TUTORIAL 9 (19 23 MAY)

A Model of Output and Inflation The AD-AS Model

Textbook Reference: Chapter 9
Main Concepts
Aggregate demand (AD) curve
Aggregate supply (AS) curve
Review Questions
Question 1
(i)
What two variables are related by the AD curve?

The Aggregate Demand curve shows the relationship between the inflation rate and short-run
equilibrium output in the economy. Along the AD curve we are at short run equilibrium and since
this means aggregate expenditure is equal to real GDP, the AD curve gives us the relationship
between aggregate expenditure when it is in short run equilibrium, and the rate of inflation.

(ii)

Explain how the behaviour of the central bank determines the slope of the AD curve.

The central bank has a responsibility to maintain a low and stable rate of inflation. In Australia, the
RBA has an explicit objective to keep inflation between the range of 2 to 3%. One situation that
leads to higher inflation is an expansionary output gap. When output is above potential firms must
produce at above capacity to meet demand and will eventually raise prices, leading to higher
inflation. As the inflation rate rises, the Reserve Bank will target a higher real interest rate, which
reduces consumption and investment expenditure and in turn, short-run equilibrium output. (i.e. a
movement along the RBAs policy reaction function). Therefore, along the AD curve, as the inflation
rate rises, the output level falls, leading to a downward-sloping curve (with inflation on the vertical
axis and output on the horizontal axis).

(iii)

What other factors might affect the slope of the AD curve?

Other factors that could lead to this downward slope include:

Inflationary effects on wealth and consumption. If the purchasing power of wealth

decreases due to an increase in inflation, there is a wealth effect of a decrease in autonomous
consumption.

Inflationary effects on the redistribution of income and wealth, which in turn affects
consumption.

Inflationary effects on investment spending, since there will be greater uncertainty and
profit expectations will be affected.

Inflationary effects on net exports (for a given exchange rate).

(iv)

What variables influence the position of the AD curve?

The aggregate Demand Curve will shift due to:

Exogenous increases or decreases in spending (consumption, investment, government

spending, exports, imports);

Changes in the monetary policy stance of the central bank, which is reflected in a shift in
the policy reaction function, i.e. a monetary policy response to an output gap rather than a response
to inflation.
(v)

What variables would influence the positions of the SRAS and LRAS curves?

SRAS will shift due to the presence of output gaps and inflation shocks. The key drivers of shifts in
the SRAS are:

Changes in wages that are either purely exogenous (inflation shock) or due to an output gap
resulting in a labour market disequilibrium. For example, when there is an expansionary
gap, the demand for labour tends to be greater than the supply of labour, and the
unemployment rate to be lower than the natural rate. The labour shortage creates upward
pressure on wages, increasing the cost of labour and the cost of production, and shifting the
SRAS curve upwards.

Changes in energy prices such as the price of crude oil that may lead to an increase/decrease
in the costs of production.
LRAS curve represents the level of production at the natural rate of unemployment, or potential
output. Anything that can cause a change in potential output will shift the LRAS curve.

(vi)
Explain how the government and the central bank may aim to close output gaps using the
AD-AS model.

Suppose that there is an expansionary gap

created by excessive demand. An expansionary
gap is inflationary, since the number of people looking for work is likely to be less than the number
of jobs available, and wages will tend to increase. To avoid the negative consequences of higher
inflation, the central bank may adopt a contractionary monetary policy stance, targeting a higher
cash rate, and as interest rates rise, consumption and investment fall shifting the AD curve from
to
. Likewise, the government may decide to implement a contractionary fiscal policy by
decreasing government purchases, or increasing taxes.

Suppose that there is a contractionary gap

created by deficient demand. A contractionary
gap may be deflationary, but always leads to higher unemployment since although the number of
people looking for work is likely to be more than the number of jobs available, wages will tend to be
sticky downwards, so the unemployment may not be eliminated by lower wages. To avoid the
negative consequences of higher unemployment, the government may implement an expansionary
fiscal policy by increasing government purchases, or decreasing taxes. The increased government
spending and the higher consumption that is stimulated by an increase in disposable income would
shift the AD curve rightwards from
to
Likewise the central bank may act on the low
inflation of respond to their secondary objective of full employment and implement an expansionary
monetary policy stance, targeting a lower cash rate, and as interest rates fall, consumption and
investment rise shifting the AD curve from
to
.

