1. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND INFLATION Chapter 25 1

2. THE AGGREGATE DEMAND CURVE One of the most important issues in macroeconomics is the determination of the overall price level Up to now, we took the price level as fixed in our analysis The place to begin our explanation of the price level is the money market Remember that demand for money depends on income (Y), the interest rate (r) and the price level 2

3. 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 3

4. THE AGGREGATE DEMAND CURVE aggregate demand The total demand for goods and services in the economy To derive the aggregate demand curve, we examine what happens to aggregate output (income) (Y) when the price level (P) changes The aggregate demand curve is derived by assuming that the fiscal policy variables (G and T) and the monetary policy variable (M S ) remain unchanged The government does not take any action to affect the economy in response to changes in the price level 4

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7. DERIVING 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 7

8. 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 A lower price level causes money demand to fall, which leads to a lower interest rate and lower interest rate stimulates planned investment spending, increasing planned aggregate spending, that leads to an increase in Y 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 8

9. THE AGGREGATE DEMAND CURVE THE AGGREGATE DEMAND CURVE: A WARNING A demand curve shows the quantity of output demanded (by an individual) at every price, ceteris paribus We assume that other prices and income are fixed The reason that the quantity demanded of a particular good falls when its price rises is that other prices do not rise The good therefore becomes more expensive relative to other goods and households respond by substituting other goods for the good whose price increased Things are different when the overall price level rises When the overall price level rises, many prices rise together So we can not use the ceteris paribus assumption to draw the AD curve 9

10. THE AGGREGATE DEMAND CURVE 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 10

11. THE AGGREGATE DEMAND CURVE OTHER REASONS FOR A DOWNWARD-SLOPING AGGREGATE DEMAND CURVE The Consumption Link 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 increases the demand for money, which leads to an increase in the interest rate, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output (income) 11

12. THE AGGREGATE DEMAND CURVE 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 An increase in the price level lowers the real value of some types of wealth This leads to a decrease in consumption, which leads to a decrease in aggregate output (income) There is a negative relationship between the price level and output through this real wealth effect 12

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14. THE AGGREGATE DEMAND CURVE When the price level rises (M D increases, ED for money, interest rate increases, planned investment decreases) it is planned aggregate expenditure that decreases (hence aggregate output decreases), moving us up the aggregate demand At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G 14

15. THE AGGREGATE DEMAND CURVE SHIFTS OF THE AGGREGATE DEMAND CURVE Consider an increase in the quantity of money supplied If the quantity of money is expanded at any given price level (ES of money), the interest rate will fall, causing planned investment spending (and planned aggregate expenditure) to rise The result is an increase in output at the given price level An increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right 15

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17. THE AGGREGATE DEMAND CURVE SHIFTS OF THE AGGREGATE DEMAND CURVE Consider an increase in the government purchases or a decrease in net taxes An increase in government purchases directly increases planned aggregate expenditure, which leads to an increase in output A decrease in net taxes results in a rise in consumption, which increases planned aggregate expenditure, which also leads to an increase in output Remember that some of the increase will be crowded out if the money supply is held constant An increase in government purchases or a decrease in net taxes at a given price level shifts the aggregate demand curve to the right 17

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19. THE AGGREGATE SUPPLY CURVE 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 19

20. THE AGGREGATE SUPPLY CURVE THE AGGREGATE SUPPLY CURVE: A WARNING A supply curve shows the quantity of output an individual firm would supply at every price, ceteris paribus We assume that input prices, including wage rates, are constant A individual firm’s supply curve shows what would happen to the firm’s output if the price of its output changes with no corresponding increase in costs Things are different when the overall price level rises The outputs of some firms are the inputs of other firms If output prices rise, there will be an increase in at least some input prices Because all input prices (including wage rates) are not constant as the overall price level changes, individual firms’ supply curve shift as the overall price level changes, so we can not sum them to get an aggregate supply curve 20

21. THE AGGREGATE SUPPLY CURVE Because input prices change when the overall price level changes and because many firms in the economy set prices as well as output 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 The AS curve is not the sum of all the individual supply curves in the economy It is not a market supply curve 21

22. THE AGGREGATE SUPPLY CURVE AGGREGATE SUPPLY IN THE SHORT RUN Many argue that the aggregate supply curve has a positive slope, at least in the short-run To understand the shape of the AS curve, consider the output and price response of markets and firms to an increase in aggregate demand brought about by an expansionary fiscal or monetary policy The reaction of firms to such an expansion is likely to depend on two factors: How close the economy is to capacity at the time of expansion How rapidly input prices respond to increases in the overall price level 22

23. THE AGGREGATE SUPPLY CURVE Capacity Constraints Short run describes the time in which firms’ decisions are constrained by some fixed factor of production A firm is producing at full capacity if it is fully utilizing the capital and labor it has on hand Firms may have excess capital and excess labor on hand Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment (people willing to work but can not find jobs) 23

24. THE AGGREGATE SUPPLY CURVE Output Levels and Price/Output Responses In periods of low output, there is likely to be excess capacity in the economy as a whole There will be cyclical unemployment in the economy in periods of low output It is likely that firms will respond to an increase in demand by increasing output much more than they increase prices Firms are below capacity, so the extra cost of producing more output is likely to be small Firms can get more labor (from the ranks of the unemployed) without much increase in wages rates 24

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26. THE AGGREGATE SUPPLY CURVE 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 Aggregate output is higher at B than at A, but the price level at B is only slightly higher than it is at A If aggregate output continues to expand, firms begin to move closer to capacity and their response to an increase in demand is likely to change form increasing output to increasing prices As firms continue to increase output, so the economy will be approaching its capacity 26

