Aggregate Supply, Aggregate Demand

and Inflation:
Putting It Altogether /

Goodwin et.al. 2018, European edition Ch.8 & 12

Goodwin et.al. 2019, 3rd edition Ch.9 & 13
Goodwin et.al. 2023, 4th edition Ch.8 & 12
Outline

1. Introduction: Booms and Recessions

2. Aggregate Expenditure and Inflation: Aggregate
Demand Curve
3. Macroeconomic production capacity and Inflation:
Aggregate Supply Curve
4. Putting the AS/AD Model to Work
5. Competing Theories: Classical vs. Keynesian
 Neoclassical vs. Keynesian Theories of Unemployment
Neoclassical vs. Keynesian Theories of Economic Crises

Debate:
LS • When (involuntary) unemployment arises
wage

as a result of an economic recession,

• What should be the policy reaction?

A E Moving onto a connected, larger

w* macroeconomics debate:
w2 • on economic recessions/crises:
G • How to explain them?
• What should be the policy reaction?
LD ⥥
LD’ Aggregate Supply and Aggregate Demand
Model
Quantity of labour
 AS-AD Model: Simplified Graphical Representation

Price
Level
or
Inflation rate
Aggregate
supply

Equilibrium
price level
or inflation rate

Aggregate
demand

Equilibrium Quantity of
output Output

Copyright © 2004 South-Western

 Macroeconomic Cycles: Booms and Recessions
Economists use the model of aggregate demand and aggregate
supply to explain
1. determination of output in the short-run and medium-run
2. short-run fluctuations in economic activity around its long-run
trend.
Figure 8.1: U.S. Real GDP and Recessions, 1985–2021

Source: BEA quarterly data 1985–2021, and NBER.

Figure 8.2: U.S. Unemployment Rate and Recessions,
1985–2017

Source: BLS monthly data 1985–2021, and NBER.

 Figure 8.3: U.S. Inflation Rate and Recessions,
1985–2017

Source: “Economic Report of the President” 1985–2021; rate is calculated as a

three-month moving average of the CPI; NBER.
Figure 8.4: A Stylized Business Cycle
Figure 8.5: The Output-Income-Spending Flow of
an Economy in Equilibrium
Figure 8.6: The Output-Income-Spending Flow with Leakages
and Injections
Figure 8.9: Macroeconomic Equilibrium at Full
Employment in the Classical Model
Figure 8.17: Movement to an Unemployment Equilibrium
 AS-AD Model: An Overview

Price
Level
or
Inflation rate
Aggregate
supply

Equilibrium
price level
or inflation rate

Aggregate
demand

Equilibrium Quantity of
output Output

Copyright © 2004 South-Western

 AS-AD Model: An Overview

Two variables are used to develop the model:

1. The economy’s output of goods and services measured by real GDP
(output Y).
2. The overall price level measured by the CPI or the GDP deflator (P
level) or the change in P level, i.e. the rate of inflation.

The aggregate-demand curve shows the quantity of goods and services

demanded by households, firms, and the government at each price
level. P level → Output Y
The aggregate-supply curve shows the price level at each level of
quantity of goods and services supplied by producers.
Output Y → P level

The model requires simultaneous equilibrium in the goods, financial, and

labor markets
– Aggregate supply derives from equilibrium in the labor market;
– Aggregate demand derives from equilibrium in the goods and financial
markets.
 Macroeconomic Cycles: Booms and Recessions
Economists use the model of aggregate demand and aggregate supply to explain
1. determination of output in the short-run and medium-run
2. short-run fluctuations in economic activity around its long-run trend.

3 analytical time frameworks in classical macroeconomics:

§ Short-run: Output Y is determined by AD.

§ Medium-run: Output Y is determined by AS or the full-employment level of output

Yfe (which in turn is determined by the amount of factor endowments of the
economy (K,L,N) and the average level of technology/productivity).

§ Long-run: Output Y is determined by the change in the natural rate of output Yfe
over time (dependent on the changes in factor endowments of the economy, K,L,N
and the change in technology/productivity).
Inflation (change in the P level) and
the Aggregate Demand Curve
Aggregate Demand AD

AD = C + I + G + NX

• C = Consumption spending
• I = Investment spending
• G = Government spending on goods & services
• (excluding transfers to households or firms)
• NX = Net Export spending = X – IM
 Aggregate Demand AD
• AD = C + I + G + NX

– Consumption function C = c0 + c1(Y-T)

– Investment function I = I0 + i1(Y) - b(i)
– Net exports function NX = X0+ X(Y*,e) – (IM0+ IM(Y,e))

– T: taxation; c0: autonomous consumption; c1:marginal propensity to

consume
– I0 : autonomous investment; i1: marginal propensity to invest; b: reaction
parameter of investment spending to interest rate i
– X0: autonomous export demand; IM0: autonomous import demand;
– e: real exchange rate; Y*: foreign income/output (income/output of the rest
of the world)
 13.1 The Aggregate Demand curve
ü The Aggregate Demand (AD) curve shows the negative correlation between inflation
and aggregate demand
ü This analysis shows the impact of different inflation levels on Aggregate Demand.

