L7-9: 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: Imagine the economy is like a car cruising perfectly on the highway; it's at its top speed without straining. This is the long-run equilibrium. It means everyone's using all available resources efficiently, like workers having jobs and machines running smoothly. Prices and wages adjust quickly to changes in what people want or what's available, keeping everything in balance. For example, if many people want to buy bread, the price of bread goes up, encouraging bakers to make more.

• IS-MP Model: Think of this as a simple tool to understand how interest rates affect the economy. The IS part looks at how much people save and invest. If people save more, there's more money for businesses to borrow and invest. The MP part shows how the central bank sets interest rates. If the central bank lowers interest rates, it becomes cheaper to borrow money. Together, they help see how interest rates and the economy's total output are linked.

Why Not Target Zero Inflation?

• Classical Relevance: In the long run, the economy tends to fix itself, no matter what the central bank does. It's like saying if you let the car run, it will eventually find its best speed. However, in the short run, prices don't always change quickly. This can lead to problems. For instance, if people suddenly stop buying things, companies might not lower prices right away, causing them to produce less.

• Central Bank's Inflation Target: Most central banks aim for around 2% inflation each year. A bit of inflation encourages people to spend and invest because they anticipate prices will increase later. If you know a TV will cost more next year, you might buy it now.

• Real Interest Rate Consideration: The real interest rate matters because it affects borrowing and investment decisions. It's the nominal interest rate (the advertised rate) minus inflation. For example, if a bank offers a 5% interest rate but inflation is 2%, the real interest rate is 3%. Central banks focus on this to influence whether people borrow money to buy homes or whether businesses invest in new equipment.

Interest Rates and Inflation Targeting:

• Central banks try to predict what inflation will be and then set interest rates to keep it at their desired level. It's like driving a car; you look ahead and steer to stay on the road. If a central bank thinks inflation will rise, it might increase interest rates to slow down spending.

• Changes in monetary policy shift the real interest rate schedule. If the central bank wants to boost the economy, it might lower interest rates. This makes it cheaper to borrow money, encouraging people to spend more and businesses to invest.

Aggregate Demand Schedule:

• AD Curve Dynamics: The aggregate demand (AD) curve shows the total amount of goods and services people want to buy at different price levels. If inflation increases, the central bank usually raises interest rates. Higher interest rates increase the cost of borrowing, so people reduce spending and investment, influencing aggregate demand. It’s like if prices go up, people buy less.

• Slope of the AD Schedule:

  • Flat AD Schedule: If the AD curve is flat, small changes in prices lead to big changes in how much people buy. This happens when interest rate decisions strongly affect spending. For instance, if a small increase in prices greatly reduces buying, the curve is flat.

Shifts in the AD Curve:

• Influencing Factors: Monetary and fiscal policy changes can shift the AD curve. If the government spends more money (fiscal expansion) or if a country exports more goods (increase in net exports), the AD curve shifts to the right. This means that at any given inflation rate, there's more demand in the economy. It’s like saying, at the same price, more people want to buy stuff.

Aggregate Supply Side:

• Potential Output: This is the maximum amount of goods and services an economy can produce when it's using all its resources efficiently. It depends on factors like the number of available workers, the amount of machinery, and how well these resources are used. Think of it as the economy’s maximum capacity.

• Wage and Price Flexibility: In classical economics, it’s assumed wages and prices adjust quickly to changes in the economy. If inflation rises, it doesn't affect real output or employment because everything adjusts proportionally (this is the monetary neutrality assumption). The aggregate supply (AS) curve is vertical at the potential output level, indicating that output is fixed in the long run. It's like saying that no matter how prices change, the amount produced stays the same.

Equilibrium Output and Inflation:

• Equilibrium happens where the AD and AS curves intersect. This is the point where the quantity of goods and services demanded equals the quantity supplied. It's where everyone’s buying desires match what’s being made.

• The central bank uses interest rates to try to keep inflation at its target level, which in turn influences aggregate demand. It’s a balancing act. They adjust interest rates to manage how much people spend and, therefore, to control inflation.

• Long-Run Implications: In the long run, aggregate demand affects the price level (inflation), but not how much the economy produces or how many people are employed. The economy tends to go back to its potential output level over time. It's like saying that in the long run, we'll always produce as much as we can, but prices might change.

Impact of Supply Shocks:

• Positive Supply Shock: This increases the economy's ability to produce goods and services. For example, if there's a big increase in productivity due to new technology, that can lower prices (deflationary effect). It’s like suddenly being able to make more goods for less.

• Negative Supply Shock: This decreases the economy's ability to produce goods and services. For example, if energy prices go up, that can increase prices (inflationary outcomes). It’s like something making it harder to produce goods, so prices rise.

Demand Shock Responses:

• If there's a demand shock (like a sudden increase in consumer spending), the central bank might change interest rates to bring aggregate demand back to where it was before. If inflation goes above the target, they'll likely raise interest rates to cool down the economy. It’s like tapping the brakes when the car is going too fast.

Input Prices and Temporary Supply Shocks:

• Temporary shocks, like a short-term increase in oil prices, can significantly impact real output and employment. Analyzing these shocks means looking at how the aggregate supply (AS) curve responds. This involves understanding how short-term disruptions affect production and jobs.

Adjustments from Short to Long Run:

• If monetary policy shifts the aggregate demand (AD) curve, it can cause temporary changes in output. But, in the long run, the economy tends to stabilize as other factors come into play. In the long run, prices and wages adjust, allowing the AS curve to shift back to its original position, thereby restoring the economy to its potential output level. It’s like saying, we might swerve a bit, but we’ll eventually get back on course.

Distinction Between Demand and Supply Shocks:

• It’s easier for central banks to manage demand shocks because they can adjust interest rates to control inflation and output. Supply shocks are trickier because they can cause inflation and lower output simultaneously. It’s easier to steer when you know the car is just speeding up, but harder when the engine is also sputtering.

Inflation Targeting with Different Shocks:

• Targeting inflation is straightforward when most shocks are from the demand side. But when there are supply shocks, it gets complicated as policymakers must balance the need to control rising prices with the need to stimulate growth, often leading to difficult trade-offs.

• IMPACT OF A TEMPORARY SUPPLY SHOCK

• A temporary supply shock can lead to a short-term increase in prices due to constraints on supply while simultaneously dampening economic growth, as businesses struggle to meet demand.

• During this period, inflation may rise quickly, prompting central banks to consider raising interest rates, which could further suppress output.