Aggregate Demand, Aggregate Supply,

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Aggregate Demand, Aggregate Supply, Inflation

• Chapter 14

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Introduction

• In this chapter, aggregate demand and aggregate
  supply are put together, and how equilibrium
  price level is determined in the economy are
  discussed.
• This allows us to see how the price level affects
  the economy and how the economy affects the price
  level.

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The Aggregate Demand Curve

• The demand for money is a function of the
  interest rate, the level of real income, and the
  price level.
• Money demand will increase if the real level of
  output increases, the price level increases, or
  the interest rate declines.

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A. Deriving the Aggregate Demand Curve

• Aggregate demand is the total demand for goods
  and services in the economy.
• It is derived assuming no action by the
  government to affect the economy in response to
  changes in the price level.

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• An increase in the price level causes the level
  of aggregate output to fall, because the increase
  causes an increase in money demand, which
  increases the interest rate and reduces planned
  investment spending and aggregate expenditure.

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• The reverse occurs for a decrease in the price
  level. The negative relationship between
  aggregate output and the price level is the
  aggregate demand curve.
• Each point on it represents equilibrium in both
  the goods market and the money market.

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B. The Aggregate Demand Curve

• A WarningThe aggregate demand curve is not a
  market demand curve and it is not the sum of all
  market demand curves in the economy.
• It has a negative slope because of the effect of
  the higher interest rate (caused by the increased
  demand for money due to the higher price level)
  on aggregate output.

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Other Reasons for a Downward-Slope Aggregate
Demand Curve

• 1. The consumption link the higher interest rate
  results in a decrease in consumption as well as
  investment, and so is another reason for the
  downward slope.
• 2. The real wealth effect the price level
  increase lowers the real value of some types of
  wealth, hence resulting in a decrease in
  consumption and another reason for the downward
  slope of the AD curve.

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Aggregate Expenditure Aggregate Demand

• At every point along the AD curve the aggregate
  quantity demanded is exactly equal to planned
  aggregate expenditure

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Causes of the Shifts of aggregate Demand Curve

• 1. An increase in the quantity supplied of
  Money results in a lower interest rate,
  increasing I and aggregate expenditure, thus
  shifting AD to the right.
• 2. An increase in government purchases or a
  decrease in net taxes they affect aggregate
  expenditure, and shift AD to the right.
• 3. Decreases would shift AD to the left.

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The Aggregate Supply Curve

• The Aggregate Supply curve represents the total
  supply of goods and services in the economy.

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A. The Aggregate Supply Curve A Warning

• The AS curve shows the relationship between the
  aggregate quantity of output supplied by all the
  firms in an economy and the overall price level.
• It is not a market supply curve and it is not the
  sum of all the individual supply curves in the
  economy.

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• This is because we cannot assume that costs are
  constant, and firms set prices instead of simply
  responding to them.
• What we have is a price/output response, which is
  a curve that traces out the price decisions and
  output decisions of all the markets and firms in
  the economy given a set of circumstances.

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B. Aggregate Supply in The Short Run

• Aggregate supply in the short run is considered
  to have an upward slope and to be fairly flat at
  low levels of aggregate output and vertical at
  high levels.
• To understand this shape, consider the response
  of firms to increases in aggregate demand the
  response will depend on

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• 1. Capacity constraints at low levels of
  utilization, increases in demand result in
  increases in output with little impact on on the
  price level.
• When the economy is producing at its maximum
  level of output (at capacity) the AS curve
  becomes vertical because no further increase in
  output is possible and the only effect is a
  higher price level.

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• 2. How rapidly input prices respond to increases
  in the overall price level input prices tend to
  lag behind increases in output prices for a
  variety of reasons.

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C. Causes in the Shifts of the Short-run AS Curve

• 1. Cost shocks whereas changes in costs that
  occur at the same time that the price level
  changes are built into the shape of AS, those
  that are not the result of changes in the overall
  price level cause shifts.
• 2. Economic growth shifts the AS curve to the
  right. This can be the result of increases in the
  supply of labor or stock of capital.

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• 3. Stagnation is the opposite of economic
  growth. If a country fails to invest in both
  public capital (infrastructure) and private
  capital the stock of capital will decline and
  the AS curve will shift to the left.
• 4. Public Policy can shift the AS curve.
  Supply-side economics in the 1980s was aimed
  at doing so.
• 5. Natural Disasters, Weather, War can all shift
  the AS curve.

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The Equilibrium Price Level

• The Equilibrium Price Level occurs at the point
  at which the AD and the AS intersect.
• At this point there is equilibrium in both the
  goods and the money markets and a set of
  price/output decisions on the part of all the
  firms in the economy.

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Causes of Inflation

• It is important to distinguish a one-time
  increase in the price level and a sustained
  inflation which is a rising of the price level
  over a fairly long period of time.
• There are many causes of one-time increase in the
  price level, but for it to continue to increase
  period after period, most economists believe that
  it must be accomodated by an expanded money
  supply.

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• Thus whatever the initial cause of the increase
  in the price level, a sustained inflation is
  essentially a monetary phenomenon.
• A. Demand-Pull Inflation inflation initiated by
  an increase in aggregate demand

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• B. Cost-Push or Supply-Side Inflation caused by
  an increase in costs. Stagflation occurs when
  output is falling at the same time prices are
  rising.
• C. Expectations and Inflation expectations about
  future prices may affect current decisions. Firms
  may raise their prices in expectation of
  competitors doing the same.

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• D. Money and Inflation if the Fed tried to keep
  the interest rate constant when the economy is
  operating on the steep part of the AS curve the
  situation could lead to a hyperinflation, a
  period of very rapid increases in the price
  level.
• E. Sustained Inflation as a Purely monetary
  Phenomenon this argument has gained wide
  acceptance.