aggregate demand and aggregate supply - … slides/lecture 17... · friday 22nd: end of chapter 15...
TRANSCRIPT
2013
Aggregate Demand and Aggregate
Supply
Outline
1. Friday 14th : Chapter 16 (AS-AD, demand policies)
2. Monday 18th
Bas Jacobs (45 to 60 minutes interactive lecture on current crisis)
Chapter 17 (debt and stabilization policies)
3. Wednesday 20th : end of Chapter 17 + Chapter 14/15
4. Friday 22nd : end of Chapter 15 + solutions to mock exam
The big picture
Introduction
Short run Medium run Long run
AS-AD in the short run
Aggregate demand and aggregate supply
Output gap
Inflation
AS
AD
Equilibrium on the goods and money market, IS-TR (Chapter 10)
Phillips curve & Okun’s law (Chapter 12)
Introduction
AS-AD in the long run
Output gap
Inflation
LAS
LAD
Introduction
Literature for AS-AD model
Lecture notes + pdf « Notes Chapter 13»
Burda & Wyplosz:
13.3.1 The Fisher equation
13.3.2 The long-run AD curve
13.3.6 Monetary Policy
13.4 – 13.4.3 How to use the AS-AD framework
In the lecture: no international capital markets in this framework (we don’t talk explicitly about exchange rate, but implicitely we assume a flexible exchange rate regime).
Skip the details on the differences between fixed and flexible exchange rate.
Model presented here based on
Mankiw, Macroeconomics, 7th edition of the international edition, Chapter 14, mainly section 14.3 and 14.4
Outline
1. Introduction
2. The Fisher equation
3. Recall: Phillips curve, expectations and aggregate supply
4. Aggregate demand
1. Long run
2. Short run
5. Using the AD-AS framework: Explaining fluctuations
1. Supply shocks
2. Demand shocks
3. Monetary policy
4. The role of Policies
Keeping track of time
We use a dynamic model of aggregate supply and demand.
Therefore: we need to introduce the time dimension
The subscript “t ” denotes the time period, e.g.
Yt = real GDP in period t
Yt -1 = real GDP in period t – 1
Yt +1 = real GDP in period t + 1
We can think of time periods as years, e.g., if t = 2008, then
Yt = Y2008 = real GDP in 2008
Yt -1 = Y2007 = real GDP in 2007
Yt +1 = Y2009 = real GDP in 2009
Introduction
The model’s variables and parameters
Endogenous variables (we see how these evolve over time):
Yt : output
πt: inflation
rt: real interest rate
it: nominal interest rate
: underlying inflation Shows us how last period’s events influences today’s outcome
Exogenous variables (determined outside of our model):
: trend output
: inflation target by CB
Demand shocks: G, T, wealth, consumer confidence…
st : Supply shocks
t~
Y
Introduction
2. … what happens to those?
1. If we change one of these…
The Fisher equation
Central bank sets the nominal interest rate i:
Distinction between nominal and real interest rate
rt : real intrest rate - relevant for spending decisions
it : nominal intrest rate - relevant for money market
: inflation that I expect today will happen between today (year t) and tomorrow (t+1)
Notation: πt : ex-post observed inflation between year t and year t+1
πt-1 : observed inflation between last period (t-1) and today (t)
gapgap bYaii
2. The Fisher equation
te
ttt ir
te
t
The Fisher equation
Example:
i= 8%, πte=10%
r=?
r=0,08-0,10= -0,02
Your money will buy 2% fewer goods
Lender: prefers low inflation
Borrower: prefers high inflation
r = only observable ex post
CB fixes the nominal interest rate and long run inflation expectations
ttt ir
2. The Fisher equation
Inflation
Unemployment
B
U
Phillips curve:
Short run:
Trade-off between inflation and unemployment possible IF no supply shocks
underlying inflation constant
Un constant.
Long-run:
No trade-off possible between
unemployment and inflation
A
Long run
Short run
Phillips
curves
Phillips curve
1~
2~
tgaptt sbU ~
UUs tttt 0&~
3. Recall: Phillips curve
Underlying inflation
Underlying inflation : expected inflation
Two components
Backward looking component (πt-1)
Forward looking component (long run inflation rate)
For the moment, we assume adaptive expectations.
