1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 13 Chapter Aggregate Demand, Aggregate Supply, and Inflation

2. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 39 Chapter Outline 13 Aggregate Demand, Aggregate Supply, and Inflation The Aggregate Demand Curve Deriving the Aggregate Demand Curve The Aggregate Demand Curve: A Warning Other Reasons for a Downward-Sloping Aggregate Demand Curve Aggregate Expenditure and Aggregate Demand Shifts of the Aggregate Demand Curve 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 Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy Long-Run Aggregate Supply and Policy Effects Causes of Inflation Inflation versus Sustained Inflation: A Reminder Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon Looking Ahead

3. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 39 THE AGGREGATE DEMAND CURVE Money demand is a function of three variables: the interest rate (r), the level of real income (Y), and the price level (P). (Remember, Y is real output, or income. It measures the actual volume of output, without regard to changes in the price level.) Money demand will increase if the real level of output (income) increases, the price level increases, or the interest rate declines. aggregate demand The total demand for goods and services in the economy.

4. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 39 THE AGGREGATE DEMAND CURVE FIGURE 13.1 The Impact of an Increase in the Price Level on the Economy–Assuming No Changes in G, T, and M s DERIVING THE AGGREGATE DEMAND CURVE

5. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 39 THE AGGREGATE DEMAND CURVE aggregate demand curve (AD) A curve that shows the negative relationship between aggregate output (income) and the price level. Each point on the AD curve is 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. DERIVING THE AGGREGATE DEMAND CURVE An increase in the price level causes the level of aggregate output (income) to fall. A decrease in the price level causes the level of aggregate output (income) to rise. FIGURE 13.2 The Aggregate Demand (AD) curve

6. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 39 Let P equal the aggregate price level. Assuming that G, T, and MS remain the same, the impact of an increase in the price level on the economy can be described as follows: a. b. c. d. e.

7. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 39 Let P equal the aggregate price level. Assuming that G, T, and M S remain the same, the impact of an increase in the price level on the economy can be described as follows: a. b.c. d. e.

8. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 39 THE AGGREGATE DEMAND CURVE THE AGGREGATE DEMAND CURVE: A WARNING Aggregate demand falls when the price level increases because the higher price level causes the demand for money (M d ) to rise. With the money supply constant, the interest rate will rise to reestablish equilibrium in the money market. It is the higher interest rate that causes aggregate output to fall. The AD curve is not the sum of all the market demand curves in the economy. It is not a market demand curve.

9. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 39 THE AGGREGATE DEMAND CURVE OTHER REASONS FOR A DOWNWARD-SLOPING AGGREGATE DEMAND CURVE Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output. Decreased consumption brought about by a higher interest rate also contributes to this effect. An increase in the price level lowers the real value of some types of wealth. The Consumption Link The Real Wealth Effect real wealth, or real balance, effect The change in consumption brought about by a change in real wealth that results from a change in the price level.

10. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 39 THE AGGREGATE DEMAND CURVE AGGREGATE EXPENDITURE AND AGGREGATE DEMAND At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G. equilibrium condition: C + I + G = Y

11. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 39 Along the aggregate demand curve, each point represents: a.Equilibrium in the goods market, regardless of the equilibrium situation in the money market. b.Equilibrium in the money market, regardless of the equilibrium situation in the goods market. c.Simultaneous equilibrium in both the goods and money markets. d.Macroeconomic equilibrium, or equilibrium in all markets of the economy.

12. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 39 Along the aggregate demand curve, each point represents: a.Equilibrium in the goods market, regardless of the equilibrium situation in the money market. b.Equilibrium in the money market, regardless of the equilibrium situation in the goods market. c.Simultaneous equilibrium in both the goods and money markets. d.Macroeconomic equilibrium, or equilibrium in all markets of the economy.

13. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 39 THE AGGREGATE DEMAND CURVE SHIFTS OF THE AGGREGATE DEMAND An increase in the quantity of money supplied at a given price level 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. FIGURE 13.3 The Impact of an Increase in the Money Supply on the AD Curve FIGURE 13.4 The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve

14. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 39 THE AGGREGATE DEMAND CURVE SHIFTS OF THE AGGREGATE DEMAND FIGURE 13.5 Factors That Shift the Aggregate Demand Curve

15. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 39 Which of the following policy mixes consistently shifts the aggregate demand curve to the right? a.Expansionary monetary policy accompanied by contractionary fiscal policy. b.Contractionary monetary policy accompanied by contractionary fiscal policy. c.Contractionary monetary policy accompanied by expansionary fiscal policy. d.Expansionary monetary policy accompanied by expansionary fiscal policy.

16. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 39 Which of the following policy mixes consistently shifts the aggregate demand curve to the right? a.Expansionary monetary policy accompanied by contractionary fiscal policy. b.Contractionary monetary policy accompanied by contractionary fiscal policy. c.Contractionary monetary policy accompanied by expansionary fiscal policy. d.Expansionary monetary policy accompanied by expansionary fiscal policy.

17. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 39 THE AGGREGATE SUPPLY CURVE THE AGGREGATE SUPPLY CURVE: A WARNING An “aggregate supply curve” in the traditional sense of the word supply does not exist. What does exist is what we might call 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. aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

18. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 39 THE AGGREGATE SUPPLY CURVE AGGREGATE SUPPLY IN THE SHORT RUN Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment. 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. That is, the aggregate supply (price/output response) curve is likely to be fairly flat at low levels of aggregate output. Capacity Constraints Output Levels and Price/Output Responses When the economy is producing at its maximum level of output—that is, at capacity— the aggregate supply curve becomes vertical. FIGURE 13.6 The Short-Run Aggregate Supply Curve

19. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 39 Which of the following factors affects the shape of the AS curve? a.Capacity constraints. b.The price of output. c.Cost shocks. d.Economic growth.

20. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 39 Which of the following factors affects the shape of the AS curve? a.Capacity constraints. b.The price of output. c.Cost shocks. d.Economic growth.

21. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 39 THE AGGREGATE SUPPLY CURVE AGGREGATE SUPPLY IN THE SHORT RUN If input prices changed at exactly the same rate as output prices, the AS 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. Input prices—particularly wage rates—tend to lag behind increases in output prices for a variety of reasons. The Response of Input Prices to Changes in the Overall Price Level

22. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 39 If input prices changed at exactly the same rate as output prices, then: a.The aggregate demand curve would be vertical. b.The aggregate demand curve would be horizontal. c.The aggregate supply curve would be vertical. d.The aggregate supply curve would be horizontal.

23. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 39 If input prices changed at exactly the same rate as output prices, then: a.The aggregate demand curve would be vertical. b.The aggregate demand curve would be horizontal. c.The aggregate supply curve would be vertical. d.The aggregate supply curve would be horizontal.

24. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 39 THE AGGREGATE SUPPLY CURVE cost shock, or supply shock A change in costs that shifts the aggregate supply (AS) curve. SHIFTS OF THE AGGREGATE SUPPLY CURVE FIGURE 13.7 Shifts of the Aggregate Supply Curve

25. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 39 THE AGGREGATE SUPPLY CURVE SHIFTS OF THE AGGREGATE SUPPLY CURVE FIGURE 13.8 Factors That Shift the Aggregate Supply Curve

26. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 39 THE EQUILIBRIUM PRICE LEVEL equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect. FIGURE 13.9 The Equilibrium Price Level

27. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 39 Refer to the graph below. At which point is Y = C + I + G? a.At Y 0, P 0 only. b.At every point along the AD curve. c.At points corresponding to high price levels, such as (Y 2, P 2 ). d.At points corresponding to low price levels, such as (Y 1, P 1 ).

28. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 39 Refer to the graph below. At which point is Y = C + I + G? a.At Y 0, P 0 only. b.At every point along the AD curve. c.At points corresponding to high price levels, such as (Y 2, P 2 ). d.At points corresponding to low price levels, such as (Y 1, P 1 ).

29. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 39 THE LONG-RUN AGGREGATE SUPPLY CURVE POTENTIAL GDP If wage rates and other costs fully adjust to changes in prices in the long run, then the long-run AS curve is vertical. potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. FIGURE 13.9 The Long-Run Aggregate Supply Curve

30. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 39 AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY FIGURE 13.11 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve FIGURE 13.12 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near Maximum Capacity 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.

31. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 39 CAUSES OF INFLATION INFLATION VERSUS SUSTAINED INFLATION: A REMINDER inflation 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. DEMAND PULL INFLATION demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

32. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 39 Sustained inflation is: a.A purely monetary phenomenon. b.Strictly a situation of too many goods chasing too few dollars. c.Exclusively attributed to the pricing practices of business firms. d.Entirely the fault of contractionary fiscal policy during periods of economic recession.

33. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 39 Sustained inflation is: a.A purely monetary phenomenon. b.Strictly a situation of too many goods chasing too few dollars. c.Exclusively attributed to the pricing practices of business firms. d.Entirely the fault of contractionary fiscal policy during periods of economic recession.

34. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 39 CAUSES OF INFLATION COST-PUSH, OR SUPPLY-SIDE, INFLATION cost-push, or supply- side, inflation Inflation caused by an increase in costs. stagflation Occurs when output is falling at the same time that prices are rising. FIGURE 13.13 Cost-Push, or Supply-Side, Inflation

35. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 39 CAUSES OF INFLATION EXPECTATIONS AND INFLATION FIGURE 13.14 Cost Shocks Are Bad News for Policy Makers

36. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 39 CAUSES OF INFLATION MONEY AND INFLATION FIGURE 13.15 Sustained Inflation from an Initial Increase in G and Fed Accommodation hyperinflation A period of very rapid increases in the price level

37. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 39 Which of the following scenarios leads to hyperinflation? a.Fed accommodation of expansionary fiscal policy, while the economy is on the flat portion of the AS curve. b.Fed accommodation of expansionary fiscal policy, while the economy is on the steep part of the AS curve. c.A decrease in the money supply when the economy finds itself on the flat portion of the AS curve. d.A decrease in the money supply when the economy finds itself on the steep portion of the AS curve.

38. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 39 Which of the following scenarios leads to hyperinflation? a.Fed accommodation of expansionary fiscal policy, while the economy is on the flat portion of the AS curve. b.Fed accommodation of expansionary fiscal policy, while the economy is on the steep part of the AS curve. c.A decrease in the money supply when the economy finds itself on the flat portion of the AS curve. d.A decrease in the money supply when the economy finds itself on the steep portion of the AS curve.

39. CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 39 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 REVIEW TERMS AND CONCEPTS equilibrium price level hyperinflation inflation inflationary gap potential output, or potential GDP real wealth, or real balance, effect stagflation sustained inflation