Friday, November 30 Handout: Aggregate Demand/Aggregate Supply Model The Dynamics Review

Transcription

1 Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Friday, November 30 Handout: Aggregate Demand/Aggregate Supply Model The Dynamics Review Aggregate Demand/Aggregate Supply Model SRAS Equilibrium Rate Aggregate Demand Equilibrium Y Aggregate Supply SRAS Expected Infl Rate Y* Curve Questions: How many SRAS Curve Questions: How many final goods and services would be final goods and services would be demanded if the inflation rate produced if the inflation rate were % given that there are were % given that no demand shocks the expected inflation rate is unchanged and Taylor Principle there are no supply shocks Infl Rate Up Curve: Illustrate Potential GDP (Y*) Int Rate Up I Down Y* = Potential GDP = GDP whenever the expected inflation AE Down Y Down rate equals the actual inflation rate Demand Shock: Anything shifting the SRAS and Keynesian AE curve other than the Intersect at the expected inflation rate Fed s application of the Taylor principle SRAS Curve Summary: Curve Summary: Upward shoping Downward sloping Shifts whenever Shifts whenever there is È The expect inflation rate changes a demand shock È There is a supply shock

2 2 Adaptive Expectations and Short Run Aggregate Supply (SRAS) Curve Dynamics Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent past Scenario 1: Stable Start Benchmark Invest Interest Actual Period GDP Pur Infl (%) SRAS This represents a stable start because the actual inflation rate and the expected inflation rate are equal Scenario 2: Actual GDP Greater Than Potential GDP Question: What will happen in Period 1? To answer this question, first ask consider inflationary expectations: The actual inflation rate in Period 0 is 93 percent As a consequence of adaptive expectations, expected inflation in Period 1 should equal about percent Since the short run and long run aggregate supply curve intersect at the expected inflation rate, the short run supply curve in Period 1 and long run aggregate In period 1, the short run aggregate supply curve shifts 93 2,008 SRAS 0 Question: What will happen in Period 2? To answer this question, first ask consider inflationary expectations: The actual inflation rate in Period 1 is percent As a consequence of adaptive expectations, expected inflation in Period 2 should equal about percent In period 2, the short run aggregate supply curve shifts Invest Interest Actual Expected Period GDP Pur Infl (%) Infl (%)

3 3 Scenario 3: Actual GDP Less Than Potential GDP Question: What will happen in Period 1? To answer this question, first ask consider inflationary expectations: The actual inflation rate in Period 0 is percent As a consequence of adaptive 104 expectations, expected inflation in Period 1 should equal about 100 percent Since the short run and long run 96 aggregate supply curve intersect at the 93 expected inflation rate, the short run supply curve in Period 1 and long run aggregate In period 1, the short run aggregate supply curve shifts 1,992 SRAS 0 Question: What will happen in Period 2? To answer this question, first ask consider inflationary expectations: The actual inflation rate in Period 1 is percent As a consequence of adaptive expectations, expected inflation in Period 2 should equal about percent In period 2, the short run aggregate supply curve shifts Interest Actual Expected Period GDP Investment Infl (%) Infl (%) Summary AS Dynamics GDP < Potential GDP GDP = Potential GDP GDP > Potential GDP Rate Rate Rate Expected Infl Rate Expected Infl Rate Expected Infl Rate SRAS SRAS SRAS GDP GDP GDP

4 4 Demand Shocks Demand shocks can be created by both the Congress and the President through the use of fiscal policies o Government purchases of goods and services o Tax (and transfer) policies and Federal Reserve Board through the use of discretionary monetary policies Govt Actual Expected Period GDP Pur Infl (%) Infl (%) We have added a column to the table that does not appear in the lab: Expected Infl Since the actual inflation rate has remained at 10 percent throughout all the periods, adaptive expectation allows us to concluded that the expected inflation rate equals 10 percent: Adaptive Expectations: The expected inflation rate depends on the inflation rate in the recent past Since the actual inflation rate equals the actual inflation rate, potential GDP must 100 equal Potential GDP (Y*): GDP whenever the 0 actual inflation rate equals the expected inflation rate SRAS 0,1

5 5 Now, we increase government expenditures by 20 from 500 to 520 in Period 1 Question: What will happen in Period 1? The curve shifts to the GDP equals The actual inflation rate equals Question: What will happen in Period 2? The actual inflation rate in Period 1 is 100 percent As a consequence of 0 adaptive expectations, expected inflation in Period 2 should equal about percent Answer: In period 2, the short run aggregate supply curve shifts SRAS 0,1 Question: What will happen in Period 3? The actual inflation rate in Period 2 is percent As a consequence of adaptive expectations, expected inflation in Period 3 should equal about percent inflation rate, the short run supply curve in Period 3 and long run aggregate Answer: In period 3, the short run aggregate supply curve shifts Govt Actual Expected Period GDP Pur Infl Infl Describe the new long run equilibrium