CHAPTER 27
What impact do rising prices have on the economy?©Blend Images/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Define the aggregate demand curve, explain why it slopes downward, and explain what may shift it.
2. LO2Define the long-run and short-run aggregate supply curves, explain their orientation, and explain what may shift them. In particular, show how the curves capture the idea of inflation inertia and the link between inflation and the output gap.
3. LO3Analyze how the economy is affected by aggregate spending shocks, inflation shocks, and shocks to potential output.
4. LO4Discuss the short-run and long-run effects of an anti-inflationary monetary policy.
On October 6, 1979, the Federal Open Market Committee, the policymaking committee of the Federal Reserve, held a highly unusual—and unusually secretive—Saturday meeting. Fed chairman Paul Volcker may have called the Saturday meeting because he knew the financial markets would be closed and thus would not be able to respond to any “leaks” to the press about the discussions. Or perhaps he hoped that the visit of Pope John Paul II to Washington on the same day would distract the news media from goings-on at the Fed. However unnoticed this meeting may have been at the time, in retrospect it marked a turning point in postwar U.S. economic history.
When Volcker called the October 6 meeting, he had been chairman of the Fed for only six weeks. Six feet eight inches tall with a booming bass voice, and a chain-smoker of cheap cigars, Volcker had a reputation for financial conservatism and personal toughness. Partly for those qualities, President Carter had appointed Volcker to head the Federal Reserve in August 1979. Carter needed a tough Fed chairman to restore confidence in both the economy and the government’s economic policies. The U.S. economy faced many problems, including a doubling of oil prices following the overthrow of the Shah of Iran and a worrisome slowdown in productivity growth. But in the minds of the public, the biggest economic worry was an inflation rate that seemed to be out of control. In the second half of 1979, the annual rate of increase in consumer prices had reached 13 percent; by the spring of 1980, the inflation rate had risen to nearly 16 percent. Volcker’s assignment: to bring inflation under control and stabilize the U.S. economy.
Volcker knew that getting rid of inflation would not be easy, and he warned his colleagues that a “shock treatment” might be necessary. His plan was couched in technical details, but in essence he proposed to reduce the rate of growth of the money supply sharply. Everyone in the room knew that slowing the growth of the money supply would cause interest rates to rise and aggregate spending to fall. Inflation might be brought down, but at what cost in terms of recession, lost output, and lost jobs? And how would the financial markets, which were already shaky, react to the new approach?
Officials in the room stirred nervously as Volcker spoke about the necessity of the move. Finally a vote was called. Every hand went up.
What happened next? We’ll return to this story before the chapter ends, but first we need to introduce the basic framework for understanding inflation and the policies used to control it. In the previous two chapters, we made the assumption that firms are willing to meet the demand for their products at preset prices. When firms simply produce what is demanded, the level of planned aggregate expenditure determines the nation’s real GDP. If the resulting level of short-run equilibrium output is lower than potential output, a recessionary output gap develops, and if the resulting level of output exceeds potential output, the economy experiences an expansionary gap. As we saw in the previous two chapters, policymakers can attempt to eliminate output gaps by taking actions that affect the level of autonomous expenditure, such as changing the level of government spending or taxes (fiscal policy) or using the Fed’s control of the money supply to change the real interest rate (monetary policy).
Paul Volcker faced a tough assignment.©Dennis Brack/Newscom
The basic Keynesian model is useful for understanding the role of spending in the short-run determination of output, but it is too simplified to provide a fully realistic description of the economy. The main shortcoming of the basic Keynesian model is that it does not explain the behavior of inflation. Although firms may meet demand at preset prices for a time, as assumed in the basic Keynesian model, prices do not remain fixed indefinitely. Indeed, sometimes they may rise quite rapidly—the phenomenon of high inflation—imposing significant costs on the economy in the process. In this chapter, we will extend the basic Keynesian model to allow for ongoing inflation. As we will show, the extended model can be conveniently represented by a new diagram, called the aggregate demand–aggregate supply diagram. Using this extended analysis, we will be able to show how macroeconomic policies affect inflation as well as output, illustrating in the process the difficult trade-offs policymakers sometimes face. We will emphasize numerical and graphical analysis of output and inflation in the body of the chapter. The appendix at the end of the chapter presents an algebraic treatment.
INFLATION, SPENDING, AND OUTPUT: THE AGGREGATE DEMAND CURVE
To begin incorporating inflation into the model, our first step is to introduce a new relationship, called the aggregate demand curve, which is shown graphically in Figure 27.1. The aggregate demand (AD) curve shows the relationship between short-run equilibrium output Y and the rate of inflation, denoted π. The name of the curve reflects the fact that, as we have seen, short-run equilibrium output is determined by total planned spending, or demand, in the economy. Indeed, by definition, short-run equilibrium output equals planned aggregate expenditure, so that we could just as well say that the AD curve shows the relationship between inflation and spending.1
FIGURE 27.1 The Aggregate Demand (AD) Curve.The AD curve shows the relationship between short-run equilibrium output Y and the rate of inflation π. Because short-run equilibrium output equals planned spending, the AD curve also shows the relationship between inflation and planned spending. The downward slope of the AD curve implies that an increase in inflation reduces short-run equilibrium output.
We will see shortly that, all else being equal, an increase in the rate of inflation tends to reduce short-run equilibrium output. Therefore, in a diagram showing inflation π on the vertical axis and output Y on the horizontal axis (Figure 27.1), the aggregate demand curve is downward-sloping.2 Note that we refer to the AD “curve,” even though the relationship is drawn as a straight line in Figure 27.1. In general, the AD curve can be either straight or curving.
Why does higher inflation lead to a lower level of planned spending and short-run equilibrium output? As we will see next, one important reason is the Fed’s response to increases in inflation.
INFLATION, THE FED, AND WHY THE AD CURVE SLOPES DOWNWARD
One of the primary responsibilities of the Fed, or any central bank, is to maintain a low and stable rate of inflation. For example, in recent years the Fed has tried to keep inflation in the United States at 2 percent over the long run. By keeping inflation low, the central bank tries to avoid the costs high inflation imposes on the economy.
What can the Fed do to keep inflation low and stable? As we have already mentioned, one situation that is likely to lead to increased inflation is an expansionary output gap, in which short-run equilibrium output exceeds potential output. When output is above potential output, firms must produce at above-normal capacity to meet the demands of their customers. Like Al’s ice cream store, described in Chapter 24, Short-Term Economic Fluctuations: An Introduction, firms may be willing to do this for a time. But eventually they will adjust to the high level of demand by raising prices, contributing to inflation. To control inflation, then, the Fed needs to dampen planned spending and output when they threaten to exceed potential output.
How can the Fed avoid a situation of economic “overheating,” in which spending and output exceed potential output? As we saw in the previous chapter, the Fed can act to reduce autonomous expenditure, and hence short-run equilibrium output, by raising the real interest rate. This behavior by the Fed is a key factor that underlies the link between inflation and output that is summarized by the aggregate demand curve. When inflation is high, the Fed responds by raising the real interest rate. Such response is implied by the Fed’s policy reaction function, introduced in Chapter 26, Stabilizing the Economy: The Role of the Fed (also called a monetary policy rule, the reaction function describes how a central bank, like the Fed, takes action in response to changes in the state of the economy). The increase in the real interest rate reduces consumption and investment spending (autonomous expenditure) and hence reduces short-run equilibrium output. Because higher inflation leads, through the Fed’s actions, to a reduction in output, the aggregate demand (AD) curve is downward-sloping, as Figure 27.1 shows. We can summarize this chain of reasoning symbolically as follows:
π ↑ ⇒ r ↑ ⇒ autonomous expenditure ↓ ⇒ Y ↓, (AD curve)
where, recall, π is inflation, r is the real interest rate, and Y is output.
OTHER REASONS FOR THE DOWNWARD SLOPE OF THE AD CURVE
Although we focus here on the behavior of the Fed as the source of the AD curve’s downward slope, there are other channels through which higher inflation reduces planned spending and thus short-run equilibrium output. Hence the downward slope of the AD curve does not depend on the Fed behaving in the particular way just described.
One additional reason for the downward slope of the AD curve is the effect of inflation on the real value of money held by households and businesses. At high levels of inflation, the purchasing power of money held by the public declines rapidly. This reduction in the public’s real wealth may cause households to restrain consumption spending, reducing short-run equilibrium output.
A second channel by which inflation may affect planned spending is through distributional effects. Studies have found that people who are less well off are often hurt more by inflation than wealthier people are. For example, retirees on fixed incomes and workers receiving the minimum wage (which is set in dollar terms) lose buying power when prices are rising rapidly. Less affluent people are also likely to be relatively unsophisticated in making financial investments and hence less able than wealthier citizens to protect their savings against inflation.
People at the lower end of the income distribution tend to spend a greater percentage of their disposable income than do wealthier individuals. Thus, if a burst of inflation redistributes resources from relatively high-spending, less affluent households toward relatively high-saving, more affluent households, overall spending may decline.
A third connection between inflation and aggregate demand arises because higher rates of inflation generate uncertainty for households and businesses. When inflation is high, people become less certain about what things will cost in the future, and uncertainty makes planning more difficult. In an uncertain economic environment, both households and firms may become more cautious, reducing their spending as a result.
A final link between inflation and total spending operates through the prices of domestic goods and services sold abroad. As we will see in the next chapter, the foreign price of domestic goods depends in part on the rate at which the domestic currency, such as the dollar, exchanges for foreign currencies, such as the British pound. However, for constant rates of exchange between currencies, a rise in domestic inflation causes the prices of domestic goods in foreign markets to rise more quickly. As domestic goods become relatively more expensive to prospective foreign purchasers, export sales decline. Net exports are part of aggregate expenditure, and so once more we find that increased inflation is likely to reduce spending. All these factors contribute to the downward slope of the AD curve, together with the behavior of the Fed.
FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVE
The downward slope of the aggregate demand, or AD, curve shown in Figure 27.1 reflects the fact that all other factors held constant, a higher level of inflation will lead to lower planned spending and thus lower short-run equilibrium output. Again, a principal reason higher inflation reduces planned spending and output is that the Fed tends to react to increases in inflation by raising the real interest rate, which in turn reduces consumption and planned investment, two important components of planned aggregate expenditure.
However, even if inflation is held constant, various factors can affect planned spending and short-run equilibrium output. Graphically, as we will see in this section, these factors will cause a change in aggregate demand, which causes the AD curve to shift. Specifically, for a given level of inflation, if there is a change in the economy that increases short-run equilibrium output, the AD curve will shift to the right (we provide an example in Figure 27.2). If, on the other hand, the change reduces short-run equilibrium output at each level of inflation, the AD curve will shift to the left [Figure 27.3(b) provides an example]. We will focus on two sorts of changes in the economy that shift the aggregate demand curve: (1) changes in spending caused by factors other than output or interest rates, which we will refer to as exogenous changes in spending, and (2) changes in the Fed’s monetary policy, as reflected in a shift in the Fed’s policy reaction function.
FIGURE 27.2 Effect of an Increase in Exogenous Spending.The AD curve is seen both before (AD) and after (AD′) an increase in exogenous spending—specifically, an increase in consumption spending resulting from a rise in the stock market. If the inflation rate and the real interest rate set by the Fed are held constant, an increase in exogenous spending raises short-run equilibrium output. As a result, the AD curve will shift to the right, from AD to AD′.
FIGURE 27.3 A Shift in the Fed’s Policy Reaction Function.If inflation has remained too high for an extended period, the Fed may choose a “tighter” monetary policy by setting the real interest rate at a higher level than usual for each given rate of inflation. Graphically, this change corresponds to an upward movement in the Fed’s policy reaction function (a). This change to a tighter monetary policy shifts the AD curve to the left (b). If a protracted recession led the Fed to decide to set a lower real interest rate at each level of inflation, the Fed’s policy reaction function would shift downward, and the AD curve would shift to the right.
Changes in Spending
We have seen that planned aggregate expenditure depends both on output (through the consumption function) and on the real interest rate (which affects both consumption and planned investment). However, many factors other than output or the real interest rate can affect planned spending. For example, at given levels of output and the real interest rate, fiscal policy affects the level of government purchases, and changes in consumer confidence can affect consumption spending. Likewise, new technological opportunities may lead firms to increase their planned investment, and an increased willingness of foreigners to purchases domestic goods will raise net exports. We will refer to changes in planned spending unrelated to changes in output or the real interest rate as exogenous changes in spending.
