Aggregate Supply, Aggregate Demand

and Inflation:
Putting it altogether

Goodwin et.al. 2018, European edition Ch.8 & 12

Goodwin et.al. 2019, 3rd edition Ch.9 & 13
Goodwin et.al. 2023, 4th edition Ch.8 & 12
-
Outline

1. Putting the AS/AD Model to Work

2. Competing Theories: Classical vs. Keynesian
Putting the AS/AD Model
to Work
The AS/AD model illustrates three points about the
macroeconomy
1. fiscal and monetary policies affect output and inflation
– expansionary fiscal and monetary policies tend to push the
economy toward higher output.
– If the economy is approaching its maximum capacity, they will
also cause inflation to rise.

– contractionary fiscal and monetary policies tend to push the

economy toward lower output.
– Inflation is unlikely to fall quickly, but a persistent recession will
tend to lower inflation over the long term.
The AS/AD Model illustrates three points about the
macroeconomy (cont.)
2. supply shock may have significant effects
– adverse supply shocks lower output and raise inflation

– beneficial supply shocks raise output and lower inflation

3. investor and consumer confidence and expectations have

important effects on output and inflation
Applications of the model to a number of cases

1. An economy in recession: Global recession 2008-09

– (covered in class)

Applications of AS-AD model for own review:

2. Stagflation in the 1970s and 1980s
3. A hard line against inflation: Disinflation in the 1980s
4. An overheated economy: The German reunification
5. Austerity policies and structural reforms
Case 1: The global financial and economic crisis 2008-2009

§ unemployment was high but inflation remained low

§ governments of major OECD countries passed stimulus
packages with tax cuts and spending increases
§ stimulus packages helped European economies to recover from
recession
– effects not large enough to reach full employment

– inflation did not rise

13.6 Aggregate Demand and supply equilibrium in
recession

Unemployment ü The position of the AD curve

indicates a low level of aggregate
AS demand, leading to an economy
with unemployment at equilibrium
Inflation rate (π )

E1. At this point on the AS curve,

inflationary pressures are low.

E0 AD0
E1
AD1

Output (Y )
Y*
Figure 13.7 Expansionary fiscal policy in response to a
recession

Unemployment ü An expansion of
AS government spending, as
Inflation rate (π )

well as a program of tax

cuts, shifts the AD curve
to the right. This reduces
unemployment, but since
the economy is in the flat
portion of the AS curve at
E2 equilibrium E2, it has little
effect on inflation.

E1
AD1 AD2

Y* Output (Y )
The reaction in the U.S. was different

§ Fed embarked early on quantitative easing

§ The fiscal stimulus was also higher in the U.S.
§ idea: combination of monetary expansion plus
recovering confidence of consumers and businesses
leads to a more complete recovery
§ larger shift in AD brings economy back to
full-employment
Figure 13.8 A greater expansion of aggregate demand

Unemployment
ü If Aggregate Demand
AS increases by a larger
Inflation rate (π )

amount, it can bring the

economy back into the
full employment zone. At
equilibrium point E1 the
AS/AD model indicates
the possibility of a slightly
higher inflation level.
E2
E1
AD1 AD2

Y* Output (Y )
Case 2: Stagflation
Prelude: The 1950s and 1960s

§ robust economic growth and low unemployment

§ inflation under control
§ believe: trade-off between unemployment and inflation
 13.9 The Phillips Curve for the U.S. in the 1960s

6
Inflation (percent per year)

ü In the 1960s economist A.W.

5 Phillips identified an inverse
1969
1968
relationship between inflation
4 and unemployment. While this
basic relationship still holds
1967
3 true, events of the 1970s and
1966 later showed that inflation can
2 be much more variable than the
1965 simple Phillips principle implies.
1964
1963
1

0
0 1 2 3 4 5 6 7 8

Unemployment Rate (percent)

The 1970s

§ 1973-1974: “oil-price shock”

§ increase in inflation and unemployment
§ stagflation: a combination of rising inflation and
economic stagnation

How can we explain this effect ?

