Chapter 13 Dünhaupt Dullien Goodwin Harris Nelson Roach Torras Learning goals After todays lecture you will be able to Explain the derivation of the Aggregate Demand curve relating inflation and output levels and how it shifts ID: 760523
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Slide1
Aggregate Supply, Aggregate Demand, and Inflation: Putting It All Together
Chapter 13
© Dünhaupt, Dullien, Goodwin, Harris, Nelson, Roach,
Torras
Slide2Learning goals
After today‘s lecture, you will be able to:Explain the derivation of the Aggregate Demand curve relating inflation and output levels, and how it shifts.Explain the derivation of the Aggregate Supply curve relating inflation and output levels, and how it shifts.Use the AS/AD model to describe the consequences of changes in fiscal policy, monetary policy, supply shocks, and investor and consumer confidence, depending on whether an economic is in a recession or at full employment.Apply the AS/AD model to understanding major European macroeconomic developments of the last several decades.Discuss how classical and Keynesian economic theories differ in how they understand the macroeconomy.
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Slide3Chapter outline
Aggregate Expenditure and InflationCapacity and the Aggregate Supply CurvePutting the AS/AD Model to WorkCompeting Theories
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Slide4Aggregate Expenditure and Inflation
Slide5From the AE-curve to the AD-curve
Reminder: The AE-curve has shown us points at which points investment and savings are in equilibrium (I=S)However, this is not the end of the storyAs discussed in chapter 12, ECB will react to inflationary pressures with higher interest ratesHigher interest rates lead to lower equilibrium AESolution: Another curve in a new diagram: The AD curveAD curve shows link between inflation and aggregate demand, including ECB reaction
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Slide6Reminder: Figure 12.6 The ECB’s reaction function
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Interest rate (r)
Inflation rate (
π
)
If inflation rises…
…the
ECB increases interest rates
r
0
π
1
π
0
r
1
A
B
As the ECB’s primary objective is to keep inflation low and stable, it will react to increases in inflationary pressure with hikes in its main refinancing rate
Slide7How is inflation impacting on aggregate demand?
Mechanism A: For economies with their own central bank and floating exchange rates (e.g. the whole euro area, the US, Japan etc.):if inflation increases (decreases), central bank will increase (decrease) interest rates this will dampen (increase) aggregate demand
Mechanism B: For economies without their own central bank (e.g. the single member states of the euro area):ECB looks at the overall inflation rate in the euro areasmall countries not likely to have impact on ECB’s interest rate decision But: higher inflation reduces competitiveness of exportsResult: Higher inflation leads to less aggregate demand
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Slide813.1 The Aggregate Demand curve
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Output (
Y
)
Inflation rate (
π
)
If inflation rises…
…the
level of Aggregate Demand falls
Y
1
π1
π0
Y0
A
B
This analysis shows the impact of different inflation levels on Aggregate Demand.
Slide9What determines the position of the AD curve?
specific levels ofgovernment spendingtaxationautonomous consumptionautonomous investmentautonomous net exportschanges in these variables will cause the AD curve to shift
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Slide1013.2 The Effect of Expansionary Fiscal Policy or Increased Confidence on the AD curve
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Output (
Y
)
Inflation rate (
π
)
AD0
AD
1
If government spending increases, taxes decrease, consumers or investors become more confident, or net exports increase, demand for goods in the economy
Slide11What happens if central banks change their policy?
active form of central bank intervention:changing inflation targetfocus on fighting unemploymentsame level of inflation would result in higher (lower) real interest rates set by the central bankdampening (increasing) investment and shift the AD curve
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Slide12Capacity and the Aggregate Supply Curve
Slide1313.3 The Aggregate Supply curve
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Output (
Y
)
Inflation rate (
π
)
Aggregate Supply (AS)
Maximum Capacity
Y*
Unemployment
Wage-Price Spiral
As the economy approaches its maximum capacity, inflation levels tend to rise as excessive demand for workers, goods and services, and production inputs pushes up wages and prices.
Slide14The Aggregate Supply curve at high output levels
maximum capacity output: the level of output an economy would produce if every resource in the economy were fully utilized wage-price spiral: when pressure on wages creates upward pressure on prices and, as a result, further upward pressure on wages At maxiumum capacity, inflation levels tend to rise
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Slide1513.4 The effect of an increase in inflationary expectations on the aggregate supply curve
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Output (
Y
)
Inflation rate (
π )
AS0
AS
1
5 % -
3
% -
If people come to expect higher inflation, these expectations get built in to wage and price contracts, leading to a generally higher level of inflation throughout the economy.
