FIGURE 3 The Inflation Rate and the Federal Funds Rate, 2007- 2009 ‘The Fed began an ag- gressive autonomous easing of monetary pol- icy in September 2007, ringing down its policy rate, the federal funds rate, despite the continu ing high inflation, CHAPTER 21 The Monetary Policy and Aggregate Demand Curves 519 Federal Funds rate Federal Funds Rate and Inflation Rate (% annual rate) 2007 2008 2009 Year A movement along the MP curve would have suggested that the Fed would continue to keep hiking interest rates because inflation was rising, but instead it did the opposite ‘The Fed thus shifted the monetary policy curve down from MP, to MP3, asin Figure 2. The Fed pursued this autonomous monetary policy easing because the negative shock to the economy from the disruption to financial markets (discussed in Chapter 9) indicated that, despite current high inflation rates, the economy was likely to weaken in the near future and the inflation rate would fall. Indeed, this is exactly what came to pass, with the economy going into recession in December 2007 and the inflation rate falling sharply after July 2008, THE AGGREGATE DEMAND CURVE We are now ready to derive the relationship between the inflation rate and aggregate output when the goods market is in equilibrium, the aggregate demand curve. The MP curve we developed demonstrates how central banks respond to changes an infla- tion with changes in interest rates, in line with the Taylor principle. The IS curve we developed in Chapter 20 showed that changes in real interest rates, in turn, affect equilibrium output. With these two curves, we can now link the quantity of aggregate nut demanded with the inflation rate, given the public's expectations of inflation and the stance of monetary policy The aggregate demand curve is central to the aggregate demand and supply analysis we develop further in the next chapter, which allows us to explain short-run fluctuations in both aggregate output and inflation Deriving the Aggregate Demand Curve Graphically Using the hypothetical MP curve from Equation 2, we know that when the inflation rate rises from 1% to 2% to 3%, real interest rates rise from 1.5% to 2% to 2.5%. We plot Wwww.rasabourse.com520. PART 6 — Monetary Theory these points in panel (a) of Figure 4 to create the MP curve. In panel (b), we graph the IS curve described in Equation 13 of Chapter 20 (Y = 12 — r). As the real interest rate rises from 1.5% to 2% to 2.5%, the equilibrium moves from point 1 to point 2 to point 3 and aggregate output falls ftom $10.5 trillion to $10 trillion to $9.5 million, In other words, as real interest rates rise, investment and net exports decline, leading to a reduction in aggregate demand, Panels (a) and (b) demonstrate that as inflation rises from 1% to 2% to 3%, the equilibrium moves from point I to point 2 to point 3 in panel (©), and aggregate ‘output falls from $10.5 trillion to $10 trillion to $9.5 tillion. The line that connects the three points in panel (c) is the aggregate demand curve, AD, and it indicates the level of aggregate output corresponding to cach of the three real interest rates consistent with equilibrium in the goods market for any given inflation rate. The aggregate demand curve has a downward slope, be; a higher inflation rate leads the central bank to raise real interest rates, thereby lowering planned spending, and hence lowering the level of equilibrium aggregate output, By using some algebra (see the FYI box, "Deriving the Aggregate Demand Curve Algebraically”), the AD curve in Figure 4 can be written numerically as follows: Y=11l-050 @) Factors That Shift the Aggregate Demand Curve Movements along the aggregate demand curve describe how the equilibrium level of aggregate output changes when the inflation rate changes. When factors besides the inflation rate change, however, the aggregate demand curve can shift, We first review the factors that shift the IS curve, and then consider other factors that shift the AD ) 7 FYI Deriving the Aggregate Demand Curve Algebraically To derive the numerical AD curve, we start by taking y = [C + 7— df + G+ NX — mpc x T] the numerical IS curve, Equation 13, from the previ- ous chapter, e YeWrr and then substitute in for r from the numerical MP ahd then substitute for r from the algebraic MP curve curve in Equation 2, r= 1.0 + 0.5 7, to yield Y=12- (0+ 05m) 3s. ee = (2-)-057 Y= ([C+i-G+G+NX— mp xT] =1-05r At x G4 am) as im the text mpc Similarly, we can derive a more general version of the AD curve, using the algebraic version of the IS curve from Equation 12 in Chapter 20: d+x race irik in Equation 1,r = 7 + Am, toyield the more general AD curve: www.rasabourse.comFIGURE 4 Deriving the AD Curve ‘The MP curve in panel (a) shows that as infla- tion rises from 1.0% to 2.0% to 3.0%, the real Interest rate rises from 1.5% to 2.0% to 2.5%, The IS curve in panel (6) then shows that higher real interest rates lead to lower planned investment spending, and hence ag- sgregate output falls from $10.5 willion to $10.0 trillion to $9.5 trillion Finally, panel (e) plots the level of equilibrium output corresponding to cach of the three infla- tion rates: the line that connects these points is the AD curve, and itis downward sloping. cHaPT, ER 21 The Monetary Policy and Aggregate Demand Curves 521 Real Interest Rate, (9) 2.5% 2.0% 