13.10 The effect of the oil price shock of the 1970s
ü A drastic increase in the price of a key resource reduces the economy’s
total capacity and shifts the AS curve up and to the left. Both inflation
and unemployment get worse at equilibrium point E1.
Inflation rate (π )

AS1 E1

AS0 E0

AD
Lower
Capacity

Output (Y )
 Figure 13.11a: German inflation and unemployment,
1969-1975
ü The oil price shock of the 1970s pushed inflation in Germany only up a
few percentage points and price pressure quickly subsided again.
However, unemployment more than doubled.
20
18
16
14
12
percent

10
8
Inflation
6
4
Unemployment
2
0 Source: AMECO
1969 1970 1971 1972 1973 1974 1975 database, 2016.
Figure 13.11b: Italian inflation and unemployment,
1969-1975
ü In Italy, inflation surged during the oil price shock of the 1970s.
However, unemployment remained almost unaffected.

20
18
16
14
12
percent

Inflation
10
8
Unemployment
6
4
2
0 Source: AMECO
1969 1970 1971 1972 1973 1974 1975 database, 2016.
How can we explain these different outcomes using
our AS/AD Model?
§ Germany:
– Inflation increased during oil-price shock
– German Bundesbank increased interest rates (contractionary monetary
policy)
– Unemployment increased even more, but relatively lower increase in
inflation and
§ Italy:
– increase in public spending (expansionary fiscal policy )
– expansionary monetary policy to finance part of government
expenditure
– higher inflation but no increase in unemployment
13.12 The Italian reaction to oil price shock of the
1970s

ü Initially, the oil price

shock has led to
increased unemployment
and higher inflation (a
Inflation rate (π )

movement from E0 to E1).

E2 Yet, the Italian
AS1 E1 government reacted with
expansionary fiscal and
AS0 E0 monetary stimulus which
pushed inflation further
up (to E2).
AD0 AD1
Lower
Capacity

Output (Y )
This was not the end of inflation in the 1970s …

§ in countries like Italy, inflationary expectations

permanently shifted upward
– expectation of higher inflation built into wage and price
contracts

– permanently high inflation rate

§ in countries like Germany and Switzerland, inflation
came down by 1978
Case 4: Inflation can also be caused by an overheated
economy and an excess of aggregate demand
§ German reunification boom in the early 1990s
– additional demand for consumer goods

– increase in confidence of West German firms

– huge public investment program

13.14 Excessively high aggregate demand causes
inflation
Wage- ü Expansionary policy
Price causes the
Spiral economy to “heat
AS up.” In the short
Inflation rate (π )

run, people
respond by
increasing output,
E1 but tight markets
for labor and other
AD1 resources cause
E0 inflation to rise as
well at equilibrium
AD0 point

Y* Output (Y )
What happened next?

§ German economy hit by negative shocks

– Bundesbank increased interest rates sharply

– consumer and investor confidence decreased

– 1992: European Monetary System crisis

– decline in German exports

– decline in inflation, rise in unemployment

Chapter 13 27
Case 5: Austerity policies and structural reforms

§ euro-crisis: austerity packages and structural reforms

– from 2010, investors got concerned about debt
sustainability

– high interest rates for borrowers

– EU: cut public spending, increase taxes, and implement

structural reforms
Figure 13.15a A loss of investor confidence in the
AS/AD model
ü When investors lose confidence in one country and cut credit lines to
the countries’ firms, the AD curve shifts left. GDP contracts and
unemployment increases.

AS0
Inflation rate (π )

E2 E1 E0

AD2 AD1 AD0

Output (Y )
Figure 13.15b Structural reforms in the AS/AD model

ü If the government reacts to the fall in output with reforms which increase
potential output, in a second step, the AS curve shifts right. GDP increases
again, but prices fall. It is not clear, however, whether a return to the initial
GDP level is possible.