Adaptive expectations: focus on backward looking component Realistic when π relatively stable
Later & Chapter 16: Incorporate again the forward looking component: Inflation target fixed
by the central bank
~
1~
t
e
ttt
3. Recall: Phillips curve
From the Phillips curve to aggregate supply
Infla
tio
n
Output
Aggregate supply
Inflation
Unemployment
(a) Phillips curve
U
Y
Output
Unem
plo
ym
ent
Y
U
(b) Okun‘s law
saYgap ~
sbUgap ~
gapgap hYU
3. Recall: Phillips curve
Aggregate supply curve
describes, for each given level of inflation, π, the quantity of output firms are willing to supply, Y
Medium run: upward sloping,
long run: vertical
Derived from the Phillips curve: Inflation unemployment
Aggregate supply curve
tgaptt saY ~
Inflation
Output Y
A B
Long run AS
Short
run AS 1
~
2~
Shift of AS (and Phillips) curve:
• Change in underlying inflation
• Supply shock, s ≠0
• (Change in natural U or natural Y)
3. Recall: Philips curve
Aggregate demand
Aggregate demand curve
all the combinations of output and inflation such that
the market for goods is in equilibrium (IS)
the money market is in equilibrium (TR )
To draw the aggregate demand curve:
How does the equilibrium on the goods and money markets change when prices change?
1. Long run AD curve
2. Short run AD curve
Here: closed or big and open economy (!!DIFFERENT from Ch. 13 of Burda & Wyplosz!!) we do not worry about the exchange rate here
Framework here: based on Mankiw, Macroeconomics, 7th edition of the international edition, Chapter 14
4. Aggregate demand
The model’s long run equilibrium
We know (from the LAS curve) that in the long run
Intersection of LAS and LAD curve: Long run equilibrium of the economy
What determines inflation in the long run?
CB fixes the inflation target and thus long run inflation
It follows:
Real economy gives natural level of real interest rate:
t tY Y
ri
tt ~
tt~
rrt
4.1 Aggregate demand – Long run
The aggregate demand curve in the long run
LAD = target
inflation frate
Central bank chooses a target for the long run inflation Inflation independent from output
Inflation
Output gap
ribYaii gapgap where, :ruleTaylor
4.1 Aggregate demand – Long run
Deriving the short run AD curve:
How does a change in prices affect the equilibrium in the IS-TR model?
Taylor rule:
Interest rate responds not only to changes in Y but also to changes in π ECB: a = 1.5 i ↑ if πgap >0. (note: i increases by more than πgap !)
r increases also (i – π = r)
When inflation changes shift of TR curve If inflation raises, for every level of output, the interest rate will be
higher, so the TR curve shifts up
Aggregate demand curve in the short run
gapgap bYaii
4.2 Aggregate demand – Short run
Taylor rule and inflation
How does the CB change i when inflation increases?
gapgap bYaii
)( gapbYaii
gapbYaππaii
This constant term will change, when π changes
when i
TR
i
Y gap
TR‘
i
0
4.2 Aggregate demand – Short run
Rate
of in
flation
Output gap
Inte
rest
rate
Output gap
A
A
Drawing the short run AD curve
At point A:
TR
0
0
gap
We start
from long-run
equilibrium,
where
0
and .
Y
Along TR is
held constant
at .
iiY Y and
i
4.2 Aggregate demand – Short run
AD
A ́
Rate
of in
flation
Output gap
Inte
rest
rate
Output gap
TR ́
A
A ́
A
TR
With π : TR TR’.
IS
0
0
Drawing the short run AD curve 4.2 Aggregate demand – Short run
gapgap bYaii
Question:
Why is r automatically
here, after the ECB
increases i according to
the Taylor rule (a = 1.5)?
Nominal and real interest rate Investment, Y
AD slopes downward: When inflation rises, the central bank raises the (real) interest rate, reducing the demand for goods & services.
Ygap
π
AD curve shifts in response to changes in • the inflation target (↑ shifts AD to the right) • demand shocks (ε = changes in G, T, wealth, …) (↑ in demand shift to the right)
ADt
AD determined by changes in the IS-TR equilibrium due to change in inflation
The short run AD curve
BAYgap )(
4.2 Aggregate demand – Short run
AS-AD In
flation
0
AS
AD
LAD
LAS
Output gap
5. Using the AD-AS framework: Explaining fluctuations
Simulation of economic fluctuations Now that we have built our AS-AD model, we can see how
fluctuations emerge.
What are the effects? 1. Supply shock
2. Demand shock
3. Change in monetary policy
4. Contractionary versus expansionary policies
Here we make the assumption of adaptive expectations:
We always start from the LR equilibrium: The only disturbance to the economy is in year t. We then see how the economy adjusts over the years to this disturbance via changes in the interest rate and inflation expectations.
1
~ t
tt
e
t
5. Using the AD-AS framework: Explaining fluctuations
Period t – 1: initial equilibrium at point A
Period t: Supply shock (s > 0) AS shifts upward, π rises CB responds to
higher π by raising the (real) interest rate, output falls.
