Download ppt - 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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2 of 47© 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

The Goods Marketand the Money Market

• The goods market is the market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined.

• The money market is the market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

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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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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 or other factors remain constant 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 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.

• 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 AS curve shows the relationship between the aggregate quantity of output supplied by all the firms in an economy and the overall price level.

• 2. The AS curve is not a market supply curve and it is not the sum of all the individual supply curves in the economy.

• a. When we derived the supply curve for a firm we assumed per unit production costs were constant in the short run. Firms set prices instead of simply responding to them.

• b. The AS curve is a price/output response curve. It traces out the price decisions and output decisions of all the markets and firms in the economy given a 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. 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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• When the economy is producing at its maximum level of output—that is, at capacity—the aggregate supply curve becomes vertical.

• Between C and D in, the AS curve is vertical. Moving from C to D results in no increase in aggregate output but a large increase in the price level.

• Aggregate output is considerably higher at B than at A, but the price level at B is only slightly higher than it is at A.

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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

• At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to 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• A cost shock with no

change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This would prevent output from falling, but it would raise the price level further, to P2.

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Expectations and Inflation

• Expectations about changes in future prices may affect current decisions.

• 2. Firms may raise their prices in expectation of competitors doing the same.

• 3. Workers may ask for higher wages because they expect higher inflation in the future.

• 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• An increase in G with the

money supply constant shifts the AD curve from AD0 to AD1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, 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

sustained 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