Burda6e - PPT - ch13 (2) 1

Oxford University Press, 2012. All rights reserved.
Burda & Wyplosz MACROECONOMICS 6

th
edn
Chapter 13
Aggregate Demand and
Aggregate Supply
Burda & Wyplosz MACROECONOMICS 6/e
Figure 13.1: Aggregate Demand
and Aggregate Supply
Aggregate Demand and Aggregate Supply,
Short Run and Long Run
Figure 13.1
Figure 13.1 (a): Animation 1 (Short
Run)
Output
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Figure 13.1 (a)
AS
AD
AS
AD
Aggregate Demand and Aggregate Supply:
Short Run
Figure 13.1 (b): Animation 2 (Long
Run)
Output
I
n
f
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a
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i
o
n

Figure 13.1 (b)
LAD
Aggregate Demand and Aggregate Supply:
Long Run
Figure 13.1 (c): Animation 3
(Transition)
Aggregate Demand and Aggregate Supply
Transition from Short Run to Long Run
Output
I
n
f
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a
t
i
o
n

Figure 13.1 (c)
LAS
AS
LAD
AD
AS
AD
Figure 13.2: Inflation in Denmark
and the Euro Area
Inflation in Denmark and the Euro Area
1992-2010
Figure 13.2
Source: IMF, World Economic Outlook Database
Figure 13.3: Aggregate Demand
Curve, Fixed Exchange Rates
I
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Output
I
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Output

IFM
LAD line
IS

A

A

A

A

A

A

Y

Y

Y

Y

t*

t

IS

IS

Y

Y

t

Figure 13.3
i*

AD
The Aggregate
Demand Curve
Under Fixed
Exchange Rates
Figure 13.3 (a): Animation 1 (Initial
equilibrium)
Aggregate Demand, Fixed Exchange Rates
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Output
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Output

IFM
IS

A

A

LAD line
t*

Y

Y

Interest rates
determined by
rate of return
on assets in
the rest of the
world.
We start from
a general
equilibrium at
point A where
t = t-
Figure 13.3 (a)
i*

Figure 13.3 (b): Animation 2
(Increase in Inflation)
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Output
I
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Output

IFM
LAD line
IS

A

A

A
A

Y

Y

t*

IS

Y

t

Because
prices at
home have
risen faster
than abroad,
the demand
for our
exports will
decrease,
shifting the IS
curve to the
left.
Figure 13.3 (b)
Suppose domestic inflation t > t- ...
Y

(Decrease in Inflation)
R
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Output
I
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Output

IFM
LAD
IS

A

A

A

A

A

A

Y

Y

Y

Y

t*

t

IS

IS

Y

Y

t

Because prices
at home have
risen more slowly
than abroad, the
demand for our
exports will
increase, shifting
the IS curve to
the right.
Figure 13.3 (c)
Now suppose domestic inflation t < t-...
i*

AD
Figure 13.4: Shifts in the AD Curve
Shifts in the Aggregate Demand Curve
Figure 13.4
AD
2
Figure 13.4 (a): Animation 1
Shifts in the Aggregate Demand Curve
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Output
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Output

IFM
LAD
IS
1
A
1
A
2
A
1
Y
1
Y
1
t

IS
2
A
2
Y
2
Y
2
Suppose
G increases:
IS shifts to the
right.
Figure 13.4 (a)
AD
1
Exogenous
shift in IS
shifts AD in
same
direction
Figure 13.5: AD & AS Under Fixed
Exchange Rates
Aggregate Demand and Supply
Under Fixed Exchange Rates
Figure 13.5
Figure 13.5 (a): Animation 1 (Long
Run)
Under Fixed Exchange Rates: Long Run
I
n
f
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a
t
i
o
n

A
0
LAS
Output gap
LAD
t
*
Assumption: real
exchange rate is
unchanged
Any inflation rate
is sustainable
along the output
trend.
Figure 13.5 (a)
Long run:
t = t* =