Point B
πt – 1
Yt –1
π
ASt -1
Y
AD
A
ASt
Yt
B πt
An adverse supply shock
Y gap
tgaptt saY ~
5.1 AD-AS framework: Supply shock
πt – 1
Yt –1
Period t + 1: Supply shock is over (s = 0) but AS does not return to its initial position due to higher inflation expectations.
Period t + 2: As πt , underlying inflation AS shifts downward Y rises.
π
ASt -1
Y
AD
A
ASt
Yt
B πt
ASt +1
C
ASt +2
D
Yt + 2
πt + 2
This process continues until output returns to its natural rate. LR equilibrium at point A.
An adverse supply shock
Y gap
tgaptt saY ~
1
~ tt
5.1 AD-AS framework: Supply shock
tY
t
A one-period
supply shock
affects output
for many
periods.
An adverse supply shock
5.1 AD-AS framework: Supply shock
t
tBecause
inflation
expectations
adjust only
slowly, actual
inflation
remains high
for many
periods.
An adverse supply shock
5.1 AD-AS framework: Supply shock
tr
The real
interest rate
takes many
periods to
return to its
natural rate.
ti
An adverse supply shock
5.1 AD-AS framework: Supply shock
Period t – 1: at point A
πt – 1
π
ASt -1,t
Y
ADt ,t+1,…,t+4
ADt -1
Yt –1
A
ASt + 1
C
Yt
B πt
Period t: Positive demand shock until t = 4 (ε > 0) AD shifts to the right Y and π .
Period t + 1: Higher inflation in t raises inflation expectations for t + 1 AS shifts up. Y and π even more
Positive demand disturbance
Y gap
5.2 AD-AS framework: Demand shock
πt – 1
π
ASt -1,t
Y
ADt ,t+1,…,t+4
ADt -1
Yt –1
A
ASt + 1
C
ASt +2
D
ASt +3
E
ASt +4
F
Yt
B πt
Periods t + 2 to t + 4 : Higher inflation in previous period raises inflation expectations AS curve continues to shift up. Y and π
Positive demand disturbance
Y gap
5.2 AD-AS framework: Demand shock
πt – 1
π
ASfinal
Y
ADt ,t+1,…,t+4
ADt -1, t+5
ASt +5
Yfinal
A
Yt
B πt
Yt + 5
G πt + 5
Period t + 5: AS is higher due to higher π in preceding period, but demand shock ends AD returns to its initial position. Equilibrium in t+5 at point G.
Periods t + 6 and higher: AS gradually shifts down as π and fall, the economy gradually recovers until reaching again LR equilibrium at A.
Positive demand disturbance
~
Y gap
F πt + 4
ASt +4
5.2 AD-AS framework: Demand shock
tY
t
The demand
shock raises
output for
five periods.
When the
shock ends,
output falls
below its
natural level,
and recovers
gradually.
Positive demand disturbance
5.2 AD-AS framework: Demand shock
t
t
The
demand
shock causes
inflation
to rise.
When the
shock ends,
inflation
gradually
falls toward
its initial
level.
Positive demand disturbance
5.2 AD-AS framework: Demand shock
tr
The demand
shock raises the
real interest rate.
After the shock
ends, the real
interest
rate falls and
approaches its
initial level.
Positive demand disturbance
ti
5.2 AD-AS framework: Demand shock
Conclusion:
A fiscal policy (or any other demand disturbance) can only increase output temporarily
Economy will always come back to it’s natural output level Either: AD curve shifts back (e.g. fiscal policy not sustainable) back
to natural level of Y (Option 1)
Or: change in underlying inflation leads to upward shift of AS-curve decrease in output and increase in inflation back to natural level of Y (but with higher inflation in the long run, i.e. CB accepts higher π in the long run = higher inflation target) (Option 2)
The role of demand policies
Increasing government expenditure has only an effect on output in the short run, NO impact in the long run
5.2 AD-AS framework: Demand shock
πt – 1
π
ASt -1,t
Y
ADt ,t+1,…,t+4
ADt -1, t+5
Yt –1
A
ASt + 1
ASt +n
Yt
B πt
Positive demand disturbance
Y gap
Option 2: AS shifts to new long run equilibrium (point Z). Here CB accepts higher inflation target (LAD shifts up to point Z)
Option 1: AD curve shifts back to initial long run equilibrium in point A (has to be the case when CB doesn’t change the inflation target)
Z
Yfinal
Which option occurs? Depends on CB!
