Aggregate Demand and Aggregate Supply 2013 Outline Friday 14 th : - - PowerPoint PPT Presentation

2013

Aggregate Demand and Aggregate Supply

Outline

1.

Friday 14th : Chapter 16 (AS-AD, demand policies)

2.

Monday 18th

 Bas Jacobs (45 to 60 minutes interactive lecture on current crisis)  Chapter 17 (debt and stabilization policies)

3.

Wednesday 20th : end of Chapter 17 + Chapter 14/15

4.

Friday 22nd : end of Chapter 15 + solutions to mock exam

The big picture

Introduction Short run Medium run Long run

AS-AD in the short run

 Aggregate demand and aggregate supply

Output gap Inflation

AS

AD

Equilibrium on the goods and money market, IS-TR (Chapter 10) Phillips curve & Okun’s law (Chapter 12) Introduction

AS-AD in the long run

Output gap Inflation LAS LAD

Introduction

Literature for AS-AD model

 Lecture notes + pdf « Notes Chapter 13»  Burda & Wyplosz:

 13.3.1 The Fisher equation  13.3.2 The long-run AD curve  13.3.6 Monetary Policy  13.4 – 13.4.3 How to use the AS-AD framework

 In the lecture: no international capital markets in this framework (we

don’t talk explicitly about exchange rate, but implicitely we assume a flexible exchange rate regime).

 Skip the details on the differences between fixed and flexible exchange

rate.  Model presented here based on

 Mankiw, Macroeconomics, 7th edition of the international edition,

Chapter 14, mainly section 14.3 and 14.4

Outline

1.

Introduction

2.

The Fisher equation

3.

Recall: Phillips curve, expectations and aggregate supply

4.

Aggregate demand

1.

Long run

2.

Short run

5.

Using the AD-AS framework: Explaining fluctuations

1.

Supply shocks

2.

Demand shocks

3.

Monetary policy

4.

The role of Policies

Keeping track of time

 We use a dynamic model of aggregate supply and demand.

 Therefore: we need to introduce the time dimension

 The subscript “t ” denotes the time period, e.g.

 Yt = real GDP in period t  Yt -1 = real GDP in period t – 1  Yt +1 = real GDP in period t + 1

 We can think of time periods as years, e.g., if t = 2008, then

 Yt = Y2008 = real GDP in 2008  Yt -1 = Y2007 = real GDP in 2007  Yt +1 = Y2009 = real GDP in 2009 Introduction

The model’s variables and parameters

 Endogenous variables (we see how these evolve over time):

 Yt : output  πt: inflation  rt: real interest rate  it: nominal interest rate  : underlying inflation

 Shows us how last period’s events influences today’s outcome

 Exogenous variables (determined outside of our model):

 : trend output  : inflation target by CB  Demand shocks: G, T, wealth, consumer confidence…  st : Supply shocks

t

 ~ Y



Introduction

• 2. … what happens to those?
• 1. If we change one of these…

The Fisher equation

 Central bank sets the nominal interest rate i:  Distinction between nominal and real interest rate

 rt : real intrest rate - relevant for spending decisions  it : nominal intrest rate - relevant for money market  : inflation that I expect today will happen between today (year t)

and tomorrow (t+1)  Notation:

 πt : ex-post observed inflation between year t and year t+1  πt-1 : observed inflation between last period (t-1) and today (t)

gap gap

bY a i i    

• 2. The Fisher equation

t

e t t t

i r   

t

e t



The Fisher equation

Example:

 i= 8%, πt

e=10%

  r=?

 r=0,08-0,10= -0,02  Your money will buy 2% fewer goods  Lender: prefers low inflation  Borrower: prefers high inflation

 r = only observable ex post

• CB fixes the nominal interest rate and long run inflation

expectations

t t t

i r   

• 2. The Fisher equation

Inflation Unemployment

B

U

 Phillips curve:  Short run:

 Trade-off between inflation and unemployment possible IF

 no supply shocks  underlying inflation constant  Un constant.

 Long-run:

 No trade-off possible between

unemployment and inflation

A

Long run Short run Phillips curves

Phillips curve

1

~ 

2

~ 

t gap t t

s bU     ~

U U s

t t t t

    & ~  

• 3. Recall: Phillips curve

Underlying inflation

 Underlying inflation : expected inflation

 Two components

 Backward looking component (πt-1)  Forward looking component (long run inflation rate)

 For the moment, we assume adaptive expectations.  Adaptive expectations: focus on backward looking component

 Realistic when π relatively stable

 Later & Chapter 16:

 Incorporate again the forward looking component: Inflation target fixed

by the central bank

 ~

1

~



 

t e t t

t

  

