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Aggregate Demand, Aggregate Supply, and Inflation

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  • If prices have been rising, and if people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—then firms may continue raising prices even if demand is slowing or contracting.
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    • 1. Aggregate Demand, Aggregate Supply, and Inflation
    • 2. The Aggregate Demand Curve
      • 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.
    • 3. 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.
    • 4. 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.
    • 5. The Aggregate Supply Curve
      • 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.
    • 6. The Equilibrium Price Level
      • 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.
    • 7. 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.
      • 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.
    • 8. 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.
    • 9. 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-push inflation is one possible cause of stagflation —a situation in which output is falling at the same time that prices are rising.
    • 10. 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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