Aggregate Demand, Aggregate Supply, and Inflation

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Aggregate Demand,Aggregate Supply,and Inflation
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The Aggregate Demand Curve

• Aggregate demand is the total demand for goods
  and services in the economy.

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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 (Ms).

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Deriving the Aggregate Demand Curve
The Impact of an Increase in the Price Level on
the Economy Assuming No Changes in G, T, and Ms
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Deriving the Aggregate Demand Curve

• The aggregate demand (AD) curve is a curve that
  shows the negative relationship between aggregate
  output (income) and the price level.

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The Aggregate Demand CurveA Warning

• The AD curve is not a market demand curve. It is
  a more complex concept.
• We cannot use the ceteris paribus assumption to
  draw an AD curve. In reality, many prices
  (including input prices) rise together.

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The Aggregate Demand CurveA Warning

• A higher price level causes the demand for money
  to rise, which causes the interest rate to rise.
• Then, the higher interest rate causes aggregate
  output to fall.

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The Aggregate Demand CurveA Warning

• At all points along the AD curve, both the goods
  market and the money market are in equilibrium.

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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.

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Other Reasons for a Downward-Sloping Aggregate
Demand Curve

• The real wealth effect, or real balance, effect
  is the change in consumption brought about by a
  change in real wealth that results from a change
  in the price level.

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Aggregate Expenditureand Aggregate Demand

• At every point along the aggregate demand curve,
  the aggregate quantity of output demanded is
  exactly equal to planned aggregate expenditure.

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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.

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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.

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Shifts of the Aggregate Demand Curve
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The Aggregate Supply Curve

• Aggregate supply is the total supply of all goods
  and services in the economy.

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The Aggregate Supply Curve

• 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.

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The Aggregate Supply CurveA Warning

• The aggregate supply curve is not a market supply
  curve or the sum of all the individual supply
  curves in the economy.

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The Aggregate Supply CurveA Warning

• 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.

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The Aggregate Supply CurveA Warning

• When we draw a firms supply curve, we assume
  that input prices are constant. In
  macroeconomics, an increase in the overall price
  level means that at least some input prices will
  be rising as well.
• The outputs of some firms are the inputs of other
  firms.

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The Aggregate Supply CurveA Warning

• Rather than an aggregate supply curve, what does
  exist is a price/output response curve a
  curve that traces out the price and output
  decisions of all the markets and firms in the
  economy under a given set of circumstances.

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Aggregate Supply in the Short Run

• In the short run, the aggregate supply curve (the
  price/output response curve) has a positive slope.

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Aggregate Supply in the Short Run

• 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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Aggregate Supply in the Short Run

• Macroeconomists focus on whether or not the
  economy as a whole is operating at full capacity.
• As the economy approaches maximum capacity, firms
  respond to further increases in demand only by
  raising prices.

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Output Levels andPrice/Output Responses

• When the economy is operating at low levels of
  output, an increase in aggregate demand is likely
  to result in an increase in output with little or
  no increase in the overall price level.

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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.

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The Response of Input Prices to Changes in the
Overall Price Level

• 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.

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Shifts of the Short-RunAggregate Supply Curve

• A cost shock, or supply shock, is a change in
  costs that shifts the aggregate supply (AS) curve.

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Shifts of the Short-RunAggregate Supply Curve
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The Equilibrium Price Level

• The equilibrium price level is the point at which
  the aggregate demand and aggregate supply curves
  intersect.

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The Equilibrium Price Level

• P0 and Y0 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.

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The Long-RunAggregate Supply Curve

• Costs lag behind price-level changes in the short
  run, resulting in an upward-sloping AS curve.

• Costs and the price level move in tandem in the
  long run, and the AS curve is vertical.

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The Long-RunAggregate Supply Curve

• Output can be pushed above potential GDP by
  higher aggregate demand. The aggregate price
  level also rises.

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The Long-RunAggregate Supply Curve

• When output is pushed above potential, there is
  upward pressure on costs, and this causes the
  short-run AS curve to the left.

• Costs ultimately increase by the same percentage
  as the price level, and the quantity supplied
  ends up back at Y0.

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The Long-RunAggregate Supply Curve

• Y0 represents the level of output that can be
  sustained in the long run without inflation. It
  is also called potential output or potential GDP.

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Aggregate Demand, AggregateSupply, and Monetary
and Fiscal Policy

• 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.

• 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.

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Aggregate Demand, AggregateSupply, and Monetary
and Fiscal Policy

• On the steep portion of the AS curve,
  expansionary policy does not work well. The
  multiplier is close to zero.

• 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.

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Long-Run AggregateSupply 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, the multiplier effect of a
  change in government spending or taxes on
  aggregate output is zero.

