Aggregate Demand, Aggregate Supply, and Inflation

Flashcards covering key concepts related to aggregate demand, aggregate supply, and inflation, based on lecture notes.

Aggregate Demand (AD) Curve

Shows the relationship between short-run equilibrium output Y and the rate of inflation, p. Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping.

Distributional effects of Inflation

Inflation hurts people with lower incomes more, causing them to spend less, leading to a drop in output (Y).

Uncertainty (Effect on Aggregate Demand)

Inflation causes uncertainty about future prices, leading to more cautious spending.

Exports (Effect of Inflation)

Inflation causes prices of exported goods to rise, lowering exports.

Shifts of the Aggregate Demand Curve

Any factor that changes Y (output) at a given p (inflation rate) shifts the AD curve. These shifts can be caused by changes in exogenous spending or changes in the Fed’s policy reaction function.

Exogenous Spending

Spending unrelated to Y or r (interest rate). Examples include fiscal policy, technology, and foreign demand.

Inflation Inertia

If operating at Y* (potential output) and there are no external shocks to the price level, inflation will remain roughly constant. This occurs due to inflation expectations and long-term wage and price contracts.

Inflation Expectations

Negotiated wages and prices for future sales are based on expectations about inflation. High inflation expectations can lead to actual inflation.

Long-Term Wage and Price Contracts

Union wage contracts and contracts setting the price of raw materials often cover several years, reflecting inflation expectations at the time they are signed.

Three factors that can increase the inflation rate

Output gap, inflation shock, and shock to potential output.

Long-run aggregate supply (LRAS)

A vertical line showing the economy’s potential output Y*

Short-run Aggregate Supply (SRAS)

A horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions.

Short-run equilibrium

A situation in which inflation equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate. Graphically, it occurs at the intersection of the AD curve and the SRAS line.

Long-run equilibrium

A situation in which actual output equals potential output and the inflation rate is stable. Graphically, it occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point.

Adjustment Process to a Recessionary Gap

Firms selling less than they want to start to lower prices. As p (inflation) falls, the Fed lowers r (interest rate) and AD increases. Falling p reduces uncertainty, which also increases AD. As Y (output) increases, cyclical unemployment falls.

The Self-Correcting Economy (Long-Run)

The economy tends to be self-correcting in the long run through price adjustments.

Fiscal and Monetary Policy (Effectiveness)

Fiscal and monetary policy can help stabilize the economy with a slow self-correcting mechanism, however, these policies are most useful when attempting to eliminate large output gaps.

Impact of War and Military Buildup On Inflation

Military spending increase leads to AD increase, expansionary gap (Y > Y*), p increases, SRAS shifts, leading to a new long-run equilibrium.

Inflation Shock

A sudden change in the normal behavior of inflation, unrelated to the nation’s output gap. Examples include the OPEC embargo of 1973 and the drop in oil prices in 1986.

Aggregate Supply Shock

An inflation shock or a shock to potential output.

Short-Run Effects of an Anti-inflationary Monetary Policy

Fed shifts AD to AD’, leading to a short-run equilibrium where Y < Y* (recessionary gap). Long-run correction occurs.

Long-Run Effects of an Anti-inflationary Monetary Policy

Output decreases to Y < Y, Inflation decreases to 3% , and output rises to Y. Long-run equilibrium is achieved through lower prices @ Y*.

Algebra of Aggregate Demand and Aggregate Supply , Y=

Y = [ ( 1 1 −) C + cT + I + G + NX - (a + b)(r + gπ)] This combined with reaction function r = r + gπ

Example Algebra of Aggregate Demand and Aggregate Supply

Y = 4,950 – 5,000π