24ECA001 - Lecture 7, 8 and 9

Aggregate Supply, Prices and Adjustment to Shocks

• Lecturer: Dr. Sinchan Mitra, Principles of Macroeconomics Lecture 7, 8 and 9.

Alumni Masterclass

• Event: Career insights in Banking

• Speaker: Ross McEwan, Managing Director at Citi

• Date: Wednesday, 5 March 2025

  • Session 1: 14:00 - 15:00 - Career Insights

  • Session 2: 15:30 - 16:30 - The Future of Finance

References

• Key Texts:

  • Economics, 12th edition by Begg et al. (Chapter 24 assigned on Connect)

  • Economics, 13th edition by Lipsey and Chrystal (Chapter 21)

Assumptions of the Classical Model

• Long-run Equilibrium: Output is at potential levels with flexible prices and wages.

• IS-MP Model: Focus on both demand and supply sides of the economy.

Why Not Target Zero Inflation?

• Classical Relevance: Long-run equilibrium vs. short-run price rigidity leading to Keynesian results.

• Central Bank's Inflation Target: Commonly around 2%.

• Real Interest Rate Consideration:

  • Example: Nominal rate at 5%, inflation at 2% results in a real interest rate of 3%.

Interest Rates and Inflation Targeting

• Central banks forecast inflation and set nominal rates accordingly.

• Changes in monetary policy shift real interest rate schedules; looser policy implies lower interest rates for any inflation rate.

Aggregate Demand Schedule

• AD Curve Dynamics: Higher inflation induces the central bank to raise real interest rates, leading to changes in aggregate demand.

• Slope of the AD Schedule:

  • Flat AD Schedule: When interest rate decisions react strongly to inflation, having a significant effect on aggregate demand.

Shifts in the AD Curve

• Influencing Factors:

  • Monetary and fiscal policy changes, such as fiscal expansions or increases in net exports, shift the AD curve to the right.

Aggregate Supply Side

• Potential Output: Determined by factors of production and resource efficiency.

• Wage and Price Flexibility: Rise in inflation does not affect real output or employment (monetary neutrality assumption).

  • Vertical AS curve at the potential output level.

Equilibrium Output and Inflation

• Equilibrium occurs where AD and AS curves intersect.

• Central bank adjusts interest rates to meet inflation targets, influencing aggregate demand.

• Long-Run Implications: Aggregate demand determines the price level but not employment/output.

Impact of Supply Shocks

• Positive Supply Shock:

  • Deflationary effect, e.g., productivity gains.

• Negative Supply Shock:

  • Inflationary outcomes, e.g., increased energy prices.

Demand Shock Responses

• Central bank responses to demand shocks may involve adjusting interest rates to return AD to its original position if inflation exceeds targets.

Input Prices and Temporary Supply Shocks

• Temporary shocks significantly influence real output and employment; analysis includes responses from AS curves.

Adjustments from Short to Long Run

• Changes in the aggregate demand (AD) curve due to monetary policy shifts result in temporary output changes while long-run factors stabilize.

Distinction Between Demand and Supply Shocks

• Easier for central banks to manage when dealing with demand shocks, establishing a balance between output and inflation.

Inflation Targeting with Different Shocks

• Discuss the complexities of targeting inflation amidst either all demand shocks or all supply shocks, noting that supply shocks disrupt this balance.

Monetary and Fiscal Policy Insights

• Questions posed regarding practical challenges and dynamics of implementing fiscal policies in real-world scenarios.

Output Gap Analysis

• Measurements of actual vs. potential output indicate economic conditions (booms or slumps).

Concept Checks

• Discuss the vertical long-run aggregate supply curve and the positive slope of the short-run aggregate supply curve.

• Analyze the impacts of consumption shocks, examining Keynesian criticisms, and the respective effectiveness of inflation targeting strategies.