Inflation & Aggregate Supply Chapter 15

Chapter 15 Learning Objectives: you should be able to: 1.Define the Fed’s policy reaction function. 2.Explain why the AD curve has a downward slope. 3.Identify situations that will cause the AD curve to shift. 4.Explain why the SRAS curve is horizontal. 5.Show output gaps on the AD-AS diagram. 6.Explain what it means to say the economy is self-correcting.

Fed Policy Reaction Function The real rate of interest targeted by the Fed as a function of the rate of inflation and the output gap.

Fed’s Policy Reaction Function

AD has a negative slope because … 1.Fed slows economy when inflation rises (I↓, C↓). 2.Households lose real wealth when inflation rises and as a result consume less (C↓). 3.As inflation rises poor people lose out more than rich people and poor people have a higher marginal propensity to consume (C↓). 4.Higher inflation causes uncertainty which puts a damper on spending (I↓, C↓).

Movement along the curve … … means that aggregate demand is changing as a result of a change in the inflation rate.

Shifts of the curve … … mean that aggregate demand is changing as a result of a change in something other than the inflation rate.

Shift Factors Changes in C, I, G, NX that are unrelated to inflation. moRe: shift Right Less: shift Left

How will the following affect the AD curve? Military spending is reduced. Firms throughout the country update their computer technology. Households increase their level of saving. Taxes are reduced. Exports increase.

Short-Run Aggregate Supply Curve Horizontal at the current rate of inflation. It says that inflation is sticky in the short-run. A change in AD will affect output but not inflation in the short-run.

Assume that employers and workers agree that real wages should rise by 2 percent next year. a.If inflation is expected to be 2 percent next year, what will happen to nominal wages next year? b.If inflation is expected to be 4 percent next year, what will happen to nominal wages next year? c.Use your answers from parts a and b to explain how an increase in expected inflation will tend to affect the following years actual rate of inflation.

Output Gaps & Inflation Recessionary gap causes inflation to fall. Inflationary (expansionary) gap causes inflation to increase.

Long Run Aggregate Supply Vertical at the level of potential output. It says that in the long-run all output gaps are eliminated.