1. 1 of 25 CHAPTER OUTLINE: The Aggregate Supply Curve The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve The Equilibrium Price Level The Long-Run Aggregate Supply Curve Potential GDP Monetary and Fiscal Policy Effects Long-Run Aggregate Supply and Policy Effects Causes of Inflation Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon The Behavior of the Central Bank

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3. 3 of 25 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.

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5. 5 of 25 cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.

6. 6 of 25 equilibrium price level The price level 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.

7. 7 of 25 The Long-Run Aggregate Supply Curve When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back at Y0. Y0 is sometimes called potential GDP.

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9. 9 of 25 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve Aggregate demand 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. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A’.

10. 10 of 25 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near Maximum Capacity If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B ’.

11. 11 of 25 It is important to realize that 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 conclusion that policy has no effect on aggregate output in the long run is perhaps startling.

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13. 13 of 25 Cost-Push, or Supply-Side, Inflation An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls.

14. 14 of 25 Cost Shocks Are Bad News for Policy Makers 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 policy would raise aggregate output Y again, but it would raise the price level further, to P2.

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16. 16 of 25 Sustained Inflation from an Initial Increase in G and Central Bank Accommodation 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 Central Bank 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 even hyperinflation.

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20. 20 of 25 The Central Bank’s Response to Low Output/Low Inflation During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Central Bank is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD 0 to AD 1, and lead to an increase in output with very little increase in the price level.

21. 21 of 25 During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Central Bank is likely to increase the interest rate (and thus contract the money supply). This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output. The Central Bank’s Response to High Output/High Inflation

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