Frank & Bernanke
3rd edition, 2007
Ch. 15: Inflation, Aggregate
Supply, and Aggregate Demand
1
Introduction
The Keynesian model assumes that
producers meet demand at preset prices.
 The shortcoming of their assumption is
that it does not explain the behavior of
inflation.

2
Introduction

The aggregate demand/aggregate supply
model will allow us to see how
macroeconomic policy affects inflation and
output.
3
The Aggregate Demand Curve

Aggregate Demand (AD) Curve
Shows the relationship between short-run
equilibrium output Y and the rate of inflation, 
 The name of the curve reflects the fact that
short-run equilibrium output is determined by,
and equals, total planned spending in the
economy

4
The Aggregate Demand Curve

Aggregate Demand (AD) Curve

Increases in inflation reduce planned
spending and short-run equilibrium output, so
the aggregate demand curve is downwardsloping
5
The Aggregate Demand Curve
Inflation 
An increase in  reduces Y
(all other factors held constant)
Aggregate Demand Curve
AD
Output Y
6
The Fed and the AD Curve

A primary objective of the Fed is to
maintain a low and stable inflation rate.
Inflation is likely to occur when Y > Y*.
 To control inflation, the Fed must keep Y from
exceeding Y*.
 The Fed should lower the AD curve when
Y>Y*.
 The Fed can reduce autonomous expenditure
by raising the interest rate.

 increases r increases autonomous spending
decreases Y decreases (AD curve)
7
The Aggregate Demand Curve and the
Monetary Policy Reaction Function
r2
r1
Inflation 
Real interest rate
set by the Fed, r
B
A
2
1
1
2
B
A
Output Y
Inflation 
8
Other Reasons for the Downward
Slope of the AD Curve
 Real
value of money
 Distributional effects
 Uncertainty
 Prices of domestic goods and
services sold abroad
9
Increase In Exogenous Spending
AD’
Inflation 
AD
Exogenous Spending: spending
unrelated to Y or r
•Fiscal policy
•Technology
•Foreign demand
An increase in exogenous
spending shifts AD to AD’ and
vice versa
Output Y
10
AD
New monetary
policy reaction
function
B
r*
A
2*
Old monetary
policy
reaction
function
1*
Inflation 
Fed “tightens” monetary policy
– shifting reaction curve
AD’
Inflation 
Real interest rate set by Fed, r
Fed Targets Higher r
A
B
Output Y
The new Fed policy increases r
and AD shifts to AD’
11
Movements Along the AD Curve

and Y are inversely related
 Changes in  cause a change in Y or
a movement along the AD curve
  increases r increases planned
spending decreases Y decreases
(stationary monetary policy reaction
function)
12
Shifts of the AD Curve
Any factor that changes Y at a given 
shifts the AD curve.
 Shifts of the AD curve can be caused by:

Changes in exogenous spending.
 Changes in the Fed’s policy reaction function.

13
Inflation and Aggregate Supply
Inflation will remain roughly constant, or
have inertia, if operating at Y* and there
are no external shocks to the price level.
 Inflation Inertia

In industrial economies (U.S.), inflation tends
to change slowly from year to year.
 The inflation inertia occurs for two reasons:

 Inflation
expectations
 Long-term wage and price contracts
14
A Virtuous Circle
15
Long-term Contracts
Union wage contracts set wages for
several years.
 Contracts setting the price of raw materials
and parts for manufacturing firms also
cover several years.
 These long-term contracts reflect the
inflation expectations at the time they are
signed.

16
Inflation and Aggregate Supply

Three factors that can increase the
inflation rate
Output gap
 Inflation shock
 Shock to potential output

17
The Output Gap and Inflation
Relationship of output
to potential output
Behavior of inflation
1. No output gap
Y = Y*
Inflation remains unchanged
2. Expansionary gap
Y > Y*
Inflation rises
3. Recessionary gap
Y < Y*
Inflation falls


18
Aggregate Supply

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
19
Short-run Equilibrium
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, short-run equilibrium occurs at
the intersection of the AD curve and the
SRAS line

20
Equilibrium
Long-run
aggregate
supply, LRAS
Short-run
aggregate
supply, SRAS
A
Inflation 
Short-run equilibrium
•Y: SRAS() = AD
•Y < Y* -- recessionary gap
• and Y adjust to the gap
• decreases & Y increases
Long-run equilibrium
• AD, SRAS (*), LRAS (Y*)
will intersect at the same
point
Aggregate demand,
AD
Y
Y*
Output
21
The Adjustment of Inflation
When a Recessionary Gap Exists
LRAS
Inflation

A
SRAS1
SRAS2
SRAS3
B
’
SRASFinal
AD
Y
Y*
Output
22
Long-run Equilibrium
A situation in which actual output equals
potential output and the inflation rate is
stable
 Graphically, long-run equilibrium occurs
when the AD curve, the SRAS line, and
the LRAS line all intersect at a single point

