RETP A HC 13

Aggregate Demand,
Aggregate Supply,
and Inflation

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 The Aggregate Demand Curve

• Aggregate demand
is the total demand for
goods and services in
the economy.
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 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).
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 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 → Md ↑ → r ↑ → I↓ → A ↓E → Y ↓
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 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.
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 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.
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 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.
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 The Aggregate Demand Curve:
A Warning

• At all points along the

AD curve, both the
goods market and the
money market are in
equilibrium.
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 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.
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 Other Reasons for a Downward-
Sloping 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.
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 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
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 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.
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 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.
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 Shifts of the Aggregate Demand Curve

Factors That Shift the Aggregate Demand Curve

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
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 The Aggregate Supply Curve

• Aggregate supply is the

total supply of all goods
and services in the
economy.
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 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.
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 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.
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 The Aggregate Supply Curve:
A Warning

• 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.
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 The Aggregate Supply Curve:
A Warning

• When we draw a firm’s 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.
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 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.
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 Aggregate Supply in the Short Run

• In the short run, the

aggregate supply
curve (the price/output
response curve) has a
positive slope.
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 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.
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 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.
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 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.
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 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.
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 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.
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 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.
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 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
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 The Equilibrium Price Level

• The equilibrium price

level is the point at
which the aggregate
demand and aggregate
supply curves intersect.
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 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.
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 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.
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 The Long-Run
Aggregate Supply Curve

• Output can be pushed

above potential GDP by
higher aggregate
demand. The
aggregate price level
also rises.
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 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.
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 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.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34 of 47
 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.
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 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.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 36 of 47
 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.
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 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.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38 of 47
 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.
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 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.
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 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.
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 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.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 42 of 47
 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.
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 Money and Inflation

• Hyperinflation is a
period of very rapid
increases in the price
level.
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 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.
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 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.
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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 46 of 47
 Review Terms and Concepts

aggregate demand hyperinflation

aggregate demand (AD) curve inflation
aggregate supply inflationary gap
aggregate supply (AS) curve potential output, or potential GDP
cost-push, or supply-side, inflation real wealth, or real balance, effect
cost shock, or supply shock stagflation
demand-pull inflation sustained inflation
equilibrium price level
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