Slide16Shifts of the AS curve: inflationary expectations
if people expect higher inflation, expectations get built into wage and price contracts Inflation can be self-fulfillingin the short run: inflation rate the same as in the pastin the medium run: a rise in inflation tends to increase people’s expectations
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Slide17Shifts of the AS curve: supply shocks
supply shock: a change in the productive capacity of an economy e.g. bumper crop in agriculture, new invention, increase in labor productivitythe real capacity of the economy expandsthe economy can produce more than beforenote: there can also be adverse supply shockse.g. natural occurrences or warreduce economy’s capacity to produce
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Slide18Figure 13.5 A beneficial supply shock: expansion of output capacity
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Output
(
Y
)
Inflation rate (π )
AS1
AS
0
Expansion of Maximum Capacity
An expansion of output capacity could be a result of new technology or improved labor productivity
Slide19Putting the AS/AD Model to Work
Slide20The AS/AD model illustrates three points about the macroeconomy
fiscal and monetary policies affect output and inflationexpansionary fiscal and monetary policies tend to push the economy toward higher output. If the economy is approaching its maximum capacity, they will also cause inflation to rise. contractionary fiscal and monetary policies tend to push the economy toward lower output. Inflation is unlikely to fall quickly, but a persistent recession will tend to lower inflation over the long term.
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Slide21The AS/AD Model illustrates three points about the macroeconomy (cont.)
supply shock may have significant effectsadverse supply shocks lower output and raise inflationbeneficial supply shocks raise output and lower inflationinvestor and consumer confidence and expectations have important effects on output and inflation
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Slide22We will now apply the model to a number of cases
An economy in recessionStagflation in the 1970s and 1980sA hard line against inflation: Disinflation in the 1980sAn overheated economy: The German reunificationAusterity policies and structural reforms
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Slide23Case 1: The global financial and economic crisis 2008-2009
unemployment was high but inflation remained lowgovernments of major OECD countries passed stimulus packages with tax cuts and spending increasesstimulus packages helped European economies to recover from recessioneffects not large enough to reach full employmentinflation did not rise
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Slide2413.6 Aggregate Demand and supply equilibrium in recession
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Output (
Y
)
Inflation rate (
π
)
AS
Y*
AD
E
0
Unemployment
The position of the AD curve indicates a low level of aggregate demand, leading to an economy with unemployment at equilibrium
E
0
. At this point on the AS curve, inflationary pressures are low.
Slide25Figure 13.7 Expansionary fiscal policy in response to a recession
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Output (
Y
)
Inflation rate (
π
)
Y*
AD
1
AD
0
E
1
E
0
Unemployment
AS
An expansion of government spending, as well as a program of tax cuts, shifts the AD curve to the right. This reduces unemployment, but since the economy is in the flat portion of the AS curve at equilibrium
E
1
, it has little effect on inflation.
Slide26The reaction in the U.S. was different
Fed embarked early on quantitative easingidea: combination of monetary expansion plus recovering confidence of consumers and businesses leads to a more complete recoverylarger shift in AD brings economy back to full-employment
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Slide27Figure 13.8 A greater expansion of aggregate demand
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Output (
Y
)
Inflation rate (
π
)
Y*
AD
1
AD
0
E
1
E
0
Unemployment
AS
If Aggregate Demand increases by a larger amount, it can bring the economy back into the full employment zone. At equilibrium point
E
1
the AS/AD model indicates the possibility of a slightly higher inflation level.
Slide28Case 2: StagflationPrelude: The 1950s and 1960s
robust economic growth and low unemploymentinflation under controlbelieve: trade-off between unemployment and inflation
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Slide2913.9 The Phillips Curve for the U.S. in the 1960s
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29
Unemployment Rate (percent)
Inflation (percent per year)
In the 1960s economist A.W. Phillips identified an inverse relationship between inflation and unemployment. While this basic relationship still holds true, events of the 1970s and later showed that inflation can be much more variable than the simple Phillips principle implies.