23
Adjustment to Recessionary Gap





Firms that are selling less than they want to will
start to lower prices.
As  falls the Fed lowers r and AD increases.
Falling  reduces uncertainty which also
increases AD
As Y increases, cyclical unemployment falls
(Okun’s Law)
Adjustment continues until long-run equilibrium
is reached.
24
The Adjustment of Inflation
When A Expansionary Gap Exists
LRAS
Inflation
Short-run Eq. Y
•Expansionary gap Y > Y*
• rises, AD falls – Y falls
•Long-run equilibrium at Y*, *
B
’
SRASFinal
SRAS3
SRAS2
A

SRAS
AD
Output
Y*
Y
25
The Self-Correcting Economy
In the long-run the economy tends to be
self-correcting.
 The Keynesian model does not include a
self-correcting mechanism.
 The Keynesian model concentrates on the
short-run with no price adjustment.
 The self-correcting mechanism
concentrates on the long-run with price
adjustments.

26
The Self-Correcting Economy

A slow self-correcting mechanism


Fiscal and monetary policy can help stabilize
the economy.
A fast self-correcting mechanism

Fiscal and monetary policy are not effective
and may destabilize the economy.
27
The Self-Correcting Economy

The speed of correction will depend on:
The use of long-term contracts.
 The efficiency and flexibility of labor markets.


Fiscal and monetary policy are most useful
when attempting to eliminate large output
gaps.
28
Sources of Inflation
Excessive Aggregate Spending
 Inflation Shocks
 Shocks to Potential Output

29
Military Buildup and Inflation
•Increase in military spending causes AD to increase
•Creates an expansionary gap -- Y > Y*
• increases shifting SRAS to SRASFinal
•Long-run equilibrium back to Y* with  *
LRAS
LRAS
C

B
SRAS
A
Inflation
Inflation
’

SRASFinal
B
A
AD’
SRAS3
SRAS2
SRAS
AD’
AD
Y
Y*
Output
Y
Y*
Output
30
Sources of Inflation

What Do You Think?

Does the Fed have the power to prevent the
increased inflation that is induced by a rise in
military spending?
 Hint:

Can the Fed reduce AD?
What is the cost of avoiding inflation during a
military buildup?
31
Sources of Inflation in 1960



1959-63 inflation averaged about 1%
By 1970 inflation was 7%
Fiscal policy


Increased spending on Great Society and war on
poverty initiatives
Increases in defense spending



1965 = $50.6 billion or 7.4% of GDP
1968 = $81.9 billion or 9.4% of GDP
Monetary policy

The Fed did not try to offset the increase in government
spending
32
Sources of Inflation

Inflation Shock


A sudden change in the normal behavior of
inflation, unrelated to the nation’s output gap
Inflation Shock -- Examples
OPEC embargo of 1973
 Drop in oil prices in 1986

33
Adverse Inflation Shock
Inflation
LRAS
’
• Equilibrium @ A--Y* = Y
• Inflation shock,  increases to  ‘ (SRAS’)
• Short-run eq. At B, Y < Y*; recessionary gap
and higher inflation (stagflation)
• No policy --  falls; long-run eq. at A
• With policy--AD shifts to AD’; Y = Y*;  rises
to  *
C
B
SRAS’
A

SRAS
AD’
AD
Y’
Y*
Output
34
Sources of Inflation
What is the macroeconomic policy dilemma
created by an inflation shock? (stagflation)?
 Sustained inflation is possible only if monetary
policy is sufficiently expansionary.

35
Shock To Potential Output
Inflation
LRAS’
’
LRAS
B
•Equilibrium at A -- Y* = Y
•Y* falls to Y*’
•Y > Y* -- expansionary gap
• increases--SRAS rises to SRAS’
•Equilibrium at B
•Y = Y*’
• increased to  ‘
•Decline in output is permanent
SRAS’
A

SRAS
AD
Y*’
Y*
Output
http://www.npr.org/templates/story/story.php?storyId=101386052
36
Aggregate Supply Shock
Either an inflation shock or a shock to
potential output
 Adverse aggregate supply shocks of both
types reduce output and increase inflation
 Inflation shocks

 Stagflation
 Temporary
reduction in output
37
U.S. Macroeconomic Data,
Annual Averages, 1985-2000
Was Greenspan right in 1996?
Years
% Growth in Unemployment Inflation
real GDP
rate (%)
rate (%)
Productivity
growth (%)
1985-1995
2.8
6.3
3.5
1.4
1995-2000
4.1
4.8
2.5
2.5
38
Greenspan
Inflation
LRAS
’
LRAS’
•Equilibrium at B -- Y*’ = Y
•Productivity increases
•Y*’ shifts to Y*
•Recessionary gap -- Y*’ < Y*
• falls to 
•Equilibrium at A
•Lower inflation; higher output
B
SRAS’
A

SRAS
AD
Y*’
Y*
Output
39
Fiscal Policy and the Supply Side

Supply-side Policy
A policy that affects potential output
 Examples

 Roads
and highways
 Airports
 Schools
 Government tax and transfer programs
40
Fiscal Policy and the Supply Side

Marginal Tax Rate


The amount by which taxes rise when beforetax income rises by one dollar
Average Tax Rate

Total taxes divided by total before-tax income
41
The Potential Effects of Tax Rate
Reductions on Both AD and AS
Inflation
LRAS
LRAS’
AD
AD’
Y*
Y*’
Output
42
Fiscal Policy and the Supply Side

Effect on Supply of Labor
Lower rates may give people an incentive to
seek further education and engage in
entrepreneurial activity.
 Lower rates may give workers an incentive to
work less.
 Married women are more responsive to tax
changes than men.

