Notes Aggregate Demand Aggregate Supply Point of the class Math Combining equations Using graphs Model building Combining previous models to explain a larger portion of the economy Writing simple equations that capture ideas Economic concepts and intuition In the short run output is determined by aggregate demand given the level of inflation o Changes in the level of inflation change the real money supply and the interest rate o Changes in the interest rate change the quantity of output demanded In the short run inflation is determined by past inflation o Inflation is inertial o Inflation responds slowly to output gaps In the long run output is determined by long run aggregate supply by potential output o Long run output is not affected by inflation and it is not determined by demand In the long run inflation is flexible and adjusts to cause the quantity of output demanded to be equal to potential output o Short run discrepancies between output demanded and potential output lead to output gaps o Output gaps cause inflation to change o Changes in inflation change output demanded until output returns to potential Definitions Long Run Short Run Aggregate Supply Curve Short Run equilibrium Short Run Long Run Aggregate Supply Curve Long Run Equilibrium Aggregate Demand curve Inflation Shock Homework Problems On the webpage 1 Income and Inflation in the Short Run and in the Long Run Building Blocks Aggregate Demand Inflation and Expenditure Higher inflation reduces expenditure through a number of channels Higher inflation causes interest rates to rise which pushes consumption and investment down Lower inflation leads to lower interest rates higher consumption and investment and higher output PAE 1 5 PAE PAE 3 PAE 4 5 Y 4 5 Y 3 Y 1 5 Y PAE 4 5 4 5 13tr 3 14tr 3 1 5 15tr 1 5 Y 4 5 13tr Y 3 14tr Y 1 5 15tr Y 2 We can state the relation between output and inflation as and are parameters that indicate the relation between inflation and output indicates the effect of changes in inflation on output Because of the negative sign the relation is negative AD Curve Higher inflation lowers output demanded o Higher inflation raises interest rates o Higher interest rates reduce investment o Lower investment is multiplied and leads to lower output The AD curve is downward sloping An increase in represents a monetary expansion a fiscal expansion an increase in consumer confidence an increase in autonomous investment an expansion in foreign countries etc Increases in money supply increase output demanded at any level of inflation o A larger money supply at a given level of inflation lowers interest rates o Lower interest rates increase investment o Higher investment is multiplied and leads to larger output The AD curve is shifts out if monetary policy is expansionary at any level of inflation Higher autonomous expenditure increases output demanded at any level of inflation increase output at any level of inflation o Higher or o Lower increases output at any level of inflation The AD curve shifts out if fiscal policy is expansionary or if any other component of autonomous expenditure increases at any level of inflation 3 Movement Along the Demand Curve Higher Inflation Higher Money Demand Higher Interest Rates Lower Output Demanded Lower Planned Aggregate Expenditure Lower Consumption and Investment Smaller multi plier More frequent transactions Bank Panic S h i f t s o f Decline in Consumer or Business Confidence Monetary Contraction t h e D e m Higher Taxes a n Lower Government Expenditure d C u Lower Exports Higher Imports r v e 4 PAE PAE 3 M 700bn PAE 3 M 350bn Y 3 M 350bn Y 3 M 700bn PAE 3 AD Y 3 M 350bn AD Y 3 M 700bn 5 Going Behind the Scenes The reason that Aggregate Expenditure is negatively related to inflation along the Aggregate Demand curve is that higher inflation raises money demand and interest rates in the financial market higher interest rates push consumption and investment down and therefore output is pushed down in the goods market the income expenditure diagram So higher inflation leads to lower expenditure and output Money Supply and Money Demand In the money market the interest rate is determined by the equality of money supply and money demand the latter depends on income and prices o Suppose the money supply is constant Higher inflation will mean you need more cash to buy the same amount of stuff So higher inflation increases the demand for cash You demand more cash which raises the price of borrowing cash That is at a given level of money supply higher inflation raises the interest rate Given o if if Given inflation and money 2 money supply demand a larger lowers interest rates this is a monetary expansion i MS 4 MD 3 MD 1 1 5bn rises falls Md rises Md falls M rises falls i MS M S 5 3 MD 1 1 5bn Given if rises falls if falls rises 1 7bn M 6 Interest Rates and Expenditure PAE Both consumption spending and planned investment spending decline when real interest rates increase PAE r 3 5 PAE r 5 PAE r 7 5 Y r 7 5 Other things equal if if rises falls Y r 5 C and I fall C and I rise Y r 3 5 Y falls Y rises The real interest rate is the difference between nominal interest rates and expected inflation In the short run expectations of inflation are constant so things that change the nominal interest rate will also change the real interest rate Income and Expenditure 1 1 Suppose 2400 0 5 900 400 600 1000 200 1100 This means 3550 0 5 1000 And 1 3550 1 0 5 1 1000 1 0 5 The real interest rate is the difference between nominal interest rates and expected inflation In the short run expectations of inflation are constant so things that change the nominal interest rate will also change the real interest rate 7 Because higher inflation raises interest rates higher inflation lowers output And because lower inflation lowers interest rates lower inflation raises output The current inflation rate determines the level of autonomous expenditure which determines short run equilibrium output is constant given is constant Y is constant falls falls Y rises rises rises Y falls We can express this in math as Shifts in AD Changes in Increases in money supply increase output demanded at any level of inflation Higher autonomous expenditure increases output demanded at any level of inflation Movement Along AD PAE PAE 1 Higher inflation lowers output demanded PAE 3 Y 3 Y 1 PAE 3 1 AD Y 3 Y 1 8 Aggregate Supply Short Run Aggregate Supply Inflation tends to change very slowly and by small amounts inflation is