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MACROECONOMICS
TENTH EDITION
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CHAPTER OUTLINE The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning Aggregate Supply in the Short Run Shifts of the Short-Run Aggregate Supply Curve
Causes of Inflation
Demand-Pull Inflation Cost-Push, or Supply-Side, Inflation Expectations and Inflation Money and Inflation Sustained Inflation as a Purely Monetary Phenomenon
Looking Ahead
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The aggregate supply curve is not a market supply curve, and it is not the simple sum of all the individual supply curves in the economy. Because many firms in the economy set prices as well as output, we can say an aggregate supply curve is really a price/output response curvea curve that traces out the price decisions and output decisions of all firms in the economy under a given set of circumstances.
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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, Y*, the curve is vertical.
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At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. At this level (Y*), the AS curve is vertical.
At low levels of output, the AS curve is flatter. Small price increases may be associated with relatively large output responses. We may observe relatively sticky wages upward at this point on the AS curve.
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cost shock, or supply shock A change in costs that shifts the shortrun aggregate supply (AS) curve.
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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When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back at Y0. Y0 is sometimes called potential GDP.
PART III The Core of Macroeconomic Theory 2012 Pearson Education, Inc. Publishing as Prentice Hall
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EC ON OMIC S IN PRACTICE
Despite insights the kinked aggregate supply curve provides, most economists find it unlikely that the whole economy suddenly runs into a capacity wall at a specific level of output.
As output expands, some firms and industries will hit capacity before others.
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FIGURE 13.5 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve
Aggregate demand 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. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A.
PART III The Core of Macroeconomic Theory 2012 Pearson Education, Inc. Publishing as Prentice Hall
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FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating At or Near Maximum Capacity
If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B.
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Some argue that wages do not fall during slack periods and that the economy can get stuck at an equilibrium below potential output. In this case, monetary and fiscal policy would be necessary to restore full employment.
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Causes of Inflation
Demand-Pull Inflation demand-pull inflation Inflation that is initiated by an increase in aggregate demand. If the economy is operating on the steep portion of the AS curve at the time of the increase in aggregate demand, most of the effect will be an increase in the price level instead of an increase in output.
PART III The Core of Macroeconomic Theory
If the economy is operating on the flat portion of the AS curve, most of the effect will be an increase in output instead of an increase in the price level.
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Causes of Inflation
Cost-Push, or Supply-Side, Inflation cost-push, or supply-side, inflation Inflation caused by an increase in costs.
FIGURE 13.7 Cost-Push, or Supply-Side, Inflation
An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls.
PART III The Core of Macroeconomic Theory
stagflation Occurs when output is falling at the same time that prices are rising.
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Causes of Inflation
Cost-Push, or Supply-Side, Inflation
FIGURE 13.8 Cost Shocks Are Bad News for Policy Makers
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 policy would raise aggregate output Y again, but it would raise the price level further, to P2.
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Causes of Inflation
Expectations and Inflation When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, it may raise its own price. The firms profit-maximizing optimum price is presumably not too far from the average of its competitors prices.
PART III The Core of Macroeconomic Theory
Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral. If prices have been rising and if peoples expectations are adaptive, firms may continue raising prices even if demand is slowing or contracting. Given the importance of expectations in inflation, central banks aim to keep them low.
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EC ON OMIC S IN PRACTICE
It is also interesting to note that many people believed the official statistics on inflation understated their own experience. Inflation Perceptions Run High in China The Wall Street Journal
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Causes of Inflation
Money and Inflation
FIGURE 13.9 Sustained Inflation from an Initial Increase in G and Fed Accommodation
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 even hyperinflation.
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Causes of Inflation
Sustained Inflation as a Purely Monetary Phenomenon Virtually all economists agree that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left. It is also generally agreed that for a sustained inflation to occur, the Fed must accommodate it.
PART III The Core of Macroeconomic Theory
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During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Fed is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD0 to AD1, and lead to an increase in output with very little increase in the price level.
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During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Fed is likely to increase the interest rate (and thus contract the money supply). This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output.
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EC ON OMIC S IN PRACTICE
The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid 1980s on. It aggressively lowered interest rates in the 1990 III1991 I, 2001 I 2001 III, and 2008 I 2009 II recessions. Output is the percentage deviation of real GDP from its trend. Inflation is the 4-quarter average of the percentage change in the GDP deflator. The interest rate is the 3-month Treasury bill rate.
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Looking Ahead
In this chapter, we introduced the aggregate supply curve.
PART III The Core of Macroeconomic Theory
By using the aggregate supply and aggregate demand curves, we can determine the equilibrium price level in the economy and understand some causes of inflation.
We have still said little about employment, unemployment, and the functioning of the labor market in the macroeconomy.
The next chapter will link everything we have done so far to this third major market arenathe labor marketand to the problem of unemployment.
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aggregate supply aggregate supply (AS) curve cost-push, or supply-side, inflation cost shock, or supply shock demand-pull inflation
PART III The Core of Macroeconomic Theory
equilibrium price level inflation targeting potential output, or potential GDP stagflation
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