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Money & Banking ­ MGT411
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Lesson 43
THE AGGREGATE SUPPLY CURVE
The aggregate supply curve tells us where on the aggregate demand curve the economy will end
up, explaining the relationship between inflation and real output in the process.
The short run aggregate supply curve tells us where the economy will settle at any particular
time
Long run curve tells us the levels of inflation and output the economy is moving toward.
Inflation persistence
Inflation tends to change slowly; when it is low one year it tends to be low the next year, and
when it is high it tends to stay high. This is called inflation persistence
If inflation remains steady over shorter periods, while real output adjusts, then the short-run
aggregate supply curve must be flat at the current level of inflation
Figure: Inflation Statistics of Pakistan
Inflation statistics of Pakistan
14
12
10
8
6
4
2
0
Figure: Inflation in the Euro Area, 1991-2004
This figure shows the 12-month change in the harmonized
index of consumer prices for the 12 countries of the euro area.
6
5
4
3
2
1
0
1992
1994
1996 1998
2000
2002
2004
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Money & Banking ­ MGT411
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Inflation is persistent for two reasons
First, when people expect inflation to continue, they adjust their prices and wages
accordingly.
When people expect inflation in the near future they raise wages and prices in a way that
causes the inflation they expect to occur.
Therefore, current inflation is at least partially determined by expected inflation
Inflation is persistent for two reasons
Second, not all wage and price decisions are made at the same time.
Price and wage adjustments are staggered, and this slows down the adjustment process
causing persistence in inflation
The fact that inflation is persistent means that it is fixed in the short run, so the short-run
aggregate supply curve is horizontal at the current level of inflation.
Figure: Short Run Aggregate Supply Curve
Inflation persistence means the short run aggregate supply curve is horizontal.
Inflation ()
Current
Inflation
Short Run Aggregate Supply Curve (SRAS)
Output (Y)
Firms simply do not adjust the rate of their price increases in the short run; instead, they
adjust the quantities they produce and sell.
Over periods of several years or more, inflation does change, shifting the short-run
aggregate supply curve up or down
Shifts in the Short-Run Aggregate Supply Curve
There are two reasons why the short run aggregate supply curve can shift
Deviations of current output from potential output, causing changes in inflation
Changes in external factors driving production costs
Output Gaps
When current output equals potential output so that there is no output gap, the short-run
aggregate supply curve remains stable
But when current output rises above or falls below potential output, so that an output gap
develops, inflation will rise or fall.
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Money & Banking ­ MGT411
VU
Figure: Shifts in the Short Run Aggregate Supply Curve
Response to an Output Gap
When current output rises above potential output, creating an
expansionary output gap, the short run aggregate supply curve shifts
upward. When current output falls below potential output, creating a
recessionary output gap, the short run aggregate supply curve shifts
downward.
Inflation ()
When current output
is above than the
potential output, the
SRAS shifts up
Current
SRAS
Inflation
When current
output is below
the potential
output, the SRAS
shifts down
Potential
Output (Y)
Output
When current output is below potential output, part of the economy's capacity is idle, and firms
tend to raise their prices and wages less than they did when current output equaled potential
output.
When current output exceeds potential output, the opposite happens; firms increase their prices
and wages more than they would if they were operating at normal levels
Thus when current output deviates from potential output, inflation adjusts, and the effect takes
time to be felt.
Economists have differing views on how quickly inflation reacts and the short-run aggregate
supply curve shifts.
Those who believe in flexible prices think it happens quickly,
While those who emphasize that many price and wage decisions involve long-term contracts
think the adjustment is sluggish.
Inflation Shocks
An inflation shock is a change in the cost of producing output and causes the short-run
aggregate supply curve to shift.
This can be the result of changes in the cost of raw materials or labor, or (as is most common) a
change in the price of energy.
A positive inflation shock causes the short-run aggregate supply curve to shift upward, causing
inflation to rise
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Money & Banking ­ MGT411
VU
Figure: Shifts in the Short-Run Aggregate Supply Curve
Response to an inflation shock
A rise in labor costs, the prices of raw materials or expected future level of inflation creates an inflation
shock that shifts the SRAS upward, causing inflation to rise.
Inflation ()
Positive Inflation Shock
An increase in the cost of
production shifts the SRAS up
Output (Y)
The Long-Run Aggregate Supply Curve
In the long run the economy moves to the point where current output equals potential output,
while inflation is determined by money growth
The long-run aggregate supply curve is vertical at the point where current output equals
potential output.
Figure: The Long Run and Short Run Aggregate Supply Curves
The long run aggregate supply curve is vertical at the point where current output
equals the potential output.
Inflation ()
LRAS
Current
SRAS
Inflation
Potential Output
Output (Y)
Changes in expected inflation operate like cost shocks, shifting the short-run aggregate supply
curve up and down.
For the economy to remain in long-run equilibrium, then, in addition to current output equaling
potential output, current inflation must equal expected inflation
At any point along the long-run aggregate supply curve, current output equals potential output
and current inflation equals expected inflation
Potential output is constantly rising as a result of investment and technological improvements
(the sources of economic growth), which increase the normal output level.
Changes in the economy's productive capacity will shift the long-run aggregate supply curve;
increases will shift it right and decreases will shift it left.
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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