It redistribute income in arbitrary ways

It diverts resources from productive

activities to inflation forecasting.
It increases uncertainty & reduces
investment
It decreases our international
competitiveness
Eliminating inflation is costly because it
brings a period of greater than average
unemployment.




Does inflation impose
costs on the economy? . . .
Yes
Causes of Inflation
Demand-pull inflation is a rise in the
general price level resulting from an
excess of total spending (demand)
over supply.
Prices are pulled up by the pressure
from buyers total expenditures.
Demand-pull inflation tends to occur
when the economy is operating close
to full employment boom conditions
Causes of Inflation
Cost-push inflation is a rise in the
general price level resulting from an
increase in the cost of production,
irrespective of demand conditions.
This could be caused by cost
increases for labour, raw materials
e.g. oil, construction, equipment,
borrowing (interest rates) etc.

Which of the following is a correct
description of inflation?
A) Inflation refers to an increase in
relative prices throughout the
economy.
B) Inflation is the change in the price
level from one year to another.
C) Inflation is when there is a one-time
jump in the price level.
D) Inflation is a sustained increase in
the price level.
Check Your Knowledge
If the anticipated rate of inflation is 3%
but the subsequent actual rate of
inflation is 5%, the likely outcome will be
that the purchasing power of money will
A) fall and lenders will benefit.
B) increase and lenders will benefit.
C) fall and borrowers will benefit.
D) increase and borrowers will benefit.
Check Your Knowledge
The unemployment rate is 10 per cent.
This means
A. 10 per cent of the labour force are
unemployed.
B. 10 per cent of the population are
unemployed.
C. 90 per cent of the population are
employed.
D. 10 per cent of the population aged 15
and over are unemployed.
Check Your Knowledge
Economics 100
No lecture or tuts on Friday
Either attend the Thursday 2pm
lecture or view the ilecture

Carolines Friday tutorial classes
* Date: Friday, 29 April 2011
* Time: 10:00am-11.30pm
* 401.155



Economics 100
Topic 7
Aggregate Demand and
Aggregate Supply
Learning Objectives
The business cycle
The aggregate demand (AD) curve
The aggregate supply (AS) curve
SRAS
LAS
Macroeconomic equilibrium and the
effects of changes in AD and AS
Economic Growth and
Fluctuations
Every business cycle has two
phases:
1. A contraction
2. An expansion
and two turning points:
1. A peak
2. A trough
The Business Cycle
Business Cycle Definitions
A contraction is a significant decrease in
aggregate economic activity or a slowdown
in the growth rate of activity that lasts more
than a few months
A contraction begins just after the economy
reaches a peak of activity and ends as the
economy reaches its trough. Between
trough and peak, the economy is in an
expansion.
A severe contraction, in which real GDP
decreases for at least two quarters, is
called a recession.
Hypothetical Business Cycle
An Australian Business Cycle



Fluctuations in real GDP, Australia,
1960-2007
-3
-2
-1
0
1
2
3
4
5
6
7
8
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
P
e
r

c
e
n
t
Identify periods of recession
What happens during a business cycle?
Each business cycle is different, however
all share some similarities.
The end of an expansion is typically
associated with rising interest rates, rising
wages, and profits begin to fall.
A recession often begins with decreased
spending by firms on capital goods, and/or
decreased spending by households on new
houses and consumer durables.

The business cycle
Australias GDP Growth
What happens during a business cycle?
The effect of the business cycle on the
inflation rate.
During economic expansions the inflation
rate usually increases.
Exception: If the expansion is due to rising
productivity levels and an expansion of
potential GDP.
During recessions the inflation rate usually
decreases.
Exception: The recession is caused by a
supply shock.
The business cycle
What happens during a business cycle?
The effect of the business cycle on the
unemployment rate.
Recessions cause the unemployment rate
to increase.
The rate of unemployment continues to
rise after the recession is over, because:
Discouraged workers re-enter the labour
force.
Firms continue to operate below capacity
after the recession is over and may not re-
hire workers for some time.
The business cycle
Why is the economy more stable?
The increasing importance of services
and the declining importance of goods.
The establishment of unemployment
benefits and other government transfer
programs that provide funds to the
unemployed.
Active government policies to stabilise the
economy.


