Week7.ppt - ECF2331 Topic 7 Aggregate Demand and Aggregate...

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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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