Aggregate Demand, Aggregate Supply, and Inflation

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Aggregate Demand,Aggregate Supply,

and Inflation

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair 2 of 47

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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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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• 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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• 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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• 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.

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

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Factors That Shift the Aggregate Demand CurveExpansionary 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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• 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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• 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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• 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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• 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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• 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

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 LeftDecreases in Aggregate Supply

Shifts to the RightIncreases 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-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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• Output can be pushed above potential GDP by higher aggregate demand.

The aggregate price level also rises.

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• 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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• 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

• 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, AggregateSupply, and Monetary and Fiscal Policy

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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 “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.

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Keynesian Macroeconomics: Aggregate Demand and the Multiplier Effect

• John Maynard Keynes, The General Theory of Employment, Interest and Money (1936)

• Great Depression (1929-1938) shows possibility of underemployment equilibrium -- actual GDP had not been equal to potential for years.

• The Keynesian model distinguishes:

• Actual GDP -- what GDP happens to be right now

• Potential GDP -- full employment GDP

• Equilibrium GDP -- a level of GDP at which there are no forces tending to change the level of GDP.

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John Maynard Keynes, 1919 and 1945

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The Keynesian system: Planned and actual investmentInvestment has three components:

• Plant and equipment -- drill presses, factory buildings, etc.

• Residential investment -- new housing construction

• Inventory investment -- Change in Business Inventories

The first two are consciously planned (although plans can change, and typically do during a recession);

inventory investment can be unplanned -- if a store fails to sell what it had expected to, it winds up with more inventory than it had expected.

Stores with unplanned inventory investment will cut back on orders -- resulting in reduced production at the factory, layoffs and recession.

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The Consumption Function: the key to Keynes

Consumption depends on the level of DISPOSABLE INCOME (DPI)(disposable personal income = income - taxes = Y - T)

Some consumption is autonomous (= “independent” of DPI):it may depend on other factors such as wealth or stock

values. (even at zero income, Bill Gates would consume something)

The consumption function proposed by Keynes is:

C = C0 + Cy ( Y - T)

C0 = Autonomous consumption

Cy = Marginal propensity to consume

The marginal propensity to consume plays a central role in the Keynesian system. Keep your eye on the MPC in the following slides.

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The Keynesian model: National income identity and equilibrium

The National income identity is:

Y = C + I + G + NX

The Keynesian equilibrium equation is:

Y = C0 + Cy ( Y - T) + Ip + G + NX

Notice that C has been replaced by the consumption function, and investment by planned investment.

Given values for autonomous consumption = 300

for the marginal propensity to consume = 0.8

for planned investment = 1500

and finally for G = 1200, T = 1000, and NX = 500

the equation can be solved for Y.

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Keynesian equilbrium: Solution procedure Start with the equation in general form:

Y = C0 + Cy ( Y - T) + Ip + G + NX

Substitute in the given numbers:

Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500

Collect all the constant terms:

Y = 3500 + 0.8Y - 800

Y = 2700 + 0.8Y

Subtract 0.8 Y from both sides of the equation:

0.2 Y = 2700

Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (2700) = 13, 500

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The Multiplier

Rerun the previous exercise, raising planned investment by 500.

Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500Collect all the constant terms:

Y = 4000 + 0.8Y - 800

Y = 3200 + 0.8Y


0.2 Y = 3200


Y = 5 (3200) = 16, 000 GDP is UP BY 2,500, NOT up by only 500.

Investment spending has a MULTIPLIER EFFECT of 5

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The Multiplier: Government Spending and Net ExportsInstead of raising planned investment by 500, as on the last slide:

• Raise Government Spending by 500

• Raise Net Exports by 500

• Cut taxes by 500

What happens in each case? You should find that the increases in government spending and in investment raise income by 2,000 -- that the multiplier for investment, government spending and net exports is exactly the same.

Hence the major policy proposals made by Keynes:

-- raise government spending to expand the economy.

-- ensure stability in the world trading system (IMF, WTO)

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The Tax Multiplier

Tax cuts have a multiplier effect, but not the same effect as direct government spending. Reason: part of any tax cut is saved, not spent.

Consider the tax cut of 500:

Y = 300 + 0.8 ( Y - 500) + 1500 + 1200 + 500

Collect all the constant terms:

Y = 3500 + 0.8Y - 400 or Y = 3100 + 0.8Y


0.2 Y = 3100


Y = 5 (3100) = 15, 500

GDP is UP BY 2,000, NOT up by 2,500 as with investment.

Tax cut has a MULTIPLIER EFFECT of 4.0 ( not 5.0 )

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