The business cycle
Australias GDP Growth

Note absence of recessions
The aggregate demand and
aggregate supply model is a model
that explains short-run fluctuations in
real GDP and the price level.
Real GDP and the price level are
determined in the short run by the
intersection of the AD curve and the
short-run AS curve.
AD/AS Model
Aggregate demand curve (AD): A curve
showing the relationship between the price
level and the quantity of real GDP
demanded by households, firms and the
government.
Short-run aggregate supply curve:
(SRAS): A curve showing the relationship
in the short-run between the price level and
the quantity of real GDP supplied by firms.
AD/AS Model
Price level
Real GDP (billions of
dollars)
0
$1000
100
Short-run
aggregate
supply,
SRAS

AD/AS Model
Aggregate
demand, AD
The Two-Way Relationship Between Output
and the Price Level
Price
Level
Real
GDP
Aggregate Demand Curve
Aggregate Supply Curve
Aggregate Demand
The Aggregate Demand curve
shows the equilibrium level of real
GDP (where total spending = total
output) for each price level.
AD = C + I + G + X-M at each price
level
The AD curve is not to be confused
with the microeconomic demand
curve
The Aggregate Demand Curve
The AD curve
is a negative
function of
the price level
AD
1
Real GDP
Price Level
The AD Curve
The AD curve slopes downward for 3
reasons:
Wealth effect
Interest rate effect
International trade effect

Aggregate Demand
Why the AD curve slopes downward
1. Wealth effect
An increase in the price level will
decrease the real value of household
wealth & reduce consumption.
2. Interest rate effect
An increase in the price level raises
interest rates (increases D for money)
which decreases investment (& C).
Why the AD curve slopes downward
3. International trade effect
An increase in the price level causes
imports to become relatively cheaper &
exports to be more expensive, thus
decreasing net exports.

Aggregate Demand
Changes in Aggregate
Demand
A change in any influence on C, I, G or
net Xs other than the price level shifts
the aggregate demand curve.
Some of the main influences on
aggregate demand are:
1. Consumer & business confidence
2. The world economy
3. Fiscal policy and monetary policy
4. Expectations
Shifts of the AD curve
AD
2
AD
1
Real GDP
Price Level
AD will increase if
C, I, G or net Xs
increase
T is decreased
RBA lowers i/rs
$A depreciates

Determinants of Aggregate Demand
a) Rising interest rates cause a drop in consumer
optimism as households become concerned
about their ability to meet mortgage payments.
AD will shift to the _______ , real GDP will
________ and the price level will ________
b) The Australian dollar decreases in value against
the US dollar and other major currencies.
AD will shift to the _______ , real GDP will
________ and the price level will ________
Aggregate Supply
The aggregate supply curve shows the
effect of changes in total output or real
GDP on the price level (via changes in unit
costs)
As total output increases
greater amounts of inputs may be
needed to produce a unit of output
price of inputs will rise
The AS curve should not to be confused
with the micro supply curve
The Aggregate Supply Curve
Price Level
Real GDP ($ billions)
130
100
80
C
AS
1200
1000 700
A
B
Starting at point A, an
increase in output
raises unit costs.
Firms raise prices,
and the overall price
level rises.
Shifts of the AS Curve
Price Level
Real GDP
AS
2
AS
1
AS will increase if
L or K increases
Productivity increases
Oil prices fall
Technology improves
Long run Aggregate Supply
Long-Run Aggregate Supply
The macroeconomic long run is a
time frame when real GDP equals
potential GDP and there is full
employment.
The LAS curve is vertical because
potential GDP is independent of the
price level.
Shifts in the long-run AS curve.
The LRAS curve shifts because potential
real GDP increases over time.
Increases in potential GDP (or economic
growth) are due to:
1. An increase in resources such as the
labour force and the capital stock
2. New technology.
Aggregate Supply
Price level
Real GDP
(billions of dollars)
0
$1100
100
LRAS
2006
The long-run AS curve
$1140 $1170
95
112
LRAS
2007
LRAS
2008
In long-run equilibrium, the
aggregate demand and short-run
aggregate supply curves intersect
at a point along the long-run
aggregate supply curve.