For a given inflation rate (and thus for a given real interest rate set by the Fed), an exogenous increase in spending raises short-run equilibrium output, for the reasons we have discussed in the past two chapters. Because it increases output at each level of inflation, an exogenous increase in spending shifts the AD curve to the right. This result is illustrated graphically in Figure 27.2. Imagine, for example, that a rise in the stock market makes consumers more willing to spend (the wealth effect). Then, for each level of inflation, aggregate spending and short-run equilibrium output will be higher, a change which is shown as a shift of the AD curve to the right, from AD to AD′.
Similarly, at a given inflation rate, an exogenous decline in spending—for example, a fall in government purchases resulting from a more restrictive fiscal policy—causes short-run equilibrium output to fall. We conclude that an exogenous decrease in spending shifts the AD curve to the left.
CONCEPT CHECK 27.1
Determine how the following events will affect the AD curve:
a. Due to widespread concerns about future weakness in the economy, businesses reduce their spending on new capital.
b. The federal government reduces income taxes.
Changes in the Fed’s Policy Reaction Function
Recall that the Fed’s policy reaction function describes how the Fed sets the real interest rate at each level of inflation. This relationship is built into the AD curve—indeed, it accounts in part for the curve’s downward slope. As long as the Fed sets the real interest rate according to an unchanged reaction function, its adjustments in the real rate will not cause the AD curve to shift. Under normal circumstances, the Fed generally follows a stable policy reaction function.
However, on occasion the Fed may choose to be significantly “tighter” or “easier” than normal for a given rate of inflation. For example, if inflation is high and has stubbornly refused to decrease, the Fed might choose a tighter monetary policy, setting the real interest rate higher than normal at each given rate of inflation. This change of policy can be interpreted as an upward shift in the Fed’s policy reaction function, as shown in Figure 27.3(a), where the real interest rate on the vertical axis is depicted as a function of inflation on the horizontal axis. A decision by the Fed to become more “hawkish” about inflation—that is, to set the real interest rate at a higher level for each given rate of inflation—reduces planned expenditure and thus short-run equilibrium output at each rate of inflation. Thus an upward shift of the Fed’s policy reaction function leads the AD curve to shift to the left [Figure 27.3(b)]. Later in the chapter, we will interpret Chairman Volcker’s attack on inflation in 1979 as precisely such a policy shift.
Similarly, if the nation is experiencing an unusually severe and protracted recession, the Fed may choose to change its policies and set the real interest rate lower than normal, given the rate of inflation. This change in policy can be interpreted as a downward shift of the Fed’s policy reaction function. Given the rate of inflation, a lower-than-normal setting of the real interest rate will lead to higher levels of expenditure and short-run equilibrium output. Therefore, a downward shift of the Fed’s policy reaction function causes the AD curve to shift to the right.
CONCEPT CHECK 27.2
Explain why a shift in monetary policy like that shown in Figure 27.3 can be interpreted as a decline in the Fed’s long-run “target” for the inflation rate. (Hint: In the long run, the real interest rate set by the Fed must be consistent with the real interest rate determined in the market for saving and investment.)
SHIFTS OF THE AD CURVE VERSUS MOVEMENTS ALONG THE AD CURVE
Let’s end this section by reviewing and summarizing the important distinction between movements along the AD curve and shifts of the AD curve.
The downward slope of the AD curve captures the inverse relationship between inflation, on the one hand, and short-run equilibrium output, on the other. As we have seen, a rise in the inflation rate leads the Fed to raise the real interest rate, according to its policy reaction function. The higher real interest rate, in turn, depresses planned spending and hence lowers short-run equilibrium output. The downward slope of the AD curve embodies this relationship among inflation, spending, and output. Hence changes in the inflation rate, and the resulting changes in the real interest rate and short-run equilibrium output, are represented by movements along the AD curve. In particular, as long as the Fed sets the real interest rate in accordance with a fixed policy reaction function, changes in the real interest rate will not shift the AD curve.
However, any factor that changes the short-run equilibrium level of output at a given level of inflation will shift the AD curve—to the right if short-run equilibrium output increases or to the left if short-run equilibrium output decreases. We have identified two factors that can shift the AD curve: exogenous changes in spending (that is, changes in spending unrelated to output or the real interest rate) and changes in the Fed’s policy reaction function. An exogenous increase in spending or a downward shift of the Fed’s policy reaction function increases short-run equilibrium output at every level of inflation, hence shifting the AD curve to the right. An exogenous decline in spending or an upward shift in the Fed’s policy reaction function decreases short-run equilibrium output at every level of inflation, shifting the AD curve to the left.
CONCEPT CHECK 27.3
What is the difference, if any, between the following?
a. An upward shift in the Fed’s policy reaction function.
b. A response by the Fed to higher inflation, for a given policy reaction function.
How does each scenario affect the AD curve?
RECAP
THE AGGREGATE DEMAND (AD) CURVE
· The AD curve shows the relationship between short-run equilibrium output and inflation. Higher inflation leads the Fed to raise the real interest rate, which reduces autonomous expenditure and thus short-run equilibrium output. Therefore, the AD curve slopes downward.
· The AD curve may also slope downward because (1) higher inflation reduces the real value of money held by the public, reducing wealth and spending; (2) inflation redistributes resources from less affluent people, who spend a high percentage of their disposable income, to more affluent people, who spend a smaller percentage of disposable income; (3) higher inflation creates greater uncertainty in planning for households and firms, reducing their spending; and (4) for a constant rate of exchange between the dollar and other currencies, rising prices of domestic goods and services reduce foreign sales and hence net exports (a component of aggregate spending).
· An exogenous increase in spending raises short-run equilibrium output at each value of inflation, and so shifts the AD curve to the right. Conversely, an exogenous decrease in spending shifts the AD curve to the left.
· A change to an easier monetary policy, as reflected by a downward shift in the Fed’s policy reaction function, shifts the AD curve to the right. A change to a tighter, more anti-inflationary monetary policy, as reflected by an upward shift in the Fed’s policy reaction function, shifts the AD curve to the left.
· Assuming no change in the Fed’s reaction function, changes in inflation correspond to movements along the AD curve; they do not shift the AD curve.
INFLATION AND AGGREGATE SUPPLY
Thus far in this chapter, we have focused on how changes in inflation affect spending and short-run equilibrium output, a relationship captured by the AD curve. But we have not yet discussed how inflation itself is determined. In the rest of the chapter, we will examine the main factors that determine the inflation rate in modern industrial economies, as well as the options that policymakers have to control inflation. In doing so, we will introduce a useful diagram for analyzing the behavior of output and inflation, called the aggregate demand–aggregate supply diagram.
Physicists have noted that a body will tend to keep moving at a constant speed and direction unless it is acted upon by some outside force—a tendency they refer to as inertia. Applying this concept to economics, many observers have noted that inflation seems to be inertial, in the sense that it tends to remain roughly constant as long as the economy is at full employment and there are no external shocks to the price level. In the first part of this section, we will discuss why inflation behaves in this way.
However, just as a physical object will change speed if it is acted on by outside forces, so various economic forces can change the rate of inflation. Later in this chapter, we will discuss three factors that can cause the inflation rate to change. The first, which we will discuss in this section, is the presence of an output gap: Inflation tends to rise when there is an expansionary output gap and to fall when there is a recessionary output gap. The second factor that can affect the inflation rate is a shock that directly affects prices, which we will refer to as an inflation shock. A large increase in the price of imported oil, for example, raises the price of gasoline, heating oil, and other fuels, as well as of goods made with oil or services using oil. Finally, the third factor that directly affects the inflation rate is a shock to potential output, or a sharp change in the level of potential output—a natural disaster that destroyed a significant portion of a country’s factories and businesses is one extreme example. Together, inflationary shocks and shocks to potential output are known as aggregate supply shocks; we postpone discussing them until the next section.
INFLATION INERTIA
In low-inflation industrial economies like that of the United States today, inflation tends to change relatively slowly from year to year, a phenomenon that is sometimes referred to as inflation inertia. If the rate of inflation in one year is 2 percent, it may be 3 percent or even 4 percent in the next year. But unless the nation experiences very unusual economic conditions, inflation is unlikely to rise to 6 percent or 8 percent or fall to −2 percent in the following year. This relatively sluggish behavior contrasts sharply with the behavior of economic variables such as stock or commodity prices, which can change rapidly from day to day. For example, oil prices might well rise by 20 percent over the course of a year and then fall 20 percent over the next year. Over the past 25 years or so, however, the U.S. inflation rate has generally remained in the range of 2–3 percent per year, with only small and short-lived deviations.
Why does inflation tend to adjust relatively slowly in modern industrial economies? To answer this question, we must consider two closely related factors that play an important role in determining the inflation rate: the behavior of the public’s inflation expectations and the existence of long-term wage and price contracts.
Inflation Expectations
First, consider the public’s expectations about inflation. In negotiating future wages and prices, both buyers and sellers take into account the rate of inflation they expect to prevail in the next few years. As a result, today’s expectations of future inflation may help to determine the future inflation rate. Suppose, for example, that office worker Fred and his boss Colleen agree that Fred’s performance this past year justifies an increase of 2 percent in his real wage for next year. What nominal, or dollar, wage increase should they agree on? If Fred believes that inflation is likely to be 3 percent over the next year, he will ask for a 5 percent increase in his nominal wage to obtain a 2 percent increase in his real wage. If Colleen agrees that inflation is likely to be 3 percent, she should be willing to go along with a 5 percent nominal increase, knowing that it implies only a 2 percent increase in Fred’s real wage. Thus the rate at which Fred and Colleen expect prices to rise affects the rate at which at least one price—Fred’s nominal wage—actually rises.
A similar dynamic affects the contracts for production inputs other than labor. For example, if Colleen is negotiating with her office supply company, the prices she will agree to pay for next year’s deliveries of copy paper and staples will depend on what she expects the inflation rate to be. If Colleen anticipates that the price of office supplies will not change relative to the prices of other goods and services, and that the general inflation rate will be 3 percent, then she should be willing to agree to a 3 percent increase in the price of office supplies. On the other hand, if she expects the general inflation rate to be 6 percent, then she will agree to pay 6 percent more for copy paper and staples next year, knowing that a nominal increase of 6 percent implies no change in the price of office supplies relative to other goods and services.
Economywide, then, the higher the expected rate of inflation, the more nominal wages and the cost of other inputs will tend to rise. But if wages and other costs of production grow rapidly in response to expected inflation, firms will have to raise their prices rapidly as well in order to cover their costs. Thus a high rate of expected inflation tends to lead to a high rate of actual inflation. Similarly, if expected inflation is low, leading wages and other costs to rise relatively slowly, actual inflation should be low as well.
CONCEPT CHECK 27.4
Assume that employers and workers agree that real wages should rise by 2 percent next year.
a. If inflation is expected to be 2 percent next year, what will happen to nominal wages next year?
b. If inflation is expected to be 4 percent next year, rather than 2 percent, what will happen to nominal wages next year?
c. Use your answers from parts a and b to explain how an increase in expected inflation will tend to affect the following year’s actual rate of inflation.
The conclusion that actual inflation is partially determined by expected inflation raises the question of what determines inflation expectations. To a great extent, people’s expectations are influenced by their recent experience. If inflation has been low and stable for some time, people are likely to expect it to continue to be low. But if inflation has recently been high, people will expect it to continue to be high. If inflation has been unpredictable, alternating between low and high levels, the public’s expectations will likewise tend to be volatile, rising or falling with news or rumors about economic conditions or economic policy.
Figure 27.4 illustrates schematically how low and stable inflation may tend to be self-perpetuating. As the figure shows, if inflation has been low for some time, people will continue to expect low inflation. Increases in nominal wages and other production costs will thus tend to be small. If firms raise prices only by enough to cover costs, then actual inflation will be low, as expected. This low actual rate will in turn promote low expected inflation, perpetuating the “virtuous circle.” The same logic applies in reverse in an economy with high inflation: A persistently high inflation rate leads the public to expect high inflation, resulting in higher increases in nominal wages and other production costs. This in turn contributes to a high rate of actual inflation, and so on in a vicious circle. This role of inflation expectations in the determination of wage and price increases helps to explain why inflation often seems to adjust slowly.
