i. Demand shifts, which cause them to rise and fall together.

ii. Supply shifts, which cause one to rise ad the other falls.