Frank & Bernanke
4th edition, 2009
Ch. 13: Aggregate
Demand and
Aggregate Supply
1
Aggregate Demand-Aggregate
Supply
π
LRAS
AS
AD
Y*
Y
2
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.

3
Introduction

The aggregate demand/aggregate supply
model will allow us to see how
macroeconomic policy affects inflation and
output.
4
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

5
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
6
The Aggregate Demand Curve
Inflation 
An increase in  reduces Y
(all other factors held constant)
Aggregate Demand Curve
AD
Output Y
7
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)
8
r (by Fed)
DERIVATION OF THE AD CURVE
Monetary Policy Rule
π
π
450
π
PAE
π
Fed responds to inflation rate
and sets the federal funds interest
rate. In the short run nominal and
real interest rates remain the same
because inflationary expectations
haven’t changed. The real interest
rate determines the C, I, NX and
consequently the PAE. The
Keynesian Cross gives us the
equilibrium Y. We now have a
AD
point on the AD curve because
Y we know the equilibrium Y
and the inflation.
450
PAE
Y
9
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.

10
SHIFTS IN AD IN RESPONSE TO
SHIFTS IN PAE: G down
r (by Fed)
What changes make the PAE shift?
π
π
π
In the Keynesian Cross diagram, what
changes might have happened?
450
If inflation hasn’t changed, and Fed
has not changed the r, where do the
inflation rate and equilibrium Y meet?
π
PAE
AD
AD’
Y
450
Try your hand at the
diagrams when G increases
or T decreases.
Y
11
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’
Output Y
12
THE IMPACT OF MONETARY
POLICY RULE CHANGE ON AD
r (by Fed)
What does it mean to shift MPR up?
π
π
Monetary policy is more restrictive
π
Follow the resulting changes.
π
AD
AD’
Y
Show what happens to AD when
the monetary policy becomes
expansionary.
PAE
Y
13
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’
14
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)
15
INCREASE IN INFLATION
r (by Fed)
Upward movement along AD
π
π
π
π
AD
AD’
Y
PAE
Y
16
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
17
A Virtuous Circle
18
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.

19
Inflation and Aggregate Supply

Three factors that can increase the
inflation rate
Output gap
 Inflation shock
 Shock to potential output

20
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 (D>S for firms)
3. Recessionary gap
Y < Y*
Inflation falls (D<S for firms)


21
Aggregate Supply
Current inflation (π) is the result of
expected inflation plus the inflationary
impact of the output gap.
π
If the economy is at Y*, current and
expected inflation are the same. If there
is an expansionary gap (Y>Y*) inflation
increases to π1. If there is a
recessionary gap (Y<Y*) inflation
falls to π2.
π1
π0
π2
Y2
Y*
Y1
22
AS Shifts
CHANGE IN INFLATIONARY EXPECTATIONS
Expected inflation is higher at Y*.
AS1
AS0
π1
A SUDDEN INFLATION SHOCK
A sudden economy-wide cost increase
π0
Y*
23
Short-run Equilibrium
Inflation equals the value determined by
past expectations and output gap (AS) and
output equals the level of short-run
equilibrium output that is consistent with
that inflation rate (AD)
 Graphically, short-run equilibrium occurs
at the intersection of the AD curve and the
AS line

24
Equilibrium
LRAS
Inflation 
AS
Long-run equilibrium
• AD, AS (*), LRAS (Y*)
will intersect at the same
point
π*
AD
Y*
Output
25
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 AS line, and the
LRAS line all intersect at a single point

26
Recessionary Gap
LRAS
Inflation 
AS
π0
π*
AD
Y0
Y*
Output
27
Adjustment to Recessionary Gap





Y<Y* means firms 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.
28
Expansionary Gap
LRAS
π*
AS
Inflation 
π
AD
Y*
Output
29
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.

30
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.
31
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.
32
Sources of Inflation
Excessive Aggregate Spending
 Inflation Shocks
 Shocks to Potential Output
 Try to draw each one.

33
EXCESSIVE AGGREGATE SPENDING
r (by Fed)
In the Keynesian Cross diagram, what
changes might have happened? Military
expenditures?
π
π
π
450
If inflation hasn’t changed, and Fed
has not changed the r, where do the
inflation rate and equilibrium Y meet?
π
PAE
AD’
AD
Y
450
PAE’
PAE
Y
34
Excessive Aggregate Spending
LRAS
π*
AS
Inflation 
π
Show the impact
on Fed Policy
Rule. What does
it mean?
AD
Y*
Output
35
Higher Inflation and Fed
r
π
36
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?
 What did Germany do during early 1990s?

37
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
38
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

39
Inflation Shock
LRAS
Two Options:
Don’t do anything.
AS’
Inflation 
AS
π*
AD
Y*
Output
40
Inflation Shock
LRAS
Two Options:
Fed lowers r – easing
money supply.
AS’
Inflation 
AS
π*
AD’
AD
Y*
Output
41
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
42
Shock To Potential Output
LRAS’ LRAS
Inflation 
AS
π*
Loss of capital, loss
of labor, sudden
abandonment of
machinery (capital
loss), extended
recession (human
capital loss).
AD
Y*’
Y*
http://www.npr.org/templates/story/story.php?storyId=101386052
Output
43
Greenspan
LRAS
Inflation 
AS
π*
AD
Y*
Output
44