FIGURE 27.4 A Virtuous Circle of Low Inflation and Low Expected Inflation.Low inflation leads people to expect low inflation in the future. As a result, they agree to accept small increases in wages and in the prices of the goods and services they supply, which keeps inflation—and expected inflation—low. In a similar way, high inflation leads people to expect high inflation, which in turn tends to produce high inflation.
Long-Term Wage and Price Contracts
The role of inflation expectations in the slow adjustment of inflation is strengthened by a second key element, the existence of long-term wage and price contracts. Union wage contracts, for example, often extend for three years into the future. Likewise, contracts that set the prices manufacturing firms pay for parts and raw materials often cover several years. Long-term contracts serve to “build in” wage and price increases that depend on inflation expectations at the time the contracts were signed. For example, a union negotiating in a high-inflation environment is much more likely to demand a rapid increase in nominal wages over the life of the contract than would a union in an economy in which prices are stable.
To summarize, in the absence of external shocks, inflation tends to remain relatively stable over time—at least in low-inflation industrial economies like that of the United States. In other words, inflation is inertial (or as some people put it, “sticky”). Inflation tends to be inertial for two main reasons. The first is the behavior of people’s expectations of inflation. A low inflation rate leads people to expect low inflation in the future, which results in reduced pressure for wage and price increases. Similarly, a high inflation rate leads people to expect high inflation in the future, resulting in more rapid increases in wages and prices. Second, the effects of expectations are reinforced by the existence of long-term wage and price contracts, which is the second reason inflation tends to be stable over time. Long-term contracts tend to build in the effects of people’s inflation expectations.
Although the rate of inflation tends to be inertial, it does of course change over time. We next discuss a key factor causing the inflation rate to change.
CONCEPT CHECK 27.5
Based on Figure 27.4, discuss why the Federal Reserve has a strong incentive to maintain a low inflation rate in the economy.
THE OUTPUT GAP AND INFLATION
An important factor influencing the rate of inflation is the output gap, or the difference between actual output and potential output (Y − Y*). We have seen that, in the short run, firms will meet the demand for their output at previously determined prices. For example, Al’s ice cream shop will serve ice cream to any customer who comes into the shop at the prices posted behind the counter. The level of output that is determined by the demand at preset prices is called short-run equilibrium output.
At a particular time the level of short-run equilibrium output may happen to equal the economy’s long-run productive capacity, or potential output. But that is not necessarily the case. Output may exceed potential output, giving rise to an expansionary gap, or it may fall short of potential output, producing a recessionary gap. Let’s consider what happens to inflation in each of these three possible cases: no output gap, an expansionary gap, and a recessionary gap. The resulting outcomes are summarized in Table 27.1.
No Output Gap: Y = Y*
If actual output equals potential output, then by definition, there is no output gap. When the output gap is zero, firms are satisfied in the sense that their sales equal their normal production rates. As a result, firms have no incentive either to reduce or increase their prices relative to the prices of other goods and services. However, the fact that firms are satisfied with their sales does not imply that inflation—the rate of change in the overall price level—is zero.
To see why, let’s go back to the idea of inflation inertia. Suppose that inflation has recently been steady at 3 percent per year, so that the public has come to expect an inflation rate of 3 percent per year. If the public’s inflation expectations are reflected in the wage and price increases agreed to in long-term contracts, then firms will find their labor and materials costs are rising at 3 percent per year. To cover their costs, firms will need to raise their prices by 3 percent per year. Note that if all firms are raising their prices by 3 percent per year, the relative prices of various goods and services in the economy—say, the price of ice cream relative to the price of a taxi ride—will not change. Nevertheless, the economywide rate of inflation equals 3 percent, the same as in previous years. We conclude that, if the output gap is zero, the rate of inflation will tend to remain the same.
Expansionary Gap: Y > Y*
Suppose instead that an expansionary gap exists so that most firms’ sales exceed their normal production rates. As we might expect in situations in which the quantity demanded exceeds the quantity firms desire to supply, firms will ultimately respond by trying to increase their relative prices. To do so, they will increase their prices by more than the increase in their costs. If all firms behave this way, then the general price level will begin to rise more rapidly than before. Thus, when an expansionary gap exists, the rate of inflation will tend to increase.
Recessionary Gap: Y < Y*
Finally, if a recessionary gap exists, firms will be selling an amount less than their capacity to produce, and they will have an incentive to cut their relative prices so they can sell more. In this case, firms will raise their prices less than needed to cover fully their increases in costs, as determined by the existing inflation rate. As a result, when a recessionary gap exists, the rate of inflation will tend to decrease.
EXAMPLE 27.1Spending Changes and Inflation
How will a fall in consumer confidence affect the rate of inflation?
In Chapter 25, Spending and Output in the Short Run, and Chapter 26, Stabilizing the Economy: The Role of the Fed, we saw that changes in spending can create expansionary or recessionary gaps. Therefore, based on the discussion above, we can conclude that changes in spending also lead to changes in the rate of inflation. If the economy is currently operating at potential output, what effect will a fall in consumer confidence that makes consumers less willing to spend at each level of disposable income have on the rate of inflation in the economy?
An exogenous decrease in consumption spending, C, for a given level of inflation, output, and real interest rates, reduces aggregate expenditures and short-run equilibrium output. If the economy was originally operating at potential output, the reduction in consumption will cause a recessionary gap since actual output, Y, will now be less than potential output, Y*. As indicated above, when Y < Y*, the rate of inflation will tend to fall because firms’ sales fall short of normal production rates, leading them to slow down the rate at which they increase their prices.
CONCEPT CHECK 27.6
Suppose that firms become optimistic about the future and decide to increase their investment in new capital. What effect will this have on the rate of inflation, assuming that the economy is currently operating at potential output?
THE AGGREGATE DEMAND–AGGREGATE SUPPLY DIAGRAM
The adjustment of inflation in response to an output gap can be shown conveniently in a diagram. Figure 27.5, drawn with inflation π on the vertical axis and real output Y on the horizontal axis, is an example of an aggregate demand–aggregate supply diagram, or AD-AS diagram for short. The diagram has three elements, one of which is the downward-sloping AD curve, introduced earlier in the chapter. Recall that the AD curve shows how planned aggregate spending, and hence short-run equilibrium output, depends on the inflation rate. The second element is a vertical line marking the economy’s potential output Y*. Because potential output represents the economy’s long-run productive capacity, we will refer to this vertical line as the long-run aggregate supply (LRAS) line. The third element in Figure 27.5, and a new one, is the short-run aggregate supply line, labeled SRAS in the diagram. The short-run aggregate supply (SRAS) line is a horizontal line that shows the current rate of inflation in the economy, which in the figure is labeled π. We can think of the current rate of inflation as having been determined by past expectations of inflation and past pricing decisions. The short-run aggregate supply line is horizontal because, in the short run, producers supply whatever output is demanded at preset prices.
FIGURE 27.5 The Aggregate Demand–Aggregate Supply (AD-AS) Diagram.This diagram has three elements: the AD curve, which shows how short-run equilibrium output depends on inflation; the long-run aggregate supply (LRAS) line, which marks the economy’s potential output Y*; and the short-run aggregate supply (SRAS) line, which shows the current value of inflation π. Short-run equilibrium output, which is equal to Y here, is determined by the intersection of the AD curve and the SRAS line (point A). Because actual output Y is less than potential output Y*, this economy has a recessionary gap.
The AD-AS diagram can be used to determine the level of output prevailing at any particular time. As we have seen, the inflation rate at any moment is given directly by the position of the SRAS line—for example, current inflation equals π in Figure 27.5. To find the current level of output, recall that the AD curve shows the level of short-run equilibrium output at any given rate of inflation. Since the inflation rate in this economy is π, we can infer from Figure 27.5 that short-run equilibrium output must equal Y, which corresponds to the intersection of the AD curve and the SRAS line (point A in the figure). Notice that in Figure 27.5, short-run equilibrium output Y is smaller than potential output Y*, so there is a recessionary gap in this economy.
The intersection of the AD curve and the SRAS line (point A in Figure 27.5) is referred to as the point of short-run equilibrium in this economy. When the economy is in short-run equilibrium, inflation equals the value determined by past expectations and past pricing decisions, and output equals the level of short-run equilibrium output that is consistent with that inflation rate.
Although the economy may be in short-run equilibrium at point A in Figure 27.5, it will not remain there. The reason is that at point A, the economy is experiencing a recessionary gap (output is less than potential output, as indicated by the LRAS line). As we have just seen, when a recessionary gap exists, firms are not selling as much as they would like to and so they slow down the rate at which they increase their prices. Eventually, the low level of aggregate demand that is associated with a recessionary gap causes the inflation rate to fall.
The adjustment of inflation in response to a recessionary gap is shown graphically in Figure 27.6. As inflation declines, the SRAS line moves downward, from SRAS to SRAS′. Because of inflation inertia (caused by the slow adjustment of the public’s inflation expectations and the existence of long-term contracts), inflation adjusts downward only gradually. However, as long as a recessionary gap exists, inflation will continue to fall, and the SRAS line will move downward until it intersects the AD curve at point B in the figure. At that point, actual output equals potential output and the recessionary gap has been eliminated. Because there is no further pressure on inflation at point B, the inflation rate stabilizes at the lower level. A situation like that represented by point B in Figure 27.6, in which the inflation rate is stable and actual output equals potential output, is referred to as long-run equilibrium of the economy. Long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point.
FIGURE 27.6 The Adjustment of Inflation When a Recessionary Gap Exists.At the initial short-run equilibrium point A, a recessionary gap exists, which puts downward pressure on inflation. As inflation gradually falls, the SRAS line moves downward until it reaches SRAS′, and actual output equals potential output (point B). Once the recessionary gap has been eliminated, inflation stabilizes at π*, and the economy settles into long-run equilibrium at the intersection of AD, LRAS, and SRAS′ (point B).
Figure 27.6 illustrates the important point that when a recessionary gap exists, inflation will tend to fall. It also shows that as inflation declines, short-run equilibrium output rises, increasing gradually from Y to Y* as the short-run equilibrium point moves down the AD curve. The source of this increase in output is the behavior of the Federal Reserve, which lowers the real interest rate as inflation falls, stimulating aggregate demand. Falling inflation stimulates spending and output in other ways, such as by reducing uncertainty.3 As output rises cyclical unemployment, which by Okun’s law is proportional to the output gap, also declines. This process of falling inflation, falling real interest rates, rising output, and falling unemployment continues until the economy reaches full employment at point B in Figure 27.6, the economy’s long-run equilibrium point.
What happens if instead of a recessionary gap, the economy has an expansionary gap, with output greater than potential output? An expansionary gap would cause the rate of inflation to rise, as firms respond to high demand by raising their prices more rapidly than their costs are rising. In graphical terms, an expansionary gap would cause the SRAS line to move upward over time. Inflation and the SRAS line would continue to rise until the economy reached long-run equilibrium, with actual output equal to potential output. This process is illustrated in Figure 27.7. Initially, the economy is in short-run equilibrium at point A, where Y > Y* (an expansionary gap). The expansionary gap causes inflation to rise over time; graphically, the short-run aggregate supply line moves upward, from SRAS to SRAS′. As the SRAS line rises, short-run equilibrium output falls—the result of the Fed’s tendency to increase the real interest rate when inflation rises. Eventually the SRAS line intersects the AD curve LRAS and line at point B, where the economy reaches long-run equilibrium, with no output gap and stable inflation.
FIGURE 27.7 The Adjustment of Inflation When an Expansionary Gap Exists.At the initial short-run equilibrium point A, an expansionary gap exists. Inflation rises gradually (the SRAS line moves upward) and output falls. The process continues until the economy reaches long-run equilibrium at point B, where inflation stabilizes and the output gap is eliminated.
THE SELF-CORRECTING ECONOMY
Our analysis of Figures 27.6 and 27.7 makes an important general point: the economy tends to be self-correcting in the long run. In other words, given enough time, output gaps tend to disappear without changes in monetary or fiscal policy (other than the change in the real interest rate embodied in the Fed’s policy reaction function). Expansionary output gaps are eliminated by rising inflation, while recessionary output gaps are eliminated by falling inflation. This result contrasts sharply with the basic Keynesian model, which does not include a self-correcting mechanism. The difference in results is explained by the fact that the basic Keynesian model concentrates on the short-run period, during which prices do not adjust, and does not take into account the changes in prices and inflation that occur over a longer period.
