Aggregate Demand,

Aggregate Supply,
and Inflation
The Aggregate Demand Curve

 Aggregate demand
is the total demand
for goods and services
in the economy.
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).
 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 
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.
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.
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.
The Aggregate Demand Curve:
A Warning
 At all points along
the AD curve, both
the goods market
and the money
market are in
equilibrium.
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.
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.
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
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.
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.
 Shifts of the Aggregate Demand
Curve
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy Contractionary monetary policy

Ms AD curve shifts to the right Ms AD curve shifts to the left

Expansionary fiscal policy Contractionary fiscal policy

G AD curve shifts to the right G AD curve shifts to the left

T AD curve shifts to the right T AD curve shifts to the left
The Aggregate Supply Curve

 Aggregate supply is
the total supply of all
goods and services in
the economy.
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.
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.
The Aggregate Supply Curve:
A Warning
 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.
The Aggregate Supply Curve:
A Warning
 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.
The Aggregate Supply Curve:
A Warning
 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.
Aggregate Supply in the Short Run
 In the short run,
the aggregate
supply curve (the
price/output
response curve)
has a positive
slope.
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.
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.
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.
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.
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.
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.
 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 Higher costs
lower input prices higher input prices
lower wage rates higher wage rates

Economic growth Stagnation

more capital capital deterioration
more labor
technological change

Public policy Public policy

supply-side policies waste and inefficiency
tax cuts over-regulation
deregulation

Good weather Bad weather, natural

disasters, destruction
from wars
The Equilibrium Price Level
 The equilibrium
price level is the
point at which the
aggregate demand
and aggregate
supply curves
intersect.
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.
The Long-Run
Aggregate 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.
The Long-Run
Aggregate Supply Curve
 Output can be
pushed above
potential GDP by
higher aggregate
demand. The
aggregate price
level also rises.
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.
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.
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.
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.
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.
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.
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.
 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.
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.
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.
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.
Money and Inflation
 Hyperinflation is
a period of very
rapid increases in
the price level.
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.
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.
 Review Terms and Concepts
aggregate demand hyperinflation
aggregate demand (AD) curve inflation
aggregate supply inflationary gap
aggregate supply (AS) curve potential output, or potential GDP
cost-push, or supply-side, inflation real wealth, or real balance, effect
cost shock, or supply shock stagflation
demand-pull inflation sustained inflation
equilibrium price level
Aggregate Supply
Aggregate Supply
 Aggregate supply is the relationship between the
price level in the economy and the quantity of
aggregate output firms are willing and able to
supply, other things held constant
 The foundation of aggregate supply is the labor
market
 Like any market, the labor market has a demand
side and a supply side
 A good understanding of aggregate supply requires
a correct understanding of the demand and supply
sides of the labor market
Labor Supply
 The supply of labor
depends primarily on the
wage rate (the dollar
cost of a unit of labor,
such as an hour of work)
 The supply of labor also
depends on
 The size of the adult
population
 The skills (productivity)
of the adult population
 Households’ preferences
for work versus leisure
The Nominal Wage and the Real
Wage
 The nominal wage is the wage measured
in terms of current dollars
 The real wage is the wage measured in
terms of dollars of constant purchasing
power
 The real wage is the wage measured in terms
of the quantity of goods it will purchase
 Both workers and employers care more
about the real wage than the nominal
wage
Wages and Price Level
Expectations
 Nominal wages are
important because
resource agreements
(such as wage
contracts) are
typically negotiated in
nominal wages
 Since wage contracts
are negotiated ahead
of time, they are
based on workers’
expectation for the
price level
Potential Output and the Natural Rate of
Unemployment

 Potential output is the economy’s

maximum sustainable output level, given
the supply of resources, technology, and
the underlying economic institutions
 Another point of view is the that potential
output is the level of output where there are
no “surprises” about the price level
 The natural rate of unemployment is the
rate that occurs when the economy is
producing it potential level of output
The Actual Price Level is Higher
Than Expected
 Firms experience higher profits, which stimulates
the demand side of the labor market, pushing the
economy past its potential output in the short run
 Workers will respond by supplying more labor if
 They are legally bound to do so by labor contracts
 There is a large pool of unemployed labor causing
workers to be cautious about asking for wage
increases
 Workers are uninformed concerning the increase in
the economy’s price level
 In the long run, wages will rise, bringing the
economy to potential output
The Actual Price Level is Lower
Than Expected
 In this case, firms experience lower
profits, which depresses the
demand side of the labor market,
pushing the economy below its
potential output in the short run
 Workers may respond by lowering
wage demands as time passes
The Short-Run Supply Curve
 If the price level is higher
than expected, the Price Level
quantity supplied is
above the economy’s
SRAS
potential output
 If the price level is lower
than expected, the
quantity supplied
decreases
 As a result, there is a
positive short-run
relationship between the
price level and aggregate
output supplied
Real GDP
The Short Run
 The short run is a
period during
which some
resources prices,
especially labor,
are fixed by
agreement
 Aggregate Supply and Equilibrium

Price
Level AD
SRAS

Potential
output Real GDP
 The Actual Price Level is Higher
Than Expected
Potential
Price AD output
Level SRAS’

SRAS

expansionary Real GDP

gap
 The Actual Price Level is Lower
Than Expected
Potential
Price output
Level AD SRAS

SRAS’

contractionary Real GDP

gap
Changes in Aggregate Supply
 Adverse supply
Price Level
shocks are
LRAS LRAS’
unexpected events AD
that reduce SRAS
aggregate supply SRAS’

 Beneficial supply
shocks are
unexpected events
that reduce
aggregate supply
Real GDP
 Demand and Supply in the Labor
Market

Nominal
wage rate D
S

Millions of workers
 The Effect of a Higher Price Level

Nominal
D’
wage rate D S’
S

Millions of workers