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CHAPTER 24

Aggregate Demand, Aggregate


Supply, and Inflation

Prepared by: Fernando Quijano


and Yvonn Quijano

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Aggregate Demand Curve

• Aggregate demand is
the total demand for
goods and services in
the economy.
• The aggregate
demand (AD) curve is
a curve that shows the
negative relationship
between aggregate
output (income) and
the price level.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 2
Deriving the Aggregate Demand Curve

• To derive the aggregate


demand curve, we examine
what happens to aggregate
output (income) (Y) when the
price level (P) changes,
assuming no changes in
government spending (G),
net taxes (T), or the monetary
policy variable (Ms).

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 3
Deriving the Aggregate Demand Curve

 P  M d   r   I   AE   Y 
• Each pair of values of P and Y on the
aggregate demand curve corresponds to
a point at which both the goods market
and the money market are in equilibrium.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 4
The Aggregate Demand Curve:
A Warning
• The AD curve is not a market demand
curve, and it is not the sum of all market
demand curves in the economy. It is a
more complex concept.
• We cannot use the ceteris paribus
assumption to draw the AD curve because
when the overall price level rises, many
prices (including input prices) rise
together.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 5
The Aggregate Demand Curve:
A Warning
• Aggregate demand falls when the price
level increases because the higher price
level causes the demand for money to
rise, which causes the interest rate to rise.
• It is the higher interest rate that causes
aggregate output to fall.
• At all points along the AD curve, both the
goods market and the money market are
in equilibrium.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 6
Other Reasons for a Downward-
Sloping Aggregate Demand Curve
• The consumption link: The decrease in
consumption brought about by an increase
in the interest rate contributes to the
overall decrease in output.
• The real wealth effect, or real balance,
effect: When the price level rises, there is
a decrease in consumption brought about
by a change in real wealth.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 7
Aggregate Expenditure and
Aggregate Demand
How are aggregate demand
and aggregate expenditure
related?
• At every point along the
aggregate demand curve,
the aggregate quantity of
output demanded is exactly
equal to planned aggregate
expenditure.
Y=C+I+G
equilibrium condition
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 8
Shifts of the Aggregate Demand Curve

• An increase in the
quantity of money
supplied at a given
price level shifts the
aggregate demand
curve to the right.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 9
Shifts of the Aggregate Demand Curve

• An increase in
government purchases
or a decrease in net
taxes shifts the
aggregate demand
curve to the right.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 10
Shifts of the Aggregate Demand Curve

Shifts in the Aggregate Demand Curve: A Summary


Expansionary monetary policy Contractionary monetary policy
Ms AD curve shifts to the right Ms AD curve shifts to the left

Expansionary fiscal policy Contractionary fiscal policy


G AD curve shifts to the right G AD curve shifts to the left
T AD curve shifts to the right T AD curve shifts to the left

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 11
The Aggregate Supply Curve

• Aggregate supply is the total supply of all


goods and services in the economy.
• The aggregate supply (AS) curve is a
graph that shows the relationship between
the aggregate quantity of output supplied
by all firms in an economy and the overall
price level.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 12
The Aggregate Supply Curve:
A Warning
• The aggregate supply curve is not a
market supply curve and it is not the
simple sum of all the individual supply
curves in the economy.
• One reason is that firms do not simply respond
to market-determined prices, but they actually
set prices. Price-setting firms do not have
individual supply curves because these firms
are choosing both output and price at the same
time. We can add something that does not
exist!

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 13
The Aggregate Supply Curve:
A Warning
• Another reason is that when we draw a
firm’s supply curve, we assume that
input prices are constant. If the overall
price level is rising, there will be an
increase in at least some input prices.
• The outputs of some firms are the inputs of
other firms.
• As wage rates and other input prices rise,
the firms’ individual supply curves are
shifting, so we can not sum them to get an
aggregate supply curve.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 14
The Aggregate Supply Curve:
A Warning

• What does exist is a “price/output


response” curve—a curve that
traces out the price decisions and
output decisions of all the markets
and firms in the economy under a
given set of circumstances.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 15
Aggregate Supply in the Short Run

• In the short run, the


aggregate supply curve
(the price/output response
curve) has a positive
slope.
• At low levels of aggregate
output, the curve is fairly
flat. As the economy
approaches capacity, the
curve becomes nearly
vertical. At capacity, the
curve is vertical.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 16
Aggregate Supply in the Short Run

• Macroeconomists focus on whether or not


the economy as a whole is operating at full
capacity.
• Even if firms are not holding excess labor
and capital, the economy may be
operating below its capacity if there is
cyclical unemployment.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 17
Output Levels and Price Responses

• An increase in aggregate
demand when the
economy is operating at
low levels of output is
likely to result in an
increase in output with
little or no increase in the
overall price level.