Does the economy’s tendency to self-correct imply that aggressive monetary and fiscal policies are not needed to stabilize output? The answer to this question depends crucially on the speed with which the self-correction process takes place. If self-correction takes place very slowly, so that actual output differs from potential for protracted periods, then active use of monetary and fiscal policy can help to stabilize output. But if self-correction is rapid, then active stabilization policies are probably not justified in most cases, given the lags and uncertainties that are involved in policymaking in practice. Indeed, if the economy returns to full employment quickly, then attempts by policymakers to stabilize spending and output may end up doing more harm than good, for example, by causing actual output to “overshoot” potential output.
The speed with which a particular economy corrects itself depends on a variety of factors, including the prevalence of long-term contracts and the efficiency and flexibility of product and labor markets. (For a case study, see the comparison of U.S. and European labor markets in Chapter 20, The Labor Market: Workers, Wages, and Unemployment.) However, a reasonable conclusion is that the greater the initial output gap, the longer the economy’s process of self-correction will take. This observation suggests that stabilization policies should not be used actively to try to eliminate relatively small output gaps, but that they may be quite useful in remedying large gaps—for example, when the unemployment rate is exceptionally high.
RECAP
Inflation, AD-AS, AND THE SELF-CORRECTING ECONOMY
· The economy is in short-run equilibrium when inflation equals the value determined by past expectations and pricing decisions, and output equals the level of short-run equilibrium output that is consistent with that inflation rate. Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line. We refer to the fact that inflation is determined by past inflation (which affects past expectations and pricing decisions) as inflation inertia.
· The economy is in long-run equilibrium when actual output equals potential output (there is no output gap) and the inflation rate is stable. Graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line intersect at a common point.
· Inflation adjusts gradually to bring the economy into long-run equilibrium (a phenomenon called the economy’s self-correcting tendency). Inflation rises to eliminate an expansionary gap and falls to eliminate a recessionary gap. Graphically, the SRAS line moves up or down as needed to bring the economy into long-run equilibrium.
· The more rapid the self-correction process, the less need for active stabilization policies to eliminate output gaps. In practice, policymakers’ attempts to eliminate output gaps are more likely to be helpful when the output gap is large than when it is small.
SOURCES OF INFLATION
We have seen that inflation can rise or fall in response to an output gap. But what creates the output gaps that give rise to changes in inflation? And are there factors besides output gaps that can affect the inflation rate? In this section, we use the AD-AS diagram to explore the ultimate sources of inflation. We first discuss how excessive growth in aggregate spending can spur inflation; then we turn to factors operating through the supply side of the economy.
EXCESSIVE AGGREGATE SPENDING
One important source of inflation in practice is excessive aggregate spending—or, in more colloquial terms, “too much spending chasing too few goods.” Example 27.2 illustrates.
EXAMPLE 27.2Military Buildups and Inflation
Can the Fed do anything to prevent inflation caused by wars or military buildups?
Wars and military buildups are sometimes associated with increased inflation. Explain why, using the AD-AS diagram. Can the Fed do anything to prevent the increase in inflation caused by a military buildup?
Wars and military buildups are potentially inflationary because increased spending on military hardware raises total demand relative to the economy’s productive capacity. In the face of rising sales, firms increase their prices more quickly, raising the inflation rate.
The two panels of Figure 27.8 illustrate this process. Looking first at Figure 27.8(a), suppose that the economy is initially in long-run equilibrium at point A, where the aggregate demand curve AD intersects both the short-run and long-run aggregate supply lines, SRAS and LRAS, respectively. Point A is a long-run equilibrium point, with output equal to potential output and stable inflation. Now suppose that the government decides to spend more on armaments. Increased military spending is an increase in government purchases G, an exogenous increase in spending. We saw earlier that, for a given level of inflation, an exogenous increase in spending raises short-run equilibrium output, shifting the AD curve to the right. Figure 27.8(a) shows the aggregate demand curve shifting rightward, from AD to AD′, as the result of increased military expenditure. The economy moves to a new, short-run equilibrium at point B, where AD′ intersects SRAS. Note that at point B actual output has risen above potential, to Y > Y*, creating an expansionary gap. Because inflation is inertial and does not change in the short run, the immediate effect of the increase in government purchases is only to increase output, just as we saw in the Keynesian cross analysis in Chapter 24, Short-Term Economic Fluctuations: An Introduction.
FIGURE 27.8 War and Military Buildup as a Source of Inflation.(a) An increase in military spending shifts the AD curve to the right, from AD to AD′. At the new short-run equilibrium point B, actual output has risen above potential output Y*, creating an expansionary gap. (b) This gap leads to rising inflation, shown as an upward movement of the SRAS line, from SRAS to SRAS′. At the new long-run equilibrium point C, actual output has fallen back to the level of potential output, but at π′ inflation is higher than it was originally.
The process doesn’t stop there, however, because inflation will not remain the same indefinitely. At point B, an expansionary gap exists, so inflation will gradually begin to increase. Figure 27.8(b) shows this increase in inflation as a shift of the SRAS line from its initial position to a higher level, SRAS′. When inflation has risen to π′, enough to eliminate the output gap (point C), the economy is back in long-run equilibrium. We see now that the increase in output created by the military buildup was only temporary. In the long run, actual output has returned to the level of potential output, but at a higher rate of inflation.
Does the Fed have the power to prevent the increased inflation that is induced by a rise in military spending? The answer is yes. We saw earlier that a decision by the Fed to set a higher real interest rate at any given level of inflation—an upward shift in the policy reaction function—will shift the AD curve to the left. So if the Fed aggressively tightens monetary policy (shifts its reaction function) as the military buildup proceeds, it can reverse the rightward shift of the AD curve caused by increased government spending. Offsetting the rightward shift of the AD curve in turn avoids the development of an expansionary gap, with its inflationary consequences. The Fed’s policy works because the higher real interest rate it sets at each level of inflation acts to reduce consumption and investment spending. The reduction in private spending offsets the increase in demand by the government, eliminating—or at least moderating—the inflationary impact of the military purchases.
We should not conclude, by the way, that avoiding the inflationary consequences of a military buildup makes the buildup costless to society. As we have just noted, inflation can be avoided only if consumption and investment are reduced by a policy of higher real interest rates. Effectively, the private sector must give up some resources so that more of the nation’s output can be devoted to military purposes. This reduction in resources reduces both current living standards (by reducing consumption) and future living standards (by reducing investment).
The Economic Naturalist 27.1
How did inflation get started in the United States in the 1960s?
In the United States from 1959 through 1963, inflation hovered around 1 percent per year. Beginning in 1964, however, inflation began to rise, reaching nearly 6 percent in 1970. Why did inflation become a problem in the United States in the 1960s?
Increases in government spending, plus the failure of the Federal Reserve to act to contain inflation, appear to explain most of the increase in inflation during the 1960s. On the fiscal side, military expenditures increased dramatically in the latter part of the decade as the war in Vietnam escalated. Annual defense spending, which hovered around $70 billion from 1962 to 1965, rose to more than $100 billion by 1968 and remained at a high level for some years. To appreciate the size of this military buildup relative to the size of the economy, note that the increase in military spending alone between 1965 and 1968 was about 1.3 percent of GDP—from 9.5 percent of GDP in 1965 to 10.8 percent of GDP in 1968. For comparison, in 2016 the total U.S. defense budget was 3.9 percent of GDP, so its share of the economy would have to increase by about 33 percent over three years to have a similar relative increase. Moreover, at about the same time as the wartime military buildup, government spending on social programs—reflecting the impact of President Lyndon Johnson’s Great Society and War on Poverty initiatives—also increased dramatically.
These government-induced increases in total spending contributed to an economic boom. Indeed, the 1961–1969 economic expansion was the longest in history at the time, being surpassed only 30 years later by the long expansion of the 1990s. However, an expansionary gap developed and eventually inflation began to rise, as would have been predicted by the analysis in Example 27.2.
An interesting contrast exists between these effects of the 1960s military buildup and those of the 1980s buildup under President Reagan, which did not lead to an increase in inflation. One important difference between the two eras was the behavior of the Federal Reserve. As we saw in Example 27.2, the Fed can offset the inflationary impact of increased government spending by fighting inflation more aggressively (shifting its policy reaction function upward). Except for a brief attempt in 1966, the Federal Reserve generally did not try actively to offset inflationary pressures during the 1960s. That failure may have been simply a miscalculation, or it may have reflected a reluctance to take the politically unpopular step of slowing the economy during a period of great political turmoil. But in the early 1980s, under Paul Volcker, the Federal Reserve acted vigorously to contain inflation. As a result, inflation actually declined in the 1980s, despite the military buildup.
CONCEPT CHECK 27.7
In Example 27.1, we found that a decline in consumer spending tends to reduce the rate of inflation. Using the AD-AS diagram, illustrate the short-run and long-run effects of a fall in consumer spending on inflation. How does the decline in spending affect output in the short run and in the long run?
Whereas output gaps cause gradual changes in inflation, on occasion an economic shock can cause a relatively rapid increase or decrease in inflation. Such jolts to prices, which we call inflation shocks, are the subject of the next section.
INFLATION SHOCKS
In late 1973, at the time of the Yom Kippur War between Israel and a coalition of Arab nations, the Organization of Petroleum-Exporting Countries (OPEC) dramatically cut its supplies of crude oil to the industrialized nations, quadrupling world oil prices. The sharp increase in oil prices was quickly transferred to the price of gasoline, heating oil, and goods and services that were heavily dependent on oil, such as air travel. The effects of the oil price increase, together with agricultural shortages that increased the price of food, contributed to a significant rise in the overall U.S. inflation rate in 1974.4
OPEC’s 1974 cutback in oil production created long lines, rising prices, and frayed tempers at the gas pump.©Everett Collection Historical/Alamy Stock Photo
The increase in inflation in 1974 is an example of what is referred to as an inflation shock. An inflation shock is a sudden change in the normal behavior of inflation, unrelated to the nation’s output gap. An inflation shock that causes an increase in inflation, like the large rise in oil prices in 1973, is called an adverse inflation shock. An inflation shock that reduces inflation is called a favorable inflation shock.
In contrast with the experience of the 1970s, when sharp increases in oil prices led to higher inflation, since the mid-1980s the effects of oil price changes on inflation have been much smaller. Economic Naturalist 27.2 gives more details on the economic effects of inflation shocks, and discusses explanations for the smaller effects of oil price changes on inflation in more recent years.
The Economic Naturalist 27.2
Why did oil price increases cause U.S. inflation to escalate in the 1970s but not in the 2000s?
Having risen in the second half of the 1960s, inflation continued to rise in the 1970s. Already at 6.2 percent in 1973, inflation jumped to 11.0 percent in 1974. After subsiding from 1974 to 1978, it began to rise again in 1979, to 11.4 percent, and reached 13.5 percent in 1980. Why did inflation increase so much in the 1970s?
We have already described the quadrupling of oil prices in late 1973 and the sharp increases in agricultural prices at about the same time, which together constituted an adverse inflation shock. A second inflation shock occurred in 1979, when the turmoil of the Iranian Revolution restricted the flow of oil from the Middle East and doubled oil prices yet again.
Figure 27.9 shows the effects of an adverse inflation shock on a hypothetical economy. Before the inflation shock occurs, the economy is in long-run equilibrium at point A, at the intersection of AD, LRAS, and SRAS. At point A, actual output is equal to potential output Y*, and the inflation rate is stable at π. However, an adverse inflation shock directly increases inflation so that the SRAS line shifts rapidly upward to SRAS′. A new short-run equilibrium is established at point B, where SRAS′ intersects the aggregate demand curve AD. In the wake of the inflation shock, inflation rises to π′ and output falls, from Y* to Y′. Thus an inflation shock creates the worst possible scenario: higher inflation coupled with a recessionary gap. The combination of inflation and recession has been referred to as stagflation, or stagnation plus inflation. The U.S. economy experienced a stagflation in 1973–1975, after the first oil shock, and again in 1980, after the second oil shock.
