Aggregate Demand and Supply: Macroeconomic Equilibrium PDF

T H E AG G R E G AT E D E M A N D A N D S U P P LY : M AC RO E C O N O M I C E Q U I L I B R I U M Week 8 V I VA L D O MENDES I NSTITUTO UNIVERSITÁRIO DE LISBOA – ISCTE- IUL [email protected] N OVEMBE R 2024 1/23 1. R e c a p : t h...

T H E AG G R E G AT E D E M A N D A N D S U P P LY : M AC RO E C O N O M I C E Q U I L I B R I U M Week 8 V I VA L D O MENDES I NSTITUTO UNIVERSITÁRIO DE LISBOA – ISCTE- IUL [email protected] N OVEMBE R 2024 1/23 1. R e c a p : t h e A D & A S C u rv e s 2/23 T h e A D C u rv e Recall the AD curve Y = m · A − m · φ · (r + λπ) (1) where: A = C + I − d · f + G + NX − c · T (Autonomous Aggregate Demand) m= 1 1−c (multiplier) φ=b+d+x (to simplify notation) λ (parameter) 3/23 A D : M ov e m e n t s - A l o n g v s S h i f t s Y = m · A − m · φ · (r + λπ) A movement along the AD curve: π changes, everything else constant. For example: π ↑ ⇒ r ↑ ⇒ {I ↓ , C ↓ , N X ↓} ⇒ Y ↓ A shift in the AD curve: π constant, everything else changes. For example:  A ↑, r ↓ ⇒ Y ↑ 4/23 T h e A S c u rv e Recall the AS curve π e +γ Y − Y P + ρ
π = |{z} (2) =π−1 Short-run: Y 6= Y P and π 6= π e and the AS has a positive slope given by γ. Long-run: Y = Y P and π = π e and the AS is vertical with Y = Y P. 5/23 A D : M ov e m e n t s - A l o n g v s S h i f t s π e +γ Y − Y P + ρ
π = |{z} =π−1 A movement along the AS: Y changes and everything else constant: Y ↑ ⇒ π↑ Y ↓ ⇒ π↓ A shift in the AS: Y constant, everything else changes. For example: ρ ↑ ⇒ π↑ , πe ↑ ⇒ π ↑ , YP ↑ ⇒ π ↓ 6/23 2. M ac ro e c o n o m i c E q u i l i b r i u m : A D = A S 7/23 T h e S h o rt Ru n E q u i l i b r i u m On this equilibrium, we will have: Y = Y ∗ , π = π ∗ 8/23 T h e S h o rt Ru n E q u i l i b r i u m a b ov e Y P Suppose the economy starts with Y1 > Y P : 9/23 P r e v i o u s S l i d e ’ s D e ta i l s : R e a d at H o m e Consider that Y1 > Y P : point 1. Unemployment is below the natural unemployment rate: U < Un and wages increase (Phillips curve). Firms raise their prices. Inflation rises above its initial level: π > π1. In the next period, expectations of inflation, π e , are revised upward due to rising inflation and the short-run AS curve shifts upwards from AS1 to AS2. As long as Y > Y P wages and prices will continue to increase, causing the AS curve to shift upward: self-correcting supply mechanism. The process repeats itself until Y = Y P , i.e., the economy reaches its long-run equilibrium. 10/23 T h e S h o rt Ru n E q u i l i b r i u m b e l ow Y P Suppose the economy starts with Y1 < Y P : 11/23 P r e v i o u s S l i d e ’ s D e ta i l s : R e a d at H o m e The short-term equilibrium is below potential GDP: Y1 < Y P : point 1. Unemployment is above the natural rate of unemployment: U > Un and inflation falls below its initial level: π < π1. Inflation expectations, π e , are revised downward due to falling inflation, shifting the short-run AS curve downward from AS1 to AS2. As long as Y < Y P , expected inflation declines, shifting the AS down. The process repeats until Y = Y P and the long-run equilibrium is reached. 12/23 3. Ag g r e g at e D e m a n d S h o c k s 13/23 A Positive Demand Shock Consider that A increases 14/23 P r e v i o u s S l i d e ’ s D e ta i l s : R e a d at H o m e We start from the long-run equilibrium at point 1. The AD curve shifts to the right: we will have point 2. At this point, Y > Y P and inflation increases. The supply self-correction mechanism comes into operation until it passes to AS3 and GDP equals Potential GDP. The short-run effect: an economic expansion and an increase in inflation. The long run effect: inflation rises, but the economy returns to Potential GDP (Y P ). 15/23 4. Ag g r e g at e S u p p ly S h o c k s 16/23 A T e m p o r a ry N e g at i v e S u p p ly S h o c k Suppose that oil prices increase temporarily (ρ ↑) 17/23 P r e v i o u s S l i d e ’ s D e ta i l s : R e a d at H o m e We start from the long-run equilibrium at point 1. An increase in ρ shifts AS to the left, from AS1 to AS2. We move to point 2, where Y < Y P leading to an increase in inflation. However, the productive capacity of the economy (the LRAS) remains unchanged. The self-correcting supply mechanism will make the adjustment along AD1, back to the initial equilibrium point. The short run effect: an economic recession and an increase in inflation. In the long run: output and inflation return to their initial equilibrium, Y P and π = 2%. 18/23 P e r m a n e n t S u p p ly S h o c k s A permanent negative supply shock: a war that cuts off forever the supply of cheap oil or gas and leads to permanently higher energy costs. A permanent negative supply shock increases inflation and reduces output both in the short and long run. Another permanent negative supply shock: regulations that cause the economy to be less efficient. A permanent positive supply shock: the development of new technology that raises productivity or an increase in the supply of labor. A permanent positive supply shock lowers inflation and raises output both in the short and long run. 19/23 A P e r m a n e n t N e g at i v e S u p p ly S h o c k A decrease in potential output from Y1P = $10 trillion to Y1P = $8 trillion. 20/23 P r e v i o u s S l i d e ’ s D e ta i l s : R e a d at H o m e We start from the long-run equilibrium at point 1. A permanent (negative) supply shock shifts supply to the left, from LRAS1 to LRAS2. Inflation increases, shifting short-run supply to the left, from AS1 to AS2, moving to point 2. At this point we see Y > Y P , which causes inflation to increase again, shifting AS to AS3. The new long-run equilibrium occurs at point 3. The short-run effect: a fall in GDP and an increase in inflation. In the long run: potential GDP falls and inflation rises, both permanently. 21/23 5. Readings 22/23 Readings Read Chapter 12 of the adopted textbook: Frederic S. Mishkin (2015). Macroeconomics: Policy & Practice, Second Edition, Pearson Editors. 23/23