25 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Aggregate Demand, Aggregate Supply, and Inflation

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 47 The Aggregate Demand Curve Aggregate demand is the total demand for goods and services in the economy.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 47 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 (M s ).

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 47 Deriving the Aggregate Demand Curve The Impact of an Increase in the Price Level on the Economy – Assuming No Changes in G, T, and M s

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 47 The Aggregate Demand Curve: A Warning At all points along the AD curve, both the goods market and the money market are in equilibrium.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 47 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

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 47 Shifts of the Aggregate Demand Curve Factors That Shift the Aggregate Demand Curve Expansionary monetary policy M s AD curve shifts to the right Contractionary monetary policy M s 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

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 47 The Aggregate Supply Curve Aggregate supply is the total supply of all goods and services in the economy.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 47 Aggregate Supply in the Short Run In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 47 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

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 47 The Equilibrium Price Level The equilibrium price level is the point at which the aggregate demand and aggregate supply curves intersect.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 47 The Equilibrium Price Level P 0 and Y 0 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 47 The Long-Run Aggregate Supply Curve Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 47 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 Y 0.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 47 The Long-Run Aggregate Supply Curve Y 0 represents the level of output that can be sustained in the long run without inflation. It is also called potential output or potential GDP.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 47 Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy 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. 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 47 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. On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero. Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 47 The Simple “Keynesian” Aggregate Supply Curve The output of the economy cannot exceed the maximum output of Y F. The difference between planned aggregate expenditure and aggregate output at full capacity is sometimes referred to as an inflationary gap.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 41 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 42 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 43 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 44 of 47 Money and Inflation Hyperinflation is a period of very rapid increases in the price level.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 45 of 47 Money and Inflation An increase in G with the money supply constant shifts the AD curve from AD 0 to AD 1. This leads to an increase in the interest rate and crowding out of planned investment.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 46 of 47 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.

CHAPTER 25: Aggregate Demand, Aggregate Supply, and Inflation © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 47 of 47 Review Terms and Concepts hyperinflation inflation inflationary gap inflationary gap potential output, or potential GDP potential output, or potential GDP real wealth, or real balance, effect real wealth, or real balance, effect stagflation sustained inflation sustained inflation aggregate demand aggregate demand aggregate demand (AD) curve aggregate demand (AD) curve aggregate supply aggregate supply aggregate supply (AS) curve aggregate supply (AS) curve cost-push, or supply-side, inflation cost-push, or supply-side, inflation cost shock, or supply shock cost shock, or supply shock demand-pull inflation demand-pull inflation equilibrium price level equilibrium price level