AS0
Inflation rate (π )

AS1

E2 E0

E3
Higher
Capacity
AD2 AD0

Output (Y )
Figure 13.16: Unemployment in Ireland and Greece

ü During the euro crisis, unemployment both in Ireland and Greece was
significantly above pre-crisis levels. However, as of 2016, unemployment in
Ireland has come down significantly, while it has remained stubbornly high in
Greece.
30

Greece
25

20
percent

15
Ireland
10

0 Source: Eurostat,
2011 2012 2013 2014 2015 2016.
Figure 13.17: Inflation in Ireland and Greece
ü Inflation fell both in Ireland and Greece after austerity packages and structural
reform measures were enacted. However, inflation fell further in Greece than in
Ireland.

1
Ireland
0
percent

2012 2013 2014 2015 2016

-1

Greece
-2

-3 Source:
Eurostat,
-4 2016.
Figure 13.18a Macroeconomic results of austerity and
structural reforms in Ireland
ü As Ireland is a very open economy, falling inflation caused by structural reforms
boosted exports and aggregate demand. As a consequence, structural reforms
were able to counteract part of the negative impacts of austerity.

AS0
Inflation rate (π )

AS1

E2 E0

E3
Higher
AD2 AD0 Capacity

Output (Y )
Figure 13.18b Macroeconomic results of austerity and
structural reforms in Greece
ü As aggregate demand in Greece does not react much to changes in inflation,
structural reforms have not been able to increase employment significantly. The
combination of austerity and structural reforms has led to lower inflation, but also
high unemployment.

AS0
Inflation rate (π )

AS1

E2 E0

E3
Higher
AD0 Capacity
AD2

Output (Y )
Competing Theories
 QUESTIONS:

Was it necessary to enact expansionary fiscal policy in

order to get the European economies out of the 2008–
2009 recession?

Was it a good idea for the ECB to lower interest rates to

zero (and below for deposits) in 2015–2016 to try to
promote recovery?
Classical macroeconomics

§ assumptions:
– self-adjusting properties of free-markets

– labor markets clear at an equilibrium wage

– markets for loanable funds cause savings and investment to

be equal at an equilibrium interest rate
Ø in theory, a smoothly functioning economy should be
at full-employment
13.19 The classical view of AS/AD

ü the vertical AS curve represents the classical view that the economy will tend to
return to full employment automatically.

Classical AS
Inflation rate (π )

AD

Y* Output (Y )
Figure 13.18b Macroeconomic results of austerity and
structural reforms in Greece
ü As aggregate demand in Greece does not react much to changes in inflation,
structural reforms have not been able to increase employment significantly. The
combination of austerity and structural reforms has led to lower inflation, but also
high unemployment.

AS0
Inflation rate (π )

AS1

E2 E0

E3
Higher
AD0 Capacity
AD2

Output (Y )
The classical view of AS/AD

§ AS curve at full-employment level

– people make optimizing choices

– unemployed workers bid down wages

– full-employment restored
§ AD level determines only the inflation rate
What is the effect of aggregate demand-management
policies?
§ expansionary fiscal or monetary policy has no effect
on the output level
§ government spending “crowds out” private spending
– more spending by government means less spending by
consumers and businesses
§ monetary expansions lead only to increased inflation
– central bank should choose a certain growth rate of the
money supply or level of the interest rate
Keynesian macroeconomics

§ market economies are inherently unstable

§ business cycles can be explained by changes in
investors’ confidence
§ macroeconomic phenomena cannot be explained by
assuming rational, optimizing behavior by individuals
§ inherent tendency toward market instability requires
active government intervention
Figure 13.7 Expansionary fiscal policy in response to a
recession

Unemployment ü An expansion of
AS government spending, as
Inflation rate (π )

well as a program of tax

cuts, shifts the AD curve
to the right. This reduces
unemployment, but since
the economy is in the flat
portion of the AS curve at
E2 equilibrium E2, it has little
effect on inflation.

E1
AD1 AD2

Y* Output (Y )
What to take home

§ higher inflation rates tend to reduce aggregate

demand, as central banks increase interest rate
§ fiscal and monetary policies affect output and
inflation
§ supply shocks may have significant effects
§ investor and consumer confidence and expectations
have important effects on output and inflation
§ Classical and Keynesian economists provide different
arguments about economic analysis and policy