FIGURE 27.9 The Effects of an Adverse Inflation Shock.Starting from long-run equilibrium at point A, an adverse inflation shock directly raises current inflation, causing the SRAS line to shift upward to SRAS′. At the new short-run equilibrium, point B, inflation has risen to π′ and output has fallen to Y′, creating a recessionary gap. If the Fed does nothing, eventually the economy will return to point A, restoring the original inflation rate but suffering a long recession in the process. The Fed could ease monetary policy by shifting down its policy reaction function, shifting the AD curve to AD′, and restoring full employment more quickly at point C. The cost of this strategy is that inflation remains at its higher level.
An adverse inflation shock poses a difficult dilemma for macroeconomic policymakers. To see why, suppose monetary and fiscal policies were left unchanged following an inflationary shock. In that case, inflation would eventually abate and return to its original level. Graphically, the economy would reach its short-run equilibrium at point B in Figure 27.9 soon after the inflation shock. However, because of the recessionary gap that exists at point B, eventually inflation would begin to drift downward, until finally the recessionary gap is eliminated. Graphically, this decline in inflation would be represented by a downward movement of the SRAS line, from SRAS′ back to SRAS. Inflation would stop declining only when long-run equilibrium is restored, at point A in the figure, where inflation is at its original level of π and output equals potential output.
However, although a “do-nothing” policy approach would ultimately eliminate both the output gap and the surge in inflation, it would also put the economy through a deep and protracted recession, as actual output remains below potential output until the inflation adjustment process is completed. To avoid such an economically and politically costly outcome, policymakers might opt to eliminate the recessionary gap more quickly. By aggressively easing monetary policy (more precisely, by shifting down its policy reaction function), for example, the Fed could shift the AD curve to the right, from AD to AD′, taking the economy to a new long-run equilibrium, point C in Figure 27.9. This expansionary policy would help to restore output to the full-employment level more quickly, but as the figure shows, it would also allow inflation to stabilize at the new, higher level.
In sum, inflation shocks pose a true dilemma for policymakers. If they leave their policies unchanged, inflation will eventually subside, but the nation may experience a lengthy and severe recession. If, instead, they act aggressively to expand aggregate spending, the recession will end more quickly, but inflation will stabilize at a higher level. In the 1970s, though U.S. policymakers tried to strike a balance between stabilizing output and containing inflation, the combination of recession and increased inflation hobbled the economy.
The 1970s were not the last time, however, that oil prices sharply increased. Since the late 1990s, oil prices have swung even more wildly than in the 1970s, yet inflation remained relatively stable. Why did the oil price increases of the 2000s not lead to the effects analyzed in Figure 27.9?
Economists proposed different answers to this important question, and it appears that for a full explanation, several factors should be combined. For example, the economists Olivier Blanchard and Jordi Galí, who studied this question, focused on the following three explanations, and concluded that all three are likely to have played an important role.5 First, labor markets have become more flexible, and wages less sticky, since the 1970s. If wages and prices adjust more quickly, the economy in Figure 27.9 would return to point A more quickly, even with a do-nothing policy by the Fed. Second, the share of oil in the economy has declined since the 1970s. With oil less important in both production and consumption, the effects of oil price changes on the economy are expected to be smaller.
Third, and most closely related to the discussion in this chapter, the public’s expectations regarding the Fed’s reaction to oil price increases were dramatically different in the 2000s compared with those in the 1970s. Specifically, in the 1970s, people did not believe that the Fed would return inflation to a low level following an oil price increase. As a result, firms responded by increasing their prices more quickly, and workers demanded wage increases to reflect higher costs of living. But in the 2000s, after Fed chairs Paul Volcker and his successor Alan Greenspan had brought inflation down and showed that the Fed was committed to keeping it low, expectations of inflation were much more stable and, as a result, the oil price shocks did not lead to extended periods of increases in wages and other prices.
Economic Naturalist 27.2 ended by returning to the idea that a central bank’s credibility and perceived commitment to maintaining low inflation can by themselves help in achieving the goal of low inflation. This idea has already appeared on several occasions earlier in the chapter—for example, when we discussed Volcker’s reputation of conservatism and toughness (in the introduction) and when we illustrated the virtuous cycle of low expected inflation and low inflation (in Figure 27.4). We will revisit this idea again later in the chapter, when mentioning some central banks’ commitment to an explicit inflation target.
In Chapter 22, Money, Prices, and the Federal Reserve, we discussed the long-run relationship between inflation and money growth. The example of an inflation shock shows that inflation does not always originate from excessive money growth; it can arise from a variety of factors. However, our analysis also shows that, in the absence of monetary easing, inflation that arises from factors such as inflation shocks will eventually die away. By contrast, sustained inflation requires that monetary policy remain easy, that is, policymakers allow the money supply to rise rapidly. In this respect, our analysis of this chapter is constant with the earlier long-run analysis, which concluded that sustained inflation is possible only if monetary policy is sufficiently expansionary.
CONCEPT CHECK 27.8
Inflation shocks can also be beneficial for the economy, such as when oil prices declined in the late 1990s. What effect would a decrease in oil prices have on output and inflation?
SHOCKS TO POTENTIAL OUTPUT
In analyzing the effects of increased oil prices on the U.S. economy in the 1970s, we assumed that potential output was unchanged in the wake of the shock. However, the sharp rise in oil prices during that period probably affected the economy’s potential output as well. As oil prices rose, for example, many companies retired less energy-efficient equipment or scrapped older “gas-guzzling” vehicles. A smaller capital stock implies lower potential output.
If the increases in oil prices did reduce potential output, their inflationary impact would have been compounded. Figure 27.10 illustrates the effects on the economy of a sudden decline in potential output. For the sake of simplicity, the figure includes only the effects of the reduction in potential output, and not the direct effect of the inflation shock. (Problem 7 at the end of the chapter asks you to combine the two effects.)
FIGURE 27.10 The Effects of a Shock to Potential Output.The economy is in long-run equilibrium at point A when a decline in potential output, from Y* to Y*′, creates an expansionary gap. Inflation rises, and the short-run aggregate supply line shifts upward from SRAS to SRAS′. A new long-run equilibrium is reached at point B, where actual output equals the new, lower level of potential output, Y*′, and inflation has risen to π′. Because it is the result of a fall in potential output, the decline in output is permanent.
Suppose once again that the economy is in long-run equilibrium at point A. Then potential output falls unexpectedly, from Y* to Y*′, shifting the long-run aggregate supply line leftward from LRAS to LRAS′. After this decline in potential output, is the economy still in long-run equilibrium at point A? The answer is no, because output now exceeds potential output at that point. In other words, an expansionary gap has developed. This gap reflects the fact that although planned spending has not changed, the capacity of firms to supply goods and services has been reduced.
As we have seen, an expansionary gap leads to rising inflation. In Figure 27.10, increasing inflation is represented by an upward movement of the SRAS line. Eventually the short-run aggregate supply line reaches SRAS′, and the economy reaches a new long-run equilibrium at point B. (Why is point B a long-run, and not just a short-run, equilibrium?) At that point, output has fallen to the new, lower level of potential output, Y*′, and inflation has risen to π′.
Sharp changes in potential output and inflation shocks are both referred to as aggregate supply shocks. As we have seen, an adverse aggregate supply shock of either type leads to lower output and higher inflation and, therefore, poses a difficult challenge for policymakers. A difference between the two types of aggregate supply shocks is that the output losses associated with an adverse inflation shock are temporary (because the economy self-corrects and will ultimately return to its initial level of potential output), but those associated with a fall in potential output are permanent (output remains lower even after the economy has reached a new long-run equilibrium).
The Economic Naturalist 27.3
Why was the United States able to experience rapid growth and low inflation in the latter part of the 1990s?
The second half of the 1990s was a boom period in the U.S. economy. As Table 27.2 shows, real GDP growth during the 1995–2000 period was 4.3 percent per year, significantly higher than the average growth rate over the previous decade; and unemployment averaged only 4.6 percent, also significantly better than the prior decade. Despite this rapid economic growth, inflation during 1995–2000 was contained, averaging only 2.5 percent per year. Why was the United States able to enjoy both rapid growth and low inflation in the latter 1990s?
During the latter part of the 1990s, the U.S. economy benefited from a positive shock to potential output. An important source of the faster-than-usual expansion of potential output was impressive technological advance, particularly in computers and software, as well as the application of these advances in areas ranging from automobile production to retail inventory management. One of the most prominent developments, the rapid growth of the Internet, not only made it possible for consumers to shop or find information online, but also helped companies to improve their efficiency—for example, by improving coordination between manufacturers and their suppliers. These advances were reflected in more rapid productivity growth; as Table 27.2 shows, average annual growth of output per employed worker accelerated from 1.4 percent during the 1985–1995 period to a remarkable 2.4 percent during 1995–2000 (see Economic Naturalist 19.2).
Graphically, the effects of a positive shock to potential output are just the reverse of those seen in Figure 27.10, which shows the effects of an adverse shock. A positive shock to potential output causes the LRAS line to shift right, leading in the short run to a recessionary gap (output is lower than the new, higher level of potential output). Inflation declines, reflected in a downward movement of the SRAS line. In the new, long-run equilibrium, output is higher and inflation lower than initially. These results are consistent with the U.S. experience of the latter part of the 1990s.
CONCEPT CHECK 27.9
What if productivity hadn’t increased in the late 1990s? How would the economy have been different in 2000?
RECAP
SOURCES OF INFLATION
· Inflation may result from excessive spending, which creates an expansionary output gap and puts upward pressure on inflation. An example is a military buildup, which raises government purchases. Monetary policy or fiscal policy can be used to offset excessive spending, preventing higher inflation from emerging.
· Inflation may also arise from an aggregate supply shock, either an inflation shock or a shock to potential output. An inflation shock is a sudden change in the normal behavior of inflation, unrelated to the nation’s output gap. An example of an inflation shock is a run-up in energy and food prices large enough to raise the overall price level. In the absence of public beliefs that the central bank is committed to maintaining low inflation, an inflation shock would lead to stagflation, a combination of recession and higher inflation.
· Stagflation poses a difficult dilemma for policymakers. If they take no action, eventually inflation will subside and output will recover, but in the interim the economy may suffer a protracted period of recession. If they use monetary or fiscal policy to increase aggregate demand, they will shorten the recession but will also lock in the higher level of inflation.
· A shock to potential output is a sharp change in potential output. Like an adverse inflation shock, an adverse shock to potential output results in both higher inflation and lower output. Because lower potential output implies that productive capacity has fallen, however, output does not recover following a shock to potential output, as it eventually does following an inflation shock.
CONTROLLING INFLATION
High or even moderate rates of inflation can impose significant costs to the economy. Indeed, over the past several decades a consensus has developed among economists and policymakers that low and stable inflation is important and perhaps necessary for sustained economic growth. What, then, should policymakers do if the inflation rate is too high? As Example 27.3 will show, inflation can be slowed by policies that shift the aggregate demand curve leftward. Unfortunately, although they produce long-term gains in productivity and economic growth, such policies are likely to impose significant short-run costs in the form of lost output and increased unemployment.
EXAMPLE 27.3The Effects of Anti-Inflationary Monetary Policy
How will output, unemployment, and inflation react to a monetary-policy tightening?
Suppose that, although the economy is at full employment, the inflation rate is 10 percent—too high to be consistent with economic efficiency and long-term economic growth. The Fed decides to tighten monetary policy to reduce the inflation rate to 3 percent. What will happen to output, unemployment, and inflation in the short run? Over the long run?
The economic effects of a monetary tightening are very different in the short and long run. Figure 27.11(a) shows the short-run effect. Initially, the economy is in long-run equilibrium at point A, where actual output equals potential output. But at point A, the inflation rate (10 percent) is high, as indicated by the aggregate supply line, SRAS.
FIGURE 27.11 Short-Run and Long-Run Effects of an Anti-inflationary Monetary Policy.(a) Initially the economy is in long-run equilibrium at point A, with actual output equal to potential and the inflation rate at 10 percent. If an anti-inflationary policy shift by the Fed shifts the AD curve to the left, from AD to AD′, the economy will reach a new short-run equilibrium at point B, at the intersection of AD′ and SRAS. As short-run equilibrium output falls to Y, a recessionary gap opens up. The inflation rate does not change in the short run. (b) Following the tightening of monetary policy, a recessionary gap exists at point B, which eventually causes inflation to decline. The short-run aggregate supply line moves downward, from SRAS to SRAS′. Long-run equilibrium is restored at point C. In the long run, real output returns to potential and inflation stabilizes at a lower level (3 percent in this figure).
