Aggregate Demand,Aggregate Supply,and Inflation

The Aggregate Demand CurveAggregate demand is the total demand for goods and services in the economy.

Deriving the Aggregate Demand CurveTo 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 CurveThe Impact of an Increase in the Price Level on the Economy Assuming No Changes in G, T, and Ms

Deriving the Aggregate Demand CurveThe 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 WarningThe 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 WarningA 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 WarningAt all points along the AD curve, both the goods market and the money market are in equilibrium.

Other Reasons for a Downward-Sloping Aggregate Demand CurveThe 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 Downward-Sloping Aggregate Demand CurveThe 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 Expenditureand Aggregate DemandAt every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expenditure.

Shifts of the Aggregate Demand CurveAn 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 CurveAn 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 CurveExpansionary monetary policy Ms AD curve shifts to the rightContractionary monetary policy Ms AD curve shifts to the leftExpansionary fiscal policy G AD curve shifts to the rightContractionary fiscal policy G AD curve shifts to the leftT AD curve shifts to the rightT AD curve shifts to the left

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

The Aggregate Supply CurveThe 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 WarningThe 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 WarningFirms 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.

The Aggregate Supply Curve:A WarningWhen 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 WarningRather 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 RunIn the short run, the aggregate supply curve (the price/output response curve) has a positive slope.

Aggregate Supply in the Short RunAt 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 RunMacroeconomists 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 andPrice/Output ResponsesWhen 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 LevelThere 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 LevelWage 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-RunAggregate Supply CurveA cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve.

Shifts of the Short-RunAggregate Supply Curve

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

The Equilibrium Price LevelP0 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-RunAggregate Supply CurveCosts 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-RunAggregate Supply CurveOutput can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

The Long-RunAggregate Supply CurveWhen 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-RunAggregate Supply CurveY0 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, AggregateSupply, and Monetary and Fiscal PolicyExpansionary 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.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.

Aggregate Demand, AggregateSupply, and Monetary and Fiscal PolicyWhen 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.On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero.

Long-Run AggregateSupply and Policy EffectsIf 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 KeynesianAggregate Supply CurveThe 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 InflationInflation 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 InflationDemand-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 InflationStagflation 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 InflationCost 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 InflationIf 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 InflationHyperinflation is a period of very rapid increases in the price level.

Money and InflationAn 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 InflationIf 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 Conceptshyperinflationinflationinflationary gappotential output, or potential GDPreal wealth, or real balance, effectstagflationsustained inflationaggregate demandaggregate demand (AD) curveaggregate supplyaggregate supply (AS) curvecost-push, or supply-side, inflationcost shock, or supply shockdemand-pull inflationequilibrium price level

Aggregate Supply

Aggregate SupplyAggregate 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 constantThe foundation of aggregate supply is the labor marketLike any market, the labor market has a demand side and a supply sideA good understanding of aggregate supply requires a correct understanding of the demand and supply sides of the labor market

Labor SupplyThe 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 onThe size of the adult populationThe skills (productivity) of the adult populationHouseholds preferences for work versus leisure

The Nominal Wage and the Real WageThe nominal wage is the wage measured in terms of current dollarsThe real wage is the wage measured in terms of dollars of constant purchasing powerThe real wage is the wage measured in terms of the quantity of goods it will purchaseBoth workers and employers care more about the real wage than the nominal wage

Wages and Price Level ExpectationsNominal wages are important because resource agreements (such as wage contracts) are typically negotiated in nominal wagesSince wage contracts are negotiated ahead of time, they are based on workers expectation for the price level

Potential Output and the Natural Rate of UnemploymentPotential output is the economys maximum sustainable output level, given the supply of resources, technology, and the underlying economic institutionsAnother point of view is the that potential output is the level of output where there are no surprises about the price levelThe natural rate of unemployment is the rate that occurs when the economy is producing it potential level of output

The Actual Price Level is Higher Than ExpectedFirms experience higher profits, which stimulates the demand side of the labor market, pushing the economy past its potential output in the short runWorkers will respond by supplying more labor ifThey are legally bound to do so by labor contractsThere is a large pool of unemployed labor causing workers to be cautious about asking for wage increasesWorkers are uninformed concerning the increase in the economys price levelIn the long run, wages will rise, bringing the economy to potential output

The Actual Price Level is Lower Than ExpectedIn 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 runWorkers may respond by lowering wage demands as time passes

The Short-Run Supply CurveIf the price level is higher than expected, the quantity supplied is above the economys potential outputIf the price level is lower than expected, the quantity supplied decreasesAs a result, there is a positive short-run relationship between the price level and aggregate output suppliedReal GDPPrice LevelSRAS

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

Aggregate Supply and EquilibriumReal GDPPriceLevelSRASADPotentialoutput

The Actual Price Level is Higher Than ExpectedReal GDPPriceLevelSRASADPotentialoutputSRASexpansionarygap

The Actual Price Level is Lower Than ExpectedReal GDPPriceLevelSRASADPotentialoutputSRAScontractionarygap

Changes in Aggregate SupplyAdverse supply shocks are unexpected events that reduce aggregate supplyBeneficial supply shocks are unexpected events that reduce aggregate supplyReal GDPPrice LevelSRASLRASSRASLRASAD

Demand and Supply in the Labor MarketMillions of workersNominalwage rateSD

The Effect of a Higher Price LevelMillions of workersNominalwage rateSDDS

Firms may at time have excess capital and excess labor on hand. The reasons for this are associated with the costs of getting rid of capital and labor.Firms may at time have excess capital and excess labor on hand. The reasons for this are associated with the costs of getting rid of capital and labor.If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.Cost shocks refer to an increase in costs, which may be the result of an increase in wage rates, energy prices, natural disasters, economic stagnation, and the like.If prices have been rising, and if peoples expectations are adaptivethat is, if they form their expectations on the basis of past pricing behaviorthen firms may continue raising prices even if demand is slowing or contracting.If prices have been rising, and if peoples expectations are adaptivethat is, if they form their expectations on the basis of past pricing behaviorthen firms may continue raising prices even if demand is slowing or contracting.If prices have been rising, and if peoples expectations are adaptivethat is, if they form their expectations on the basis of past pricing behaviorthen firms may continue raising prices even if demand is slowing or contracting.If prices have been rising, and if peoples expectations are adaptivethat is, if they form their expectations on the basis of past pricing behaviorthen firms may continue raising prices even if demand is slowing or contracting.