…the level of Aggregate

Demand falls

B
Inflation rate (π )

π1
If inflation rises…
A
π0

Y1 Y0

Output (Y )
 Why is the AD-curve downward sloping?

§ As inflation ↑ ⇢ Aggregate Demand (AD) ↓ (and vice versa)

due to 4 causal mechanisms:

1. Real wealth effect

– higher P level means lower wealth
• real wealth = nominal wealth/P level
– people spend less
– Consumption spending C ↓

2. Real Money supply effect

– real money supply = M/P (M: nominal money supply)
– higher P means lower real money supply
• similar effect to contractionary monetary policy
– Interest rate ↑ (assuming constant money demand)
– Investment spending I ↓
 Why is the AD-curve downward sloping?

3. Real exchange rate effect

– Real e.r. e = E (P/P*)
– E: nominal e.r.; P = domestic price level; P*=foreign price level
– Higher P means higher e,
– Domestic goods become relatively more expensive compared to foreign
goods,
– hence lower net export spending, NX ↓
– Remember: NX = X0+ X(Y*,e) – (IM0+ IM(Y,e))
+, - +,+

4. Central Bank reaction

– CB generally responds to higher inflation by increasing interest rates
– Higher interest rates tends to lower investment and total demand
– Remember: Investment function I = I0 + i1(Y) - b(i)
+ -
 Figure 12.6 The CB’s reaction function
ü To the extent that the CB’s primary objective is to keep inflation low and stable,
it will react to increases in inflationary pressure with hikes in its main
refinancing rate
Inflation rate (π )

π1
If inflation
rises… A
π0
B …the ECB increases interest
rates

r0 r1
Interest rate (r)
Aggregate Demand

§ The aggregate demand relation captures the effect

of the price level on output. It is derived from the
equilibrium conditions in the goods and financial
markets.
§ Recall the equilibrium conditions for the goods and
financial markets:

IS relation: Y = C(Y - T ) + I (Y , i ) + G

M
LM relation: = YL(i )
P
Aggregate Demand

The Derivation of the Aggregate

Demand Curve
An increase in the price level leads
to a decrease in output.
M
­ P® ¯ ® i ­ ® ¯ demand ® ¯ Y
P

A parallel mechanism is that when

there is an inflationary pressure,
Central Banks usually increase the
interest rate to achieve price
stability.
13.1 The Aggregate Demand curve
ü This analysis shows the impact of different inflation levels on Aggregate Demand.

…the level of Aggregate

Demand falls

B
Inflation rate (π )

π1
If inflation rises…
A
π0

Y1 Y0

Output (Y )
What determines the position of the AD curve?

• Variables that determine the level of AD

• other than the rate of inflation (or the P level)
• autonomous of the level of income/output Y

Namely;
1. Government spending G and Taxation T – both policy variables
2. autonomous consumption C = C0 + c1(Y-T)
3. autonomous investment I = I0 + i1(Y) - b(i)
4. autonomous net exports NX = X0+X(Y*,e) – (IM0+ IM(Y,e))
• 2,3,4 determined by future expectations of consumers and investors
domestically and abroad

• changes in these variables will cause the AD curve to shift inward/outward

13.2 The Effect of Expansionary Fiscal Policy or
Increased Confidence on the AD curve
ü If government spending G increases, taxes T decrease, consumers or investors
become more confident such that C0 or I0 increase, or NX0 increases, demand
for goods&services AD increases in the economy for each level of inflation
Inflation rate (π )

AD1

AD0

Output (Y )
 What happens if central banks change their policy?
§ active form of central bank intervention:
– changing inflation target
– focus on fighting unemployment rather than price instability
Ø same level of inflation would result in higher (lower) real interest rates set
by the central bank
Ø dampening (increasing) investment and shift the AD curve
Inflation rate (π )

