EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION

<< THE AGGREGATE SUPPLY CURVE:Inflation Shocks

SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY >>

Money & Banking MGT411

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 (š)

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 (š)

LRAS

Current

Inflation

SRAS

Expansio

nary

Output

ADC

Gap

Potential

Current

Output (Y)

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

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Money & Banking MGT411

LRAS

Inflation (š)

Current

Inflation

SRAS

Recessionary

ADC

Gap

Output (Y)

Current

Potential

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 (š)

LRAS

SRAS

Target Inflation

(šT)

New AD

Original AD

Potential

Current

Output (Y)

Output

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

1. Start at Long-Run Equilibrium

Y = Potential Output

š = Target Inflation

2. Aggregate Demand Shifts Right

Original AD shifts to New AD

Y > Potential Output

Inflation Is Unchanged

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Money & Banking MGT411

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

(š)

SRAS

Target

Inflation

(šT)

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

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 (š)

LRAS

New SRAS

Old SRAS

Target Inflation

(šT)

ADC

Current

Potential

Output (Y)

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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