• 3. Recall: Phillips curve

From the Phillips curve to aggregate supply

Inflation Output

Aggregate supply

Inflation Unemployment

(a) Phillips curve



U



Y

Output Unemployment

Y

U

(b) Okun‘s law

s aYgap     ~ s bUgap     ~

gap gap

hY U  

• 3. Recall: Phillips curve

 Aggregate supply curve

 describes, for each given level of inflation, π, the quantity of

• utput firms are willing to supply, Y

 Medium run: upward sloping,  long run: vertical

 Derived from the Phillips curve:

 Inflation  unemployment

Aggregate supply curve

t gap t t

s aY     ~

Inflation Output

Y

A B

Long run AS Short run AS

1

~ 

2

~ 

Shift of AS (and Phillips) curve:

• Change in underlying inflation
• Supply shock, s ≠0
• (Change in natural U or natural Y)
• 3. Recall: Philips curve

Aggregate demand

 Aggregate demand curve

 all the combinations of output and inflation such that

 the market for goods is in equilibrium (IS)  the money market is in equilibrium (TR )

 To draw the aggregate demand curve:

 How does the equilibrium on the goods and money markets change

when prices change?

• 1. Long run AD curve
• 2. Short run AD curve

 Here: closed or big and open economy (!!DIFFERENT from Ch. 13 of Burda

& Wyplosz!!) we do not worry about the exchange rate here

 Framework here: based on Mankiw, Macroeconomics, 7th edition of the

international edition, Chapter 14

• 4. Aggregate demand

The model’s long run equilibrium

 We know (from the LAS curve) that in the long run

  Intersection of LAS and LAD curve: Long run equilibrium of the

economy

 What determines inflation in the long run?

 CB fixes the inflation target and thus long run inflation  It follows:  Real economy gives natural level of real interest rate:

t t

Y Y 

   r i

t t

  ~ 

    

t t

~

r r

t 

4.1 Aggregate demand – Long run



The aggregate demand curve in the long run

LAD = target inflation frate

Central bank chooses a target for the long run inflation  Inflation independent from output

Inflation



Output gap

       r i bY a i i

gap gap

where , : rule Taylor

4.1 Aggregate demand – Long run

 Deriving the short run AD curve:

 How does a change in prices affect the equilibrium in the IS-

TR model?

 Taylor rule:

• Interest rate responds not only to changes in Y but also to

changes in π

• ECB: a = 1.5  i ↑ if πgap >0. (note: i increases by more than πgap !)
•  r increases also (i – π = r)
• When inflation changes  shift of TR curve
• If inflation raises, for every level of output, the interest rate will be

higher, so the TR curve shifts up

Aggregate demand curve in the short run

gap gap

bY a i i    

4.2 Aggregate demand – Short run

Taylor rule and inflation

• How does the CB change i when inflation increases?

gap gap

bY a i i    

 

) (

gap

bY a i i      

 

gap

bY aπ π a i i    

This constant term will change, when π changes

    when i

TR

i Y gap

TR‘

i

4.2 Aggregate demand – Short run

Rate of inflation Output gap Interest rate Output gap

A A

Drawing the short run AD curve

 At point A:

TR



gap

We start from long-run equilibrium, where and . Y    

Along TR  is held constant

at . 

i i Y Y     and  

i

4.2 Aggregate demand – Short run



AD A´

Rate of inflation Output gap Interest rate Output gap

TR´ A A´ A TR



With π : TR TR’.

IS

Drawing the short run AD curve

4.2 Aggregate demand – Short run

gap gap

bY a i i    

Question: Why is r automatically  here, after the ECB increases i according to the Taylor rule (a = 1.5)?

Nominal and real interest rate   Investment, Y 

AD slopes downward: When inflation rises, the central bank raises the (real) interest rate, reducing the demand for goods & services.

Ygap π

AD curve shifts in response to changes in

• the inflation target (↑  shifts

AD to the right)

• demand shocks (ε = changes in

G, T, wealth, …) (↑ in demand  shift to the right) ADt  AD determined by changes in the IS-TR equilibrium due

to change in inflation

The short run AD curve

   B A Ygap     ) (

4.2 Aggregate demand – Short run

AS-AD

Inflation

AS

AD

LAD

LAS

Output gap



• 5. Using the AD-AS framework: Explaining fluctuations

Simulation of economic fluctuations

 Now that we have built our AS-AD model, we can see how

fluctuations emerge.

• What are the effects?

1.

Supply shock

2.

Demand shock

3.

Change in monetary policy

4.

Contractionary versus expansionary policies



Here we make the assumption of adaptive expectations:



We always start from the LR equilibrium: The only disturbance to the economy is in year t. We then see how the economy adjusts over the years to this disturbance via changes in the interest rate and inflation expectations.