Macroeconomic Equilibrium
Price level
Real GDP (billions of
dollars)
0
$1000
100
SRAS

Long-run equilibrium
AD
LRAS

Full
employment
Demand pull inflation: Inflation that
is caused by an increase in the
aggregate demand for goods and
services.
Production levels are unable to meet
this demand immediately, especially if
the economy is at full employment.
Upward pressure is put on prices and
nominal wages


Using the AD/AS Model
Price level
Real GDP (billions of
dollars)
0
$1200
SRAS
1
AD
1
LRAS

AD
2
B 112
1300
A
An increase in
aggregate
demand shifts AD
to the right,
causing demand-
pull inflation.
108
Demand-pull inflation
Price level
rises & real
GDP increases
Cost-push inflation: Inflation that arises as
a result of a negative supply shock - that is,
anything that causes a decrease in the
aggregate supply of goods and services.
Increases in the price of oil.
Increases in wages.
Increases in indirect taxation.
Using the AD/AS Model
Price level
Real GDP (billions of
dollars)
0
1200
SRAS
1
AD
1
LRAS

B
112
$1100
SRAS
2
A
1. An increase in
production costs
shifts SRAS to
the left
2. moving
short-run
equilibrium to
point B, with lower
real GDP and a
higher price level.
108
Cost-push inflation
A natural
disaster, such as
a severe drought
or flood, can
cause a supply
shock cost
inflation
Macroeconomic
Equilibrium
Real GDP fluctuates around
potential GDP in a business cycle.
This means that unemployment and
inflation fluctuate at the same time.
Business Cycles occur because
aggregate demand and short-run
aggregate supply shift causing real
GDP to be either above or below
potential GDP.
Macroeconomic
Equilibrium
Below Full-employment
Equilibrium
A macroeconomic equilibrium in
which potential GDP exceeds real
GDP
The difference is called a
recessionary gap.
AD
0
LAS
SAS
0
A
Recessionary
gap
Below full-employment
equilibrium
0
The Business Cycle
85
115
135
95
105
125
Real GDP
860 900 940 880 920
Price level
Year
880
900
920
1 2 3
A
0 4
Recesssionary
gap
Potential
GDP
Actual
GDP
The Business Cycle
Real GDP
Year
1 2 3
A
0 4
Recessionary
gap
Potential
GDP
B
Full
employment
Actual
GDP
The Business Cycle
880
900
920
Real GDP
Macroeconomic
Equilibrium
Above Full-employment
Equilibrium
A macroeconomic equilibrium in
which real GDP exceeds potential
GDP
The difference is called an
inflationary gap.
AD
2
LAS
SAS
2
Inflationary
gap
Above full-employment
equilibrium
c
0
The Business Cycle
85
115
135
95
105
125
860 900 920
Real GDP
Price level
Year
880
900
920
1 2 3
A
0 4
Recessionary
gap
Potential
GDP
B
Full
employment
Inflationary
gap
C
Actual
GDP
The Business Cycle
Real GDP
Macroeconomic
Equilibrium
Fluctuations in Aggregate Demand
Real GDP can fluctuate as a result
of changes in aggregate demand.
Examine the effect of this on Real
GDP, and the price level in the:
Short run
Long run
Recession
1. The short-run effect of a decline in
aggregate demand.
AD curve shifts left, and real GDP
declines.
2. Adjustment back to potential GDP in the
long run.
Automatic adjustment mechanism:
SRAS curve shifts right, (which may
take several years).
Macroeconomic
equilibrium
Price level
Real GDP (billions of
dollars)
0
1000
100
SRAS
1
The short-run and long-run effects of a
decrease in AD
AD
1
LRAS

