Aggregate Demand Aggregate Supply 1 Y. f P

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1 ublic Aairs 974 Menzie D. Chinn Fall 202 Social Sciences 748 Universiy o Wisconsin-Madison Aggregae Demand Aggregae Supply. The Basic Model wih Expeced Inlaion Se o Zero Consider he hillips curve relaionship: + e In order o analyze he model more closely, le s make a simpliying assumpion, namely ha expeced inlaion is zero. This leads o: Rearranging: + Muliplying boh sides by he previous price level: + This equaion indicaes ha he curren price level is equal o las period s price level i oupu las period equaled poenial GD. I will be higher han las period s i las period s oupu exceeded poenial. Now consider wha would happen saring rom a posiion o iniial res. Assume o begin wih in periods 0 and, and A A, M M. Then suppose in period 2, auonomous spending increases o A 2 (perhaps because o an increase in governmen spending). Then oupu rises in period 2 o 2, bu he price level says consan. Only in period 3 does he price level rise (since 2 > ). Figure : Noe Λ 2 > Λ AD Λ, M FE AD Λ 2, M AD Λ, M 3

2 How does his AD-AS diagram relae o he IS-LM diagram we used beore? One way o hink abou he diagram is ha movemens along he predeermined price line were consisen wih he soluion o he IS-LM diagram. To see wha happens in he process o adjusmen o lower income as he price level rises, consider his pairing o diagrams. i LM M, Final LM M, 3 i Final LM M, i 3 i 2 IS Λ 2 Final AD Λ 2, M AD Λ, M 0 Final FE 3 2 Figure 2: Noe 3 > 2 Noice ha over he longer erm, he price level keeps on rising (as long as oupu exceeds poenial GD), he real money sock keeps on alling, shiing back he LM curve, unil inally oupu equals poenial, he price level equals Final, he ineres rae equals i Final.

3 3. The Expecaions Augmened hillips Curve Consider he hillips curve: + e Where i is assumed ; his is oen called he expecaions augmened hillips curve wih adapive inlaionary expecaions (i.e., expeced inlaion is jus equal o las period s ex pos inlaion rae). The resul o his revision is o make he price level overshoo is long run level, and oupu o undershoo. Evenually, e oupu and he price level reurn o where hey would have gone i 0 (as in he previous handou). Le s reconsider he graphs we used in he previous handou, his expression. The key here is o muliply ou o see how he price level evolves, aer aking ino accoun expeced inlaion (here equal o lagged inlaion): + + Now consider wha would happen saring rom a posiion o iniial res, and iniial inlaion equal zero. Assume o begin wih in periods 0 and, and A A, M M. Then suppose in period 2, auonomous spending increases o A 2 (perhaps because o an increase in governmen spending). Then oupu rises in period 2 o 2, bu he price level says consan. 5 Final AD A 2, M AD A, M 0 Final 3 2 Figure 3: Expansionary iscal policy in eriod 2, wih no iniial inlaion, and expecaions augmened hillips curve Only in period 3 does he price level rise (since 2 > ). + +

4 Bu since inlaion in period 2 was zero, hen expeced inlaion in period 3 is also zero, and he rise o 3 is he same here as in he previous handou. In period 4, prices rise again, bu noice ha since 3 > 2, > 3 0 : So prices would rise more han in he case where inlaionary expecaions were already zero. Noice ha since lagged inlaion is incorporaed ino he price level, hen he price level will overshoo is long run level (as i does a 4 ). Noice ha going o period 5, he previous period s oupu gap is negaive, so ha porion will exer negaive pressure on he price level. The way I ve drawn his igure, lagged inlaion ouweighs lagged (negaive) oupu gap, so ha he price level coninues o rise. Only in period 6 does he (very large) negaive oupu gap overwhelm he upward momenum rom lagged inlaion, so ha prices all o 6. The exac rajecory depends on he magniudes o he parameer (.) (as well as he slope o he aggregae demand curve), bu as long as expeced inlaion equals lagged inlaion, hen he price level will overshoo he long run value, beore evenually seling a Final (which is he same as i would be in he case where inlaionary expecaions did no maer). Technically, boh and will oscillae wih ever shrinking deviaions o heir inal values o Final and. 4. Incorporaing Supply Shocks In order o incorporae a role or supply shocks, consider he revision o he hllips curve: + + Z This is he hillips curve wih a supply shock eec, Z. How does his variable behave? Consider wha would i here were a one period increase in he price level o inpus (like oil). In ha case Z > 0 or one period, and 0 hereaer. Le s now examine he impac o an oil price shock on he model. Saring rom a posiion o iniial res, wih zero inlaion in periods 0 and and. Suppose in period 2, Z 2 > 0. Then oupu alls in period 2 o 2, as he price level rises. In period 3, since inlaion in period 2 was greaer han zero, expeced period 3 inlaion is also greaer han zero. Z is zero or his period, so wih he lagged oupu gap negaive, he price level alls. Then oupu rises in period 3 relaive o ha in period 2.

5 2 2 0 Final AD A, M 2 3 Final Figure 4: Oil Shock in eriod 2, expecaions augmened hillips curve, no oseing policy Evenually, oupu will reurn o poenial, and he price level o he iniial price level. However, here will be overshooing on he way o seady sae equilibrium. An alernaive scenario involves he governmen responding wih a policy o ry o mainain oupu a poenial. Suppose he same shock occurs, bu he moneary auhoriies increase he money supply in an aemp o mainain oupu. Then he money supply rises rom M o M2, and he AD curve shis ou Final AD A, M 3 AD A, M 2 AD A, M Final Figure 5: Oil Shock in eriod 2, expecaions augmened hillips curve, expansionary moneary policy in eriod 2.

6 Noe ha when period 3 occurs, inlaion will be equal o period 2 s inlaion; hence he price line will rise again (despie he ac ha Z0 in period 3). In order o keep oupu a poenial, he money supply will have o be increased again. There is a siuaion where he eec o an oil shock is more pernicious: i he supply shock (higher oil prices) causes some porion o he capial sock o depreciae. Since ФF(K, N), declines, he end-poin or he economy is a a permanenly lower oupu level and higher price level. AS LR 2 Final 0 AD A, M 2 Figure 6: Oil Shock in eriod 2 which permanenly reduced poenial GD, expecaions augmened hillips curve, no oseing policy I ve skipped he seps ha show overshooing due o lagged inlaion eeding ino curren inlaion. A974_ADAS_2.doc