Slide30The 1970s
increase in inflation and unemployment1973-1974: “oil-price shock”stagflation: a combination of rising inflation and economic stagnationHow can we explain this effect ?
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Slide31Chapter 13
31
Output (
Y
)
Inflation rate (
π )
AS0
AS
1
AD
E
1
E
0
Lower Capacity
13.10 The
effect
of the
oil price shock
of the 1970s
A drastic increase in the price of a key resource reduces the economy’s total capacity and shifts the AS curve up and to the left. Both inflation and unemployment get worse at equilibrium point E
1
.
Slide32Figure 13.11a: German inflation and unemployment, 1969-1975
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The oil price shock of the 1970s pushed inflation in Germany only up a few percentage points and price pressure quickly subsided again. However, unemployment more than doubled.
Source:
AMECO database, 2016.
Slide33Figure 13.11b: Italian iInflation and unemployment, 1969-1975
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In Italy, inflation surged during the oil price shock of the 1970s. However, unemployment remained almost unaffected.
Source:
AMECO database, 2016.
Slide34How can we explain these different outcomes using our AS/AD Model?
Germany: Inflation increased during oil-price shockGerman Bundesbank increased interest ratesincrease in inflation and unemploymentItaly:increase in public spendingexpansionary monetary policy to finance part of government expenditurehigher inflation but no increase in unemployment
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Slide3513.12 The Italian reaction to oil price shock of the 1970s
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Output (
Y
)
Inflation rate (
π )
AS0
AS
1
AD
0
E
1
E
0
Lower Capacity
E
2
AD
1
Initially, the oil price shock has led to increased unemployment and higher inflation (a movement from E
0
to E
1
). Yet, the Italian government reacted with expansionary fiscal and monetary stimulus which pushed inflation further up (to E
2
).
Slide36This was not the end of inflation in the 1970s …
in countries like Italy, inflationary expectations permanently shifted upwardexpectation of higher inflation built into wage and price contractspermanently high inflation ratein countries like Germany and Switzerland, inflation came down by 1978
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Slide371980: tight monetary policy
Situation in the U.S.: high inflation led to people’s discontentRemember: high rates of inflation can wipe out people’s savings and make it difficult to plan, save, and investU.S. central bank, the Federal Reserve, under Paul Volcker, implemented very contractionary monetary policiesmost European central banks followed and increased interest ratesResult: Fall in inflation, but long recession and increase in unemployment
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Slide3813.13 The effects of The Fed’s “tight money” policies in the 1980s
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Output (
Y
)
Inflation rate (
π
)
AS0
Y*
Unemployment
AD
0
AD
1
E
0
E
1
AS
1
E
2
A very restrictive monetary policy drives the
AD
curve sharply to the left, pushing unemployment to very high levels. But a resulting decrease in inflationary expectations shown in aggregate supply curve
AS
1
lowers inflation and allows the economy to recover to equilibrium point
E
2.
Slide39Disinflation in the early 1980s
media reports on the commitment of central banks to bring inflation downinflation expectations fell over timeBut: significant human and economic costUnemployment stayed higher for long in Europe than in the U.S.
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39
Slide40How can one explain different performance in the U.S. and Europe?
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40
inflexible European labor market
firms reluctant to hire new workers due to legal difficulties to get rid of them if business declines
it takes a long time of economic growth before firms start hiring and unemployment fallsunemployed workers loose skillscyclical unemployment turns into structural unemploymentlower potential output
central bankers did not lower interest rates enough
excessively tight monetary policies limited speed of Europe’s recovery
Past experience:
fear of inflationary expectations which can only be reduced by policies that cause economic pain
Slide41Case 4: Inflation can also be caused by an overheated economy and an excess of aggregate demand
German reunification boom in the early 1990sadditional demand for consumer goodsincrease in confidence of West German firmshuge public investment program
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Slide4213.14 Excessively high aggregate demand causes inflation
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Output (
Y
)
Inflation rate (
π
)
AS
Y*
AD
1
AD
0
E
1
E
0
Wage-Price Spiral
Expansionary policy causes the economy to “heat up.” In the short run, people respond by increasing output, but tight markets for labor and other resources cause inflation to rise as well at equilibrium point
Slide43What happened next?
