Introductory Macroeconomics Lecture 12: The AD-AS Model II PDF

Introductory Macroeconomics Lecture 12: The AD-AS Model II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Working with the AD-AS model (1) Temporary shock (a) investment boom (b) confidence...

Introductory Macroeconomics Lecture 12: The AD-AS Model II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Working with the AD-AS model (1) Temporary shock (a) investment boom (b) confidence slump (c) energy price hike (2) Permanent shocks (a) increase in natural output (b) decrease in inflation target BOFAH Chapter 11 2  Recap: Aggregate Demand AD Curve: downward sloping relationship between π and Y Y − Y ∗ = −αγ(π − π ∗ ) + εD (AD) This is due to the fact that: – higher inflation π leads central bank to increase real interest rate r – higher real interest rate r reduces output Y Shocks to components of aggregate demand εD shift AD curve AD curve is flatter when central bank reaction coefficient α is higher (more aggressive response to inflation) 3  Recap: Aggregate Supply SRAS Curve: upward sloping relationship between π and Y π = π e + ϕβ(Y − Y ∗ ) + εS (SRAS) LRAS Curve: but in long run no relationship between π and Y π = π + ϕβ(Y − Y ∗ ) ⇒ Y = Y∗ (SRAS) This is due to the fact that: – short run Phillips Curve tradeoff between inflation π and unemployment u hence output Y – but in long run inflation expectations consistent π e = π, natural rate hypothesis holds, u = u∗ hence Y = Y ∗ Shocks to εS shift SRAS curve 4  Initial Long Run Equilibrium inflation LRAS SRAS0 (⇡ e = ⇡ ⇤ , "S = 0) ⇡⇤ AD0 ("D = 0) Y⇤ output 5  Worked Examples Now let’s see some examples Each example will begin in an initial long run equilibrium – in particular, π e = π ∗ – hence in absence of shocks Y = Y ∗ We will then consider different kinds of changes – temporary shocks εD , εS , short run effects but no long run effects – permanent shocks, short run effects and long run effects 6 Temporary Shocks 7  (1)(a) Investment Boom Suppose investment temporarily high, εD > 0 (Why?) On impact, AD curve shifts out along unchanged SRAS curve – output increases from Y ∗ to Y1 – inflation increases from π ∗ to π1 Intuition – increase in investment demand increases output, decreases unemployment, increases wages and business costs, hence increases inflation along SRAS – important: inflation expectations remain ‘anchored ’ – households / firms retain beliefs about long term inflation despite higher short term inflation - implicitly assumes central bank is credible Long run equilibrium unchanged, inflation returns to π ∗ and output returns to Y ∗ as investment returns to trend. 8  Investment Boom inflation LRAS SRAS0 ⇡1 ⇡⇤ AD1 "D > 0 AD0 Y⇤ Y1 output 9  (1)(b) Confidence Slump Suppose consumer confidence temporarily low, εD < 0 (Why?) On impact, AD curve shifts in along unchanged SRAS curve – output decreases from Y ∗ to Y1 – inflation decreases from π ∗ to π1 Intuition – decrease in consumption demand decreases output, increases unemployment, decreases wages and business costs, hence decreases inflation along SRAS important (again): inflation expectations remain anchored Long run equilibrium unchanged, inflation returns to π ∗ and output returns to Y ∗ as consumer confidence recovers 10  Confidence Slump inflation LRAS SRAS0 ⇡⇤ ⇡1 "D < 0 AD0 AD1 Y1 Y⇤ output 11  (1)(c) Energy Price Spike Suppose energy prices temporarily high, εS > 0 (Why?) On impact, SRAS curve shifts up along unchanged AD curve – output decreases from Y ∗ to Y1 – inflation increases from π ∗ to π1 Intuition – increase in inflation leads central bank to increase real interest rates, thereby reducing investment and consumption, hence output decreases along AD In the long run, inflation returns to π ∗ and output returns to Y ∗ as energy prices return to trend 12  Energy Price Spike inflation LRAS SRAS1 SRAS0 "S > 0 ⇡1 ⇡⇤ AD0 Y1 Y⇤ output 13  Demand vs. Supply Shocks Demand shocks drive inflation and output in same direction – both rise in response to positive demand shocks – both fall in response to negative demand shocks Supply shocks drive inflation and output in opposite directions – inflation rises and output falls in response to positive supply shocks – inflation falls and output rises in response to negative supply shocks By looking at whether inflation and output are moving together or not, we have a tell-tale sign of whether demand shocks or supply shocks are dominant 14  Slopes of Demand and Supply Curves For given sized shock, slope of curves determines whether large or small inflation and output responses e.g., if AD curve is flat, most of the response to supply shock is a change in output with little change in inflation Slope of AD curve is dπ 1 =− dY αγ (requires you to re-arrange AD curve so inflation π is on the LHS) AD curve is flat if α or γ is high, e.g., higher α implies central bank reacts aggressively to inflation 15  Flat AD Curve inflation LRAS SRAS1 SRAS0 ⇡1 ⇡10 ⇡⇤ AD00 high ↵ d⇡ 1 = dY ↵ AD0 Y10 Y1 Y⇤ output 16 Permanent Shocks 17  Growth in Potential Output Suppose output permanently high, Y ∗ higher (Why?) Shifts both LRAS and LRAD curves out Y − Y ∗ = −αγ(π − π ∗ ) (LRAD) Y = Y∗ (LRAS) Output rises, but no effect on inflation, remains at π ∗ Growth in output need not increase inflation, depends on whether growth is due to LR increase in Y ∗ or SR increase in εD 18  (2)(a) Growth in Potential Output inflation LRAS0 LRAS1 ⇡⇤ AD1 AD0 Y⇤ Y ⇤⇤ output 19  (2)(b) Disinflation Suppose central bank sets permanently lower inflation target AD curve shifts down permanently along unchanged SRAS curve – output decreases from Y ∗ to Y1 – inflation decreases from π ∗ to π1 Over time, inflation expectations π e fall from π ∗ to new π ∗∗ , shifting down SRAS until new long run equilibrium at Y ∗ and π ∗∗ Disinflation creates recession until expected inflation adjusts. Economy starts recovery only after expectations fall in line with new target Size of recession is mild if SRAS is steep, but deep if SRAS is flat 20  Disinflation inflation LRAS SRAS0 ⇡e = ⇡⇤ ⇡⇤ ⇡1 AD0 ⇡ ⇤⇤ target ⇡ ⇤ AD1 target ⇡ ⇤⇤ Y1 Y⇤ output 21  Disinflation inflation SRAS00 LRAS SRAS0 ⇡⇤ ⇡1 ⇡10 AD0 ⇤⇤ target ⇡ ⇤ ⇡ AD1 target ⇡ ⇤⇤ Y1 Y10 Y⇤ output 22  Learning Outcomes 1 Understand and explain the impacts and long run outcomes of demand and supply shocks, linking the shock back to intuitive economic behaviour and chains of causality. 2 Understand and explain the importance of anchored inflation expectations. 3 Understand and explain the difference between a demand shock and a supply shock. 4 Understand and explain the impact of varying slope parameters within the model (α, γ, ϕ, β) linking them back to intuitive economic interpretation. 5 Understand and explain long run shocks in relation to trend growth in output and policy change from the central bank. 23  New Formula(s) and Notation None! 24  Next Lecture Beginning of topics in long run macro Savings and capital formation – basic saving and investment concepts – equilibrium real interest rate – examples: shocks to determinants of saving and investment BOFAH chapter 4 25