1 Short‐Run Effect of Shocks Autonomous Planned Aggregate Expenditure declines at any level of inflation. Output falls. Equilibrium output now occurs below potential output: a recessionary gap opens. The recessionary output gap leads to higher unemployment; workers accept smaller raises. Firms pass the cost‐savings along to their customers by raising prices less fast: inflation falls. (lower consumer confidence, less business confidence, lower government spending, higher taxes, an reduction in net exports, etc.) There is a favorable inflation shock. Firms are able to raise prices more slowly because their costs rise more slowly. The AS curve shifts down, so that inflation falls at any level of output. Lower inflation reduces money demand, lowers interest rates, and expands expenditure and output along the AD curve. An expansionary gap results. (lower costs of raw materials, lower costs of intermediate inputs, lower wages, weaker labor unions, lower costs of energy, lower expected inflation, etc.) ߨ௧ାଵAS ߨ௧ൌߨ௘ܻכൌܻ௧ ܻ௧ାଵ ADLRAS AS’ߨ௧ൌߨ௡௘௪௘ߨ௧ାଵAS AD’ ߨ௧ൌߨ௘ܻכൌܻ௧ ܻ௧ାଵADLRAS ASADπ YY*LRAS2 Potential Output increases. The LRAS curve shifts out, so that more output can be produced at any level of inflation. Since the economy is capable of producing more, it is also capable of producing more cheaply. Inflation falls. The economy is already at Long‐Run equilibrium. (This also means that the AS curve shifts down, so that equilibrium output matches the new level of potential output. The new AS curve is not drawn for neatness.) (increased worker productivity, greater availability of capital, labor, or natural resources, improvement in the legal, economic, or political structure of the economy, etc.) Autonomous Planned Aggregate Expenditure increases at any level of inflation. There is an adverse inflation shock. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS ߨ௧ାଵߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS ܻ௡௘௪כൌܻ௧ାଵLRAS’3 Potential Output decreases. Consumer confidence declines. Business confidence improves: investment rises as firms by more capital goods. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS 4 Government expenditure falls. Congress passes a Tax Cut. Net Exports improve due to economic recovery abroad. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS 5 The cost of raw materials goes up. Energy costs (gas, electricity, etc.) decline. Expectations of inflation fall. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS 6 Worker Productivity improves. An increase in population increases potential output. The discovery of a new technology increases the country’s productive capacity. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS 7 Transition to the Long Run: AD shocks There is a recessionary gap caused by a decrease in spending. Policymakers do not have an activist policy response. They “accommodate the AD shock:” they allow output to be low for a while. The negative AD shock moves the economy to point (2). If Y<Y*, then π<πe. If inflation is below what people expect, eventually people will adjust their expectations. Since their expectations turned out to be too high, they will lower their expectations: Expected Inflation will fall. As πe falls, AS shifts down. The economy moves along the AD curve. Inflation falls, increasing output. The process continues until Y=Y*, at point (3). There is an expansionary gap caused by an increase in spending. Policymakers do not have an activist policy response. They “accommodate the AD shock:” they allow output to be high for a while. There is a recessionary gap caused by a decrease in spending. Policymakers have an activist policy response. They “do not accommodate the AD shock:” they fight the decrease in output. AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS AS ߨ௧ൌߨ௘ܻכൌܻ௧ ADLRAS ߨ௧ାଵAS AD’ ߨ௧ൌߨ௘ܻכൌܻ௧ ܻ௧ାଵLRAS AS’ ߨ௧ାଶൌߨ௡௘௪௘AD 23 1 8 There is an expansionary gap caused by an increase in spending. Policymakers have an activist policy response. They “do not accommodate the AD sho