Aggregate Demand, Aggregate Supply, and Inflation

The Goods Market and the Money Market The goods market is the market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined. The money market is the market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

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

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 or other factors remain constant 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 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.

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.

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

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.

The Aggregate Supply Curve: A Warning The AS curve shows the relationship between the aggregate quantity of output supplied by all the firms in an economy and the overall price level. 2. The AS curve is not a market supply curve and it is not the sum of all the individual supply curves in the economy. a. When we derived the supply curve for a firm we assumed per unit production costs were constant in the short run. Firms set prices instead of simply responding to them. b. The AS curve is a price/output response curve. It traces out the price decisions and output decisions of all the markets and firms in the economy given a 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. 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. 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.

Aggregate Supply in the Short Run When the economy is producing at its maximum level of output—that is, at capacity—the aggregate supply curve becomes vertical. Between C and D in, the AS curve is vertical. Moving from C to D results in no increase in aggregate output but a large increase in the price level. Aggregate output is considerably higher at B than at A, but the price level at B is only slightly higher than it is at A. 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.

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. If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

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. If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

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. 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.

Shifts of the Short-Run Aggregate Supply Curve Bad weather, natural disasters, destruction from wars Good weather Public policy waste and inefficiency over-regulation Public policy supply-side policies tax cuts deregulation Stagnation capital deterioration Economic growth more capital more labor technological change Higher costs higher input prices higher wage rates Lower costs lower input prices lower wage rates Shifts to the Left Decreases in Aggregate Supply Shifts to the Right Increases in Aggregate Supply Factors That Shift the Aggregate Supply Curve

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 At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to 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 A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This would prevent output from falling, but it would raise the price level further, to P2.

Expectations and Inflation Expectations about changes in future prices may affect current decisions. 2. Firms may raise their prices in expectation of competitors doing the same. 3. Workers may ask for higher wages because they expect higher inflation in the future. 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.” If prices have been rising, and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—then firms may continue raising prices even if demand is slowing or contracting. 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. If prices have been rising, and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—then firms may continue raising prices even if demand is slowing or contracting.

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. If prices have been rising, and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—then firms may continue raising prices even if demand is slowing or contracting.

Money and Inflation An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps hyperinflation. If prices have been rising, and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—then firms may continue raising prices even if demand is slowing or contracting.

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