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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 YY* 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
selffulfilling
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 Selfcorrecting 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 shortrun
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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This note was uploaded on 12/15/2011 for the course ECON EC21A taught by Professor Georgiamcleod during the Fall '09 term at University of the West Indies at Mona.
 Fall '09
 GeorgiaMcleod
 Macroeconomics

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