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Lecture_8 - Aggregate Demand and Price Adjustment II Price...

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Unformatted text preview: Aggregate Demand and Price Adjustment II Price Why is there a negative relationship between aggregate Why demand and the price level? demand What can shift the AD curve? Explain why price adjustment is termed a dynamic process. Explain the three (3) alternatives to the SRAS. What is the Phillips curve? Explain the two relationships summarized by the Phillips curve. What factors can affect expected inflation? What is the equation for the Phillips curve and what conclusions What can be drawn from it? can The Phillips Curve The relates the inflation rate to the output gap relates and expected inflation. Also, the Phillips curve relates the Also, inflation rate to the unemployment rate. inflation There is a positive relationship between There the inflation rate and the output gap. Recall: output gap is Y-Y* Given the definition of potential Given output, the economy cannot consistently operate above or below its potential level. When Y > Y*, labour demand will When be high When labour demand is high, When wages tend to increase. Since wages is a significant Since portion of firms’ cost, firms increase prices when wages increase. increase. There is also a positive relationship There between expected inflation rate and actual inflation rate. actual If firms expect prices to increase, then in all If likelihood firms will increase their prices too. Inflation that is driven mainly by expectations Inflation illustrates the idea of self-fulfilling expectations. expectations. Expected inflation may take many forms. Expected Expected inflation can be modeled as a function of: function the inflation rate of a single past period the the inflation rate of many past periods. The Phillips Curve takes two forms: π = π − β (u − u ) e Yt −1 − Y πt = π + f * Y e t N * Inflation Yt −1 − Y * π t = π te + f Y* Output Gap Yt −1 − Y πt = π + f * Y e t * The coefficient f determines the slope of the Phillips Curve determines and hence and tells how quickly prices adjust to return the tells economy to the potential output. economy Yt −1 − Y πt = π + f * Y e t * When the output gap is equal to zero actual When inflation is equal to the expected inflation rate. rate If output is permanently above the potential If level, the rate of inflation will constantly Starting point: Starting Assume equilibrium exists where actual Assume output is equal to potential output so that inflation is equal to the expected level. Assume also that expected inflation is zero, Assume which implies there is zero inflation. Y=Y* and πt = πte , πte = 0 so that πt = 0 Self-correcting Mechanism: The gradual adjustment of prices moves the economy The from the short run to the long run. towards the natural level of output. In the short-run equilibrium, if * Y >Y * Y <Y * Y =Y then over time, the price level will rise fall remain constant P LRAS P6 P7 P5 8 SRAS6 SRAS7 P4 P3 P2 P1 SRAS4 SRAS3 SRAS2 SRAS1 SRAS5 8 AD1 AD1 Y6 Y* Y4Y3Y2 Y1 Y P LRAS P6 P7 P8 SRAS6 SRAS7 P4 P3 P2 P1 SRAS4 SRAS3 SRAS2 SRAS1 SRAS8 AD2 AD1 Y6 Y* Y4Y3Y2 Y1 Y An expansionary monetary policy An Short Run Short ↑M → ↓ R → ↑ Y Long Run Long (Y>Y*) → ↑ P → ↓(M/P) → ↑ R → ↓(I, NX) (Y>Y When the money supply increases, prices will increase proportionally When so that interest rates will eventually return to their original level. Investment and net exports will likewise return to its original level. Investment However prices will be at a permanently higher level. However Money neutrality – all variables except for the price level return to Money their original level in the long run in response to a monetary policy change. Note that money is not neutral in the short run. An expansionary fiscal policy has the same long run outcome as An an expansionary monetary policy. ↑ G →↑ Y , ↑ R In the short run In ↑ R →↓ government spending crowds out some The increase in I , ↓ NX The investment and net exports. investment But Y still increase (Y1 > Y *) →↑ P Actual output is above the potential level and so prices increase in Actual the following period. the This leads to a reduction in real money supply and This consequently a further increase in the interest rate. consequently M ↑P → ↓ ↑ ↓ → R → ( NX , I ) P This process will continue until investment and net This exports decrease sufficiently for output to return to the potential level. Government spending completely crowds out private Government spending Investment and net exports declines in the long run by Investment exactly the amount that government spending increased by. Example of Aggregate Demand Curve M Y = 1,750 + 2.5 + 1.5G P Example of Phillips Curve Example Yt −1 − Y * π t = 0.4π t −1 + 0.2 * Y Enjoy the studying ...
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