Unformatted text preview: Aggregate Demand and
Price Adjustment II
Price Why is there a negative relationship between aggregate
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
can be drawn from it?
can The Phillips Curve
The relates the inflation rate to the output gap
and expected inflation. Also, the Phillips curve relates the
inflation rate to the unemployment rate.
inflation There is a positive relationship between
the inflation rate and the output gap. Recall: output gap is Y-Y* Given the definition of potential
output, the economy cannot
consistently operate above or
below its potential level. When Y > Y*, labour demand will
be high When labour demand is high,
wages tend to increase. Since wages is a significant
portion of firms’ cost, firms
increase prices when wages
increase. There is also a positive relationship
between expected inflation rate and
actual inflation rate.
actual If firms expect prices to increase, then in all
likelihood firms will increase their prices too. Inflation that is driven mainly by expectations
expectations. Expected inflation may take many forms.
Expected inflation can be modeled as a
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
t N * Inflation Yt −1 − Y *
π t = π te + f
Y* Output Gap Yt −1 − Y
πt = π + f
t * The coefficient f determines the slope of the Phillips Curve
and tells how quickly prices adjust to return the
economy to the potential output.
economy Yt −1 − Y
πt = π + f
t * When the output gap is equal to zero actual
inflation is equal to the expected inflation
rate If output is permanently above the potential
level, the rate of inflation will constantly Starting point:
Starting Assume equilibrium exists where actual
output is equal to potential output so that
inflation is equal to the expected level. Assume also that expected inflation is zero,
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
* Y >Y
Y =Y then over time, the
price level will
remain constant P LRAS P6
AD1 Y6 Y* Y4Y3Y2 Y1 Y P LRAS P6
SRAS1 SRAS8 AD2
AD1 Y6 Y* Y4Y3Y2 Y1 Y An expansionary monetary policy
An Short Run
↑M → ↓ R → ↑ Y Long Run
(Y>Y*) → ↑ P → ↓(M/P) → ↑ R → ↓(I, NX)
(Y>Y When the money supply increases, prices will increase proportionally
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
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 expansionary monetary policy.
↑ G →↑ Y , ↑ R In the short run
↑ R →↓ government spending crowds out some The increase in I , ↓ NX
investment and net exports.
investment But Y still increase (Y1 > Y *) →↑ P Actual output is above the potential level and so prices increase in
the following period.
the This leads to a reduction in real money supply and
consequently a further increase in the interest rate.
M ↑P → ↓
↓ → R → ( NX , I )
P This process will continue until investment and net
exports decrease sufficiently for output to return to the
potential level. Government spending completely crowds out private
spending Investment and net exports declines in the long run by
exactly the amount that government spending increased
by. Example of Aggregate Demand Curve
Y = 1,750 + 2.5 + 1.5G
P Example of Phillips Curve
Yt −1 − Y *
π t = 0.4π t −1 + 0.2
Y Enjoy the studying ...
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