1.8% Real Interest Rate, r °% 25% 2.0% 1.8% Inflation Rate, 3 % 3.0% 2.0% 1.0% (0) MP Curve (6) 5 Curve (c) Aggregate Demand Curve Inflation Rate, = (%) Aggregate Output, ¥ (§trilions) an ees Petr enOeny para Aggregate Output, ¥ (6 tllons) www.rasabourse.com522 PART 6 Monetary Theory Shifts in the IS Curve We saw in the previous chapter that six factors cause the IS curve to shift. It turns out that the same factors cause the aggregate demand curve to shift as well 1. Autonomous consumption expenditure 2. Autonomous investment spending Government purchases Taxes Autonomous net exports Financial frictions ausu We examine how changes in these factors lead to a shift in the aggregate demand curve in Figure 5. Suppose that inflation is at 2.0% and so the MP curve shows that the real inter- est rate is at 2.0% in Figure 5 panel (a). The IS, curve in panel (b) then shows that the equilibrium level of output is at $10 trillion at point A), which corresponds to an equilibrium level of output of $10 trillion at point A, on the AD, curve in panel (). Now suppose there is rise in, for example, government purchases by $1 trillion. Panel (b) shows that with the inflation rate and real interest both held constant at 2.0%, the equilibrium moves from point A, to point A,, with output rising to $12.5 trillion,’ so the IS curve shifts to the right from IS, to IS,. The rise in output to $12.5 uillion means that holding inflation and the real interest rate constant, the equilibrium in panel () also moves from point A, to point Ay, and so the AD curve also shifis to the right from AD, to AD). Figure 5 shows that any factor that shifts the IS curve shifts the aggregate demand curve in the same direction. Therefore, “animal spirits’ that encourage a rise in autonomous consumption expenditure or planned investment spending, a rise in government purchases, an autonomous rise in net exports, a fall n taxes, or a decline in financial frietions—all of which shift the IS curve to the right—will also shift the aggregate demand curve to the right. Conversely, a fall in autonomous consumption expenditure, a fall in planned investment spending, a fall in government purchases, & fall in net exports, arise in taxes, or a rise in financial frictions will cause the aggregate demand curve to shift to the left Shifts in the MP Curve We now examine what happens to the aggregate de- mand curve when the MP curve shifis. Suppose that the Federal Reserve decides to autonomously tighten monetary policy by raising the real interest rate by one per- centage point at any given level of the inflation rate because it is worried about the economy overheating, At an inflation rate of 2.0%, the real interest rate rises from 2.0% to 3.0% in Figure 6. The MP curve shifts up from MP, to MP, in panel (a). Panel () shows that when the inflation rate is at 2.0%, the higher interest rate results in the equilibrium moving from point A, to A; on the IS curve, with output falling from $10 trillion to $9 trillion, The lower output of $9 trillion occurs because the higher real interest leads to a decline in investment and net exports, which lowers aggregate demand. The lower output of $9 tillion then decreases the equilibrium output level from point A; to point A; in panel (c), and so the AD curve shifts to the left ftom AD, to AD, "as we saw inthe numerical example it, Chapter 20, risen government purchases by $1 tilhon leads to 2 $2.5 snlion increase in equlbium outa st any given real interest rate, and the ts why output ise from $10 nllion 0 $125 talon when the cea interest rate ts 2.0%. www.rasabourse.comFIGURE 5 Shift in the AD Curve from Shifts in the IS Curve ‘Av a2% inflation rate in panel (@), the monetary policy curve indicates thatthe real interest rate 45.2%, An increase in government purchases shilts the IS curve to the right in panel (b) Ava given inflation rate and real interest rate of 2.0%, equilibrium output rises from $10 tilion to $125 tillion, which is shown as a movement from point A; to point Ay in panel (€, shifting the aggregate demand curve Co the right from AD, {0 AD,, Any factor that shifts the IS curve shifts the AD curve inthe same direction. CHAPTER 21 The Monetary Policy and Aggregate Demand Curves 523 Real Interest Rate, (%6) 2.0% Real Interest Rate, r %) 2.0% Inflation Rate, 6) 2.0% (@) MP Curve 2.0%: Inflation Rate, x (96) (6) 1S Curve Aggregate Output, ¥ ($ trillions) (©) Aggregate Demand Curve Aggregate Output, ¥ ($ trillions) www.rasabourse.com524 PART 6 — Monetary Theory FIGURE 6 Shift in the AD Curve from Autonomous Real Monetary Policy Interest Tightening Rato,r (61 Autonomous monetary Lightening that raises real interest rates by one percentage point at any given inflation rate shifts the MP curve up from MP, to MP, in panel (a). With the inflation rate at 2.0%, the higher 3% interest rate results in a movement from point A to A; on the IS curve, with ouput falling from $10 trillion to $9 trillion, This change in equilibrium output leads to movement from point ‘Ay to point Ay in panel (O, shifting the aggregate demand curve to the left from AD, to AD}, 3.0% 2.0% Real Interest Rate, cy 3.0% 2.0% Inflation Rate, = % 2.0% ro (a) MP ee 2.0% Inflation Rate, = (4) output 2.0 10.0 Aggregate Output, ¥ ($ trillions) {c) Aggregate Demand 2.0 10.0 Aggregate Output, ¥ ($ trillions) www.rasabourse.com