Economic Fluctuations Notes

The Keynesian model has limitations as it cannot explain inflation and assumes fixed prices, which is unrealistic.
The aggregate demand-aggregate supply model extends the Keynesian model by considering short-run (fixed prices) and long-run (adjustable prices) time frames.
The aggregate demand-aggregate supply model relates output (GDP) to either the inflation level or changes in price, with an upward-sloping SRAS curve.
Aggregate demand (AD) shows the relationship between equilibrium output (y) and the inflation rate ( $\pi$ ) or price changes.
Aggregate demand reflects an economy's planned spending at a given price level, representing total demand.
The AD curve slopes downward: high inflation means low demand, and low inflation means high demand.

Interest Rates:
- Inflation influences interest rates, which in turn affect planned spending.
- High inflation prompts the RBA to increase interest rates, reducing consumption and investment.
- Lower interest rates increase consumption and investment.
Real Value of Net Assets (Wealth):
- Inflation reduces purchasing power, decreasing the real value of net assets, especially money.
- Lower real asset value reduces planned spending, lowering aggregate demand.
Distributional Effect:
- Inflation disproportionately affects lower-income individuals, who reduce spending more.
- People on fixed incomes or minimum wages are particularly vulnerable.
- Higher inflation prompts wealthier individuals to save more, further reducing aggregate demand.
Uncertainty:
- Inflation creates uncertainty for households and businesses.
- Uncertainty about future costs leads to cautious spending and decreased demand.
Decline in Exports:
- Inflation makes a country's exports relatively more expensive.
- If domestic inflation increases the price of exports, without a change in the exchange rate, then exports become less competitive.
- Decreased exports reduce planned spending and aggregate demand.

Changes in the inflation rate cause movement along the AD curve.
Increased planned spending shifts the AD curve to the right.
Decreased planned spending shifts the AD curve to the left.
Factors causing changes in equilibrium output include:
- Changes in exogenous spending (factors other than interest rates).
- Changes in interest rates (RBA's Policy Reaction Function).

Various factors influence planned spending, such as fiscal policy, consumer confidence, technology, and export demand.
Increased exogenous spending increases aggregate demand (shifts curve right).
Decreased exogenous spending decreases aggregate demand (shifts curve left).

Tighter monetary policy (higher interest rates) decreases aggregate demand (shifts curve left).
Looser monetary policy (lower interest rates) increases aggregate demand (shifts curve right).

Inflation has inertia: it tends to persist at a constant rate unless influenced by external factors.
Inflation remains stable when planned spending equals actual spending (no output gaps, full employment).
Inflation changes due to:
- Output gaps: higher inflation during expansionary gaps, lower during contractionary gaps.
- Inflation shocks: sudden price increases (e.g., oil shocks).
- Potential output shocks: natural disasters.
Inflationary expectations and long-term wage/price contracts contribute to inflation inertia.
The RBA targets an inflation rate of 2-3%.
Wage and price contracts are set according to inflationary expectations, creating a self-reinforcing cycle of low inflation.
Inflation inertia occurs at full employment; output gaps lead to inflation changes.
Expansionary gaps are associated with higher inflation; contractionary gaps with lower inflation.