CH 28

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level
Aggregate Supply and the Equilibrium Price Level
28 11
CHAPTER OUTLINE
The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve
The Equilibrium Price Level The Long-Run Aggregate Supply Curve

Potential GDP
Monetary and Fiscal Policy Effects

Long-Run Aggregate Supply and Policy Effects
Causes of Inflation
Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon
The Behavior of the Central Bank

Controlling the Interest Rate The CBs Response to the State of the Economy Inflation Targeting
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
Objectives of the Chapter

What causes price levels to rise and why might rising price levels be a problem for an economy? What are the tools to control inflation? These are the questions we will ask in this chapter. We will also analyze the aggregate supply curve.
We will analyze how fiscal and monetary policies affect the price level.

aggregate supply The total supply of all goods and services in an economy.
The Aggregate Supply Curve: A Warning aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. The AS curve is not the simple sum of all the individual supply curves in the economy. An aggregate supply curve in the traditional sense of the word supply does not exist because many firms in the economy set prices as well as output. What does exist is what we might call a price/output response curvea curve that traces out the price decisions and output decisions of all firms in the economy under a given set of circumstances.

Aggregate Supply in the Short Run In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical.
FIGURE 28.1 The ShortRun Aggregate Supply Curve

Aggregate Supply in the Short Run Why might the AS curve have a positive slope in the short run? One reason is that wages may lag prices in responding to a change in demand. Suppose that there is an increase in the aggregate demand and the firms in the economy are imperfectly competitive. If the firms marginal cost curves do not shift, they can raise profits by increasing prices and output. The key assumption is that the MC curves do not shift. Labor costs (wages) are a large fraction of total costs.
Why does the AS curve have first a flat part and then a steeper part?
To answer this question we use the concept of capacity utilization. Capacity utilization is a measure of how much of a firms existing capital and labor the firm is using.

Aggregate Supply in the Short Run When firms are at low levels of capacity utilization, increasing output can be accomplished without large cost increases. When firms are approaching full capacity utilization, further expansions are harder to do. Consider segment AB on the previous graph. The economy is operating at a low level of output, and thus firms are likely to have excess capacity. Firms may be holding more capital and labor than they need for their current production levels. With excess labor and capital, the costs of producing an additional unit of output in response to demand increases will not rise much. The response of a firm in this position will be primarily be to increase output rather than to increase its price. In moving from A to B, there is a large increase in output and only a small increase in the price level. If demand continues to increase, things will change. As firms move closer to capacity, their response to demand increases change from mainly increasing output to mainly increasing prices.

Aggregate Supply in the Short Run As demand increases firms move toward holding no excess capital and excess labor. In any short-run period, firms output decisions are constraint by some fixed factor of production.
Because firms cannot easily expand their capital stock, increasing output typically involves rising marginal costs.
Thus, firms rise prices rather than output.
At some level of aggregate demand it is virtually impossible for firms to expand any further, and firms will respond to any further increases in demand only by rising prices. (segment CD on the graph)

Shifts of the Short-Run Aggregate Supply Curve cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.
FIGURE 28.2 Shifts of the Short-Run Aggregate Supply Curve

Shifts of the Short-Run Aggregate Supply Curve The AS curve could also shift to the right because of technical progress or because of labor force growth. Immigration can also shift the AS curve. Receiving an important number of immigrants would shift a countrys AS curve to the right.
The Equilibrium Price Level

equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect.
At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/ output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to a set of price/output decisions on the part of all the firms in the economy.
FIGURE 28.3 The Equilibrium Price Level
The Long-Run Aggregate Supply Curve
FIGURE 28.4 The Long-Run When the AD curve shifts from AD0 to Aggregate Supply Curve AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. The movement along AS0 assumes that wages lag prices. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back at Y0. Y0 is sometimes called potential GDP. Over time wages adjust to higher prices. If wages fully adjust to prices in the long-run AS curve will be vertical. By looking at the AS curves we can see why the shape of the AS curve is so important in policy debates. If the AS curve is vertical, then policies that shift the AD curve to the right such as an increase in G will simply cause an increase in the price level.
The Long-Run Aggregate Supply Curve

Potential GDP potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. When output is pushed above the potential output, there is upward pressure on wages. Rising wages shift the short-run AS curve to the left and drive output back to its initial level.

Aggregate demand can shift to the right for a number of reasons, including an increase in the MS, a tax cut, or an increase in G. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A. This is the case in which an expansionary policy works well. There is an increase in output with little increase in the price level.
FIGURE 28.5 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve

FIGURE 28.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at
or Near Maximum Capacity
If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B. The multiplier is therefore close to 0.

The two previous graphs show that it is important to know where the economy is before a policy change is put into effect.
Suppose that the economy is on the steep part of the AS curve and G is increased. The first thing that happens when G increases is an unanticipated decline in firms inventories. Firms cannot increase their production very much. Thus there will be a substantial increase in the price level. This will cause an increase in the money demand which will lead to an increase in the interest rate, decreasing planned investment. There will be nearly complete crowding out of investment.

