PART III The Core of Macroeconomic Theory

CASE FAIR OSTER

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Prepared by: Fernando Quijano & Shelly

Tefft
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PART V The Core of Macroeconomic Theory

Aggregate Supply and

the Equilibrium Price
Level

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CHAPTER OUTLINE
The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning
Aggregate Supply in the Short Run
Shifts of the Short-Run Aggregate Supply Curve

The Equilibrium Price Level

The Long-Run Aggregate Supply Curve
Potential GDP

Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects
PART V The Core of Macroeconomic Theory

Causes of Inflation

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Demand-Pull Inflation
Cost-Push, or Supply-Side, Inflation
Expectations and Inflation
Money and Inflation
Sustained Inflation as a Purely Monetary Phenomenon

The Behavior of the Fed

Targeting the Interest Rate
The Feds Response to the State of the Economy
Fed Behavior Since 1970
Interest Rates Near Zero
Inflation Targeting

Looking Ahead
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The Aggregate Supply Curve

aggregate supply The total supply of
all goods and services in an economy.
The Aggregate Supply Curve: A Warning

PART V The Core of Macroeconomic Theory

aggregate supply (AS) curve A

graph that shows the relationship
between the aggregate quantity of
output supplied by all firms in an
economy and the overall price level.
The aggregate supply curve is not a market supply curve, and it is not
the simple sum of all the individual supply curves in the economy.
Because many firms in the economy set prices as well as output, we
can say an aggregate supply curve is really a price/output response
curvea curve that traces out the price decisions and output decisions
of all firms in the economy under a given set of circumstances.

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The Aggregate Supply Curve

Aggregate Supply
in the Short Run

PART V The Core of Macroeconomic Theory

FIGURE 28.1 The Short-Run

Aggregate Supply Curve

In the short run, the

aggregate supply curve (the
price/output response curve)
has a positive slope.
At low levels of aggregate
output, the curve is fairly
flat.
As the economy approaches
capacity, the curve becomes
nearly vertical.
At capacity, Y*, the curve is
vertical.

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The Aggregate Supply Curve

Aggregate Supply in the Short Run
Why an Upward Slope?
Wages are a large fraction of total costs and wage changes
lag behind price changes. This gives us an upward sloping
short-run AS curve.

PART V The Core of Macroeconomic Theory

Why the Particular Shape?

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At some level the overall economy is using all its capital and
all the labor that wants to work at the market wage. At this
level (Y*), the AS curve is vertical.
At low levels of output, the AS curve is flatter. Small price
increases may be associated with relatively large output
responses. We may observe relatively sticky wages upward
at this point on the AS curve.
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The Aggregate Supply Curve

PART V The Core of Macroeconomic Theory

Shifts of the Short-Run

Aggregate Supply Curve

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cost shock, or supply shock A

change in costs that shifts the shortrun aggregate supply (AS) curve.

FIGURE 28.2 Shifts of the Short-Run Aggregate Supply Curve

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The Equilibrium Price Level

equilibrium price level The price level at which the
aggregate demand and aggregate supply curves intersect.

PART V The Core of Macroeconomic Theory

FIGURE 28.3 The Equilibrium Price Level

At each point along the AD curve, both the

money market and the goods market are in
equilibrium.
Each point on the AS curve represents the
price/ output decisions of all the firms in the
economy.
P0 and Y0 correspond to equilibrium in the
goods market and the money market and to a
set of price/output decisions on the part of all
the firms in the economy.

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The Long-Run Aggregate Supply Curve

FIGURE 28.4 The Long-Run Aggregate Supply

Curve

PART V The Core of Macroeconomic Theory

When the AD curve shifts from AD0 to AD1, the

equilibrium price level initially rises from P0 to
P1 and output rises from Y0 to Y1.
Wages respond in the longer run, shifting the
AS curve from AS0 to AS1.
If wages fully adjust, output will be back at Y0.
Y0 is sometimes called potential GDP.

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E C O N O M I C S I N PRAC TI C E
The Simple Keynesian Aggregate Supply Curve

PART V The Core of Macroeconomic Theory

The simple Keynesian view of the aggregate

supply curve holds that at any given moment,
the economy has a clearly defined capacity, or
maximum, output.
With planned aggregate expenditure of AE1 and aggregate
demand of AD1, equilibrium output is Y1.
A shift of planned aggregate expenditure to AE2,
corresponding to a shift of the AD curve to AD2, causes
output to rise but the price level to remain at P1.
If planned aggregate expenditure and aggregate demand
exceed YF, however, there is an inflationary gap and the price
level rises to P3.

