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Unformatted text preview: 18 Review: Keynesian aggregate expenditure model does not include inflation . 19 PAE 0 Output ( Y ) PAE = C + Ip + G + NX Y e Aggregate Demand • In the previous Lecture we developed the following two models: • A PAE curve that depended on the real interest rate • A policy reaction function for the RBA, in which the real interest rate responded to the inflation rate • These two equations can be combined to produce a relationship between output and inflation, that is called the Aggregate Demand curve Where are we going? – The ASAD (aggregate supply  aggregate demand) model . 21 Inflation ( ) 0 Output ( Y ) AD (aggregate demand) SRAS (short run aggregate supply) LRAS (long run aggregate supply) Y* 2. AS  AD Model: Aggregate Demand . 22 0 Output ( Y ) Inflation ( ) AD (aggregate demand) AD: relates demand to the rate of inflation Constructed from a series of equilibrium points (for each level of inflation) Why does higher inflation lead to lower PAE (and equilibrium output) – or why does AD have a negative slope? Consider Inflation and interest rates: when exceeds the RBA target, the RBA will react by raising interest rates to reduce AD (move along RBA policy reaction function) – visa versa Inflation and wealth (lower wealth => lower consumption) Inflation and income distribution (greater impact on less affluent who spend greater proportion of income => impact overall spending) Inflation and uncertainty (uncertainty =>pessimistic expectations) Inflation and international competitiveness (inflation increases real exchange rate (Pd/Pf) x e and reduces competitiveness) 23 Why does equilibrium level of output change, at a given level of inflation – what causes shifts in the aggregate demand curve? AD shifts due to: • Exogenous changes in components of PAE [ = C + Ip + G + NX ] Expectations, Fiscal policy, world output and other economic conditions • Shift in the RBA policy reaction function (RBA decides to change how they want to react to a given inflation rate reflected terms of a higher or lower nominal and real interest rate at any given rate of inflation 24 2. AS  AD Model: Aggregate Demand . 25 0 Output ( Y ) Inflation ( ) AD (aggregate demand) Aggregate Demand  and a shift in RBA’s policy reaction function • . 26 r as set by RBA 0 inflation ( ) inflation ( ) Output ( Y ) old policy reaction function AD AD’ new policy reaction function 3. ASAD Model: Inflation and Aggregate Supply Aggregate supply  relationship between output and inflation Aggregate supply differs between short run and the long run – Short run: producers supply whatever output is demanded (at pre existing prices); inflationary expectations are reasonably constant – Long run: supply determined by potential output; – Y* = f ( labour, capital, technology) – does not depend on inflation rate 27 Aggregate Supply – differs in short run (SRAS) and long run (LRAS) ....
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 One '08
 henry
 Inflation, policy reaction function

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