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

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

P M d r I AE Y
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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
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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The Aggregate Demand Curve:

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 DownwardSloping 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 DownwardSloping 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 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

Contractionary monetary policy

Ms

Ms

AD curve shifts to the right

Expansionary fiscal policy

AD curve shifts to the left

Contractionary fiscal policy

AD curve shifts to the right

AD curve shifts to the left

AD curve shifts to the right

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:

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:

Firms do not simply respond to
market-determined prices, but
they actually set prices. Pricesetting 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 firms 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:

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 pricelevel 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
Factors That Shift the Aggregate Supply Curve
Shifts to the Right

Shifts to the Left

Increases in Aggregate Supply

Decreases in Aggregate Supply

Lower costs
lower input prices
lower wage rates

Higher costs
higher input prices
higher wage rates

Economic growth
more capital
more labor
technological change

Stagnation
capital deterioration

Public policy
supply-side policies
tax cuts
deregulation

Public policy
waste and inefficiency
over-regulation

Good weather

Bad weather, natural

disasters, destruction
from wars

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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 pricelevel 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
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.
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.
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Aggregate Demand, Aggregate

Supply, and Monetary and Fiscal Policy
On the steep portion of the
AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
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.
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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 supplyside, 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 Central bank 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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