Long-Run Aggregate Supply and Policy Effects It is important to realize that if the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run. Only the price level would change. The conclusion that policy has no effect on aggregate output in the long run is perhaps startling.
Do most economists agree that the AS curve is vertical in the long run?
They agree on that in the long run the AS curve will be steeper.

Long-Run Aggregate Supply and Policy Effects
How long is the long run? It depends on the lag time of wages. If wages follow output in lets say 3 to 6 months, policy has little chance to affect output. If on the other hand the long run is 3 or 4 years, policy can have significant effects.
The new classical economics assumes that prices and wages are fully flexible and adjust vey quickly to changing conditions. This view is consistent with a vertical AS curve, even in the short run.
Causes of Inflation
Demand-Pull Inflation demand-pull inflation Inflation that is initiated by an increase in aggregate demand. If the economy is operating on the steep portion of the AS curve at the time of the increase in AD, most of the effect will be an increase in the price level instead of an increase in output. If the economy is operating on the flat portion of the AS curve, most of the effect will be an increase in output instead of an increase in the price level. If the long-run AS curve is vertical, a shift in the AD curve will only cause inflation.
Causes of Inflation
Cost-Push, or Supply-Side, Inflation cost-push, or supply-side, inflation Inflation caused by an increase in costs.
Ex: Several times in the last decades oil prices in the world markets have increased sharply. As oil is used in virtually every line of business, costs have increased. An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls. stagflation Occurs when output is falling at the same time that prices are rising. Increase in costs is one possible cause of stagflation.
FIGURE 28.7 Cost-Push, or
Supply-Side, Inflation
Causes of Inflation
Cost-Push, or Supply-Side, Inflation A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This policy would raise aggregate output Y again, but it would raise the price level further, to P2. Cost shocks are thus bad news for policy makers.
FIGURE 28.8 Cost Shocks Are Bad News for Policy Makers
Causes of Inflation
Expectations and Inflation When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, in anticipation, it may raise its own price. Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral. If prices have been rising and peoples expectations are adaptive that is, if they form their expectations on the basis of past pricing behavior firms may continue rising prices even if demand is slowing or contracting. In terms of the AS/AD diagram, an increase in inflationary expectations that causes firms to increase their prices shifts the AS curve to the left.
Given the importance of expectations in inflation, the central banks of many countries survey consumers about their expectations.
Causes of Inflation
Money and Inflation An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. The higher price level causes MD to increase. This leads to an increase in the interest rate and crowding out of planned investment. The new equilibrium corresponds to higher G, lower I, a higher interest rate , and a higher price level. If the CB tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right because an increase in P will increase MD and thus increase r. The result is a sustained inflation, perhaps even hyperinflation.
FIGURE 28.9 Sustained Inflation From an Initial Increase in G and Central Bank Accommodation
Causes of Inflation
Sustained Inflation as a Purely Monetary Phenomenon Virtually all economists agree that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left. It is also generally agreed that for a sustained inflation to occur, the CB must accommodate it.
That is, it is virtually impossible to shift the AD continuously without changing the money supply.
In this sense, a sustained inflation can be thought of as a purely monetary phenomenon.
The Behavior of CB
We had seen in Chapter 25 that the CB can change the money supply by (1) changing the required reserve ratio, (2) changing the discount rate and (3) engaging in open market operations (buying and selling bonds). We also saw that the main way in which the CB changes the money supply is by engaging in open market operations. In practice the CB controls the interest rate rather than the money supply. The interest rate that the CB chooses depends on the state of the economy.
The Behavior of the CB

Controlling the Interest Rate The buying and selling of government securities by the CB has two effects at the same time: It changes the money supply, and it changes the interest rate. If the CB buys bonds, this purchase increases MS and lowers r. If the CB sells bonds, this sale decreases MS and increases r. How much the interest rate changes depends on the shape of the money demand curve. The steeper the money demand curve, the larger the change in the interest rate for a given size change in government securities. If the CB wants to achieve a particular value of the money supply, it must accept whatever interest rate value is implied by this choice. Conversely, if the CB wants to achieve a particular value of the interest rate, it must accept whatever money supply value is implied by this.

Controlling the Interest Rate Why might the CB want to control r rather than MS? In practice, it is r that directly affects economic activity, for example, by affecting firms decisions about investing. Controlling r thus gives the CB more control over the key variable that matters to the economy.
We will talk about monetary policy as being a change in the interest rate. Keep in mind that monetary policy also changes the money supply.