Long run:
output gap
equals zero
Figure 13.5 (b): Animation 2 (Short
Run)
Under Fixed Exchange Rates: Short Run
I
n
f
l
a
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i
o
n
AS
AD
A
0
LAS
LAD
t
*
The short-run
curves AS and AD
pass through the
long-run equilibrium
point A.
Figure 13.5 (b)
Output gap
Figure 13.6 Fiscal policy, fixed
exchange rates
Fiscal Policy Under
Fixed Exchange
Rates
Figure 13.6
(Anchors of System)
Fiscal Policy Under Fixed Exchange Rates (1)
Figure 13.6 (a)
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Output gap
I
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Output gap 0

0

LAD
t*

IFM
i*

LAS
A

First we
identify the
anchors of
the system
AS
Figure 13.6 (b): Animation 2 (Long
Run)
Figure 13.6 (b)
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Output gap
I
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Output gap

IFM
LAD
IS

A

0

0

t*

AD

A

i*

LAS
Starting point:
long-run
equilibrium
at point A.
Figure 13.6 (c): Animation 3 (IS
shifts)
Figure 13.6 (c)
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Output gap
I
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Output gap

IFM
LAD
IS

A

B

0

0

t*

IS

AS
AD

AD

A

B

B

IS

B

i*

LAS
IS shifts back
because increased
inflation reduces
international
competitiveness
A fiscal
expansion
shifts the
IS and AD
curves to
the right.
AS
Figure 13.6 (d): Animation 4 (AS
shifts)
Figure 13.6 (d)
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Output gap
I
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Output gap

IFM
LAD
A

B

0

0

t*

IS

AS
AD

A

B

C

i*

LAS
Underlying
inflation
catches up with
actual inflation,
AS shifts up.
IS

AS
AS
Figure 13.6 (e): Animation 5 (IS
shifts back)
Figure 13.6 (e)
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Output gap
I
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Output gap

IFM
LAD
IS

A

B

0

0

t*

IS

AD

AD

A

B

D

i*

LAS
C

C

Once the
expansionary
fiscal policy is
cancelled, the
AD and IS
curves shift
back
The new
short-run
equilibrium is
at point D.
At point C,
t > t* and
the real
exchange
rate
appreciates;
IS curve
shifts back
to IS.
AS
Figure 13.6 (f): Animation 6 (AS
shifts)
Figure 13.6 (f)
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Output gap
I
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Output gap

IFM
LAD
IS

A

B

0

0

t*

IS

AD

A

B

D

i*

LAS
C

C

D

Long-run
equilibrium
has been
reestablished
Inflation is below
core rate at D, so
AS will fall
AS
Table 13.1: Tracking Movements in
Fig. 13.6

Table 13.1
Figure 13.7: A Devaluation
A Devaluation
Figure 13.7
(Equilibrium)
A Devaluation (1)
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Output gap
I
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Output gap
IFM
LAD
IS

A

A

0

0

LAS

AS
AD
*
i
Figure 13.7 (a)
Starting at
the long-run
equilibrium
point A,
where
t = t* = ....
... a monetary
policy expansion
leads to a nominal
depreciation
t*
B

B

Figure 13.7 (b): Animation 2 (IS
shifts)
A Devaluation (2)
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Output gap
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Output gap
LAD
IS

A

A

0

0

LAS

AS
AD
AD
*
i
IFM
IS

Figure 13.7 (b)
IS

B

The
improved
current
account
shifts the
IS curve
to IS.
t*
The demand
expansion shifts
AD curve to AD
with short-run
equilibrium at
point B.
Rising
inflation
due to
output
expansion
shifts
IS to IS.
B

B

Figure 13.7 (c): Animation 3 (IS
shifts back)
A Devaluation (3)
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Output gap
I
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Output gap
LAD
IS

A

A

0

0

LAS

AS
AD
AD
*
i
IFM
IS

Figure 13.7 (c)
Inflation is
now above
the world
level and
competitive-
ness is
reduced,
shifting IS
back
t*
Figure 13.8: Expansionary
Monetary Policy, Fixed Exchange
Rates
Expansionary Monetary Policy Under a
Fixed Exchange Rate Regime
Figure 13.8
Expansionary Monetary Policy Under a
Fixed Exchange Rate Regime
Time
R
e
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e
x
c
h
a
n
g
e

r
a
t
e

t t >
*
0 A < S Devaluation ( )
} }
Figure 13.8 (a)
Periodic
realignments of
the exchange rate
Figure 13.9: The Real Exchange
Rate, France/Germany
Figure 13.9