AD
2
A
B
98
$980
SRAS
2
C
1. A decline
in investment
shifts AD to
the left
causing a
recession.
2. As firms and
workers adjust to the
price level being
lower than expected,
costs will fall, and
cause SRAS to shift
to the right.
3. Equilibrium moves from
point B back to potential
GDP at point C, with a
lower price level.
96
Supply shock
1. The short-run effect of a supply shock.
SRAS curve shifts left, real GDP falls
and the price level rises (stagflation)
2. Adjustment back to potential GDP in the
long run.
SRAS curve shifts right, (which may
take several years).
Macroeconomic
equilibrium
(b) Adjustment back to potential GDP
the long-run effect of a supply shock.
0
(a) A recession with a rising price level
the short-run effect of a supply shock.
SRAS
1
AD
100
The short-run and long-run effects of a supply shock
1000
Price
level
0
1000
2. moving short-run
equilibrium to point B,
with lower real GDP
and a higher price
level.
$970
2. Equilibrium
moves from
point B
potential GDP
at the original
price level.
1. An increase in oil
prices shifts SRAS
to the left
Price
level
Real GDP
(billions of
dollars)
Real GDP
(billions of
dollars)
104
$970
LRAS
SRAS
2
A
B
AD
LRAS SRAS
2
SRAS
1
104
100
B
A
(b) Adjustment back to potential GDP
the long-run effect of a supply shock.
0
(a) A recession with a rising price level
the short-run effect of a supply shock.
SRAS
1
AD
100
1. The recession caused by the
supply shock eventually leads to
falling wages and prices, shifting
SRAS back to its original
position.
1000
Price
level
0
1000
2. moving short-run
equilibrium to point B,
with lower real GDP
and a higher price
level.
$970
2. Equilibrium
moves from
point B to
potential GDP
at the original
price level.
1. An increase in oil
prices shifts SRAS
to the left
Price
level
Real GDP
(billions of
dollars)
Real GDP
(billions of
dollars)
104
$970
LRAS
SRAS
2
A
B
AD
LRAS SRAS
2
SRAS
1
104
100
B
A
The short-run and long-run effects of a supply shock

Using the Aggregate Demand Aggregate
Supply model.

Assume the economy is initially in
equilibrium with long-run aggregate supply
(LRAS) constant. Now suppose growing
GDP in China leads to an increase in
demand and higher prices for Australian
resources. Explain both the initial change
in equilibrium and the longer term effect.


Using the Aggregate Demand Aggregate
Supply model.

1. An increase in demand for Australian
exports will cause an increase in AD
represented by a rightward shift of the AD
curve. Short-run equilibrium will move
beyond potential GDP, causing an increase
in the price level.

Using the Aggregate Demand Aggregate
Supply model.

2. The price level is now higher than workers
and firms had expected. As workers and
firms adjust to the higher price level, prices
and wages rise, and the short-run AS
curve shifts inwards to the left.
3. Equilibrium moves back to potential GDP,
but at a higher price level.

Review
Which of the following could cause cost-
push inflation?
A. a recession brought about by
insufficient levels of aggregate
demand;
B. an increase in wages;
C. very high levels of aggregate
demand which have caused
inflation;
D. low profit levels, leading producers
to increase their prices.
Review
A change in which of the following will
cause a rightward shift in the aggregate
demand curve?
A. a decrease in net exports
B. a decrease in government
expenditures
C. an increase in investment
expenditures
D. an increase in saving
Review
An increase in money wages would shift
the short-run aggregate supply curve
_______; an increase in technology
would shift the long-run aggregate supply
curve _______.
A. leftward; leftward
B. rightward; rightward
C. rightward; leftward
D. leftward; rightward
Review
One possible result of decreases in
aggregate demand coupled with a stable
aggregate supply is
A. a rise in the stock market.
B. an economic expansion.
C. an increase in employment levels.
D. a recession.
Which of the following is usually the
cause of stagflation?
A. Reductions in government spending.
B. Increases in investment.
C. Printing money to finance government
expenditures.
D. A supply shock.
Review