The CBs Response to the State of the Economy What influences the interest rate decision? The CBs main goals are high levels of output and employment and low level of inflation. The worst situation is stagflation- high unemployment and inflation. During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the CB is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD0 to AD1, and lead to an increase in output with very little increase in the price level.
FIGURE 28.11 The Feds Response to Low Output/Low Inflation

The CBs Response to the State of the Economy During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the CB is likely to increase the interest rate (and thus contract the money supply). This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output.
FIGURE 28.12 The Feds Response to High Output/High Inflation

The CBs Response to the State of the Economy Stagflation is a more difficult problem to solve. If the CB lowers the interest rate, output will rise, but so will the inflation rate (which is already to high). If the CB increases r, the output will also fall. So, the CB is faced with a trade-off. If it dislikes high inflation more than low output, it will increase r; if it dislikes low output more than high inflation, it will lower r.
The Behavior of the Fed

Inflation Targeting Some monetary institutions around the world engage in what is called inflation targeting. inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon.
It is a special case in which the CBs focus is on setting the interest rate to keep the inflation rate within some band over some horizon and not on the output.
In US there has been much debate about whether inflation targeting is a good idea.
REVIEW TERMS AND CONCEPTS
aggregate supply
aggregate supply (AS) curve
cost-push, or supply-side, inflation

cost shock, or supply shock demand-pull inflation equilibrium price level inflation targeting potential output, or potential GDP stagflation
Exercise 1: When the aggregate supply curve is horizontal, A)the price of factors of production is fixed, with little or no upward pressure on price. B) the economy is close to full capacity. C) resources are being utilized at full capacity. D) the prices level increases with additional production. Exercise 2: If the economy is operating on the relatively vertical segment of the aggregate supply curve, an increase in aggregate demand causes a ________ change in the price level and a ________ change in output. A) small; small B) big; big C) big; small D) small; big Exercise 3: An increase in aggregate demand when the economy is operating at high levels of output is likely to result in A) a large increase in both output and the overall price level. B) an increase in the overall price level but little or no increase in output. C) an increase in output but little or no increase in the overall price level. D) little or no increase in either output or the overall price level.
Exercise 4: Coal is used as a source of energy in many manufacturing processes. Assume a long strike by coal miners reduced the supply of coal and increased the price of coal. This would cause A) the short-run aggregate supply curve to shift to the right. B) the short-run aggregate supply curve to become flatter. C) the short-run aggregate supply curve to shift to the left. D) the short-run aggregate supply curve to become nearly vertical at all levels of output. Exercise 5: To increase the price level the government could adopt policies that A) increase aggregate supply and aggregate demand. B) decrease aggregate supply and aggregate demand. C) increase aggregate supply and decrease aggregate demand. D) decrease aggregate supply and increase aggregate demand. Exercise 6: True or false? a. Whenever the aggregate supply curve intercepts the aggregate demand curve, the economy is producing full employment output. b. If the Central Bank sells securities on the open market, the price level will rise. c. If the economy is on the steep part of its aggregate supply curve, expansionary policy will mostly increase the price level.
Exercise 7: If the long-run aggregate supply curve is vertical, the multiplier effect of a change in net taxes on aggregate output in the long run A) depends on the price level. B) is one. C) is zero. D) is infinitely large. Exercise 8: A rightward shift in the aggregate demand curve generates a ________ inflation and ________ output. A) demand-pull; lower B) cost-push; higher C) demand-pull; higher D) cost-push; lower Exercise 9: When there is stagflation, the policy choices facing the Central Bank are A) increasing monetary growth to increase GDP but that will make inflation worse. B) increasing monetary growth to increase GDP and reduce inflation. C) reducing monetary growth to reduce inflation, but that will make shortfall in GDP worse. D) A and C
Exercise 10: An earthquake destroyed 50% of the Moldovian manufacturing base. The Moldovian government decided to use a contractionary fiscal policy to counter the effects of the earthquake on the economy. The use of the contractionary fiscal policy would have caused A) the price level to be lower and the output level to be higher than they would have been without the policy action. B) both the price level and the output level to be higher than they would have been without the policy action. C) both the price level and output level to be lower than what they would have been without the policy action. D) the price level to be higher and the output level to be lower than they would have been without the policy action. Exercise 11: For the Central Bank to keep the interest rate unchanged as the government increases spending, the Central Bank must continue to A) increase the money supply. B) decrease the money supply. C) decrease the demand for money. D) increase the demand for money.

CH 28

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 28

Uploaded by

Copyright:

Available Formats

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Aggregate Supply and the Equilibrium Price Level

The Equilibrium Price Level The Long-Run Aggregate Supply Curve

Monetary and Fiscal Policy Effects

The Behavior of the Central Bank

Objectives of the Chapter

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Aggregate Supply Curve

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

FIGURE 28.2 Shifts of the Short-Run Aggregate Supply Curve

The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Equilibrium Price Level

FIGURE 28.3 The Equilibrium Price Level

The Long-Run Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Long-Run Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

or Near Maximum Capacity

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

Monetary and Fiscal Policy Effects

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

FIGURE 28.7 Cost-Push, or

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the CB

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the CB

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the CB

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the CB

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the CB

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

REVIEW TERMS AND CONCEPTS

aggregate supply (AS) curve

cost-push, or supply-side, inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level