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Money & Banking ­ MGT411
VU
Lesson 44
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
Inflation ()
Short run Equilibrium
Current
SRAS
Inflation
ADC
Actual Output
Output (Y)
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.
Inflation ()
LRAS
2
Current
1
Inflation
SRAS
Expansio
nary
Output
ADC
Gap
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
139
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Money & Banking ­ MGT411
VU
LRAS
Inflation ()
Current
1
Inflation
SRAS
2
Recessionary
ADC
Gap
Output (Y)
Current
Potential
Output
Output
This shows that the economy does indeed have a self-correcting 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
Inflation ()
LRAS
2
SRAS
Target Inflation
(T)
New AD
Original AD
Potential
Current
Output (Y)
Output
Output
Short-Run Equilibrium Inflation and Output Following an Increase in Aggregate Demand
1. Start at Long-Run Equilibrium
Y = Potential Output
= Target Inflation
2. Aggregate Demand Shifts Right
Original AD shifts to New AD
Y > Potential Output
Inflation Is Unchanged
140
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Money & Banking ­ MGT411
VU
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
Inflation
LRAS
()
3
2
SRAS
Target
Inflation
(T)
New ADC
Potential
Output (Y)
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.
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Money & Banking ­ MGT411
VU
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".
Figure: The Effects of a Positive Inflation Shock on Short-Run Equilibrium
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.
Inflation ()
LRAS
2
New SRAS
1
Old SRAS
Target Inflation
(T)
ADC
Current
Potential
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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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY