Aggregate Demand, Aggregate Supply, and Inflation

The Aggregate Demand Curve

Aggregate

demand is the total demand for goods and services in the economy.

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).

Deriving the Aggregate Demand Curve

The Impact of an Increase in the Price Level on the Economy Assuming No Changes in G, T, and Ms

P M d r I AE Y

Deriving the Aggregate Demand Curve

The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level.

The Aggregate Demand Curve: A Warning

The AD curve is not a market demand curve. It is a more complex concept. We cannot use the ceteris paribus assumption to draw an AD curve. In reality, many prices (including input prices) rise together.

The Aggregate Demand Curve: A Warning

A higher price level causes the demand for money to rise, which causes the interest rate to rise. Then, the higher interest rate causes aggregate output to fall.

The Aggregate Demand Curve: A Warning

At all points along the AD curve, both the goods market and the money market are in equilibrium.

Other Reasons for a DownwardSloping 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.

Other Reasons for a DownwardSloping Aggregate Demand Curve

The real wealth effect, or real balance, effect is the change in consumption brought about by a change in real wealth that results from a change in the price level.

Aggregate Expenditure and Aggregate Demand

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

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.

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.

Shifts of the Aggregate Demand Curve

Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy AD curve shifts to the right Contractionary monetary policy AD curve shifts to the left

Ms

Ms

Expansionary fiscal policy AD curve shifts to the right AD curve shifts to the right

Contractionary fiscal policy AD curve shifts to the left AD curve shifts to the left

G T

G T

The Aggregate Supply Curve

Aggregate supply is the total supply of all goods and services in the economy.

The Aggregate Supply Curve

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.

The Aggregate Supply Curve: A Warning

The aggregate supply curve is not a market supply curve or the sum of all the individual supply curves in the economy.

The Aggregate Supply Curve: A Warning

Firms do not simply respond to market-determined prices, but they actually set prices. Pricesetting firms do not have individual supply curves because these firms are choosing both output and price at the same time.

The Aggregate Supply Curve: A Warning

When we draw a firms supply curve, we assume that input prices are constant. In macroeconomics, an increase in the overall price level means that at least some input prices will be rising as well. The outputs of some firms are the inputs of other firms.

The Aggregate Supply Curve: A Warning

Rather than an aggregate supply curve, what does exist is a price/output response curve a curve that traces out the price and output decisions of all the markets and firms in the economy under a given set of circumstances.

Aggregate Supply in the Short Run

In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.

Aggregate Supply in the Short Run

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.

Aggregate Supply in the Short Run

Macroeconomists focus on whether or not the economy as a whole is operating at full capacity. As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.

Output Levels and Price/Output Responses

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

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.

The Response of Input Prices to Changes in the Overall Price Level

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.

Shifts of the Short-Run Aggregate Supply Curve

A cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve.

Shifts of the Short-Run Aggregate Supply Curve

Factors That Shift the Aggregate Supply Curve
Increases in Aggregate Supply
Lower costs lower input prices lower wage rates
Economic growth more capital more labor technological change Public policy supply-side policies tax cuts deregulation Good weather

Shifts to the Right

Decreases in Aggregate Supply

Higher costs higher input prices higher wage rates
Stagnation capital deterioration

Shifts to the Left

Public policy waste and inefficiency over-regulation

Bad weather, natural disasters, destruction from wars

The Equilibrium Price Level

The equilibrium price level is the point at which the aggregate demand and aggregate supply curves intersect.

The Equilibrium Price Level

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.

The Long-Run Aggregate Supply Curve

Costs lag behind price-level changes in the short run, resulting in an upward-sloping AS curve.

Costs and the price level move in tandem in the long run, and the AS curve is vertical.

The Long-Run Aggregate Supply Curve

Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

The Long-Run Aggregate Supply Curve

When output is pushed above potential, there is upward pressure on costs, and this causes the short-run AS curve to the left.

Costs ultimately increase by the same percentage as the price level, and the quantity supplied ends up back at Y0.

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 or potential GDP.

Aggregate Demand, Aggregate Supply, 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.

Aggregate Demand, Aggregate Supply, 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.

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.

The Simple Keynesian Aggregate Supply Curve

The output of the economy cannot exceed the maximum output of YF. The difference between planned aggregate expenditure and aggregate output at full capacity is sometimes referred to as an inflationary gap.

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.

Causes of Inflation

Demand-pull inflation is inflation initiated by an increase in aggregate demand.

Cost-push, or supply-side, inflation is inflation caused by an increase in costs.

Cost-Push, or Supply-Side Inflation

Stagflation occurs when output is falling at the same time that prices are rising.
One possible cause of stagflation is an increase in costs.

Cost-Push, or Supply-Side Inflation

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.

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.

Money and Inflation

Hyperinflation is a period of very rapid increases in the price level.

Money and Inflation

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.

Money and Inflation

If the Fed tries to prevent crowding, 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.

Review Terms and Concepts

aggregate demand aggregate demand (AD) curve aggregate supply aggregate supply (AS) curve hyperinflation inflation inflationary gap potential output, or potential GDP

cost-push, or supply-side, inflation

cost shock, or supply shock demand-pull inflation equilibrium price level

real wealth, or real balance, effect

stagflation sustained inflation

Aggregate Supply

Aggregate Supply

Aggregate supply is the relationship between the price level in the economy and the quantity of aggregate output firms are willing and able to supply, other things held constant The foundation of aggregate supply is the labor market

Like any market, the labor market has a demand side and a supply side A good understanding of aggregate supply requires a correct understanding of the demand and supply sides of the labor market

Labor Supply

The supply of labor depends primarily on the wage rate (the dollar cost of a unit of labor, such as an hour of work) The supply of labor also depends on

The size of the adult population The skills (productivity) of the adult population Households preferences for work versus leisure

The Nominal Wage and the Real Wage

The nominal wage is the wage measured in terms of current dollars The real wage is the wage measured in terms of dollars of constant purchasing power

The real wage is the wage measured in terms of the quantity of goods it will purchase

Both workers and employers care more about the real wage than the nominal wage

Wages and Price Level Expectations

Nominal wages are important because resource agreements (such as wage contracts) are typically negotiated in nominal wages Since wage contracts are negotiated ahead of time, they are based on workers expectation for the price level

Potential Output and the Natural Rate of Unemployment

Potential output is the economys maximum sustainable output level, given the supply of resources, technology, and the underlying economic institutions

Another point of view is the that potential output is the level of output where there are no surprises about the price level

The natural rate of unemployment is the rate that occurs when the

The Actual Price Level is Higher Than Expected

Firms experience higher profits, which stimulates the demand side of the labor market, pushing the economy past its potential output in the short run Workers will respond by supplying more labor if

They are legally bound to do so by labor contracts There is a large pool of unemployed labor causing workers to be cautious about asking for wage increases Workers are uninformed concerning the increase in the economys price level

In the long run, wages will rise, bringing the economy to potential output

The Actual Price Level is Lower Than Expected

In this case, firms experience lower profits, which depresses the demand side of the labor market, pushing the economy below its potential output in the short run Workers may respond by lowering wage demands as time passes

The Short-Run Supply Curve

If the price level is higher than expected, the quantity supplied is above the economys potential output

Price Level

SRAS

If the price level is lower than expected, the quantity supplied decreases

As a result, there is a positive short-run relationship between the price level and aggregate output supplied

Real GDP

The Short Run

The short run is a period during which some resources prices, especially labor, are fixed by agreement

Aggregate Supply and Equilibrium

Price Level

AD SRAS

Potential output

Real GDP

The Actual Price Level is Higher Than Expected

Price Level

AD

Potential output

SRAS
SRAS

expansionary gap

Real GDP

The Actual Price Level is Lower Than Expected

Price Level
Potential output

AD

SRAS
SRAS

contractionary gap

Real GDP

Changes in Aggregate Supply

Adverse supply Price Level shocks are LRAS unexpected events AD that reduce aggregate supply Beneficial supply shocks are unexpected events that reduce aggregate supply

LRAS
SRAS SRAS

Real GDP

Demand and Supply in the Labor Market

Nominal wage rate

D S

Millions of workers

The Effect of a Higher Price Level

Nominal wage rate

D D

S S

Millions of workers