The Real Exchange Rate:
France/Germany 1975-2011
Monetary
Union
Source: Maddison (2007)
Figure 13.10 (a): Nominal/Real
Interest Rates, Frensch Debt
Figure 13.10 (a)
Nominal and Real Interest Rates on
French Government Debt, 1998-2011
Sources: Agence France-Trsor, Reuters
Panel (a) shows nominal and
real interest rates on French
Government Bonds (OATs).
Figure 13.10 (b): Nominal/Real
Interest Rates, French Debt
Figure 13.10 (b)
Nominal and Real Interest Rates on
French Government Debt, 1998-2011
Sources: Agence France-Trsor; Reuters
Panel (b) shows the anticipated inflation rate as difference between nominal and real interest rate.
Figure 13.11: AD Under Flexible
Exchange Rates
The Aggregate
Demand Curve
Under Flexible
Exchange Rates
Figure 13.11
(Taylor rule)
( )
gap
gap
i
i r a b Y
t
t t t
| |
|
= + + +
|
|
\ .
gap gap
i i a b Y t = + +
( ) ( )
gap
Note: this constant term will
change, when changes
1 i r a a b Y
t
t t = + + +
AD Under Flexible Exchange Rates (1)
Figure 13.11 (a)
Taylor
rule
(Interest Rate Parity)
Interest rate parity (recall from Chapter 11):
The domestic rate of interest must equal the
foreign rate of return, where the foreign rate of
return includes both the foreign interest rate and
any anticipated change in the exchange rate.
i = i*
*
gap gap
0 0
IFM
i i a b Y i i t
= =
= + + = =
At long-run equilibrium the neutral rate of interest for
a Taylor rule must equal the foreign rate of return:
Figure 13.11 (b)
IFM
i*
(Equilibrium)
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Output gap
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Output gap
A

A

TR

t
Figure 13.11 (c)
0
0
( )
*
gap gap gap
Note: at , = A
i r b Y i b Y i b Y
t t
t = + + = + = +
gap
We start
from long-run
equilibrium,
where
0
and .
Y
t t
=
=
Add interest rate
parity condition.
Along TR, t is
held constant
at t
IFM i*
IS

Figure 13.11 (d): Animation 4 (IS
curve)
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Output gap
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Output gap
A

A

TR

t
Recall:
position of IS
curve is now
endogenous,
shifting with
the real
exchange
rate so it
passes
through A in
upper figure.
Figure 13.11 (d)
0
0
t
'
AD
A

Figure 13.11 (e): Animation 5 (TR
curve)
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Output gap
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Output gap
TR
A

A

A

TR

t
IFM
Higher inflation
triggers higher
interest rate via
Taylor rule: TR
shifts up to TR.
IS

IS

Figure 13.11 (e)
i*
0
0
Now
suppose
domestic
inflation
increases
to t.
Real exchange rate
appreciates, reducing
demand (point A).
t
'
AD
A

Figure 13.11 (f): Animation 6 (AD
curve)
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Output gap
A

t
Figure 13.11 (f)
0
( )
*
gap
TR
IFM
i i i a b Y t t
'
'
= = + +
( )
*
gap
0
i i a b Y t t
=
'
= +
( )
gap
slope AD
b
Y a
t t
'
=
Figure 13.12: AD & AS Under
Flexible Exchange Rates
Under Flexible Exchange Rates
Figure 13.12
Under Flexible Exchange Rates
I
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f
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a
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i
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0 Output gap
Figure 13.12 (a)
AD
AS
LAS
LAD
t
Figure 13.13: Monetary Policy,
Flexible Exchange Rates
Monetary Policy Under Flexible Exchange Rates
Figure 13.13
IS

TR
(Equilibrium)
Monetary Policy, Flexible Exchange Rates (1)
Figure 13.13 (a)
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Output gap
I
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Output gap
0
0
AS
LAS
IFM
i*
t LAD
A

AD
A

Short-run
= long-run
equilibrium
at point A.
(Taylor Rule)
Figure 13.13 (b)