To bring inflation down to 3 percent, what can policymakers do? To get “tough” on inflation, the Fed must set the real interest rate at a level higher than normal, given the rate of inflation. In other words, the Fed must shift its policy reaction function upward, as in Figure 27.11(a). At a constant rate of inflation, an increase in the real interest rate set by the Fed will reduce consumption and investment spending, lowering aggregate demand at every inflation rate. As we saw earlier in the chapter, this monetary tightening by the Fed causes the AD curve to shift leftward, from AD to AD′ in Figure 27.11(a).
After the Fed’s action, the AD′ curve and the SRAS line intersect at point B in Figure 27.11(a), the new short-run equilibrium point. At point B actual output has fallen to Y, which is less than potential output Y*. In other words, the Fed’s action has allowed a recessionary gap to develop, one result of which will be that unemployment will exceed the natural rate. At point B, however, the inflation rate has not changed, remaining at 10 percent. We conclude that in the short run, a monetary tightening pushes the economy into recession but has little or no effect on the inflation rate, because of inflation inertia.
The short-run effects of the anti-inflationary shift in monetary policy—lower output, higher unemployment, and little or no reduction of inflation—are to say the least not very encouraging, and they explain why such policy shifts are often highly unpopular in their early stages. Fortunately, however, we have not reached the end of the story—because the economy will not remain at point B indefinitely. The reason is that the existence of a recessionary gap at that point eventually causes inflation to decline, as firms become more reluctant to raise their prices in the face of weak demand.
Graphically, the eventual decline in inflation that results from a recessionary gap is represented by the downward movement of the short-run aggregate supply line, from SRAS to SRAS′ in Figure 27.11(b). Inflation will continue to fall until the economy returns to long-run equilibrium at point C. At that point, actual output has returned to potential, and the inflation rate has stabilized at 3 percent. So we see that a tight monetary policy inflicts short-term pain (a decline in output, high unemployment, and a high real interest rate) to achieve a long-term gain (a permanent reduction in inflation). Incidentally, the result that an upward shift in the monetary policy reaction function leads to a permanently lower rate of inflation suggests a useful alternative way to think about such shifts: An upward shift in the Fed’s reaction function is equivalent to a decline in its long-term target for inflation (see Concept Check 27.2). Similarly, a downward shift in the Fed’s reaction function could be interpreted as an increase in the Fed’s long-term inflation target.
Economic Naturalist 27.4 discusses the real-life episode of Fed tightening with which we began this chapter.
CONCEPT CHECK 27.10
Show the typical time paths of output, inflation, and the real interest rate when the Fed employs an anti-inflationary monetary policy. Draw a separate graph for each variable, showing time on the horizontal axis. Be sure to distinguish the short run from the long run. Specific numerical values are not necessary.
The Economic Naturalist 27.4
How was inflation conquered in the 1980s?
After reaching double-digit levels in the late 1970s, inflation in the United States declined sharply in the 1980s. After peaking at 13.5 percent in 1980, the inflation rate fell all the way to 3.2 percent in 1983, and it remained in the 2–5 percent range for the rest of the decade. In the 1990s inflation fell even lower, in the 2–3 percent range in most years. How was inflation conquered in the 1980s?
The person who was most directly responsible for the conquest of inflation in the 1980s was the Federal Reserve’s chairman, Paul Volcker. Following the secret Saturday meeting he called on October 6, 1979 (described in the introduction to this chapter), the Federal Open Market Committee agreed to adopt a strongly anti-inflationary monetary policy. The results of this policy change on the U.S. economy are shown in Table 27.3, which includes selected macroeconomic data for the period 1978–1985.
The data in Table 27.3 fit our analysis of anti-inflationary monetary policy quite well. First, as our model predicts, in the short run the Fed’s sharp tightening of monetary policy led to a recession. In fact, two recessions followed the Fed’s action in 1979, a short one in 1980 and a deeper one in 1981–1982. Note that growth in real GDP was negative in 1980 and 1982, and the unemployment rate rose significantly, peaking at 9.7 percent in 1982. Nominal and real interest rates also rose, a direct effect of the shift in monetary policy. Inflation, however, did not respond much during the period 1979–1981. All these results are consistent with the short-run analysis in Figure 27.11.
By 1983, however, the situation had changed markedly. The economy had recovered, with strong growth in real GDP in 1983–1985 (see Table 27.3). In 1984, the unemployment rate, which tends to lag the recovery, began to decline. Interest rates remained relatively high, perhaps reflecting other factors besides monetary policy. Most significantly, inflation fell in 1982–1983 and stabilized at a much lower level. Inflation has remained low in the United States ever since.
A substantial reduction in the rate of inflation, like the one the Fed engineered in the 1980s, is called a disinflation. But again, disinflation comes at the cost of a large recessionary gap and high unemployment like that experienced by the United States in the early 1980s. Is this cost worth bearing? This question is not an easy one to answer, because the costs of inflation are difficult to measure. Policymakers around the world appear to agree on the necessity of containing inflation, however, as many countries fought to bring their own inflation rates down to 2 percent or less in the 1980s and 1990s. Canada and Great Britain are among the many industrial countries that have borne the costs of sharp reductions in inflation.
Can the costs of disinflation be reduced? Unfortunately, no one has found a pain-free method of lowering the inflation rate. Accordingly, in recent decades central banks around the world have striven to keep inflation at manageable levels, to avoid the costs of disinflation. In the United States, under Alan Greenspan (Paul Volcker’s immediate successor, who was Chair of the Fed from 1987 to 2006), the Federal Reserve followed a strategy of preemptive strikes, raising interest rates at the first sign that inflation might soon begin to creep upward. This strategy appears to have been successful in keeping inflation low and avoiding the need for costly disinflation. Other countries—Canada, Great Britain, Sweden, Mexico, Brazil, Chile, Israel, and many others—have announced explicit numerical targets for the long-run inflation rate, usually in the range of 1–3 percent per year. More recently, the Fed announced that it views a 2 percent inflation rate as “most consistent over the longer run with the Federal Reserve’s statutory mandate.”6 In its statement, the Fed added: “Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored.” The philosophy behind inflation targets is the same as that behind the preemptive approach to inflation: If inflation can be kept low, the economy can enjoy the resulting long-term benefits without having to incur the short-term costs of disinflationary policies like the ones followed by Chairman Volcker.
The Economic Naturalist 27.5
Can inflation be too low?
As the last section points out, the Federal Reserve is normally focused on keeping inflation from rising too fast, but by late 2002, some Fed policymakers began to worry that inflation might actually be too low. Why?
Minutes of the Federal Reserve’s September 24, 2002, Federal Open Market Committee meeting, where Federal Reserve policymakers determine future monetary policy actions, indicate that committee members were concerned that continuing weakness in the U.S. economy was likely to lead to “quite low and perhaps declining inflation” well into 2003.7 With prices of consumer goods rising only about 1.5 percent from September 2001 to September 2002, members noted that “further sizable disinflation that resulted in a nominal inflation rate near zero could create problems for the implementation of monetary policy through conventional means in the event of an adverse shock to the economy.”
The potential for future monetary policymaking problems was raised by the combination of low inflation rates, low interest rates, and the possibility of further economic weakness. During 2001 and 2002, the Federal Reserve reduced its target for the federal funds rate to 1.75 percent, the lowest level in four decades, in an attempt to provide economic stimulus to an economy slowly emerging from recession. With an inflation rate of 1.5 percent, the resulting real rate of interest—the difference between the nominal interest rate and the inflation rate—was nearly zero percent by September 2002.
Why did this create a potential problem for the Federal Reserve? With inflation rates already low and possibly falling, if the Fed was forced in the future to further stimulate aggregate spending in response to a negative economywide spending shock—a real possibility given the concerns about a U.S. military confrontation with Iraq—it might need to reduce the real rate of interest below zero percent. As pointed out in Chapter 26, Stabilizing the Economy: The Role of the Fed, business and consumer spending respond to real interest rates, not nominal interest rates. However, in a period of declining inflation, the Federal Reserve needs to reduce nominal interest rates by more than the fall in inflation to reduce the real rate of interest. With the federal funds rate already at historic lows, Fed officials were worried that they would not be able to lower nominal interest rates enough to reduce real interest rates further. In particular, if the inflation rate fell to zero percent, the Fed would not be able to generate a negative real federal funds rate even if it pushed the (nominal) federal funds rate to its zero lower bound, thereby limiting the Fed’s ability to conduct conventional expansionary monetary policy to offset a recessionary gap. Indeed, partly as a preemptive measure to prevent further economic weakening and declines in inflation, the Fed acted at its next meeting, in November 2002, to cut the federal funds rate to 1.25 percent.
However, Fed officials at the time also noted that, even if the federal funds rate were to be reduced all the way to zero percent, the Fed would still have a variety of options available to stimulate aggregate spending in the U.S. economy. For example, the Federal Reserve could buy long-term U.S. Treasury bonds (a form of quantitative easing), reducing long-term interest rates, in an effort to spur investment spending. As pointed out in the previous chapter, the Fed’s monetary actions typically focus on the federal funds rate, a very short-term interest rate that may or may not move in concert with long-term interest rates that particularly influence mortgage lending. In addition, the Federal Reserve could increase its discount window lending to banks to promote increased consumer and business lending, intervene in foreign exchange markets to reduce the value of the dollar in an attempt to stimulate net exports, or finance a federal government tax cut by buying additional bonds, expanding the money supply in the process.
All of these nontraditional, or unconventional, Fed policy actions have the effect of injecting more money into the economy, leading to increased aggregate spending and higher inflation rates over time. By using these monetary policy tools the Fed could, if necessary, generate negative real interest rates by inducing higher inflation, even if the federal funds rate is at zero percent. Thus, while low inflation rates, coupled with low interest rates, make monetary policymaking more complicated, interest rates can’t ever really be “too low” to eliminate the Fed’s ability to stimulate the economy. Indeed, as discussed in the previous chapter, six years after these late-2002 FOMC meetings the Fed would embark on a massive campaign of unconventional expansionary monetary policy to offset the recessionary gap of the 2007–2009 recession.
Too-low inflation was again a concern in 2015 not only in the U.S., but also in other major economies, including those of Europe and Japan, where inflation persisted below central banks’ targets. To try to get inflation up to target, both the European Central Bank (ECB) and the Bank of Japan (BOJ), following the example of the Fed from a few years earlier, introduced quantitative easing programs.
RECAP
CONTROLLING INFLATION
Inflation can be controlled by policies that shift the aggregate demand curve leftward, such as a move to a “tighter” monetary policy (an upward shift in the monetary policy reaction function). In the short run, the effects of an anti-inflationary monetary policy are felt largely on output, so that a disinflation (a substantial reduction in inflation) may create a significant recessionary gap. According to the theory, in the long run output should return to potential and inflation should decline. These predictions appear to have been borne out during the Volcker disinflation of the early 1980s.