Question 2
An economys AD curve is given by
The initial inflation rate is 4 percent (0.04). Potential output equals 12,000.
(i)
Find inflation and output in short-run equilibrium.

There is an expansionary gap at short run equilibrium.

(ii)
Find inflation and output in long-run equilibrium.
In the long run output is at potential output at 12,000.

The rate of inflation has increased in the long run due to the expansionary gap.
Question 3
Suppose the relationship between short-run equilibrium output and the real interest rate is given
by:
In addition the Reserve Banks policy reaction function is given by
(i)
For whole number inflation rates between 0 and 4 percent, calculate the real interest rate
and short-run equilibrium output.

Inflation rate (%)

4
3
2
1
0
(ii)

r
0.06
0.05
0.04
0.03
0.02

Draw a graph to illustrate this AD curve.

Y
940
950
960
970
980

Discussion Questions
Question 4
Suppose that a government cuts taxes in response to a recessionary gap, but because of delays in
getting the legislation through the parliament the tax cut is not put into place for 18 months.
Assuming that the governments objective is to stabilise output and inflation, use the AD-AS
diagram to show how this policy action might prove to be counter-productive.

The figure shows a recessionary gap at short run equilibrium Y0. Suppose the government calculates
the size of the tax cut that is required to shift the AD curve so as to close the negative gap. However
there is a lag of 18 months before the tax cut is implemented. During that time the AD-AS model
implies that the negative gap will tend to reduce the rate of inflation and the SRAS will shift down.
Since with a recessionary gap, there is high unemployment and there will be downward pressure on
wages. So when the tax cut occurs the SRAS0 has shifted to SRAS1. When the tax cut is implemented
it will raise output above potential and create an expansionary gap as aggregate demand shifts from
AD0 to AD1. Over time inflation will tend to rise again.
Under these circumstances output and inflation will tend to be more volatile than if the government
had not tried to implement the tax cut.

Question 5
The Reserve Bank of Australia and the Reserve Bank of New Zealand both have inflation targets.
Suppose inflation in Australia is at its target, and the RBA decides that in order to meets its
objectives, it should increase the target for consumer price inflation from 2-3% to 4-5%.
(i)
Explain and show using the AD-AS model how the RBA can implement its new inflation
target.

BOF p.262 to 264.

In this case, the RBA would loosen monetary policy in order to stimulate output and create an
expansionary gap. The expansionary gap would create inflationary pressures leading to an upwards
shift in the SRAS curve towards the new inflation target.
(ii)
Why does a change in monetary policy shift the AD curve?
Since in this case the RBA is not responding to inflation, the RBA could change its monetary policy
stance by shifting its policy reaction function downwards in order to target a lower real interest rate.
The lower real interest rate would induce an increase in interest sensitive investment and
consumption (and increase exports via the exchange rate).
(iii)
Why does inflation increase when real GDP is above potential GDP?
When real GDP is greater than potential GDP, the unemployment rate is lower than the natural rate
of unemployment. This results in a shortage of labour at the prevailing real wage and creates
pressure for wages to rise. At the natural rate of unemployment, unemployment consists of
structural and frictional unemployment. When unemployment is lower than the natural rate, both
of these are lower than normal. This usually results in a shortage of skilled labour as many workers
that would be usually structurally unemployed would fill positions that they ordinarily would not
have the skills for. This creates a premium for skilled workers and wages begin to rise. During an
expansionary gap, other production costs also begin to rise. The SRAS curve represents the aspects
of production that directly influence consumer price inflation, such as the costs of production. As
wages and other costs of production increase, firms pass some or all of these costs on to consumers
and inflation increases as the SRAS curve shifts upwards.

(iv)
Using the AD-AS model, show how the result in part (i) affects the economy of New
Zealand in the short run if there is free trade between Australia and New Zealand. How should the
RBNZ respond if it is to maintain its inflation target?
There is free trade between Australia and New Zealand, and the two countries are trading partners.
If there is a temporary expansionary gap in Australia, the increase in income would induce an
increase in imports, including imports from New Zealand. This would increase New Zealand exports
and therefore shift the NZ AD curve to the right, also leading to an expansionary gap. In order to
maintain its inflation target, the RBNZ would need to implement a monetary contraction.