Professor Steven Wood
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Today’s lecture continues on the
Policy and Aggregate Demand and Supply
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
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
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
, increasing inflation to
, increasing the real interest rate along the MP
curve to r
, and reducing economic output to Y
To stabilize inflation at its target rate, the central
bank immediately responds with
tightening of monetary policy.
MP curve left to MP
and the AD curve left to AD
increasing the real interest rate, reducing economic
output, and reducing inflation to π
A negative output gap will shift the SRAS curve the
right to SRAS
, reducing inflation to π
the real interest rate to r
, and increasing economic
output to Y
The central bank must now respond with an
autonomous easing of monetary policy, shifting the
MP curve right to MP
and the AD curve right to
. This reduces the real interest rate to r
increases economic output to Y
, and increases
inflation to π
In the very short-run (year 1a):
In the short-run (year 1):
1. Y1 < Y
In the long-run (year x):
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.