AD1

AD0

Output (Y )
Macroeconomic production capacity
and Inflation:
Aggregate Supply Curve
 Aggregate Supply AS
Aggregate Supply AS shows the level of Output Y, i.e. GDP)

1. Long-run AS LRAS
• Shows maximum capacity output (full-employment level of output) YFE
• the level of output an economy would produce if every resource in the economy
K,L,N were fully utilized at given level of tecjnology A;
• Aggregate production function Y = f(A,K,L,N)
• K Capital; L Labor; N natural resources; A Technology/Productivity
• Growth: increasing YFE (increasing the capacity at which the economy can produce at
full employment)
• increasing AD without growth (at fixed YFE) leads to inflationary pressures

2. Short-run AS SRAS
When AS is below YFE : AS responds to increasing AD without inflationary pressures
 13.3 The Aggregate Supply curve
ü As the economy approaches its maximum capacity, inflation levels tend to rise as
excessive demand for workers, goods and services, and production inputs pushes
up wages and prices. Wage-
Price
Unemployment Spiral
SRAS horizontal: As Aggregate Supply (AS)
Y increases in LRAS vertical: As Y increases in
Inflation rate (π )

response to rising response to rising AD,

AD,
flat AS curve:
Below full capacity,
combinations of
increasing Y
and stable inflation
are possible
SRAS upward-sloping:
As Y increases in response to rising AD,
a gently rising AS curve:
due to some bottlenecks in some Y*
Chapter 13
inputs such as technical workers or energy
sharply rising AS curve:
Beyond full capacity:
wage-price spiral: when pressure
on wages creates upward pressure
on prices and, as a result, further
Maximum upward pressure on wages
Capacity
Output (Y )
 Aggregate Supply
§ The aggregate supply relation captures the effects of output on the price level.
– Output Y → P level
§ It is derived from the behavior of wages and prices; equilibrium in the labor market;
§ based on equations for wage and price determination:

§ Wage determination: wages are determined through a bargaining process

• when unemployment U is lower, the bargained wage will be higher, holding all other factors
that determine wages constant;
• When wages go up, production costs go up, prices will increase, holding all other factors that
determine prices constant:
Y­ Þ N ­
N­ Þ u ¯ Move up the (LR)AS curve

u¯ Þ W ­
W­ Þ P ­
Inward shift of the SRAS curve

– When inflationary expectations are higher, workers will demand a higher nominal wage rise
• P↑ ⟹ W ↑
 13.4 The effect of an increase in inflationary
expectations on the aggregate supply curve
ü If people come to expect higher inflation, these expectations get built in to wage and
price contracts, leading to a generally higher level of inflation throughout the economy.

Inward shift of the SRAS curve due to

increasing inflationary expectations
Inflation rate (π )

As expected P level Pe↑;

Workers increase nominal wage W
demands;
As W ↑, cost of production increases,
5% -
AS1 prices increase (i.e. inflation).

3% -
AS0 SRAS shifts in/up
The same level of output Y can now
be produced at higher level of
inflation than before.

Output (Y )
Yn
Shifts of the AS curve: inflationary expectations

§ if people expect higher inflation, expectations get built into

wage and price contracts

§ à Inflation can be self-fulfilling

§ in the short run: inflation rate the same as in the past

§ in the medium run: a rise in inflation tends to increase people’s
expectations
Shifts of the long-run AS curve LRAS: supply shocks
Remember: Aggregate production function Y = f(A,K,L,N)
• K Capital; L Labor; N natural resources; A Technology/Productivity

Any supply shock that affects the full capacity production level of the macro
economy will shift the LRAS curve right or left.

supply shock: a change in the productive capacity of an economy

§ positive supply shock
§ e.g. bumper crop in agriculture, new invention, increase in labor
productivity
§ the real capacity of the economy expands
Ø the economy can produce more than before

§ adverse supply shocks

§ e.g. natural occurrences such as a pandemic, ecological disaster, war
earthquake
Ø reduces economy’s capacity to produce
Figure 13.5 A beneficial supply shock: expansion of
output capacity
ü An expansion of output capacity could be a result of new technology or
improved labor productivity
Inflation rate (π )

AS0

AS1 Expansion of
Maximum
Capacity

Output (Y ) Yn
Putting the AS/AD Model
to Work
Applications of the model to a number of cases

1. An economy in recession: Global recession 2008-09

2. Stagflation in the 1970s and 1980s
3. A hard line against inflation: Disinflation in the 1980s
4. An overheated economy: The German reunification
5. Technology and Globalization
6. Austerity policies and structural reforms
Case 1: The global financial and economic crisis 2008-2009

§ unemployment was high but inflation remained low

§ governments of major OECD countries passed stimulus
packages with tax cuts and spending increases
§ stimulus packages helped European economies to recover from
recession
– effects not large enough to reach full employment

– inflation did not rise

13.6 Aggregate Demand and supply equilibrium in
recession

Unemployment ü The position of the AD curve

indicates a low level of aggregate
AS demand, leading to an economy
with unemployment at equilibrium
Inflation rate (π )

E1. At this point on the AS curve,

inflationary pressures are low.

ü What should be the policy

response?

E0 AD0
E1
AD1

Output (Y )
Y*
Figure 13.7 Expansionary fiscal policy in response to a
recession

Unemployment
ü An expansion of government
AS spending, as well as a
Inflation rate (π )

program of tax cuts, shifts

the AD curve to the right.

ü This increases Y and reduces

unemployment, but since
the economy is in the flat
E2 portion of the AS curve at
equilibrium E2, it has little
E1 effect on inflation.

AD1 AD2

Y* Output (Y )
The reaction in the U.S. was different

§ Fed embarked early on quantitative easing

§ The fiscal stimulus was also higher in the U.S.
§ idea: combination of monetary expansion plus
recovering confidence of consumers and businesses
leads to a more complete recovery
§ larger shift in AD brings economy back to
full-employment
Figure 13.8 A greater expansion of aggregate demand

Unemployment
ü If Aggregate Demand
AS increases by a larger amount,
Inflation rate (π )

it can bring the economy back

into the full employment
zone.
ü At equilibrium point E1 the
AS/AD model indicates the
possibility of a slightly higher
inflation level.
E2
E1
AD1 AD2

Y* Output (Y )
 13.14 Excessively high aggregate demand causes
inflation ü Neoclassical
macroeconomists are
Wage- critical of
Price expansionary fiscal
Spiral policies because they
argue:
AS Expansionary policy
Inflation rate (π )

ü
causes the economy
to “heat up.”
ü In the short run,
E1 people respond by
increasing output, but
AD1 tight markets for labor
E0 and other resources
cause inflation to rise
as well at equilibrium
AD0 point.
ü Also fiscal expansion is
based on debt
accumulation risks
unsustainable macro

Y* Output (Y ) growth;
ü Plus may crowd out
private investment.
 Figure 13.15b Neoclassical argument – Automatic recovery
over the longer-run
ü If the government reacts to the fall in output with reforms which increase potential
output, such as labor market reforms for wage flexibility;
ü Wages will fall to the equilibrium level; costs of production decrease leading to lower
inflationary expectations;
ü the AS curve shifts right. GDP increases again, but prices fall. It is not clear, however,
whether a return to the initial GDP level is possible.

AS0
Inflation rate (π )

AS1

E2 E0

E3
Higher
Capacity
AD2 AD0

Output (Y )
Competing Theories
Classical macroeconomics

§ assumptions:
– self-adjusting properties of free-markets

– labor markets clear at an equilibrium wage

– markets for loanable funds cause savings and investment to

be equal at an equilibrium interest rate
Ø in theory, a smoothly functioning economy should be
at full-employment
13.19 The classical view of AS/AD

ü the vertical AS curve represents the classical view that the economy will tend to
return to full employment automatically.

Classical AS
Inflation rate (π )

AD

Y* Output (Y )
The classical view of AS/AD

§ AS curve at full-employment level

– people make optimizing choices

– unemployed workers bid down wages

– full-employment restored
§ AD level determines only the inflation rate
What is the effect of aggregate demand-management
policies?
§ expansionary fiscal or monetary policy has no effect
on the output level
§ government spending “crowds out” private spending
– more spending by government means less spending by
consumers and businesses
§ monetary expansions lead only to increased inflation
– central bank should choose a certain growth rate of the
money supply or level of the interest rate
Keynesian macroeconomics

§ market economies are inherently unstable

§ business cycles can be explained by changes in
investors’ confidence
§ macroeconomic phenomena cannot be explained by
assuming rational, optimizing behavior by individuals
§ inherent tendency toward market instability requires
active government intervention
§ Particularly in the form of expansionary fiscal policy,
specifically increasing G because this has the fastest
and highest impact on stimulating AD.
 What to take home

§ higher inflation rates tend to reduce aggregate

demand
§ fiscal and monetary policies affect output and inflation
§ supply shocks may have significant effects
§ investor and consumer confidence and expectations
have important effects on output and inflation
§ Classical and Keynesian economists provide different
arguments about economic analysis and policy