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**Unformatted text preview: **ECF2331 Topic 7
Aggregate Demand and Aggregate Supply Monetary Palicyr Curve Aggregate Demand Curve Aggregate Suppiy Curves ADIAS Made! The Central Bank and Monetary Policy
A 3* As an instrument for monetary
policy, the central bank’s policy
interest rate for inter—bank loans
{e.g. the federal funds rate} is a
nominal short—term interest rate Real interest rate r equals the
nominal interest rate 1' minus expected inflation 1T3 Giyen that changes in monetary
policy typically does not haye an
immediate effect on inflation and
expected inflation {i.e. prices are
sticky in the short run}, real interest
rate fwill fall when the central bank lowers its policy rate for interbank
loans leg. the federal funds rate Fl: and yice—yersa. The Monetary Policy (MP) Curve - The monetary policy (MP) curve shows how monetary
policy, as measured by the real interest rate, reacts to the inflation rate, in: r=F+im
(I where
F = autonomous component of r J. = responsiveness of r' to inflation - ris a simple linear function of 11' with exogenous term F - The MP curve is upward sloping, meaning that real
interest rates rise when the inflation rate rises 2% 1.5% Why is the MP Curve Upward Sleping‘? 3.0% hﬂa‘tiun Hate. 'I' [56] The ire}:r reason for an upward—
slc-ping MP curve is that central
banks seek to keep inflatic-n stable. Fisher Equatic-n: i= r + IT
MPCurve: Hill-ll! ‘ E=F+[1+l]rt
’l‘ Taggicur Principle:
Te stahiiize inflaticun. centrai hanks must raise nerninal interest rate if}
by mere than an}:r rise in expected
inflatic-n [TU This suggests that real interest rate
r rises if inflatien 1"!" is expected te
rise. Thus. MP curve is upward
sipping. Movements Along the MP Curve
vs. Shifts in the MP Curve Ji— Autonomous Changes Autonomous ti htenin of monetar
The Tayior orincioie—driven My! Sh'ftS the MP CUWE upward '35" changes that are reﬂected as Increasing F 3133“? QWEHH movements aiong the MP CUWE Autonomous easing of monetary:
golicg shifts the MP curve downward by reducing F at any given 31' 39 Automatic Changes Mﬁﬂm WNW. Tﬂﬂlms} g thE AD Curve Graphically IVII'I
m Der
mm il-i'Ii-I-il-Iii-I
Ill-lil-l-I-I-I-IIII-I Deriving the AD Curve Algebraically - Recall that the :5 curve is ef theferm Y=A — Br - The MP curve is given by r = F + kn: - Substituting rfrem MP curve inte the i5 curve
equation, we have the AD curve ' AD curve is Y: (A — B F) — 31a."
AD is a linear functien ef TI - There is a negative Iinear relationship between
infiatian rate 11' and aggregate autput Y - Mavements along the AD curve describe the
responses af Yte changes in at Shift in the AD Curve from Shifts in the [5 Curve - ﬁlmsr factor that shifts the :5 curve also shifts the
aggregate demand curve in the same direction - Recall that the is curve is of the form ‘1’: A — Br ' The AD curve is of the form Y: (A — 3 ﬂ — BM"! . - Increase in A 9 increase in {A — 3 ﬂ - Shifts in the is curve — Autonomous consumption expenditure
— Autonomous investment spending — Government purchases — Taxes — Autonomous net exports Shift in the}!!! Curve from Autonomous |i.~“|onetar5iF Policyr Change . An autonomous tightening of monetary»F policy, that is
a rise in real interest rate for any given inflation rate, shifts the aggregate demand curve to the left *- Algebraically, an increase in F leads to a decrease in
the constant part of the AD curve, if = (A —— B F) -— Slit I ' Similarly, an autonomous easing of monetary policy
shifts the aggregate demand curve to the right * Algebraically, an decrease in F leads to an increase in
the constant part of the AD curve, Y = {A - B a - Bl?! lnﬂalian
Hate. 1: Shifts in the LRAS Curve The LRAS curve shifts tn the right where there is
Lats. LEASE - T in the teta! ameunt efcapital
T in the teta! ameunt eflaheur
T in the available technelegy I. in the naturai rate at unempiayment
Eital: ‘:..i'-I'II"I!'.:!E;'15-EII'I 313:1 '3' "' I A." ﬂppﬂﬁitﬂ mavement in
r_:a,: '..5'i .; '::I:_': a !a-:.:"":,'I|t:u::-.- .:_:.:-:: .5'.:.: . .