43
Hours Worked per Person and
Marginal Tax Rates, 1993-1996
Country
Hours worked per person per year
relative to the U.S. (U.S. = 100)
Japan
United States
United Kingdom
Canada
Germany
France
Italy
104
100
88
88
75
68
64
Marginal tax rate
37%
40
44
52
59
59
64
44
Output Gaps and Policies
AD > Y* => Expansionary Gap
 AD < Y* => Recessionary Gap
 Policies to eliminate gaps:


Fiscal policies
G
increase/decrease
 T increase/decrease

Monetary policies
 Money
supply increase/decrease (r
increase/decrease)
45
Shortcoming of the Keynesian Cross
It keeps prices constant.
 How does one include inflation into the
Keynesian cross?
 Explain what happens to AD at higher levels
of inflation and use this new diagram.
 Include the self-correcting mechanism of
the economy by differentiating short run
aggregate supply (Keynesian) from the long
run aggregate supply (Classical).

46
Why Does Aggregate Demand
Fall When Inflation Rises?

When  up => Fed Policy Reaction
Function raises r => I and C down => AD
down

Fed Policy Reaction Function (Example: Taylor
rule): r = 0.01 - 0.5[(Y*-Y)/Y*] + 0.5
47
Why Does Aggregate Demand
Fall When Inflation Rises?
When  up => wealth held in money form
erodes => C down => AD down
 When  up => MPC falls because the poor
are affected more than the rich => multiplier
falls => AD flatter
 When  up => at constant exchange rates
our exports become more expensive and
our imports become cheaper => NX falls =>
AD falls

48
Shifts in AD

Changes in autonomous aggregate demand.
Autonomous C
 Autonomous I
 Taxes
 Government purchases
 Net exports


Changes in Fed’s policy reaction function
Tightening of monetary policy
 Easing of monetary policy

49
Shifting of AD
Increase in autonomous spending shifts
AD right.
 Tightening of monetary policy raises r
and shifts AD left.
 Easing of monetary policy lowers r and
shifts AD right.
 Changes in inflation are movements
along the AD curve.

50
Movement Along AD
Any change in the vertical axis shows
as a movement along the AD line, just
like demand and supply (changes in P).
 The vertical axis measures the inflation
rate.
 Therefore, any change in the inflation
rate is shown as a movement along the
AD line.

51
Why Inflation Rate Doesn’t
Change?

Inflation has inertia.
Inflationary expectations tend to keep inflation
constant.
 Contracts include expected inflation.


Long term contracts keep inflation
constant.
52
Why Inflation Rate Changes?
1.
Output Gap.
1.
2.
Inflation shock
1.
3.
Expansionary output gaps (Y>Y*)
An increase in price of inputs that raise
the cost of production for a significant
portion of the economy. (Oil; wages for
national unions).
Shock to potential output
1.
Disasters.
53
Expansionary Gaps
How will an expansionary gap look in an
AD-AS diagram?
 How will the economy adjust to the
expansionary gap?
 What will happen to SRAS in the longrun?
 Keynesian - Classical dilemma.

54
Excessive AD

Shifts in AD that create expansionary
output gaps will raise inflation rate.
G increase: military buildup of 1960s and
1980s.
 Inflation rose in the sixties but did not in the
eighties.

 The
Fed’s policy stand is the answer.
55
Inflation Shocks
Oil price shock of the seventies pushed
the inflation up: SRAS shifts up.
 If the Fed doesn’t respond recessionary
gap will be eliminated in the long run.
 If the Fed does respond to recession,
AD will be shifted to the right but the
long run equilibrium will take place at
the higher inflation rate.

56
Shock to Potential Output
If a disaster happens or capital
becomes obsolete or expensive to use,
Y* shifts left.
 Again, stagflation occurs, just like when
inflationary shocks takes place.
 Long run equilibrium will be at a higher
inflation rate and lower Y.

57
Lowering Inflation
Suppose the country is experiencing
double digit inflation.
 Because of inflationary expectations
and contracts, the inflation will remain at
that level.
 However, to eliminate the costs of
inflation, the Central Bank embarks in a
new monetary policy.
 Show the short and long run effects.

58
Lowering Inflation
GDP
Inflation
Infl’n
Y*
r
Time
59
Can Fiscal Stimulus Work
http://www.economy.com/markzandi/documents/assissing-the-impact-ofthe-fiscal-stimulus.pdf
 Barro note

60