1

~



 

t t t

e t

  

• 5. Using the AD-AS framework: Explaining fluctuations

Period t – 1: initial equilibrium at point A Period t: Supply shock (s > 0)  AS shifts upward, π rises  CB responds to higher π by raising the (real) interest rate,

• utput falls.

 Point B

πt – 1 Yt –1 π

ASt -1

Y

AD A ASt

Yt

B

πt

An adverse supply shock

Y gap

t gap t t

s aY     ~

5.1 AD-AS framework: Supply shock

πt – 1 Yt –1

Period t + 1: Supply shock is over (s = 0) but AS does not return to its initial position due to higher inflation expectations. Period t + 2: As πt , underlying inflation   AS shifts downward  Y rises.

π

ASt -1

Y

AD A ASt

Yt

B

πt

ASt +1 C ASt +2 D

Yt + 2 πt + 2

This process continues until output returns to its natural rate. LR equilibrium at point A.

An adverse supply shock

Y gap

t gap t t

s aY     ~

1

~





t

t

 

5.1 AD-AS framework: Supply shock

t

Y

t



A one-period supply shock affects output for many periods.

An adverse supply shock

5.1 AD-AS framework: Supply shock

t



t



Because inflation expectations adjust only slowly, actual inflation remains high for many periods.

An adverse supply shock

5.1 AD-AS framework: Supply shock

t

r

The real interest rate takes many periods to return to its natural rate.

t

i

An adverse supply shock

5.1 AD-AS framework: Supply shock

Period t – 1: at point A

πt – 1 π

ASt -1,t

Y

ADt ,t+1,…,t+4 ADt -1

Yt –1

A ASt + 1 C

Yt

B

πt

Period t: Positive demand shock until t = 4 (ε > 0)  AD shifts to the right  Y and π . Period t + 1: Higher inflation in t raises inflation expectations for t + 1  AS shifts up.  Y and π  even more

Positive demand disturbance

Y gap

5.2 AD-AS framework: Demand shock

πt – 1 π

ASt -1,t

Y

ADt ,t+1,…,t+4 ADt -1

Yt –1

A ASt + 1 C ASt +2 D ASt +3 E ASt +4 F

Yt

B

πt

Periods t + 2 to t + 4 : Higher inflation in previous period raises inflation expectations AS curve continues to shift up.  Y and π 

Positive demand disturbance

Y gap

5.2 AD-AS framework: Demand shock

πt – 1 π

ASfinal

Y

ADt ,t+1,…,t+4 ADt -1, t+5 ASt +5

Yfinal

A

Yt

B

πt Yt + 5

G

πt + 5

Period t + 5: AS is higher due to higher π in preceding period, but demand shock ends AD returns to its initial position.  Equilibrium in t+5 at point G. Periods t + 6 and higher: AS gradually shifts down as π and fall, the economy gradually recovers until reaching again LR equilibrium at A.

Positive demand disturbance

 ~

Y gap

F

πt + 4

ASt +4

5.2 AD-AS framework: Demand shock

t

Y

t



The demand shock raises

• utput for

five periods. When the shock ends,

• utput falls

below its natural level, and recovers gradually.

Positive demand disturbance

5.2 AD-AS framework: Demand shock

t



t



The demand shock causes inflation to rise. When the shock ends, inflation gradually falls toward its initial level.

Positive demand disturbance

5.2 AD-AS framework: Demand shock

t

r

The demand shock raises the real interest rate. After the shock ends, the real interest rate falls and approaches its initial level.

Positive demand disturbance

t

i

5.2 AD-AS framework: Demand shock

 Conclusion:

 A fiscal policy (or any other demand disturbance) can only

increase output temporarily

 Economy will always come back to it’s natural output level

 Either: AD curve shifts back (e.g. fiscal policy not sustainable)  back

to natural level of Y (Option 1)

 Or: change in underlying inflation leads to upward shift of AS-curve 

decrease in output and increase in inflation  back to natural level of Y (but with higher inflation in the long run, i.e. CB accepts higher π in the long run = higher inflation target) (Option 2)

The role of demand policies

Increasing government expenditure has only an effect on

• utput in the short run, NO impact in the long run

5.2 AD-AS framework: Demand shock

πt – 1 π

ASt -1,t

Y

ADt ,t+1,…,t+4 ADt -1, t+5

Yt –1

A ASt + 1 ASt +n

Yt

B

πt

Positive demand disturbance

Y gap Option 2: AS shifts to new long run equilibrium (point Z). Here CB accepts higher inflation target (LAD shifts up to point Z) Option 1: AD curve shifts back to initial long run equilibrium in point A (has to be the case when CB doesn’t change the inflation target)