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The Simple KeynesianAggregate Supply Curve

• The output of the economy cannot exceed the
  maximum output of YF.
• The difference between planned aggregate
  expenditure and aggregate output at full capacity
  is sometimes referred to as an inflationary gap.

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Causes of Inflation

• 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.

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Causes of Inflation

• 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.

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Cost-Push, or Supply-Side Inflation

• Stagflation occurs when output is falling at the
  same time that prices are rising.
• One possible cause of stagflation is an increase
  in costs.

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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.

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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.

• In terms of the AD/AS diagram, an increase in
  inflationary expectations shifts the AS curve to
  the left.

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Money and Inflation

• Hyperinflation is a period of very rapid
  increases in the price level.

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Money and Inflation

• An increase in G with the money supply constant
  shifts the AD curve from AD0 to AD1. This leads
  to an increase in the interest rate and crowding
  out of planned investment.

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Money and Inflation

• If the Fed tries to prevent crowding, 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.

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Review Terms and Concepts
hyperinflation inflation inflationary
gap potential output, or potential GDP real
wealth, or real balance, effect stagflation sustai
ned inflation
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 equilibrium price level
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Aggregate Supply
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Aggregate Supply

• Aggregate supply is the relationship between the
  price level in the economy and the quantity of
  aggregate output firms are willing and able to
  supply, other things held constant
• The foundation of aggregate supply is the labor
  market
• Like any market, the labor market has a demand
  side and a supply side
• A good understanding of aggregate supply requires
  a correct understanding of the demand and supply
  sides of the labor market

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Labor Supply

• The supply of labor depends primarily on the wage
  rate (the dollar cost of a unit of labor, such as
  an hour of work)
• The supply of labor also depends on
• The size of the adult population
• The skills (productivity) of the adult population
• Households preferences for work versus leisure

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The Nominal Wage and the Real Wage

• The nominal wage is the wage measured in terms of
  current dollars
• The real wage is the wage measured in terms of
  dollars of constant purchasing power
• The real wage is the wage measured in terms of
  the quantity of goods it will purchase
• Both workers and employers care more about the
  real wage than the nominal wage

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Wages and Price Level Expectations

• Nominal wages are important because resource
  agreements (such as wage contracts) are typically
  negotiated in nominal wages
• Since wage contracts are negotiated ahead of
  time, they are based on workers expectation for
  the price level

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Potential Output and the Natural Rate of
Unemployment

• Potential output is the economys maximum
  sustainable output level, given the supply of
  resources, technology, and the underlying
  economic institutions
• Another point of view is the that potential
  output is the level of output where there are no
  surprises about the price level
• The natural rate of unemployment is the rate that
  occurs when the economy is producing it potential
  level of output

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The Actual Price Level is Higher Than Expected

• Firms experience higher profits, which stimulates
  the demand side of the labor market, pushing the
  economy past its potential output in the short
  run
• Workers will respond by supplying more labor if
• They are legally bound to do so by labor
  contracts
• There is a large pool of unemployed labor causing
  workers to be cautious about asking for wage
  increases
• Workers are uninformed concerning the increase in
  the economys price level
• In the long run, wages will rise, bringing the
  economy to potential output

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The Actual Price Level is Lower Than Expected

• In this case, firms experience lower profits,
  which depresses the demand side of the labor
  market, pushing the economy below its potential
  output in the short run
• Workers may respond by lowering wage demands as
  time passes

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The Short-Run Supply Curve

• If the price level is higher than expected, the
  quantity supplied is above the economys
  potential output
• If the price level is lower than expected, the
  quantity supplied decreases
• As a result, there is a positive short-run
  relationship between the price level and
  aggregate output supplied

Price Level
SRAS
Real GDP
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The Short Run

• The short run is a period during which some
  resources prices, especially labor, are fixed by
  agreement

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Aggregate Supply and Equilibrium
Price Level
AD
SRAS
Potential output
Real GDP
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The Actual Price Level is Higher Than Expected
Potential output
AD
Price Level
SRAS
SRAS
Real GDP
expansionary gap
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The Actual Price Level is Lower Than Expected
Potential output
Price Level
SRAS
AD
SRAS
Real GDP
contractionary gap
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Changes in Aggregate Supply

• Adverse supply shocks are unexpected events that
  reduce aggregate supply
• Beneficial supply shocks are unexpected events
  that reduce aggregate supply

Price Level
LRAS
LRAS
AD
SRAS
SRAS
Real GDP
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Demand and Supply in the Labor Market
Nominal wage rate
D
S
Millions of workers
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The Effect of a Higher Price Level
D
Nominal wage rate
S
D
S
Millions of workers