1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 13 Prepared by: Fernando Quijano and Yvonn Quijano Aggregate Demand, Aggregate Supply, and Inflation

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Demand Curve Aggregate demand is the total demand for goods and services in the economy.Aggregate demand is the total demand for goods and services in the economy. The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level.The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level.

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 ).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 ).

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Deriving the Aggregate Demand Curve Each pair of values of P and Y on the aggregate demand curve corresponds to a point at which both the goods market and the money market are in equilibrium.Each pair of values of P and Y on the aggregate demand curve corresponds to a point at which both the goods market and the money market are in equilibrium.

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Demand Curve: A Warning The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. It is a more complex concept.The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. It is a more complex concept. We cannot use the ceteris paribus assumption to draw the AD curve because when the overall price level rises, many prices (including input prices) rise together.We cannot use the ceteris paribus assumption to draw the AD curve because when the overall price level rises, many prices (including input prices) rise together.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Demand Curve: A Warning Aggregate demand falls when the price level increases because the higher price level causes the demand for money to rise, which causes the interest rate to rise.Aggregate demand falls when the price level increases because the higher price level causes the demand for money to rise, which causes the interest rate to rise. It is the higher interest rate that causes aggregate output to fall.It is the higher interest rate that causes aggregate output to fall. At all points along the AD curve, both the goods market and the money market are in equilibrium.At all points along the AD curve, both the goods market and the money market are in equilibrium.

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.The consumption link: The decrease in consumption brought about by an increase in the interest rate contributes to the overall decrease in output. The real wealth effect, or real balance, effect: When the price level rises, there is a decrease in consumption brought about by a change in real wealth.The real wealth effect, or real balance, effect: When the price level rises, there is a decrease in consumption brought about by a change in real wealth.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.At every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expenditure. How are aggregate demand and aggregate expenditure related? Y = C + I + G equilibrium condition

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.An increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right.

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Shifts of the Aggregate Demand Curve Contractionary monetary policy M s AD curve shifts to the left Contractionary fiscal policy G AD curve shifts to the left T AD curve shifts to the left Expansionary monetary policy M s AD curve shifts to the right Expansionary fiscal policy G AD curve shifts to the right T AD curve shifts to the right Shifts in the Aggregate Demand Curve: A Summary

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Supply Curve Aggregate supply is the total supply of all goods and services in the economy.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 (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.

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Supply Curve: A Warning The aggregate supply curve is not a market supply curve and it is not the simple sum of all the individual supply curves in the economy.The aggregate supply curve is not a market supply curve and it is not the simple sum of all the individual supply curves in the economy. One reason is that 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. We can add something that does not exist! One reason is that 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. We can add something that does not exist!

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Supply Curve: A Warning Another reason is that when we draw a firm’s supply curve, we assume that input prices are constant. If the overall price level is rising, there will be an increase in at least some input prices. Another reason is that when we draw a firm’s supply curve, we assume that input prices are constant. If the overall price level is rising, there will be an increase in at least some input prices. The outputs of some firms are the inputs of other firms. The outputs of some firms are the inputs of other firms. As wage rates and other input prices rise, the firms’ individual supply curves are shifting, so we can not sum them to get an aggregate supply curve. As wage rates and other input prices rise, the firms’ individual supply curves are shifting, so we can not sum them to get an aggregate supply curve.

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Aggregate Supply Curve: A Warning What does exist is a “price/output response” curve—a curve that traces out the price decisions and output decisions of all the markets and firms in the economy under a given set of circumstances.What does exist is a “price/output response” curve—a curve that traces out the price decisions and output decisions of all the markets and firms in the economy under a given set of circumstances.

16. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Aggregate Supply in the Short Run In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.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.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.

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Aggregate Supply in the Short Run Macroeconomists focus on whether or not the economy as a whole is operating at full capacity.Macroeconomists focus on whether or not the economy as a whole is operating at full capacity. Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment.Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment.

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Output Levels and Price Responses An increase in aggregate demand when the economy is operating at low levels of output is likely to result in an increase in output with little or no increase in the overall price level.An increase in aggregate demand when the economy is operating at low levels of output is likely to result in an increase in output with little or no increase in the overall price level. As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices.

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. 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.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.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Shifts of the Short-Run Aggregate Supply Curve A leftward shift of the AS curve could be caused by cost shocks.A leftward shift of the AS curve could be caused by cost shocks. A decrease in costs, economic growth, or public policy, can cause a rightward shift of the AS curve.A decrease in costs, economic growth, or public policy, can cause a rightward shift of the AS curve.

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Shifts of the Short-Run Aggregate Supply Curve deregulation deregulation Bad weather, natural disasters, destruction from wars Good weather Public policy waste and inefficiency waste and inefficiency supply-side policies supply-side policies over-regulation over-regulation tax cuts tax cuts Capital deteriorationCapital deterioration more capital more capital more labor more labor higher input prices higher input prices lower input prices lower input prices higher wage rates higher wage rates lower wage rates lower wage rates Factors That Shift the Aggregate Supply Curve Shifts to the Left Decreases in Aggregate Supply Shifts to the Right Increases in Aggregate Supply technological change technological change Stagnation Economic growth Higher costs Lower costs

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 is the point at which the aggregate demand and aggregate supply curves intersect. 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.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.

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Long-Run Aggregate Supply Curve Costs lag behind price-level changes in the short run, resulting in an upward- sloping AS curve, but ultimately move with the overall price level.Costs lag behind price-level changes in the short run, resulting in an upward- sloping AS curve, but ultimately move with the overall price level. If costs and the price level move in tandem in the long run, the AS curve is vertical.If costs and the price level move in tandem in the long run, the AS curve is vertical.

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.Y 0 represents the level of output that can be sustained in the long run without inflation. It is also called potential output. Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises.

25. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Long-Run Aggregate Supply Curve When output is pushed above potential, there is upward pressure on costs. Rising costs push the short-run AS curve to the left.When output is pushed above potential, there is upward pressure on costs. Rising costs push the short-run AS curve to the left. If costs ultimately increase by the same percentage as the price level, the quantity supplied will end up back at Y 0.If costs ultimately increase by the same percentage as the price level, the quantity supplied will end up back at Y 0.

26. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair AD, AS, 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.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.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.

27. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair AD, AS, and Monetary and Fiscal Policy 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.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.On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero.

28. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.In the long run, the multiplier effect of a change in government spending or taxes on aggregate output is zero.

29. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Causes of Inflation Inflation is an increase in the overall price level.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.Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time. Sustained inflation is essentially a monetary phenomenon. For the price level to continue to rise period after period, it must be accommodated by an expanded money supply.Sustained inflation is essentially a monetary phenomenon. For the price level to continue to rise period after period, it must be accommodated by an expanded money supply.

30. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Causes of Inflation Demand-pull inflation is inflation initiated by an increase in aggregate demand.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 is inflation caused by an increase in costs.

31. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. Cost-push inflation is one possible cause of stagflation—a situation in which output is falling at the same time that prices are rising.Cost-push inflation is one possible cause of stagflation—a situation in which output is falling at the same time that prices are rising.

32. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.”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.In terms of the AD/AS diagram, an increase in inflationary expectations shifts the AS curve to the left.

33. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Money and Inflation Hyperinflation is a period of very rapid increases in the price level.Hyperinflation is a period of very rapid increases in the price level. 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.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.

34. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Money and Inflation Hyperinflation is a period of very rapid increases in the price level.Hyperinflation is a period of very rapid increases in the price level. If the Fed tries to prevent crowding out by keeping the interest rate unchanged, 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.If the Fed tries to prevent crowding out by keeping the interest rate unchanged, 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.