27. THE AGGREGATE SUPPLY CURVE As aggregate output rises, the prices of labor and capital (input costs) will begin to rise, leading firms to increase their output prices At some level of output, all sectors will be fully utilizing their equipment In addition, there is little or no cyclical unemployment At this point, firms will respond to any further increases in demand only by raising prices When the economy is producing at its maximum level of output—that is, at capacity— the aggregate supply curve becomes vertical Moving from C to D results in no increase in aggregate output but a large increase in the price level 27

28. THE AGGREGATE SUPPLY CURVE The Response of Input Prices to Changes in the Overall Price Level The time lag between changes in input prices and changes in output prices is another reason for the aggregate supply (price/output response) curve to slope upward 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 This point has led to an important distinction between the AS curve in the long run and the AS curve in the short run 28

29. THE AGGREGATE SUPPLY CURVE SHIFTS OF THE AGGREGATE SUPPLY CURVE Anything that affects individual firm decisions also can shift the AS curve Cost shocks, economic growth, stagnation, public policy and natural disasters cost shock, or supply shock A change in costs that shifts the aggregate supply (AS) curve 29

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32. THE EQUILIBRIUM PRICE LEVEL equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect The point at which the AS and AD curves intersect corresponds to equilibrium in the goods and money markets and to a set of price/output decisions on the part of all the firms in the economy 32

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34. THE LONG-RUN AGGREGATE SUPPLY CURVE For the AS curve not to be vertical, some costs must lag behind increases in the overall price level If all prices change at the same rate, the level of aggregate output does not change We have assumed that in the short run at least some cost changes lag behind price-level changes However, some costs like wage rates tend to move very closely with the price level over time If wage rates and other costs fully adjust to changes in prices in the long run, then the long-run AS curve is vertical 34

35. THE LONG-RUN AGGREGATE SUPPLY CURVE 35

36. THE LONG-RUN AGGREGATE SUPPLY CURVE The economy is initially in equilibrium at P0 and Y0 (point A) A shift in the AD curve from AD0 to AD1 Both the price level and aggregate output rise in the short run to P1 and Y1(at point B) As costs fully adjust to prices in the long run, increase in costs cause the AS curve to shift to left from AS0 to AS1 If costs and prices have risen by exactly the same percentage, aggregate output will be back at Y0 (at point C) 36

37. THE LONG-RUN AGGREGATE SUPPLY CURVE POTENTIAL GDP The vertical portion of the short-run AS curve exists because there are limits to the amount that an economy can produce in any given time period The vertical portions of the short-run AS curve is to the right of Y0 If the vertical portions of the short-run AS curve represents “capacity”, Y0 represents the level of aggregate output that can be sustained in the long run without inflation potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation 37

38. THE LONG-RUN AGGREGATE SUPPLY CURVE If output is above Y0, there is upward pressure on costs As the economy approaches short-run capacity, wage rates tend to rise as firms try to attract more people into the labor force Rising costs shift the short-run AS curve to the left and drive output back to Y0 If short-run AS and AD curves intersect to the right of Y0, wages and other input prices will rise, causing the short-run AS curve to shift to the left and pushing GDP back down to Y0 38

39. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY Two fiscal policy variables, G and T The monetary policy tool, MS (money supply) An expansionary policy aims at stimulating the economy through an increase in G or MS or a decrease in T A contractionary policy aims at slowing down the economy through a decrease in G or MS or an increase in T An expansionary policy shifts the AD curve to the right A contractionary policy shifts the AD curve to the left 39

40. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY How do these policies affect the equilibrium values of the price level (P) and the level of aggregate output? We must be careful to note where along the (short-run) AS curve the economy is at the time of the change 40

41. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY If the economy is initially on the flat portion of the AS curve, then an expansionary policy, which shifts the AD curve to the right, results in a small price increase relative to the output increase: The increase in equilibrium Y is much greater than the increase in equilibrium P The expansionary policy works well 41

42. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY If the economy is initially on the steep portion of the AS curve, then an expansionary policy, which shifts the AD curve to the right, results in a small increase in equilibrium output and a large increase in the equilibrium price level: The increase in equilibrium P is much greater than the increase in equilibrium Y The expansionary policy does not work well Output is initially close to capacity and attempts to increase it further lead mostly to a higher price level 42

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44. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY LONG-RUN AGGREGATE SUPPLY AND POLICY EFFECTS Flat part of AS curve Firms producing below capacity Firms respond to an increase in demand by increasing output much more than they increase prices Steep part of AS curve Firms are close to capacity Firms respond to an increase in demand by increasing prices much more than they increase output 44

45. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY Assume the economy is on the steep part of AS curve Increase in G with no change in money supply An unanticipated decline in firms’ inventories As firms are very close to capacity output when the economy is on the steep part of the AS curve, they can not increase their output very much There is a substantial increase in price level The increase in price level increases the demand for money, which leads to an increase in the interest rate, decreasing planned investment There is nearly complete crowding out of investment 45

46. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND MONETARY AND FISCAL POLICY What is the effect of monetary and fiscal policy in the long run? If the long-run AS curve is vertical, as monetary and fiscal policy shift the AD curve, output always comes back to initial Y Policy affects only the price level in the long run The multiplier effect of a change in G on aggregate output in the long run is zero 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 46

47. CAUSES OF INFLATION inflation An increase in the overall price level demand-pull inflation Inflation that is initiated by an increase in aggregate demand 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 47

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