Macroeconomics

Session 18
Dr. Jithin P
IIM Raipur
AD Policy & the Keynesian
(short-run) Supply Curve

• Figure 5-9 shows the AD schedule and the

Keynesian supply schedule
• Initial equilibrium is at point E (AS = AD)
• Suppose an aggregate demand policy
increases AD to AD’ (C, I, Real Exchange
rate, Yf, Fiscal policy(G, TR,TA), Monetary
policy, M) The new equilibrium point, E’,
corresponds to the same price level, and a
higher level of output.
AD and the Long-run Aggregate Supply
curve
• In the classical case, AS schedule is vertical at
Full employment level of output
• Unlike the Keynesian case, the price level is
not given, but depends upon the interaction
between AS and AD
• Suppose AD increases to AD’
• Spending increases to E’ BUT firms produce
higher quantity of output to meet the
increased demand. Firms hire more workers.
However, wages and costs of production rise
• →firms must charge higher price
• Move up AS and AD curves to E’’ where AS =
AD’
 AD and the Long-run Aggregate Supply curve

• The increase in price from the increase

in AD reduces the real money stock, and
leads to a reduction in spending
• The economy only moves up AD until
prices have risen enough, and M/P has
fallen enough, to reduce total spending
to a level consistent with full employment
→this is true at E’’, where AD = AS
Aggregate Supply and the Price Adjustment
Mechanism
• The aggregate supply curve describes the price adjustment
mechanism of the economy.
• Figure 5-6 a shows the flat short-run aggregate supply curve in
black and the vertical long-run curve in blue. It also illustrates
an entire spectrum of intermediate-run curves.
• Initially, the economy is operating at the point of intersection
between SRAS and LRAS. Actual Y is equal to potential Y*.
Actual unemployment rate (U) is equal to natural rate of
unemployment (U*).
• Now suppose that actual inflation (5%) is equal to expected
inflation (5%). Expected inflation is what people believe
inflation to be in future (say after a year) – Now the AD
increases. The New AD curve is shown by the dashed AD curve.
Aggregate Supply and the Price Adjustment
Mechanism
• Now actual output is above potential (Y>Y*) or
actual unemployment rate is below the natural
unemployment rate (U<U*). The output gap (Y-
Y*)is positive. This is what happens in short-run.
AD determines real GDP.
• What happens afterwards (i.e., in medium run
and long run)?
• Marginal cost of production will increase (as Y>
Y*)
• Prices will increase due to increase in marginal
cost
• Inflation will increase (shown by the dashed dark
line), the SRAS rotates anti clockwise
• Actual inflation (8%) is more than the expected
inflation (5%)
Aggregate Supply and the Price Adjustment
Mechanism
• Beginning with the horizontal black line at time t=0, at Y>Y*, price higher (AS shifting up)
by t=1
• Actual inflation (8%) is more than the expected inflation (5%).
• Expected Inflation will increase to 8%.
• Workers, Landlord, lenders, suppliers will ask for high wages, rent, interest , prices for
raw materials etc.
• Cost of production increases further
=> As cost of production rises, prices will rise. SRAS rotates anticlockwise.
=>This process will go on and on …
=> Each time we find a rise in price level (i.e., inflation) and decrease in quantity demanded
of real GDP
Aggregate Supply and the Price Adjustment
Mechanism
• Process continues until U=U*
• By the end of the process, nominal variables such as money wages, money
interest rates, prices, nominal GDP will have increased without affecting
the real variables.
• Real GDP is back to its potential level and actual unemployment rate is
back to the natural rate of unemployment
• Conclusion: In long-run, productive capacity (supply side) determines the
real GDP.
Inflation, Unemployment, and
the Phillips Curve
• Two goals of economic policymakers are low inflation
and low unemployment, but often these goals conflict.
• Economy up along the short run supply curve-reduce
unemployment and raises the inflation rate.
• Contraction in aggregate demand- unemployment rises
and inflation falls
• This tradeoff between inflation and unemployment, is
called the Phillips curve.
• Phillips curve reflects the medium-run aggregate supply
curve: as policymakers move the economy along the
medium-run aggregate supply curve, unemployment,
and inflation move in opposite directions.
 Phillips Curve
• The Phillips curve in its modern form states that
the inflation rate depends on three forces:
1. expected inflation
• Solow (high inflation of the 1970s)- “we have inflation
because we expect inflation, and we expect inflation
because we’ve had it”.
2. the deviation of unemployment from the natural
rate, called cyclical unemployment; and
3. supply shocks
These three forces are expressed in the following
equation:
 Phillips Curve
• According to the Phillips curve equation,
unemployment is related to unexpected
movements in the inflation rate.
• The aggregate supply curve is more convenient
when we are studying output and the price level,
whereas the Phillips curve is more convenient
when we are studying unemployment and
inflation.
• But we should not lose sight of the fact that the
Phillips curve and the aggregate supply curve are
two sides of the same coin.
Two Causes of Rising and Falling Inflation
• The second and third terms in the Phillips curve equation show the two forces that can
change the rate of inflation.
• Low unemployment pulls the inflation rate up. This is called demand-pull inflation
because high aggregate demand is responsible for this type of inflation.
• High unemployment pulls the inflation rate down. The parameter 𝛽 measures how
responsive inflation is to cyclical unemployment.
• The third term, v, shows that inflation also rises and falls because of supply shocks. An
adverse supply shock, such as the rise in world oil prices in the 1970s, implies a positive
value of v and causes inflation to rise.
• This is called cost-push inflation because adverse supply shocks are typically events that
push up the costs of production.
The Short-Run Tradeoff Between
Inflation and Unemployment

• At any moment, expected inflation and supply shocks

are beyond the policymaker’s immediate control.
• Yet, by changing aggregate demand, the policymaker
can alter output, unemployment, and inflation.
• The policymaker can expand aggregate demand to
lower unemployment and raise inflation.
• The policymaker can depress aggregate demand to
raise unemployment and lower inflation.
• When unemployment is at its natural rate 𝑢 =
𝑢𝑛 inflation depends on expected inflation and the
supply shock.
 The Short-Run Tradeoff Between Inflation
and Unemployment
• In the short run, for a given level of expected
inflation, policymakers can manipulate aggregate
demand to choose any combination of inflation
and unemployment on this curve, called the short-
run Phillips curve.
• position of the short-run Phillips curve depends on
the expected inflation rate.
• If expected inflation rises, the curve shifts upward,
and the policymaker’s trade-off becomes less
favourable: inflation is higher for any level of
unemployment.
• Because people adjust their expectations of
inflation over time, the trade-off between inflation
and unemployment holds only in the short run.
Thank YOU!