• As the economy approaches maximum capacity, firms


respond to further increases in demand only by
raising prices.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 18
The Response of Input Prices to
Changes in the Overall Price Level
• There must be a lag between changes in
input prices and changes in output prices,
otherwise the aggregate supply
(price/output response) curve would be
vertical.
• Wage rates may increase at exactly the
same rate as the overall price level if the
price-level increase is fully anticipated.
Most input prices, however, tend to lag
increases in output prices.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 19
Shifts of the Short-Run
Aggregate Supply Curve
• A leftward shift of the • A decrease in costs,
AS curve could be economic growth, or public
caused by cost shocks. policy, can cause a rightward
shift of the AS curve.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 20
Shifts of the Short-Run
Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right Shifts to the Left
Increases in Aggregate Supply Decreases in Aggregate Supply
Lower costs Higher costs
• lower input prices • higher input prices
• lower wage rates • higher wage rates

Economic growth Stagnation


• more capital •Capital deterioration
• more labor
• technological change

Public policy Public policy


• supply-side policies • waste and inefficiency
• tax cuts • over-regulation
• deregulation

Good weather Bad weather, natural


disasters, destruction
from wars
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 21
The Equilibrium Price Level

• The equilibrium price level is the point at


which the aggregate demand and
aggregate supply curves intersect.
• P0 and Y0 correspond to
equilibrium in the goods
market and the money
market and a set of
price/output decisions
on the part of all the
firms in the economy.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 22
The Long-Run Aggregate Supply Curve

• Costs lag behind price-level changes in


the short run, resulting in an upward-
sloping AS curve, but ultimately move with
the overall price level.
• If costs and the price
level move in tandem
in the long run, the
AS curve is vertical.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 23
The Long-Run Aggregate Supply Curve

• Y0 represents the level of output that can


be sustained in the long run without
inflation. It is also called potential output.

• Output can be
pushed above
potential GDP by
higher aggregate
demand. The
aggregate price level
also rises.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 24
The Long-Run Aggregate Supply Curve

• When output is pushed above potential, there


is upward pressure on costs. Rising costs
push the short-run AS curve to the left.

• If costs ultimately
increase by the same
percentage as the
price level, the
quantity supplied will
end up back at Y0.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 25
AD, AS, and
Monetary and Fiscal Policy
• AD can shift to the right for a number of
reasons, including an increase in the
money supply, a tax cut, or an increase in
government spending.
• Expansionary policy
works well when the
economy is on the flat
portion of the AS
curve, causing little
change in P relative to
the output increase.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 26
AD, AS, and
Monetary and Fiscal Policy
• On the steep portion of the AS curve,
expansionary policy does not work well.
The multiplier is close to zero.
• When the economy is
operating near full
capacity, an increase
in AD will result in an
increase in the price
level with little increase
in output.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 27
Long-Run Aggregate Supply
and Policy Effects
• If the AS curve is vertical in the long run,
neither monetary policy nor fiscal policy
has any effect on aggregate output.
• In the long run, the
multiplier effect of a
change in
government spending
or taxes on aggregate
output is zero.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 28
Causes of Inflation

• Inflation is an increase in the overall price


level.
• Sustained inflation occurs when the
overall price level continues to rise over
some fairly long period of time.
• Sustained inflation is essentially a monetary
phenomenon. For the price level to
continue to rise period after period, it must
be accommodated by an expanded money
supply.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 29
Causes of Inflation

• Demand-pull inflation is • Cost-push, or supply-


inflation initiated by an side, inflation is inflation
increase in aggregate caused by an increase in
demand. costs.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 30
Cost-Push, or Supply-Side Inflation

• Cost-push inflation is one possible cause


of stagflation—a situation in which output
is falling at the same time that prices are
rising.
• Cost shocks are bad news
for policy makers. The
only way to counter the
output loss is by having
the price level increase
even more than it would
without the policy action.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 31
Expectations and Inflation

• If every firm expects every other firm to


raise prices by 10%, every firm will raise
prices by about 10%. This is how
expectations can get “built into the system.”
• In terms of the AD/AS
diagram, an increase
in inflationary
expectations shifts the
AS curve to the left.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 32
Money and Inflation

• Hyperinflation is a period of very rapid


increases in the price level.
• An increase in G with the
money supply constant
shifts the AD curve from
AD0 to AD1. This leads to
an increase in the interest
rate and crowding out of
planned investment.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 33
Money and Inflation

• Hyperinflation is a period of very rapid


increases in the price level.
• If the Fed tries to prevent
crowding out by keeping the
interest rate unchanged, it
will increase the money
supply and the AD curve will
shift farther and farther to the
right. The result is a
sustained inflation, perhaps
hyperinflation.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 34