Chapter 15: Aggregate Demand, Aggregate Supply, and Inflation

easing; shifts right

A downward shift in the Fed's policy reaction function is a(n) _____ of monetary policy, and the aggregate demand curve _______.

AD-AS

A key feature of the blank model is the fact that output gaps will not last indefinitely but will be closed by rising or falling inflation.

a significant rise in oil prices.

An example of an adverse inflation shock is:

aggregate demand curve; left

For a given level of inflation, if concerns about future weakness in the economy cause businesses to reduce their spending on new capital, then the _____ shifts _____.

falls

Graphically, the SRAS line blank in the presence of a recessionary gap.

inflation expectations; long-term wage and price contracts

Inflation inertia is the result of the behavior of ____ and the existence of ______.

short-run equilibrium output.

The aggregate demand curve shows the relationship between inflation and:

increases; not

The economy moves up a stationary aggregate demand curve when the Fed blank real interest rates in response to inflation, but does blank change its target inflation rate or the Fed's policy reaction function.

recessionary gaps.

The self-correcting tendency of the economy means that falling inflation eventually eliminates:

the current inflation rate; potential output

The short-run aggregate supply curve shows _____ while the long-run aggregate supply curve shows _____.

inflation inertia.

The tendency for inflation to change relatively slowly from year to year in industrial countries is called:

long-run

When actual output equals potential output and the inflation rate is equal to the expected rate of inflation, the economy is said to be in ______ equilibrium.

a recessionary; decrease

When actual output is less than potential output, there is ____ output gap and the rate of inflation will tend to ____.

recessionary gap

a blank gap exists when actual output is less than potential output.

monetary

a blank policy rule describes how a central bank, like the fed, takes action in response to changes in the state of the economy.

aggregate demand (AD) curve

a curve that shows the relationship between short-run equilibrium output Y and the rate of inflation, denoted pi.

leftward

a decrease in aggregate demand is represented by a blank shift in the AD curve.

Short-run aggregate supply (SRAS) line

a horizontal line showing the current rate of inflation, as determined by past expectations and pricing decisions

left

a negative aggregate supply shock causes the LRAS curve to shift to the blank.

change in aggregate demand

a shift of the AD curve

inflation shock

a sudden change in the normal behavior of inflation, unrelated to the nation's output gap

An inflation shock is:

a sudden change in the normal behavior of inflation, unrelated to the nation's output gap.

output gap

actual output minus potential output is called the blank gap. (Y-Y*)

potential output; inflation.

aggregate supply shocks occur when there are sharp changes in blank and when there are sharp changes in blank.

rises

all else equal, consumption and investment will fall when the real interest rate blank.

Expansionary Gap

an blank gap exists when actual output exceeds potential output. (Y>Y*)

demand

an increase in gov spending is likely to shift the aggregate blank curve to the right.

Exogenous

blank changes in spending refer to changes in planned spending not caused by changes in output or changes in the inflation rate.

distributional effects

changes in the distribution of income or wealth in the economy

recessionary gap (Y<Y*)

inflation falls

no output gap (Y=Y)

inflation remains unchanged

Expansionary Gap (Y>Y*)

inflation rises

Aggregate supply shocks

inflation shocks or shocks to potential output.

slow

long-term contracts, such as union wage contracts, contribute to the blank adjustment of inflation.

high

people expect inflation to be blank if it has been high for an extended period of time.

rises; fall

the aggregate demand (AD) curve implies that if inflation blank, then output will blank.

inflation rate

the aggregate demand curve shows the amount of output that consumers, firms, government and customers abroad want to purchase at each blank, holding all other factors constant.

cut; increase

to increase aggregate demand, the government can blank taxes and blank government spending.

increasing

when inflation increases due to an expansionary gap, the Fed typically responds by blank the real interest rate.

increasing

when inflation increases due to an expansionary gap, the fed typically responds by blank the real interest rate.

low; high

A low rate of expected inflation tends to lead to a ___ rate of actual inflation and a high rate of expected inflation tends to lead to a ____ rate of actual inflation.

long run equilibrium

A situation in which actual output equals potential output and the inflation rate is stable; graphically, long-run equilibrium occurs when the AD curve, the SRAS line, and the LRAS line all intersect at a single point.

short run equilibrium

A situation in which 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.

Long Run Aggregate Supply (LRAS) Line

A vertical line showing the economy's potential output Y*.

right

An exogeneous increase in spending will increase short-run equilibrium output at all inflation levels. As a result, the AD curve shifts to the blank.

equals the value determined by part expectations and pricing decisions; the level of short-run equilibrium output consistent with that inflation rate

At short-run equilibrium inflation _______ and output equals ______.

aggregate supply shock

Either an inflation shock or a shock to potential output; adverse aggregate supply shocks of both types reduce output and increase inflation.

aggregate demand curve; right

For a given level of inflation, if there is a greater willingness by foreigners to purchase domestic goods, then the _____ shifts _____.

downward

Higher inflation reduces spending. As a result, the AD curve is blank sloping.

reduced

Higher rates of inflation blank planned spending because the reduction in wealth, resulting from the reduced real value of money, restricts spending.

increasing; decreases; decreases

If the Fed's monetary policy reaction function does not change, then when inflation increases the Fed responds by _____ the real interest rate, which _____ consumption and investment spending, which _____ output.

rising or falling

In the AD-AS model, output gaps will not last indefinitely, but will be closed by blank or blank inflation.

increases; fall

In the AD-AS model, the AD curve is downward sloping because when inflation increases, the Fed blank real interest rates, leading output to blank.

rises; fall

as inflation rises domestically, the price of domestic goods and services blank relative to foreign goods. As a result, exports blank.

NOT

as long as the Fed sets the real interest rate in accordance with a fixed policy reaction function, changes in the real interest will blank shift the AD curve.

uncertainty; reduce

higher rates of inflation tend to create blank and blank spending.

economic uncertainty

households and firms tend to reduce their spending levels in the presence of blank.

large

how do long-term contracts "build in" wage and price increases? contracts signed during periods of high inflation will likely require blank wage increases over the duration of the contract.

raise; left

if the fed wants to lower its target rate of inflation, it should blank the real interest rate so that the aggregate demand (AD) curve shifts to the blank.

decrease; increase

if the government wants to decrease aggregate demand, then it can blank government spending and blank the real interest rate.

zero

if the output gap is blank, then the rate of inflation tends to remain constant.

- long-term wage contracts - long-term price contracts - inflation expectations

in modern economies, inflation tends to adjust slowly due to:

recessionary

in the AD-AS model, blank gaps will not persist in the long run because the AS curve will shift down due to the fall in expected future inflation, thereby eliminating the output gap.

recessionary gap

in the short run, a decrease in aggregate demand will cause a blank

recessionary gap; AS

in the short-run, a negative inflation shock such as a sharp rise in oil prices will open up a blank gap and shift the blank curve upward.

expansionary; AS

in the short-run, a positive inflation shock such as a sharp fall in oil prices will lead to an blank gap and shift the blank curve to the right.

stable

relative to other economic variables such as stock prices or commodity prices, inflation tends to be relatively blank over time.