Ch015 - Chapter 15 Inflation and Aggregate Supply Overview...

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Chapter 15 Inflation and Aggregate Supply Overview This chapter, which is introduced with the story of the pressures on Fed Chairman Alan Greenspan to increase interest rates in 1996, extends the basic Keynesian model to allow for ongoing inflation. It introduces the aggregate demand/aggregate supply model and uses it to show how macroeconomic policies affect inflation as well as output. The chapter emphasizes numerical and graphical analysis of output and inflation and has an appendix that presents a more general algebraic treatment. Core Principles Equilibrium Principle – though there is no icon on the page, the chapter presents the short-run and then further on the long-run equilibrium conditions for the aggregate demand/aggregate supply model. Cost-Benefit Principle – tax policies affect the decisions of people about supplying labor because they affect the benefits of working more. Important Concepts Covered Aggregate demand curve Policy reaction function Short-run and long-run aggregate supply line Short-run and long-run equilibrium Inflation shock Aggregate supply shock Disinflation Answers to Text Questions and Problems Answers to Review Questions 1. The AD curve shows the relationship between the inflation rate and short-run equilibrium output in the economy. As the inflation rate rises, the Federal Reserve raises the real interest rate, which reduces autonomous expenditure and in turn, short-run equilibrium output. Therefore, along the AD curve, as the inflation rate rises, the output level falls, leading to a downward-sloping curve (with inflation on the vertical axis and output on the horizontal axis). There are four other factors listed in this chapter that could lead to this downward slope: (1) inflationary effects on wealth and consumption, (2) inflationary effects on the redistribution of income and wealth, which in turn affect 241
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consumption, (3) inflationary effects on investment spending, and (4) inflationary effects on net exports (for a given exchange rate). 2a. For given levels of inflation and the real interest rate, an increase in government purchases raises aggregate demand and short-run equilibrium output. Thus an increase in government purchases shifts the AD curve to the right. b. Because it leads consumers to spend more, a cut in taxes stimulates aggregate demand at each level of inflation, shifting the AD curve to the right. c. A decline in autonomous investment spending by firms reduces aggregate demand at each level of inflation, shifting the AD curve to the left. d. For each level of inflation, a lower real interest rate stimulates consumption and investment spending, raising aggregate demand and output. Thus, an easier policy by the Fed shifts the AD curve to the right. 3.
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This note was uploaded on 04/15/2008 for the course ECO 181 taught by Professor Cherry during the Spring '07 term at SUNY Buffalo.

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Ch015 - Chapter 15 Inflation and Aggregate Supply Overview...

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