THE AGGREGATE SUPPLY CURVE:Inflation Shocks

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EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION >>

Money & Banking MGT411

Lesson 43

THE AGGREGATE SUPPLY CURVE

The aggregate supply curve tells us where on the aggregate demand curve the economy will end

up, explaining the relationship between inflation and real output in the process.

The short run aggregate supply curve tells us where the economy will settle at any particular

time

Long run curve tells us the levels of inflation and output the economy is moving toward.

Inflation persistence

Inflation tends to change slowly; when it is low one year it tends to be low the next year, and

when it is high it tends to stay high. This is called inflation persistence

If inflation remains steady over shorter periods, while real output adjusts, then the short-run

aggregate supply curve must be flat at the current level of inflation

Figure: Inflation Statistics of Pakistan

Inflation statistics of Pakistan

Figure: Inflation in the Euro Area, 1991-2004

This figure shows the 12-month change in the harmonized

index of consumer prices for the 12 countries of the euro area.

1992

1994

1996 1998

2000

2002

2004

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Money & Banking MGT411

Inflation is persistent for two reasons

First, when people expect inflation to continue, they adjust their prices and wages

accordingly.

When people expect inflation in the near future they raise wages and prices in a way that

causes the inflation they expect to occur.

Therefore, current inflation is at least partially determined by expected inflation

Inflation is persistent for two reasons

Second, not all wage and price decisions are made at the same time.

Price and wage adjustments are staggered, and this slows down the adjustment process

causing persistence in inflation

The fact that inflation is persistent means that it is fixed in the short run, so the short-run

aggregate supply curve is horizontal at the current level of inflation.

Figure: Short Run Aggregate Supply Curve

Inflation persistence means the short run aggregate supply curve is horizontal.

Inflation (š)

Current

Inflation

Short Run Aggregate Supply Curve (SRAS)

Output (Y)

Firms simply do not adjust the rate of their price increases in the short run; instead, they

adjust the quantities they produce and sell.

Over periods of several years or more, inflation does change, shifting the short-run

aggregate supply curve up or down

Shifts in the Short-Run Aggregate Supply Curve

There are two reasons why the short run aggregate supply curve can shift

Deviations of current output from potential output, causing changes in inflation

Changes in external factors driving production costs

Output Gaps

When current output equals potential output so that there is no output gap, the short-run

aggregate supply curve remains stable

But when current output rises above or falls below potential output, so that an output gap

develops, inflation will rise or fall.

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Money & Banking MGT411

Figure: Shifts in the Short Run Aggregate Supply Curve

Response to an Output Gap

When current output rises above potential output, creating an

expansionary output gap, the short run aggregate supply curve shifts

upward. When current output falls below potential output, creating a

recessionary output gap, the short run aggregate supply curve shifts

downward.

Inflation (š)

When current output

is above than the

potential output, the

SRAS shifts up

Current

SRAS

Inflation

When current

output is below

the potential

output, the SRAS

shifts down

Potential

Output (Y)

Output

When current output is below potential output, part of the economy's capacity is idle, and firms

tend to raise their prices and wages less than they did when current output equaled potential

output.

When current output exceeds potential output, the opposite happens; firms increase their prices

and wages more than they would if they were operating at normal levels

Thus when current output deviates from potential output, inflation adjusts, and the effect takes

time to be felt.

Economists have differing views on how quickly inflation reacts and the short-run aggregate

supply curve shifts.

Those who believe in flexible prices think it happens quickly,

While those who emphasize that many price and wage decisions involve long-term contracts

think the adjustment is sluggish.

Inflation Shocks

An inflation shock is a change in the cost of producing output and causes the short-run

aggregate supply curve to shift.

This can be the result of changes in the cost of raw materials or labor, or (as is most common) a

change in the price of energy.

A positive inflation shock causes the short-run aggregate supply curve to shift upward, causing

inflation to rise

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Money & Banking MGT411

Figure: Shifts in the Short-Run Aggregate Supply Curve

Response to an inflation shock

A rise in labor costs, the prices of raw materials or expected future level of inflation creates an inflation

shock that shifts the SRAS upward, causing inflation to rise.

Inflation (š)

Positive Inflation Shock

An increase in the cost of

production shifts the SRAS up

Output (Y)

The Long-Run Aggregate Supply Curve

In the long run the economy moves to the point where current output equals potential output,

while inflation is determined by money growth

The long-run aggregate supply curve is vertical at the point where current output equals

potential output.

Figure: The Long Run and Short Run Aggregate Supply Curves

The long run aggregate supply curve is vertical at the point where current output

equals the potential output.

Inflation (š)

LRAS

Current

SRAS

Inflation

Potential Output

Output (Y)

Changes in expected inflation operate like cost shocks, shifting the short-run aggregate supply

curve up and down.

For the economy to remain in long-run equilibrium, then, in addition to current output equaling

potential output, current inflation must equal expected inflation

At any point along the long-run aggregate supply curve, current output equals potential output

and current inflation equals expected inflation

Potential output is constantly rising as a result of investment and technological improvements

(the sources of economic growth), which increase the normal output level.

Changes in the economy's productive capacity will shift the long-run aggregate supply curve;

increases will shift it right and decreases will shift it left.

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