Despite insights the kinked aggregate supply

curve provides, most economists find it unlikely
that the whole economy suddenly runs into a
capacity wall at a specific level of output.
As output expands, some firms and industries will hit capacity before others.

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The Long-Run Aggregate Supply Curve

Potential GDP
potential output, or potential GDP The level of aggregate
output that can be sustained in the long run without inflation.

PART V The Core of Macroeconomic Theory

Short-Run Equilibrium Below Potential Output

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Although different economists have different opinions on how

to determine whether an economy is operating at or above
potential output, there is general agreement that there is a
maximum level of output (below the vertical portion of the
short-run aggregate supply curve) that can be sustained
without inflation.

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Monetary and Fiscal Policy Effects

FIGURE 28.5 A Shift of the Aggregate Demand

Curve When the Economy Is on the Nearly Flat Part
of the AS Curve

PART V The Core of Macroeconomic Theory

Aggregate demand can shift to the right for a

number of reasons, including an increase in
the money supply, a tax cut, or an increase in
government spending.
If the shift occurs when the economy is on the
nearly flat portion of the AS curve, the result
will be an increase in output with little
increase in the price level from point A to
point A.

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PART V The Core of Macroeconomic Theory

Monetary and Fiscal Policy Effects

FIGURE 28.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating At or Near
Maximum Capacity

If a shift of aggregate demand occurs while the economy is operating near full capacity, the
result will be an increase in the price level with little increase in output from point B to point
B.

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Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects
It is important to realize that if the AS curve is vertical in the long run,
neither monetary policy nor fiscal policy has any effect on aggregate
output in the long run.

PART V The Core of Macroeconomic Theory

The longer the lag time between wages and output prices, the greater
the potential impact of monetary and fiscal policy on aggregate output.
Some argue that wages do not fall during slack periods and that the
economy can get stuck at an equilibrium below potential output. In
this case, monetary and fiscal policy would be necessary to restore full
employment.

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Causes of Inflation
Demand-Pull Inflation
demand-pull inflation Inflation that is
initiated by an increase in aggregate demand.

PART V The Core of Macroeconomic Theory

If the economy is operating on the steep portion of the AS curve at the

time of the increase in aggregate demand, most of the effect will be an
increase in the price level instead of an increase in output.
If the economy is operating on the flat portion of the AS curve, most of
the effect will be an increase in output instead of an increase in the
price level.

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Causes of Inflation
Cost-Push, or Supply-Side, Inflation
cost-push, or supply-side, inflation Inflation caused by an increase in costs.
FIGURE 28.7 Cost-Push, or Supply-Side,
Inflation

PART V The Core of Macroeconomic Theory

An increase in costs shifts the AS curve to

the left.
By assuming the government does not
react to this shift, the AD curve does not
shift, the price level rises, and output falls.

stagflation Occurs when output is falling at the same time that prices are rising.

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Causes of Inflation
Cost-Push, or Supply-Side, Inflation

PART V The Core of Macroeconomic Theory

FIGURE 28.8 Cost Shocks Are Bad

News for Policy Makers

A cost shock with no change in

monetary or fiscal policy would
shift the aggregate supply curve
from AS0 to AS1, lower output from
Y0 to Y1, and raise the price level
from P0 to P1.
Monetary or fiscal policy could be
changed enough to have the AD
curve shift from AD0 to AD1.
This policy would raise aggregate
output Y again, but it would raise
the price level further, to P2.

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Causes of Inflation
Expectations and Inflation
When firms are making their price/output decisions, their expectations
of future prices may affect their current decisions. If a firm expects that
its competitors will raise their prices, it may raise its own price.

PART V The Core of Macroeconomic Theory

The firms profit-maximizing optimum price is presumably not too far

from the average of its competitors prices.
Expectations can lead to an inertia that makes it difficult to stop an
inflationary spiral. If prices have been rising and if peoples
expectations are adaptive, firms may continue raising prices even if
demand is slowing or contracting.
Given the importance of expectations in inflation, central banks aim to
keep them low.

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E C O N O M I C S I N PRAC TI C E
Inflationary Expectations in China
Expectations that prices
will rise can be selffulfilling as firms raise
prices in expectation that
all other prices will rise.

PART V The Core of Macroeconomic Theory

This same phenomenon

is discussed in the
context of China.
It is also interesting to
note that many people
believed the official
statistics on inflation
understated their own experience.