SUMMARY
· This chapter extended the basic Keynesian model to include inflation. First, we showed how planned spending and short-run equilibrium output are related to inflation, a relationship that is summarized by the aggregate demand curve. Second, we discussed how inflation itself is determined. In the short run, inflation is determined by past expectations and pricing decisions, but in the longer run inflation adjusts as needed to eliminate output gaps. (LO1)
· The aggregate demand (AD) curve shows the relationship between short-run equilibrium output and inflation. Because short-run equilibrium output is equal to planned spending, the aggregate demand curve also relates spending to inflation. Increases in inflation reduce planned spending and short-run equilibrium output, so the aggregate demand curve is downward-sloping. (LO1)
· The inverse relationship of inflation and short-run equilibrium output is the result, in large part, of the behavior of the Federal Reserve. To keep inflation low and stable, the Fed reacts to rising inflation by increasing the real interest rate. A higher real interest rate reduces consumption and planned investment, lowering planned aggregate expenditure and hence short-run equilibrium output. Other reasons that the aggregate demand curve slopes downward include the effects of inflation on the real value of money, distributional effects (inflation redistributes wealth from the poor, who save relatively little, to the more affluent, who save more), uncertainty created by inflation, and the impact of inflation on foreign sales of domestic goods. (LO1)
· For any given value of inflation, an exogenous increase in spending (that is, an increase in spending at given levels of output and the real interest rate) raises short-run equilibrium output, shifting the aggregate demand (AD) curve to the right. Likewise, an exogenous decline in spending shifts the AD curve to the left. The AD curve can also be shifted by a change in the Fed’s policy reaction function. If the Fed gets “tougher,” shifting up its reaction function and thus choosing a higher real interest rate at each level of inflation, the aggregate demand curve will shift to the left. If the Fed gets “easier,” shifting down its reaction function and thus setting a lower real interest rate at each level of inflation, the AD curve will shift to the right. (LO1)
· In low-inflation industrial economies like the United States today, inflation tends to be inertial, or slow to adjust to changes in the economy. This inertial behavior reflects the fact that inflation depends in part on people’s expectations of future inflation, which in turn depend on their recent experience with inflation. Long-term wage and price contracts tend to “build in” the effects of people’s expectations for multiyear periods. In the aggregate demand–aggregate supply diagram, the short-run aggregate supply (SRAS) line is a horizontal line that shows the current rate of inflation, as determined by past expectations and pricing decisions. (LO2)
· Although inflation is inertial, it does change over time in response to output gaps. An expansionary gap tends to raise the inflation rate because firms raise their prices more quickly when they are facing demand that exceeds their normal productive capacity. A recessionary gap tends to reduce the inflation rate as firms become more reluctant to raise their prices. (LO2)
· The economy is in short-run equilibrium when the inflation rate equals the value determined by past expectations and pricing decisions and output equals the level of short-run equilibrium output that is consistent with that inflation rate. Graphically, short-run equilibrium occurs at the intersection of the AD curve and the SRAS line. If an output gap exists, however, the inflation rate will adjust to eliminate the gap. Graphically, the SRAS line moves upward or downward as needed to restore output to its full-employment level. When the inflation rate is stable and actual output equals potential output, the economy is in long-run equilibrium. Graphically, long-run equilibrium corresponds to the common intersection point of the AD curve, the SRAS line, and the long-run aggregate supply (LRAS) line, a vertical line that marks the economy’s potential output. (LO2)
· Because the economy tends to move toward long-run equilibrium on its own through the adjustment of the inflation rate, it is said to be self-correcting. The more rapid the self-correction process, the smaller the need for active stabilization policies to eliminate output gaps. In practice, the larger the output gap, the more useful such policies are. (LO2)
· One source of inflation is excessive spending, which leads to expansionary output gaps. Aggregate supply shocks are another source of inflation. Aggregate supply shocks include both inflation shocks—sudden changes in the normal behavior of inflation, created, for example, by a rise in the price of imported oil—and shocks to potential output. Adverse supply shocks both lower output and—in the absence of public beliefs that the central bank is committed to maintaining low inflation—increase inflation, creating a difficult dilemma for policymakers. (LO3)
· To reduce inflation, policymakers must shift the aggregate demand curve to the left, usually through a shift in monetary policy toward greater “tightness.” In the short run, the main effects of an anti-inflationary policy may be reduced output and higher unemployment as the economy experiences a recessionary gap. These short-run costs of disinflation must be balanced against the long-run benefits of a lower rate of inflation. Over time, output and employment will return to normal levels and inflation declines. The disinflation engineered by the Fed under Chairman Paul Volcker in the early 1980s followed this pattern. (LO4)
KEY TERMS
aggregate demand (AD) curve
aggregate supply shock
change in aggregate demand
disinflation
distributional effects
inflation shock
long-run aggregate supply (LRAS) line
long-run equilibrium
short-run aggregate supply (SRAS) line
short-run equilibrium
REVIEW QUESTIONS
1. 1.What two variables are related by the aggregate demand (AD) curve? Explain how the behavior of the Fed helps to determine the slope of this curve. List and discuss two other factors that lead the curve to have the slope that it does. (LO1)
2. 2.State how each of the following affects the AD curve and explain: (LO1)
a. An increase in government purchases.
b. A cut in taxes.
c. A decline in planned investment spending by firms.
d. A decision by the Fed to lower the real interest rate at each level of inflation.
3. 3.Why does the overall rate of inflation tend to adjust more slowly than prices of commodities, such as oil or grain? (LO2)
4. 4.Discuss the relationship between output gaps and inflation. How is this relationship captured in the aggregate demand–aggregate supply diagram? (LO2)
5. 5.Sketch an aggregate demand–aggregate supply diagram depicting an economy away from long-run equilibrium. Indicate the economy’s short-run equilibrium point. Discuss how the economy reaches long-run equilibrium over a period of time. Illustrate the process in your diagram. (LO2)
6. 6.True or false: The economy’s self-correcting tendency makes active use of stabilization policy unnecessary. Explain. (LO2)
7. 7.What factors led to increased inflation in the United States in the 1960s and 1970s? (LO3)
8. 8.Why, in the absence of public beliefs that the central bank is committed to maintaining low inflation, does an adverse inflation shock pose a particularly difficult dilemma for policymakers? (LO3)
9. 9.How does a tight monetary policy, like that conducted by the Volcker Fed in the early 1980s, affect output, inflation, and the real interest rate in the short run? In the long run? (LO4)
10. 10.Most central banks place great value on keeping inflation low and stable. Why do they view this objective as so important? (LO4)
PROBLEMS
1. 1.We have seen that short-run equilibrium output falls when the Fed raises the real interest rate. Suppose the relationship between short-run equilibrium output Y and the real interest rate r set by the Fed is given by
Y = 1,000 − 1,000r.
Suppose also that the Fed’s reaction function is the one shown in the following table. For whole-number inflation rates between 0 and 4 percent, find the real interest rate set by the Fed and the resulting short-run equilibrium output. Graph the aggregate demand curve numerically. (LO1)
2. 2.For the economy in Problem 1, suppose that potential output Y* = 960. From the policy reaction function in the table in Problem 1, what can you infer about the Fed’s objective for the inflation rate in the long term? (LO1)
3. 3.An economy’s relationship between short-run equilibrium output and inflation (its aggregate demand curve) is described by the equation
Y = 13,000 − 20,000π.
Initially, the inflation rate is 4 percent, or π = 0.04. Potential output Y* equals 12,000. (LO2)
a. Find the output in short-run equilibrium.
b. Find the inflation rate in long-run equilibrium.
Show your work.
4. 4.This problem asks you to trace out the adjustment of inflation when the economy starts with an output gap. Suppose that the economy’s aggregate demand curve is
Y = 1,000 − 1,000π,
where Y is short-run equilibrium output and π is the inflation rate, measured as a decimal. Potential output Y* equals 950, and the initial inflation rate is 10 percent (π = 0.10). (LO2)
a. Find output for this economy in short-run equilibrium and inflation in long-run equilibrium.
b. Suppose that, each quarter, inflation adjusts according to the following rule:
This quarter’s Last quarter’s
inflation = inflation − 0.0004(Y* − Y).
Starting from the initial value of 10 percent for inflation, find the value of inflation for each of the next five quarters. Remember, Y will continuously change as the current inflation rate change according to the given relationship Y = 1,000 − 1,000π. Does inflation come close to its long-run value?
5. 5.For each of the following, use an AD-AS diagram to show the short-run and long-run effects on output and inflation. Assume the economy starts in long-run equilibrium. (LO1, LO2, LO3)
a. An increase in consumer confidence that leads to higher consumption spending.
b. A reduction in taxes.
c. An easing of monetary policy by the Fed (a downward shift in the policy reaction function).
d. A sharp drop in oil prices.
e. A war that raises government purchases.
6. 6.Suppose that the government cuts taxes in response to a recessionary gap, but because of legislative delays, the tax cut is not put in place for 18 months. Using an AD-AS diagram and assuming that the government’s objective is to stabilize output and inflation, show how this policy action might actually prove to be counterproductive. (LO2)
7. 7.Suppose that a permanent increase in oil prices both creates an inflationary shock and reduces potential output. Use an AD-AS diagram to show the effects of the oil price increase on output and inflation in the short run and the long run, assuming that there is no policy response. What happens if the Fed responds to the oil price increase by tightening monetary policy? (LO3)
8. 8.An economy is initially in recession. Using the AD-AS diagram, show the process of adjustment (LO2, LO4)
a. If the Fed responds by easing monetary policy (moving its reaction function down).
b. If the Fed takes no action.
What are the costs and benefits of each approach, in terms of output loss and inflation?
9. 9.*Planned aggregate expenditure in Lotusland depends on real GDP and the real interest rate according to the following equation:
PAE = 3,000 + 0.8Y − 2,000r.
The Bank of Lotusland, the central bank, has announced that it will set the real interest rate according to the following policy reaction function:
For the rates of inflation given, find autonomous expenditure and short-run equilibrium output in Lotusland. Graph the AD curve, (LO1)
10. 10.*An economy is described by the following equations:
Suppose also that the central bank’s policy reaction function is the same as in Problem 9. (LO1)
a. Find an equation relating planned spending to output and the real interest rate.
b. Construct a table showing the relationship between short-run equilibrium output and inflation, for inflation rates between 0 and 4 percent. Using this table, graph the AD curve for the economy.
c. Repeat parts a and b, assuming that government purchases have increased to 2,100. How does an increase in government purchases affect the AD curve?
11. 11.*For the economy described in Problem 10, suppose that the central bank’s policy reaction function is as follows: (LO1)
a. Construct a table showing the relationship between short-run equilibrium output and the inflation rate for values of inflation between 0 and 4 percent. Graph the aggregate demand curve of the economy.
b. Suppose that the central bank decides to lower the real interest rate by 0.5 percentage point at each value of inflation. Repeat part a. How does this change in monetary policy affect the aggregate demand curve?
ANSWERS TO CONCEPT CHECKS
1. 27.1a. At the current level of inflation, output, and real interest rate, an exogenous reduction in business spending on new capital will reduce investment, causing a decline in overall aggregate expenditures (AE) and a reduction in short-run equilibrium output. Because output has fallen for a given level of inflation, the decrease in business spending leads to a leftward shift in the AD curve. (LO1)
b. At the current level of inflation, output, and real interest rate, a reduction in federal income taxes increases consumers’ disposable income (Y − T), which leads to an exogenous increase in consumption at all income levels. The upward shift in the consumption function increases overall aggregate expenditures (AE) and leads to an increase in short-run equilibrium output. Because output has increased for a given level of inflation, the reduction in income taxes leads to a rightward shift in the AD curve. (LO1)
2. 27.2In the long run, the real interest rate set by the Fed must be consistent with the real interest rate determined in the market for saving and investment. To find the Fed’s long-run inflation target, take as given the real interest rate determined in the long run by the market for saving and investment and read off the corresponding inflation rate from the Fed’s policy reaction function. As the accompanying figure illustrates, a tightening of Fed policy (an upward shift of the policy reaction function) implies that, for any given long-run real interest rate, the Fed’s inflation target must be lower. (LO1)
3. 27.3a. An upward shift in the Fed’s policy reaction function means that the Federal Reserve is raising the real interest rate associated with a given level of inflation. An increase in the real interest rate causes both consumption and investment spending to fall, reducing overall aggregate expenditures and short-run equilibrium output. Thus, a shift in the Fed’s policy reaction function causes the output level to fall for a given level of inflation, resulting in a leftward shift in the AD curve. (LO1)
b. The Federal Reserve’s policy reaction function illustrates that the Federal Reserve responds to rising inflation rates by raising the real interest rate (a move along the policy reaction function), which causes a reduction in overall aggregate expenditures and short-run equilibrium output. However, in this case the Fed’s response to higher inflation causes a move along a given AD curve.
