Case econ08 ppt_26

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & Yvonn Quijano

26Chapter

Aggregate Demand,Aggregate Supply,and Inflation

2 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


Chapter Outline

26Aggregate Demand, Aggregate Supply, and Inflation

The Aggregate Demand CurveDeriving the Aggregate Demand CurveThe Aggregate Demand Curve: A WarningOther Reasons for a Downward-Sloping Aggregate Demand CurveAggregate Expenditure and Aggregate DemandShifts of the Aggregate Demand CurveThe Aggregate Supply CurveThe Aggregate Supply Curve: A WarningAggregate Supply in the Short RunShifts of the Short-Run Aggregate Supply CurveThe Equilibrium Price LevelThe Long-Run Aggregate Supply CurvePotential GDPAggregate Demand, Aggregate Supply, and Monetary and Fiscal PolicyLong-Run Aggregate Supply and Policy EffectsCauses of InflationInflation versus Sustained Inflation: A ReminderDemand-Pull InflationCost-Push, or Supply-Side, InflationExpectations and InflationMoney and InflationSustained Inflation as a Purely Monetary PhenomenonLooking Ahead

3 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


THE AGGREGATE DEMAND CURVE

Money demand is a function of three variables: the interest rate (r), the level of realincome (Y), and the price level (P). (Remember, Y is real output, or income. It measuresthe actual volume of output, without regard to changes in the price level.) Moneydemand will increase if the real level of output (income) increases, the price levelincreases, or the interest rate declines.

aggregate demand The total demand for goods and services in the economy.

4 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



FIGURE 13.1 The Impact of an Increase in the Price Level on the Economy–Assuming No Changes in G, T, and Ms

DERIVING THE AGGREGATE DEMAND CURVE

5 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



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.

Each pair of values of P and Y on the aggregate demand curve corresponds to a pointat which both the goods market and the money market are in equilibrium.

DERIVING 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.

FIGURE 13.2 The Aggregate Demand (AD) curve

6 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



THE AGGREGATE DEMAND CURVE: A WARNING

Aggregate demand falls when the price level increases because the higher price level causes the demand for money (Md) 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.

7 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



OTHER REASONS FOR A DOWNWARD-SLOPING AGGREGATE DEMAND CURVE

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 lowers the real value of some types of wealth.

The Consumption Link

The Real Wealth Effect

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

8 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



AGGREGATE EXPENDITURE AND AGGREGATE DEMAND

At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G.

equilibrium condition: C + I + G = Y

9 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



SHIFTS OF THE AGGREGATE DEMANDAn increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right.

An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right.

FIGURE 13.3 The Impact of an Increase in the Money Supply on the AD Curve

FIGURE 13.4 The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve

10 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



SHIFTS OF THE AGGREGATE DEMAND

FIGURE 13.5 Factors That Shift the Aggregate Demand Curve

11 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


THE AGGREGATE SUPPLY CURVE

THE AGGREGATE SUPPLY CURVE: A WARNING

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.

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.

12 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



AGGREGATE SUPPLY IN THE SHORT RUN

Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment.

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.

Capacity Constraints

Output Levels and Price/Output Responses

When the economy is producing at its maximum level of output—that is, at capacity— the aggregate supply curve becomes vertical.

FIGURE 13.6 The Short-Run Aggregate Supply Curve

13 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



AGGREGATE SUPPLY IN THE SHORT RUN

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.

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

14 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



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

SHIFTS OF THE AGGREGATE SUPPLY CURVE

FIGURE 13.7 Shifts of the Aggregate Supply Curve

15 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n



SHIFTS OF THE AGGREGATE SUPPLY CURVE

FIGURE 13.8 Factors That Shift the Aggregate Supply Curve

16 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


THE EQUILIBRIUM PRICE LEVEL

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

FIGURE 13.9 The Equilibrium Price Level

17 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


THE LONG-RUN AGGREGATE SUPPLY CURVE

POTENTIAL GDP

If wage rates and other costs fully adjust to changes in prices in the long run, then the long-run AS curve is vertical.

potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation.

FIGURE 13.9 The Long-Run Aggregate Supply Curve

18 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


AGGREGATE DEMAND, AGGREGATE SUPPLY,AND MONETARY AND FISCAL POLICY

FIGURE 13.11 A Shift of the Aggregate Demand Curve When the Economy

Is on the Nearly Flat Part of the AS Curve

FIGURE 13.12 A Shift of the Aggregate Demand Curve When the Economy

Is Operating at or Near Maximum Capacity

LONG-RUN AGGREGATE SUPPLY AND POLICY EFFECTS

If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy hasany effect on aggregate output in the long run.

19 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


CAUSES OF INFLATION

INFLATION VERSUS SUSTAINED INFLATION: A REMINDER

inflation 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.

DEMAND PULL INFLATION

demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

20 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


CAUSES OF INFLATION

COST-PUSH, OR SUPPLY-SIDE, INFLATION

cost-push, or supply-side, inflation Inflationcaused by an increase in costs.

stagflation Occurs when output is falling at the same time that prices are rising.

FIGURE 13.13 Cost-Push, or Supply-Side, Inflation

21 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


CAUSES OF INFLATION

EXPECTATIONS AND INFLATION

FIGURE 13.14 Cost Shocks Are Bad News for Policy Makers

22 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


CAUSES OF INFLATION

MONEY AND INFLATION

FIGURE 13.15 Sustained Inflation from an Initial Increase in G and Fed Accommodation

hyperinflation A period of very rapid increases in the price level

23 of 23

C

HA

PT

ER

26:

Agg

rega

te D

eman

d,

Agg

rega

te S

up

ply

, an

d I

nfl

atio

n


aggregate demandaggregate demand (AD) curveaggregate supplyaggregate supply (AS) curvecost-push, or supply-side, inflationcost shock, or supply shockdemand-pull inflation

REVIEW TERMS AND CONCEPTS

equilibrium price levelhyperinflationinflationinflationary gappotential output, or potential GDPreal wealth, or real balance, effectstagflationsustained inflation