German economy hit by negative shocksBundesbank increased interest rates sharplyconsumer and investor confidence decreased1992: European Monetary System crisisdecline in German exportsdecline in inflation, rise in unemployment
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Slide44Case 5: Austerity policies and structural reforms
euro-crisis: austerity packages and structural reformsfrom 2010, investors got concerned about debt sustainabilityhigh interest rates for borrowersEU: cut public spending, increase taxes, and implement structural reforms
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Slide45Figure 13.15a A loss of investor confidence in the AS/AD model
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Output (
Y
)
Inflation rate (
π
)
AS
0
AD
0
E
0
E
2
E
1
AD
1
AD
2
When investors lose confidence in one country and cut credit lines to the countries’ firms, the AD curve shifts left. GDP contracts and unemployment increases.
Slide46Figure 13.15b Structural reforms in the AS/AD model
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Output (
Y
)
Inflation rate (
π )
AS0
AS
1
AD
0
E
0
E
3
Higher
Capacity
E
2
AD
2
If the government reacts to the fall in output with reforms which increase potential output, in a second step, the AS curve shifts right. GDP increases again, but prices fall. It is not clear, however, whether a return to the initial GDP level is possible.
Slide47Figure 13.16: Unemployment in Ireland and Greece
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During the euro crisis, unemployment both in Ireland and Greece was significantly above pre-crisis levels. However, as of 2016, unemployment in Ireland has come down significantly, while it has remained stubbornly high in Greece.
Source:
Eurostat, 2016.
Slide48Figure 13.17: Inflation in Ireland and Greece
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48
Inflation fell both in Ireland and Greece after austerity packages and structural reform measures were enacted
. However, inflation fell further in Greece than in Ireland.
Source:
Eurostat, 2016.
Slide49Figure 13.18a Macroeconomic results of austerity and structural reforms in Ireland
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Output (
Y
)
Inflation rate (
π )
AS0
AS
1
AD
0
E
0
E
3
Higher
Capacity
E
2
AD
2
As Ireland is a very open economy, falling inflation caused by structural reforms boosted exports and aggregate demand. As a consequence, structural reforms were able to counteract part of the negative impacts of austerity.
Slide50Figure 13.18b Macroeconomic results of austerity and structural reforms in Greece
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Output (
Y
)
Inflation rate (
π )
AS0
AS
1
AD
0
E
0
E
3
Higher
Capacity
E
2
AD
2
As aggregate demand in Greece does not react much to changes in inflation, structural reforms have not been able to increase employment significantly. The combination of austerity and structural reforms has led to lower inflation, but also high unemployment.
Slide51Competing Theories
Slide52Was it necessary to enact expansionary scal policy in order to get the European economies out of the 2008–2009 recession?
Was it a good idea for the ECB to lower interest rates to zero (and below for deposits) in 2015–2016 to try to promote recovery?
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Slide53Classical macroeconomics
assumptions:self-adjusting properties of free-marketslabor markets clear at an equilibrium wagemarkets for loanable funds cause savings and investment to be equal at an equilibrium interest ratein theory, a smoothly functioning economy should be at full-employment
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Slide5413.19 The classical view of AS/AD
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Output (
Y
)
Inflation rate (
π )
Classical AS
Y*
AD
the
vertical
AS
curve
represents
the
classical
view
that
the
economy
will
tend
to
return
to
full
employment
automatically
.
Slide55The classical view of AS/AD
AS curve at full-employment levelpeople make optimizing choicesunemployed workers bid down wagesfull-employment restoredAD level determines only the inflation rate
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Slide56What is the effect of aggregate demand-management policies?
expansionary fiscal or monetary policy has no effect on the output level government spending “crowds out” private spending more spending by government means less spending by consumers and businesses monetary expansions lead only to increased inflationcentral bank should choose a certain growth rate of the money supply or level of the interest rate
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Slide57Keynesian macroeconomics
market economies are inherently unstable business cycles can be explained by changes in investors’ confidencemacroeconomic phenomena cannot be explained by assuming rational, optimizing behavior by individualsinherent tendency toward market instability requires active government intervention
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Slide58What to take home
higher inflation rates tend to reduce aggregate demand, as central banks increase interest ratefiscal and monetary policies affect output and inflationsupply shock may have significant effectsinvestor and consumer confidence and expectations have important effects on output and inflationClassical and Keynesian economists provide different arguments about economic analysis and policy
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