Z

Yfinal

Which option occurs? Depends on CB! What is the speed the speed

• f adjustment? This depends
• n inflation expectations of
• individuals. (Details Ch. 16)

5.3 AD-AS framework: Monetary policy

A Shift in Monetary Policy

Inflation Output gap Interest rate Output gap TR LAD‘

IS

C A LAS AS AD

Long run: lower inflation target  no effect on output

LAD

2



1



A

CB changes the inflation target and follows a more restrictive monetary policy

5.3 AD-AS framework: Monetary policy

A Shift in Monetary Policy

Inflation Output gap Interest rate Output gap TR LAD‘ B LAS AS AD‘ AD

IS

Short run: monetary policy has an impact on Y and π

2



LAD

1



B A TR´ A

With inflation target  : TR TR’. Shift in TR : AD  AD’ (   Y  ) On TR’: actual inflation above its new target level  i  and r   investment , Y 

   B A Ygap     ) (

5.3 AD-AS framework: Monetary policy



Period t – 1: target inflation rate = 2%, initial equilibrium: point A

πt – 1 = 2% Yt –1

Period t: CB lowers inflation target to = 1%, raises i and r to reduce π.  AD shifts left Y and π .  New eq. : point B

Y gap π ASt -1, t Y ADt – 1 A ADt, t + 1,… Yt πt B Z πfinal = 1% , Yfinal

A Shift in Monetary Policy





5.3 AD-AS framework: Monetary policy

πt – 1 = 2% Yt –1 π ASt -1, t Y ADt – 1 A ADt, t + 1,… ASfinal Yt πt B ASt +1 C

Subsequent periods: This process continues until

• utput returns to

its natural rate and inflation reaches its new target.

Z πfinal = 1% , Yfinal

A Shift in Monetary Policy

Period t + 1: The fall in πt reduces inflation expectations because    AS shifts down  Y  , π 

 ~

t

   ~

Y gap

5.3 AD-AS framework: Monetary policy

Response to a reduction in target inflation

t

Y

Reducing causes

• utput to fall

below its natural level for a while. Output recovers gradually. 

t



5.3 AD-AS framework: Monetary policy

t



Because expectations adjust slowly, it takes many periods for inflation to reach the new target.

t



Response to a reduction in target inflation

5.3 AD-AS framework: Monetary policy

t

r

To reduce inflation, the CB raises i and r to reduce aggregate demand  new eq in IS- TR. r gradually returns to its natural rate.

t



Response to a reduction in target inflation

5.3 AD-AS framework: Monetary policy

t

i

CB raises i in t. As inflation falls, the nominal rate falls too.

     r i π r i

Response to a reduction in target inflation

t



5.3 AD-AS framework: Monetary policy

 So far:

 Central bank only follows its predetermined Taylor Rule

(except in case of shift in monetary policy)

 Government is not intervening to reduce the initial shock.

 Now:

 What can policy makers do in case of a negative demand or

supply shock?

 Fiscal policy  Monetary policy  Expansionary  Contractionary

 Role of expectations: importance of forward looking

component of underlying inflation

Supply shock & demand policies

5.4 Policy responses to shocks

LAD AS´ LAS AS AD Inflation B

Stagflation results: both unemployment and inflation increase.

Output gap A

Adverse supply shock

 If s >0  Shift in the AS curve:

s aYgap     ~

5.4 Policy responses to shocks

Supply shock & demand policies

 Suppose we try to fight resulting unemployment with

expansionary demand policies... AD´ AS´ LAS LAD AD Inflation B C

We successfully fight unemployment, but at a cost of increased inflation in the long- run. New equilibrium at C.

Output gap A

5.4 Policy responses to shocks

 ... or we try to fight the inflationary impact of the adverse

supply shock through a contractionary policy. LAD AD´´ AS´ LAS AD AS Inflation B D

We successfully fight π but at a cost of increased unemployment (via point D) until we return to the long-run equilibrium at A.

Output gap A

Supply shock & demand policies

5.4 Policy responses to shocks

 Third option: Central bank announces credibly that inflation

will be at its target level. LAD AS´ LAS AD AS Inflation B

If people expect inflation to be at its target level, AS curve shifts back to its

• riginal position.

We return directly to the long-run equilibrium at A.

Output gap A

Supply shock & demand policies

5.4 Policy responses to shocks

AD´ LAS AD AS Inflation A B Output gap

Adverse demand shock

 An adverse demand shock brings the economy from point

A to point B…

5.4 Policy responses to shocks

AD´ LAS AD AS Inflation A B Output gap

Adverse demand shock

 AD policy change to offset demand shock

 Here: To go back to point A: Expansionary fiscal or expansionary

monetary policy

5.4 Policy responses to shocks