Notes Chapter 7 Point of the class Math • Simple manipulations Model building • Modifying a familiar equation to yield a new result, and then simplifying it Economic concepts and intuition • Short‐run versus medium‐run • Neutrality of Money • Disinflation • Medium‐run effects on private spending of changes in public spending Definitions • Aggregate Supply Relation • Aggregate Demand Relation • Neutrality of Money • Stagflation Homework Problems On webpage Facts • In the short run, inflation and unemployment are inversely correlated. • There is no simple medium‐run correlation between inflation and unemployment. • Inflation tends to change slowly. • When inflation changes, it tends to reduce the quantity of output demanded. • Inflation is affected by many kinds of shocks: changes in spending, changes in costs, changes in expectations. Model Building Building Blocks Aggregate Deman d: AD If the IS curve is 󰇛󰇜󰇟󰇠 and the LM curve is  ⁄ then the combination is 1󰇣󰇛1󰇜󰇤   It’s useful to emphasize the role of prices by separating the above equation into two terms: 1󰇣󰇛1󰇜󰇤1󰇣󰇛1󰇜󰇤   To save ink, one could just say that 1󰇣󰇛1󰇜󰇤 1󰇣󰇛1󰇜󰇤  So that  We can think of this as the Aggregate Demand equation (AD). Let’s see if the algebra matches the in‐tuition and the common sense. The equation says that • Higher inflation lowers output demanded. The idea is that o Higher prices reduce real money supply; o Lower real money supply raises interest rates through the LM relation (at any level of Y, so the LM curve shifts up); o Higher interest rates reduce investment (movement along the IS curve); o Lower investment is multip‐lied and leads to lower out‐put. The AD curve is downward sloping. Along the AD‐π curve, changes in prices cause changes in output. • Increases in money supply increase output demanded, at any level of prices. The idea is that o Higher  lowers interest rates, shifting the LM curve down; o Lower interest rates increase output along the IS curve: any level of prices becomes asso‐ciated with a higher level of output. The AD curve shifts out if monetary policy is expansio‐nary. A shift in the AD‐π curve increases output at any price level. Example: higher prices reduce equilibrium output. Suppose  928 and  1572 P   / Y 0.25 928 1572 6290 7217 0.5 928 1572 3145 4072 0.75 928 1572 2097 3024 1 928 1572 1572 2500 1.25 928 1572 1258 2186 1.5 928 1572 1048 1976 1.75 928 1572 899 1826 2 928 1572 786 1714 Example: higher money supply increases equilibrium output at any price level. Suppose  928 and  1655 0.25 928 1655 6621 7548 0.5 928 1655 3310 4238 0.75 928 1655 2207 3134 1 928 1655 1655 2583 1.25 928 1655 1324 2252 1.5 928 1655 1103 2031 1.75 928 1655 946 1873 2 928 1655 828 1755 • Higher autonomous expenditure  in‐creases output demanded, at any level of prices. The idea is that o Higher , , , or  increase output, shifting the IS curve to the right;  Lower  or lower  (exogenous money de‐mand) shift the IS curve to the right; o Higher output raises money de‐mand and moves the economy along the LM curve (to higher in‐terest rates); The AD‐π curve shifts out if fis‐cal policy is expansionary (or if any other component of autonomous expenditure increases). Example: higher autonomous spending increases equilibrium output at any price level. Suppose  1100 and  1572 P   / Y 0.25 1100 1572 6290 7390 0.5 1100 1572 3145 4245 0.75 1100 1572 2097 3197 1 1100 1572 1572 2672 1.25 1100 1572 1258 2358 1.5 1100 1572 1048 2148 1.75 1100 1572 899 1999 2 1100 1572 786 1886 Y P ADAD’Aggregate Deman dInflation: ADπ It will be useful to rewrite the AD equation as a relation between inflation and output. That’s quite easy to do if we realize that 󰇛1󰇜 So that1 1 We can think of this as the Aggregate Demand‐Inflation equation (AD‐π). Again, • Higher inflation lowers output demanded. o Higher inflation leads to higher pric‐es, which reduce real money supply, raise interest rates through the LM relation, reduce investment, leading to lower output. The AD‐π curve is downward slop‐ing. • Increases in money supply increase output demanded, at any level of inflation. o Higher  lowers interest rates, shifting the LM curve down; Lower interest rates increase output along the IS curve: any level of inflation becomes associated with a higher level of output. The AD‐π curve shifts out if monetary policy is expansionary. • Higher autonomous expenditure  increases output demanded, at any level of inflation, by shifting the IS curve. o The AD‐π curve shifts out if fiscal policy is expansionary (or if any other component of autonomous expenditure increases). Along the AD‐π curve, changes in inflation cause changes in output.  A shift in the AD‐π curve increases output at any inflation rate. 1 Also, change  into 󰇣󰇛󰇜󰇤󰇣 󰇡󰇢󰇤, so that it’s now divided by last year’s prices. Yπ AD AD’Aggregate SupplyInflation: ASπ Along the aggregate supply curve, we can think of firms trying to decide how much to charge for what the consumers, firms,