What is the speed the speed of adjustment? This depends on inflation expectations of individuals. (Details Ch. 16)
5.3 AD-AS framework: Monetary policy
A Shift in Monetary Policy
Inflation
Output gap
Inte
rest
rate
Output gap
TR
LAD‘
IS
C
A
0
LAS AS
AD
Long run: lower inflation target no effect on output
LAD
2
1A
CB changes the inflation target and
follows a more restrictive
monetary policy
5.3 AD-AS framework: Monetary policy
A Shift in Monetary Policy
Inflation
Output gap
Inte
rest
rate
Output gap
TR
LAD‘
B
0
LAS AS
AD‘
AD
IS
Short run: monetary policy has an impact on Y and π
2
LAD 1B
A
TR ́
A
With inflation target : TR TR’.
Shift in TR : AD AD’
( Y )
On TR’: actual inflation above its new target level i and r investment , Y
BA Ygap )(
5.3 AD-AS framework: Monetary policy
Period t – 1: target inflation rate = 2%, initial equilibrium: point A
πt – 1 = 2%
Yt –1
Period t: CB lowers inflation target to = 1%, raises i and r to reduce π. AD shifts left Y and π . New eq. : point B
Y gap
π
ASt -1, t
Y
ADt – 1
A
ADt, t + 1,…
Yt
πt B
Z πfinal = 1%
,
Yfinal
A Shift in Monetary Policy
5.3 AD-AS framework: Monetary policy
πt – 1 = 2%
Yt –1
π
ASt -1, t
Y
ADt – 1
A
ADt, t + 1,…
ASfinal
Yt
πt B
ASt +1
C
Subsequent periods: This process continues until output returns to its natural rate and inflation reaches its new target.
Z πfinal = 1%
,
Yfinal
A Shift in Monetary Policy Period t + 1: The fall in πt reduces inflation expectations because AS shifts down Y , π
~t ~
Y gap
5.3 AD-AS framework: Monetary policy
Response to a reduction in target inflation
tY
Reducing
causes
output to fall
below its
natural level
for a while.
Output
recovers
gradually.
t
5.3 AD-AS framework: Monetary policy
t
Because
expectations
adjust slowly,
it takes many
periods for
inflation to
reach the new
target.
t
Response to a reduction in target inflation 5.3 AD-AS framework: Monetary policy
tr
To reduce
inflation,
the CB raises i
and r to reduce
aggregate
demand
new eq in IS-
TR.
r gradually
returns to its
natural rate.
t
Response to a reduction in target inflation 5.3 AD-AS framework: Monetary policy
ti
CB raises i in t.
As inflation
falls, the
nominal rate
falls too.
ri
π r i
Response to a reduction in target inflation
t
5.3 AD-AS framework: Monetary policy
So far:
Central bank only follows its predetermined Taylor Rule (except in case of shift in monetary policy)
Government is not intervening to reduce the initial shock.
Now:
What can policy makers do in case of a negative demand or supply shock? Fiscal policy
Monetary policy
Expansionary Contractionary
Role of expectations: importance of forward looking component of underlying inflation
Supply shock & demand policies 5.4 Policy responses to shocks
LAD
AS ́LAS
AS
AD
Inflation
0
B
Stagflation results: both unemployment and inflation increase.
Output gap
A
Adverse supply shock
If s >0 Shift in the AS curve:
saYgap ~
5.4 Policy responses to shocks
Supply shock & demand policies
Suppose we try to fight resulting unemployment with expansionary demand policies...
AD ́
AS ́LAS
LAD
AD
Inflation
0
B
C
We successfully fight unemployment, but at a cost of increased inflation in the long-run.
New equilibrium at C.
Output gap
A
5.4 Policy responses to shocks
... or we try to fight the inflationary impact of the adverse supply shock through a contractionary policy.
LAD
AD´́
AS ́LAS
AD
AS
Inflation
0
B
D
We successfully fight π but at a cost of increased unemployment (via point D) until we return to the long-run equilibrium at A.
Output gap
A
Supply shock & demand policies 5.4 Policy responses to shocks
Third option: Central bank announces credibly that inflation will be at its target level.
LAD
AS ́LAS
AD
AS
Inflation
0
B
If people expect inflation to be at its target level, AS curve shifts back to its original position.
We return directly to the long-run equilibrium at A.
Output gap
A
Supply shock & demand policies 5.4 Policy responses to shocks
AD ́
LAS
AD
AS
Inflatio
n
0
A
B
Output gap
Adverse demand shock
An adverse demand shock brings the economy from point A to point B…
5.4 Policy responses to shocks
AD ́
LAS
AD
AS
Inflation
0
A
B
Output gap
Adverse demand shock
AD policy change to offset demand shock
Here: To go back to point A: Expansionary fiscal or expansionary monetary policy
5.4 Policy responses to shocks