EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

Short-Run Equilibrium

• Short-run equilibrium is determined by the intersection of the aggregate demand curve with the short-run aggregate supply curve.

Figure: Short Run Equilibrium of Output and Inflation
Inflation and actual output are determined by the intersection of the SRAS curve with

the ADC

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

Adjustment to Long-Run Equilibrium

• When current output exceeds potential, the resulting expansionary gap exerts upward pressure on inflation, shifting the short-run aggregate supply curve upward, a process that continues until output returns to potential; at this point inflation stops changing.

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:


Potential Current Output (Y) Output Output

• If current output is lower than potential output, the resulting recessionary gap places downward pressure on inflation, causing the short-run aggregate supply curve to shift downward, and once again the process continues until current output returns to potential

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

Current Potential Output (Y) Output Output

  • This shows that the economy does ve recting mechanism and that the manner in which the short-run aggregate supply curve shifts in response to output gaps reinforces our conclusion that the long-run aggregate supply curve is vertical
  • In long-run equilibrium, current output equals potential output and current inflation is steady and equal to target inflation, which equals expected inflation

The Impact of Shifts in Aggregate Demand on Output and Inflation

  • Suppose aggregate demand shifted right as a result of an increase in government purchases.
  • At first, current output rises but inflation does not change.
  • But the higher level of output creates an expansionary gap and the short-run aggregate supply curve starts to shift upward and inflation rises

Short-Run Equilibrium Inflation and Output Following an Increase in Aggregate Demand

1. Start at Long-Run Equilibrium

  • Y = Potential Output
  • π = Target Inflation
  • 2. Aggregate Demand Shifts Right
  • Original AD shifts to New AD
  • Y > Potential Output
  • Inflation Is Unchanged

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

Current Output

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

  • Short-run equilibrium moves from point 1 to point 2
  • Higher inflation moves policymakers along their reaction curve, leading them to raise the real interest rate and moving the economy upward along the new aggregate demand curve. Output then begins to fall back toward its long-run equilibrium level.
  • The economy will settle at the point at which the new aggregate demand curve crosses the long-run aggregate supply curve and current output again equals potential output

Adjustment of Short-Run Equilibrium Inflation and Output Following an Increase in Aggregate Demand

Adjustment:

  • At the Short-Run Equilibrium point 2:
  • Y > Potential Output
  • SRAS begins to shift up
  • Output begins to fall
  • Inflation begins to rise as economy moves along New AD
  • With no policy response, economy moves to point 3, where Current inflation >Target inflation
  • If central bankers simply sit and watch as the aggregate demand curve shifts to the right, inflation will rise
  • So long as monetary policymakers remain committed to their original inflation target, they will need to do something to get the economy back to the point where it began—point “1”
  • An increase in government purchases raises the long-term real interest rate.
  • Policymakers will compensate by shifting their monetary policy reaction curve to the left, increasing the real interest rate at every level of inflation
  • When the monetary policy reaction curve shifts, the aggregate demand curve shifts with it.
  • The aggregate demand curve will shift to the left, bringing the economy back to long-run equilibrium.
  • An increase in aggregate demand causes a temporary increase in both output and inflation.
  • A decline in aggregate demand causes a temporary decline in both output and inflation
  • This discussion implies that whenever we see a permanent increase in inflation, it must be the result of monetary policy.
  • That is, if inflation goes up or down and remains at its new level, the only explanation is that central banker must be allowing it to happen.
  • They have changed their inflation target, whether or not they acknowledge the change explicitly.

The Impact of Inflation Shocks on Output and Inflation

• An inflation shock shifts the short-run aggregate supply curve (such as an oil price increase)

• A positive shock moves it to a higher level, and the result is higher inflation and lower output, a situation called “stagflation”.

A positive inflation shock shifts the short-run aggregate supply curve upward, moving short run equilibrium from point 1 to point 2. Inflation rises and output falls.

money banking  EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION:

Inflation (π)

New SRAS Old SRAS

Target Inflation (π T)

2
1
Current Po tential ADC

Output (Y) Output Output

  • But the decline in output exerts downward pressure on inflation, causing the short-run aggregate supply curve to shift down
  • Inflation falls and output rises until the economy returns to the point where current output equals potential output and inflation equals the central bank’s target.
  • An inflation shock has no affect on the economy’s long-run equilibrium point; only a change in
  • Potential output or a change in the central bank’s inflation target can accomplish that.
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