Long RunAggregate Demand & Supply

Lecture 20

Dr. Jennifer P. Wissink©2015 Jennifer P. Wissink, all rights reserved.

April 8, 2015

i>clicker questionIf you were POTUS and you wanted expansionary policy to work really well (i.e., have the greatest multiplier impact), where would you hope AD currently intersects SR-AS?

A. In the horizontal part.

B. In the intermediate part.

C. In the vertical part.

D. Doesn’t matter.

Monetary &/or Fiscal Policy When SR-AS is Rather Flat

Expansionary Policy– Monetary OR Fiscal– Suppose we are on the

“flatter” part of SR-AS.– AD shifts out (to the right).– Policy works well when the

economy is on the flatter portion of the SR-AS curve, causing little change in PL relative to the output increase.

– Note: assuming no shift in SR-AS for now.

Expansionary Policy– Monetary OR Fiscal– Suppose we start out on the

“steeper” part of SR-AS.– AD shifts out.– When the economy is

operating near capacity, an increase in AD will result in an increase in the price level, PL, with little increase in output.

– Note: still assuming no shift in SR-AS.

Monetary &/or Fiscal Policy When SR-AS is Rather Steep

The Response of Input Prices to Changes in the Overall Price Level If the price-level increase were assumed to be fully

anticipated, then wage rates and all other prices would be predicted to increase at exactly the same rate as the overall price level ...– But many argue that this is simply not the observed case.

So... there must be a lag between changes in input prices and changes in output prices, otherwise theSR-AS (the SR price/output response) curve would be vertical.

So... we operate with the idea that enough input prices tend to lag changes in output prices to make it so we talk about SR-AS & LR-AS.

We distinguish between the– short run AS curve (SR-AS)– long run AS curve (LR-AS)

SR-AS is positively sloped and…– tends to start out rather flat/horizontal at low levels of Y– then has a section that’s positively sloped – then tends to get very steep/vertical as we approach Y-capacity (which is

different than Ypotential/YFE )– will shift with cost/supply shocks (see chart again, the one with the pics)

LR-AS is vertical.– This is because eventually all prices adjust, including input prices.– Typically we assume the LR-AS is vertical at Ypotential/YFE.– Ypotential/YFE is the level of income/output where there is no inflation.– If Y>YFE then you’ll get rising price/wage levels and a shift in the SR-AS

back to LR-AS, but now at a higher price level.– If Y<YFE then you’ll get falling price/wage levels and a shift in the SR-AS

back to LR-AS, but now at a lower price level.

SR-AS versus LR-AS

AD, LR-AS and SR-AS Curves

Recall: Some/enough input costs lag behind price-level changes in the short run, resulting in an upward-sloping SR-AS curve.

In the long run, costs and the price level move in tandem, so once costs finally “catch up” and adjust, the LR-AS curve is vertical at what we will call YPotential or YFE = Yo

Consider An Increase in AD

If AS (Long run) is vertical, then neither monetary policy nor fiscal policy has any long run effect on aggregate output.

In the long run, the multiplier effect of a change in MS, government spending or taxes on aggregate output is zero.

So is the AS (Long run) vertical?

Can policy (and what type of policy then?) change where AS (Long run) is?

BAD NEWS? AD, SR-AS, LR-AS andMonetary and Fiscal Policy: Long Run Impact

Inflation Concepts Review Inflation is an increase in the overall price

level. Sustained inflation occurs when the overall

price level continues to rise over some fairly long period of time.

Hyperinflation is a period of very rapid increases in the price level.

Stagflation occurs when output is falling at the same time that prices are rising.

TWO Major Types of Inflation Demand-pull inflation is

inflation initiated by an increase in AD (a shift rightward of AD).

Cost-push, or supply-side, inflation is inflation (stagflation) caused by an increase in costs generating a decrease (a shift leftward) in SR-AS.

Cost-Push Inflation & StagflationLeading to Demand Pull Inflation

Recall Stagflation... occurs when output is falling at the same time that prices are rising.

Suppose for example:– we’re at Yo and then...– oil prices increase– AS shifts left and we get

higher prices and less output.

– So suppose we react and use expansionary monetary or fiscal policy.

– But that increases prices even more!

Another Source of Inflation: Expectations If every firm expects every other firm to raise prices by 10%, every

firm will raise prices by about 10%. This is how expectations can get “built into the system.”

In terms of the AD/AS diagram, an increase in inflationary expectations shifts the SR-AS curve to the left.

Works like a negative cost shock.

Called expectational inflation.

Turns out to be “self-fulfilling.”

Note: Something had to “start” it, like expansionary monetary or fiscal policy. Expectational inflation can only sustain an ongoing inflation

(which typically starts with some increase in AD)

Related to an idea of “inertial inflation” when inflation continues on its own inertia when the original reason has ceased.

Money Supply and Inflation It is often said that, “You can’t have a sustained inflation

(or worse yet a hyperinflation) without monetary support.” WHY? HOW’s THAT WORK?

Consider an increase in G with the FED keeping the money supply constant.– AD curve shifts right.– When MD depends on Y & PL, this leads to an increase in MD

and therefore an increase in the interest rate and crowding out of planned investment, so AD shifts back a little leftward.

– Also once wages and other input prices catch up, SR-AS will shift left, too.

– This will all stop at a higher price level and back on LR-AS.– END OF STORY. Inflation is over....

Money Supply and Inflation BUT... If the monetary guys decide to increase the money

supply to decrease the interest rate to undo some of the crowding out effect...

...then we kind of start the whole thing over again with a rightward shift in AD.

The result is a sustained inflation, perhaps hyperinflation.

So if the Fed holds fast on the money supply, the inflation will eventually end on its own.

Albeit at a stable HIGHER overall price level.