”21;" 'r'LHI these variables shifts the r_"" .."I[-":'l':ZITIII-':.'I'I'II-':II'I .. LRAS curve tn the ﬁt midis Short-Run Aggregate Supply Curve (AS) lHAS A5 WWW 3* In the short run. wages and prices
are “sticky" {i.e. theyr adjust slowlyr
over time] Aggregate supplyr in the short run 'r'
is not necessarilyr equal to potential
output or natural rate of output 'r'F When the output gap [Y—F‘”) is
positive. output esceeds its
potential level, unemployment is
low and workers demand higher
wages. Firms will increase prices to
sell their goods. leading to higher
inﬂation. When the output gap [Y—F‘”) is
negative, inﬂation will be lower. As a result, the short—run aggregate
supply: {.451 cunre slopes upwards. Factors That Shift the Short-Run AS Curve Factor Chang Shift in Supply Cunt Expected inﬂation. 11" 1 Price shoal-1‘ T 1
55:33:??? w - Y”) i Hm; ﬂnh- Immm [T i In Ih-r: iarmrs :m 51mm. 11H: dim of cit-mm in Ih: farm wnuld be the awash: oi lime indirmd
in lhu: ‘ﬂul‘t' wlumn. Self-Correcting Mechanism How does the economy
adjust from its 5F.
equilibrium towards its
LRequilibrium? mm ““5 The "self-co rrect i ng
mechanism" ensures that. regardless of where
output is initially at, it
eventually returns to the
potential level. r" r; r ﬂoor-agate output. 3* ii- If aggregate output Y: is initially above the potential output PP, wages will start to
rise, increasing expected inﬂation and thereby shifting the short-run aggregate
supply curve .431 upward. This process continues until eventually output settles at
W— the long—run equilibrium level of output. is when wages and prices are flexible. this process can be rapid; when wages and prices
are less flexible. this can be a very slow process. Positive Aggregate Demand Shock {e.g. An unexpected fAiJ due to i“ outonornous consumption expenditure} Ste-o 1"“: .::;-r;1nr_u'r'I-..- return-s. 1:- |r.'.'-III_L§I run £'-:.'1'.JI|Ii_1rIL;."1I. -.'.-'-1i'l
i'1-'|IJ[|L'III |.'-r.:rrr':.:al|-.rr'|l|'-,-' i=..r__|i'-:.'-' .LH'AS i'E-t-Ejjl ._-"_ r'IIZr'I?._'15 r'li'] “2 -'::-I_ I i El LIP. :_'I r'.-::'. lr'l1'IJTI'ETEIf'I .'-‘:.'.r::a:'.1 2".- 1'.“ 11 .r'I-g'j Iii-7.: ”ﬁst-ﬁr": I.J!'I|ZI| Aggmgete it'iutpu't1 V vs V: i=- Short Run {point 2]: The AD curve shifts to the right. leading to a higher
output and a higher inﬂation. IF- Long Run [point 3] : Since there is now a positive output gap [YE—W}. the
short-run AS curve shifts upwards. Eventually. output it back at it potential
ieuei 'r‘”. hut infiation becomes higher. Temporary Negative Supply Shock {A temporary shock involves a restriction in supply - sag. foiipricss} Inﬂation
Hates 1t LHAS
IEEII-ep: .-_-‘ I'itj:r-e'-:.-':E.Ir'I-; i'IfIEIli-IJI'I ASE
.'_-1r1-:_1 -:Jer_:re.'_-'.:;:Ir1-:__] r_1_|l.|:_:-I_J'..
A51
I
| I
an,
:—
IntEI'EI'ilﬁsziiltltl Dutput, ‘r' 1r-I‘P - Short Run: rising inflation + falling output = "stagﬂation" - Long Run: output and inﬂation will be unchanged
because the AS curve simply returns to its initial starting point via self-correction Permanent Negative Supply Shock lnﬁatiun
Hutu. 11' Aggregate Output. r 5‘:- A permanent negative supplv she-2k decreases petentiai eutput. shifting LRAS
curve tn the ieft. Is There is new a pesitive eutput gap relative tn the new level at petentiai
eutput. The sher‘t—run AS curve will keep shifting upwards until eutput settles
at the new level (if petential eutput. 3-“- In the lung run. eutput lpermanentlv and inflatien Tpermanentlv. ...

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