Note that while the two actions appear to be similar, there is a key difference. In the first case the Fed is changing its policy rule for a given inflation rate, while in the second case the Fed is responding to a changing inflation rate. Changes in aggregate spending for a given inflation rate shift the AD curve, while changes in aggregate spending resulting from Fed policy responses to a rise or fall in inflation lead to moves along a given AD curve. (LO1)
4. 27.4a. If inflation is expected to be 2 percent next year and workers are expecting a 2 percent increase in their real wages, then they will expect, and ask for, a 4 percent increase in their nominal wages. (LO2)
b. If inflation is expected to be 4 percent next year, rather than 2 percent, workers will expect, and ask for, a 6 percent increase in their nominal wages. (LO2)
c. If wage costs rise, firms will need to increase the prices of their goods and services to cover their increased costs, leading to an increase in inflation. In part b, when expected inflation was 4 percent, firms will be faced with larger increases in nominal wages than in part a, when expected inflation was only 2 percent. Thus, we can expect firms to raise prices by more when expected inflation is 4 percent than when expected inflation is 2 percent. From this example, we can conclude that increased inflationary expectations lead to higher inflation. (LO2)
5. 27.5If the inflation rate is high, the economy will tend to stay in this high-inflation state due to expectations of high inflation and the existence of long-term wage and price contracts, while if the inflation rate is low, the economy will likewise tend to stay in this low-inflation state for similar reasons. However, since high inflation rates impose economic costs on society, the Federal Reserve has an incentive to avoid the high-inflation state by keeping inflation low, which helps to maintain people’s expectations of low inflation and leads to lower future inflation rates—perpetuating the “virtuous circle” illustrated in Figure 27.4. (LO2)
6. 27.6An increase in spending on new capital by firms for a given level of inflation, output, and real interest rate increases aggregate expenditures and short-run equilibrium output. Since the economy was originally operating at potential output, the increase in investment spending will lead to an expansionary gap; actual output, Y, will now be greater than potential output, Y*. When Y > Y*, the rate of inflation will tend to rise. (LO2)
7. 27.7The effects will be the opposite of those illustrated in Figure 27.8. Beginning in a long-run equilibrium with output equal to potential output and stable inflation (that is, where the aggregate demand (AD) curve intersects both the short-run and long-run aggregate supply lines (SRAS and LRAS, respectively), the fall in consumption spending will initially lead to a leftward shift in the AD curve and the economy moves to a new, lower, short-run equilibrium output level at the same inflation rate. The shift in AD creates a recessionary gap, since Y is now less than Y*. The immediate effect of the decrease in consumption spending is only to reduce output. However, over time inflation will fall because of the recessionary gap. As inflation falls the SRAS line will shift downward. The Federal Reserve responds to the fall in inflation by reducing real interest rates, leading to an increase in aggregate expenditure and output, a move down along the new AD curve. When inflation has fallen enough (and real interest rates have fallen enough) to eliminate the output gap the economy will be back in long-run equilibrium where output equals potential output but the inflation rate will be lower than before the fall in consumption spending. (LO3)
8. 27.8A decrease in oil prices is an example of a “beneficial” inflation shock and the economic effects of such a shock are the reverse of those illustrated in Figure 27.9. In this case, starting from a long-run equilibrium where output equals potential output, a beneficial inflation shock reduces current inflation, causing the SRAS line to shift downward. The downward shift in the SRAS curve leads to a short-run equilibrium with lower inflation and higher output, creating an expansionary gap. If the Fed does nothing, eventually the SRAS will begin to shift upward and the economy will return to its original inflation and output levels. However, the Fed may instead choose to tighten its monetary policy by shifting up its policy reaction function, raising the current real interest rate, shifting the AD curve to the left and restoring equilibrium at potential GDP, but at the new, lower inflation rate. (LO3)
9. 27.9If productivity growth hadn’t increased in the last half of the 1990s the LRAS would not have shifted as far to the right as it actually did. As a consequence, the average inflation rate would not have fallen as much as illustrated in Table 27.2 and average real GDP growth would have been smaller. Similarly, if productivity growth slows in the future from its actual 1995–2000 rate, we can expect higher inflation and lower GDP growth than we otherwise would have experienced. (LO3)
10. 27.10See graphs below. (LO4)
APPENDIX
The Algebra of Aggregate Demand and Aggregate Supply
In this appendix we will derive the aggregate demand curve algebraically. Then we will show how together aggregate demand and aggregate supply determine the short-run and long-run equilibrium points of the economy.
THE AGGREGATE DEMAND CURVE
The Chapter 26 Appendix, Monetary Policy in the Basic Keynesian Model, Equation 26A.1 showed that short-run equilibrium output depends on both exogenous components of expenditure and the real interest rate, shown here:
(26A.1)
where 1/(1 − c) is the multiplier, 
is the exogenous component of planned spending, the term in brackets is autonomous expenditure, and a and b are positive numbers that measure the effect of changes in the real interest rate on consumption and planned investment, respectively.
The aggregate demand curve incorporates the behavior of the Fed, as described by its policy reaction function. According to its policy reaction function, when inflation rises, the Fed raises the real interest rate. Thus the Fed’s policy reaction function can be written as an equation relating the real interest rate r to inflation π:
(27A.1)
where 
and g are positive constants chosen by Fed officials. This equation states that when inflation π rises by 1 percentage point—say from 2 to 3 percent per year—the Fed responds by raising the real interest rate by g percentage points. So, for example, if g = 0.5, an increase in inflation from 2 to 3 percent would lead the Fed to raise the real interest rate by 0.5 percent. The intercept term tells us at what level the Fed would set the real interest rate if inflation happened to be zero (so that the term gπ dropped out of the equation).
Equations 26A.1 and 27A.1 together allow us to derive the aggregate demand curve. We can think of the curve as being derived in two steps: First, for any given value of inflation π, use the policy reaction function, Equation 27A.1, to find the real interest rate by the Fed. Second, for that real interest rate, use Equation 26A.1 to find short-run equilibrium output Y. The relationship between inflation and short-run equilibrium output derived in these two steps is the aggregate demand curve.
Alternatively, we can combine the equation for short-run equilibrium output with the equation for the policy reaction function by substituting the right-hand side of Equation 27A.1 for the real interest rate r in Equation 26A.1:
(27A.2)
This equation, which is the general algebraic expression for the AD curve, summarizes the link between inflation and short-run equilibrium output, as shown graphically in Figure 27.1. Note that Equation 27A.2 implies that an increase in inflation π reduces short-run equilibrium output Y, so that the AD curve is downward-sloping.
For a numerical illustration, we can use the parameter values from Example 26.3. For the economy studied in Example 26.3, we assumed that 
= 640, 
= 250, 
= 250, 
= 300, 
= 20, c = 0.8, a = 400, and b = 600. To derive the aggregate demand curve, we also need values for the Fed’s policy reaction function; for illustration, we use the policy reaction function shown in Table 26.1, reproduced here as Table 27A.1 for convenience.
Table 27A.1 relates the Fed’s choice of the real interest rate to the inflation rate. To derive the aggregate demand curve, it will be useful to express the policy reaction function in the form of an equation like Equation 27A.1. To do this, note that when inflation π equals zero, the real interest rate r equals 2 percent. Therefore, the constant term in the Fed’s policy reaction function equals 2 percent, or 0.02. Second, Table 27A.1 shows that the real interest rate rises one point for each point that inflation rises; therefore the slope g of the reaction function equals 1.0. So the Fed’s policy reaction function can be expressed as
r = 0.02 + π,
which is Equation 27A.1 with = 0.02 and g = 1.
Substituting these numerical values into Equation 27A.2 and simplifying, we get the following numerical equation for the AD curve:
(27A.3)
(27A.4)
Note that in this equation, higher values of inflation imply lower values of short-run equilibrium output, so the aggregate demand curve is downward-sloping. To check this equation, suppose that inflation is 3 percent, so that the Fed sets the real interest rate at 5 percent (see Table 27A.1). Setting π = 0.03 in Equation 27A.4 yields Y = 4,800. This is consistent with the answer we found in Example 26.4, where we showed for the same economy that when r = 0.05 (the value of the real interest rate set by the Fed when π = 0.03), then short-run equilibrium output Y = 4,800.
SHIFTS OF THE AGGREGATE DEMAND CURVE
Recall that exogenous changes in spending or in the Fed’s policy reaction function will shift the AD curve. These results follow from Equation 27A.2. First, the equation shows that for a given rate of inflation π, an increase in exogenous spending, , will raise short-run equilibrium output Y. Thus an increase in exogenous spending shifts the AD curve to the right; conversely, a decrease in exogenous spending shifts the AD curve to the left.
A shift in the Fed’s policy reaction can be captured by a change in the intercept term in Equation 27A.1. For example, suppose the Fed tightens monetary policy by setting the real interest rate 1 percent higher than before at every level of inflation. Such a change is equivalent to raising the intercept term in the policy reaction function by 0.01. If you look at Equation 27A.2, you will see that with the level of inflation held constant, an increase in reduces short-run equilibrium output. Thus a tightening of monetary policy (an upward movement in the monetary policy reaction function) shifts the AD curve to the left. Conversely, an easing of monetary policy (represented by a decline in or a downward shift in the policy reaction function) shifts the AD curve to the right.
CONCEPT CHECK 27A.1
a. For the economy described above, find an algebraic equation for the AD curve after an exogenous increase in spending (say, in planned investment) of 10 units.
b. For the economy described above, find an algebraic equation for the AD curve after a tightening of monetary policy which involves setting the real interest rate 1 percent higher at each level of inflation.
SHORT-RUN EQUILIBRIUM
Recall that in short-run equilibrium, inflation is equal to its previously determined value and the SRAS line is horizontal at that value. At that level of inflation, the level of output in short-run equilibrium is given by the aggregate demand curve,
Equation 27A.2. For instance, in the economy described, suppose the current value of inflation is 5 percent. The value of short-run equilibrium output is therefore
LONG-RUN EQUILIBRIUM
In long-run equilibrium, actual output Y equals potential output Y*. Thus, in long-run equilibrium, the inflation rate can be obtained from the equation for the AD curve by substituting Y* for Y. To illustrate, let’s write the equation for the AD curve in this sample economy, Equation 27A.4, once again:
Y = 4,950 − 5,000π.
Suppose, in addition, that potential output Y* = 4,900. Substituting this value for Y in the aggregate demand equation yields
4,900 = 4,950 − 5,000π.
Solving for the inflation rate π we get
π = 0.01 = 1%.
When this economy is in long-run equilibrium, then, the inflation rate will be 1 percent. If we start from the value of inflation in short-run equilibrium, 5 percent, we can see that the short-run aggregate supply line must shift downward until inflation reaches 1 percent before long-run equilibrium can be achieved.
ANSWERS TO APPENDIX CONCEPT CHECKS
1. 27A.1 The algebraic solutions for the AD curves in each case, obtained by substituting the numerical values into the formula, are given as follows:
a. Y = 5,000 − 5,000π.
b. Y = 4,900 − 5,000π.
1It is important to distinguish the aggregate demand curve from the expenditure line, introduced as part of the Keynesian cross diagram in Chapter 25. Spending and Output in the Short Run. The upward-sloping expenditure line shows the relationship between planned aggregate expenditure and output. Again, the aggregate demand (AD) curve shows the relationship between short-run equilibrium output (which equals planned spending) and inflation.
2Economists sometimes define the aggregate demand curve as the relationship between aggregate demand and the price level, rather than inflation, which is the rate of change of the price level. The definition used here both simplifies the analysis and yields results more consistent with real-world data. For a comparison of the two approaches, see David Romer, “Keynesian Macroeconomics without the LM Curve,” Journal of Economic Perspectives, Spring 2000, pp. 149–170. The graphical analysis used in this chapter follows closely the approach recommended by Romer.
3Our explanation for the downward slope of the AD curve, earlier in the chapter, described some of these other factors.
4In Chapter 18, Measuring the Price Level and Inflation, we distinguished between relative price changes (changes in the prices of individual goods) and inflation (changes in the overall price level). In the 1973–1974 episode, changes in the prices of individual categories of goods, such as energy and food, were sufficiently large and pervasive that the overall price level was significantly affected. Thus these relative price changes carried an inflationary impact as well.
5Olivier J. Blanchard and Jordi Galí, “The Macroeconomic Effects of Oil Price Shocks: Why Are the 2000s So Different from the 1970s?” in International Dimensions of Monetary Policy (Chicago: University of Chicago Press, 2010).
6“FOMC Statement of Longer-Run Goals and Policy Strategy,” January 25, 2012, www.federalreserve.gov/ newsevents/press/monetary/20120125c.htm.
7Minutes from the Federal Reserve’s September 2002 FOMC meeting, www.federalreserve.gov/fomc/ minutes/20020924.htm.
*Denotes more difficult problem.