ECONOMICS 100B
Professor Steven Wood
03/31/11
Lecture 20
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LECTURE:
Today’s lecture continues on the
Macroeconomic
Policy and Aggregate Demand and Supply
Analysis.
ANNOUNCEMENTS:
Midterm 2 will be next
Tuesday, April 5. Know
the IS-MP-PC model, the IS-MP-AD/AS model,
and the AD/AS model.
TEMPORARY NEGATIVE AGGREGATE
SUPPLY SHOCK:
Suppose the economy is initially in general
equilibrium at the target inflation rate, and there is a
temporary negative aggregate supply shock. The
central bank responds with a policy to stabilize
inflation at π
T
in the short-run.
In the following graph, we see that a negative
temporary aggregate supply shock will shift the
SRAS curve left to SRAS
1
, increasing inflation to
π
1a
, increasing the real interest rate along the MP
curve to r
1a
, and reducing economic output to Y
1a
.
To stabilize inflation at its target rate, the central
bank immediately responds with
an autonomous
tightening of monetary policy.
This shifts
the
MP curve left to MP
1
and the AD curve left to AD
1
,
increasing the real interest rate, reducing economic
output, and reducing inflation to π
T
.
A negative output gap will shift the SRAS curve the
right to SRAS
2
, reducing inflation to π
2a
, reducing
the real interest rate to r
2a
, and increasing economic
output to Y
2a
.
The central bank must now respond with an
autonomous easing of monetary policy, shifting the
MP curve right to MP
2
and the AD curve right to
AD
2
. This reduces the real interest rate to r
2
,
increases economic output to Y
2
, and increases
inflation to π
T
.
In the very short-run (year 1a):
1. Y
1a
< Y
P0
2. π
1a
> π
T
3. r
1a
> r*0.
In the short-run (year 1):
1. Y1 < Y
1a
< Y
p0
2. π
1
= π
T
3. r
1
> r*0
In the long-run (year x):
1. Y
X
= Y
P
2. π
X
= π
T
3. r
X
= r*0.
After a temporary aggregate supply shock, a central
bank monetary policy of stabilizing inflation leads
to deviations of economic output from its potential
level, with π, r, and Y fluctuating from year to year.
Although the economy goes back to general
equilibrium in the long-run, the economic
fluctuations can continue for a long time.