Macroeconomics - Lesson

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CHAPTER 7CHAPTER 7
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
↑ → ↑ → ↑ → ↓ → ↓ → ↓P M r I A Ed
Y
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 Curve:
A 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 Curve:
A Warning
 At all points along the
AD curve, both the
goods market and the
money market are in
equilibrium.

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Aggregate Expenditure
and Aggregate Demand
 At every point along the aggregate
demand curve, the aggregate quantity
of output demanded is exactly equal to
planned aggregate expenditure.
Y = C + I + G
equilibrium condition

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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
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy
Ms
AD curve shifts to the right
Contractionary monetary policy
Ms
AD curve shifts to the left
Expansionary fiscal policy
G AD curve shifts to the right
Contractionary fiscal policy
G AD curve shifts to the left
T AD curve shifts to the right T AD curve shifts to the left

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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 Curve:
A 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 Curve:
A 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 Curve:
A Warning
 When we draw a firm’s 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 Curve:
A 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 and
Price/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-Run
Aggregate 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-Run
Aggregate Supply Curve
Bad weather, natural
disasters, destruction
from wars
Good weather
Public policy
waste and inefficiency
over-regulation
Public policy
supply-side policies
tax cuts
deregulation
Stagnation
capital deterioration
Economic growth
more capital
more labor
technological change
Higher costs
higher input prices
higher wage rates
Lower costs
lower input prices
lower wage rates
Shifts to the Left
Decreases in Aggregate Supply
Shifts to the Right
Increases in Aggregate Supply
Factors That Shift the Aggregate 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-Run
Aggregate 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-Run
Aggregate 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-Run
Aggregate 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-Run
Aggregate 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, Aggregate
Supply, and Monetary and Fiscal
Policy
 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.
• 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.

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 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.
• On the steep portion of the
AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal
Policy

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

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The Simple “Keynesian”
Aggregate 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.