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Inflation Perceptions Run High in China

The Wall Street Journal
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Causes of Inflation
Money and Inflation

PART V The Core of Macroeconomic Theory

FIGURE 28.9 Sustained Inflation from an

Initial Increase in G and Fed Accommodation

An increase in G with the money supply

constant shifts the AD curve from AD0
to AD1.
Although not shown in the figure, this
leads to an increase in the interest rate
and crowding out of planned
investment.
If the Fed tries to keep the interest rate
unchanged by increasing the money
supply, the AD curve will shift farther
and farther to the right.
The result is a sustained inflation,
perhaps even hyperinflation.

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Causes of Inflation
Sustained Inflation as a Purely Monetary Phenomenon
Virtually all economists agree that an increase in the price level can be
caused by anything that causes the AD curve to shift to the right or the
AS curve to shift to the left.

PART V The Core of Macroeconomic Theory

It is also generally agreed that for a sustained inflation to occur, the

Fed must accommodate it.
In this sense, a sustained inflation can be thought of as a purely
monetary phenomenon.

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The Behavior of the Fed

PART V The Core of Macroeconomic Theory

FIGURE 28.10 Fed Behavior

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The Behavior of the Fed

Targeting the Interest Rate
The actual variable of interest to the Fed is not the money supply, but
the interest rate.

PART V The Core of Macroeconomic Theory

In practice, it is the interest rate that directly affects economic activity,

for example, by affecting firms decisions about investing.
Targeting the interest rate thus gives the Fed more control over the
key variable that matters to the economy.

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The Behavior of the Fed

The Feds Response to the State of the Economy

PART V The Core of Macroeconomic Theory

FIGURE 28.11 The Feds Response to

Low Output/Low Inflation

During periods of low output/low

inflation, the economy is on the
relatively flat portion of the AS curve.
In this case, the Fed is likely to lower
the interest rate (and thus expand the
money supply).
This will shift the AD curve to the right,
from AD0 to AD1, and lead to an
increase in output with very little
increase in the price level.

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The Behavior of the Fed

The Feds Response to the State of the Economy

PART V The Core of Macroeconomic Theory

FIGURE 28.12 The Feds Response to

High Output/High Inflation

During periods of high output/high

inflation, the economy is on the
relatively steep portion of the AS
curve.
In this case, the Fed is likely to
increase the interest rate (and thus
contract the money supply).
This will shift the AD curve to the left,
from AD0 to AD1, and lead to a
decrease in the price level with very
little decrease in output.

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The Behavior of the Fed

Fed Behavior
Since 1970

PART V The Core of Macroeconomic Theory

FIGURE 28.13 Output,

Inflation, and the Interest
Rate 1970 I2010 I

The Fed generally had

high interest rates in the
two inflationary periods
and low interest rates
from the mid 1980s on.
It aggressively lowered
interest rates in the
1990 III1991 I, 2001 I
2001 III, and 2008 I
2009 II recessions.
Output is the percentage
deviation of real GDP
from its trend.
Inflation is the 4-quarter
average of the percentage
change in the GDP deflator.
The interest rate is the 3-month Treasury bill rate.

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The Behavior of the Fed

Interest Rates Near Zero
The Fed lowered the short-term interest rate to near zero beginning in
2008 IV.

PART V The Core of Macroeconomic Theory

Since interest rates cannot go below zero, the ability of the Fed to
stimulate the economy when interest rates are zero is severely limited.
Its main way of stimulating the economy is to lower interest rates,
which stimulates plant and equipment investment as well as
consumption of durable goods and housing investment.
This option is not available when interest rates are near zero. In this
case, stimulus must come primarily from fiscal policy.

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The Behavior of the Fed

Inflation Targeting
inflation targeting When a monetary authority chooses its
interest rate values with the aim of keeping the inflation rate
within some specified band over some specified horizon.

Looking Ahead

PART V The Core of Macroeconomic Theory

In this chapter, we introduced the aggregate supply curve.

By using the aggregate supply and aggregate demand curves, we can
determine the equilibrium price level in the economy and understand some
causes of inflation.
We have still said little about employment, unemployment, and the functioning
of the labor market in the macroeconomy.
The next chapter will link everything we have done so far to this third major
market arenathe labor marketand to the problem of unemployment.

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R E V I E W TE R M S AN D C O N C E PTS

aggregate supply
aggregate supply (AS) curve
cost-push, or supply-side, inflation
cost shock, or supply shock
demand-pull inflation

PART V The Core of Macroeconomic Theory

equilibrium price level

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inflation targeting
potential output, or potential GDP
stagflation

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