Taylor rule
Assumption: a > 1; an increase in the target inflation rate lowers
the nominal interest rate ceteris paribus: TR curve shifts down.
Note: If 0 < a < 1, an increase in the target inflation rate
increases the nominal interest rate ceteris paribus: TR curve
shifts up, but by less than the increase in the target inflation.
This situation is generally unstable and thus not considered.
+ Fisher equation
+ rearranging....
AS'
AD
IS

TR

IS

IS

TR
(Shifts)
Central bank's
target inflation
increases
permanently
Figure 13.13 (c)
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Output gap
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Output gap
TR

0
0
AS
LAS
IFM
i*
t LAD
A

C
t
'
LAD
B
IFM
i*
'
B
C
AD
A

Long run:
no output
effect but
higher
inflation
Figure 13.14: An Adverse Supply
Shock
An Adverse Supply Shock
Figure 13.14
LAD
(Equilibrium)
An Adverse Supply Shock (1)
I
n
f
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a
t
i
o
n

0
A
Output gap
Figure 13.14 (a)
AD
AS
LAS
Initial short-run=
long-run
equilibrium at
point A.
t
LAD
AS
LAS
AS
AD
Figure 13.14 (b): Animation 2 (AS
Shift)
I
n
f
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a
t
i
o
n

0
B
Stagflation results:
both unemployment
and inflation have
increased at point B.
Figure 13.14 (b)
Output gap
A
Negative
supply shock
s shifts AS
curve to AS.
t
AD
AS
LAS
LAD
AD
Figure 13.14 (c): Animation 3 (AD
Shift)
Strategy A:
fight induced
unemployment with
expansionary
demand policies
I
n
f
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a
t
i
o
n

0
B
C
Result: less
unemployment
but higher
inflation at
long-run
equilibrium C.
Figure 13.14 (c)
Output gap
A
t
LAD
AD
AS
LAS
AD
Figure 13.14 (d): Animation 4 (AD
Shift)
Strategy B:
fight induced inflation
with contractionary
demand policies.
I
n
f
l
a
t
i
o
n

0
B
D
Result:
less inflation, but
higher
unemployment
until return to the
long-run
equilibrium at A.
Figure 13.14 (d)
Output gap
A
t
Figure 13.15: An Adverse Demand
Shock
An Adverse Demand Shock
Figure 13.15
AD
An adverse
demand shock
shifts the AD curve
to the left.
LAS
AD
AS
Figure 13.15 (a): Animation 1 (AD
Shift)
An Adverse Demand Shock (1)
I
n
f
l
a
t
i
o
n

0
A
B
Figure 13.15 (a)
Output gap
AD
LAS
AD
AS
(Demand Policy)
Expansionary demand
policy to offset the
demand shock shifts
back the AD curve.
I
n
f
l
a
t
i
o
n

0
A
B
Figure 13.15 (b)
Output gap
An Adverse Demand Shock (2)
Table 13.2: Iceland/Ireland:
Economic Indicators
Table 13.2
Figure 13.19: Disinflation
Disinflation
Figure 13.19
(Equilibrium)
Policymakers want to
reduce inflation from
point A to point C.
I
n
f
l
a
t
i
o
n

0
A
Figure 13.16 (a)
LAS
AS
AD
C
Output gap
Initial equilibrium point A
is characterized by high
inflation.
Disinflation (1)
t
LAD
t

LAD
AD
LAS
AS
AD
Figure 13.19 (b): Animation 2 (AD
Shift)
Contractionary
demand-side
policies shift
AD to AD.
I
n
f
l
a
t
i
o
n

0
A
B
Figure 13.16 (b)
Output gap
Disinflation (2)
Lower inflation but
higher unemploy-
ment at short-run
equilibrium point B.
LAD
AS
AD
LAS
AS
Figure 13.19 (c): Animation 3 (AS
Shift)
Disinflation (3)
I
n
f
l
a
t
i
o
n

0
A
B
C
Speed of AS shift
depends on speed
with which core
inflation adjusts.
Output gap
Figure 13.16 (c)
At point B, actual inflation
is below underlying inflation.
Underlying inflation
decreases: AS curve
shifts to AS.

t

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Burda & Wyplosz MACROECONOMICS 6

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