Download Chapter 24: Aggregate Demand, Aggregate Supply, and Inflation

CHAPTER
13
Aggregate Demand,
Aggregate Supply,
and Inflation
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve
• Aggregate demand is
the total demand for
goods and services in
the economy.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Deriving the Aggregate Demand Curve
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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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve:
A Warning
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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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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Y=C+I+G
equilibrium condition
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Aggregate Demand Curve
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Aggregate Demand Curve
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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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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
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
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve
• Aggregate supply is the
total supply of all goods
and
services
in
the
economy.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve:
A Warning
• Firms do not simply respond to marketdetermined 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Supply in the Short Run
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• In the short run, the
aggregate supply
curve (the price/output
response curve) has a
positive slope.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Supply in the Short Run
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Equilibrium Price Level
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• The equilibrium price
level is the point at
which the aggregate
demand and aggregate
supply curves intersect.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Equilibrium Price Level
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
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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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
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• When output is pushed
above potential, there is
upward pressure on costs,
and this causes the shortrun 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
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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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
© 2004 Prentice Hall Business Publishing
• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Long-Run Aggregate
Supply and Policy Effects
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Simple “Keynesian”
Aggregate Supply Curve
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Causes of Inflation
• Demand-pull inflation is
inflation initiated by an
increase in aggregate
demand.
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• Cost-push, or supplyside, inflation is inflation
caused by an increase in
costs.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Cost-Push, or Supply-Side Inflation
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Cost-Push, or Supply-Side Inflation
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• Hyperinflation is a
period of very rapid
increases in the price
level.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Keynesian Macroeconomics: Aggregate
Demand and the Multiplier Effect
• John Maynard Keynes, The General Theory of
Employment, Interest and Money (1936)
• Great Depression (1929-1938) shows possibility of
underemployment equilibrium
-actual GDP had not been
equal to potential for years.
• The Keynesian model distinguishes:
• Actual GDP -- what GDP happens to be right
now
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Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
John Maynard Keynes, 1919 and 1945
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Principles of Economics, 7/e
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Keynesian system: Planned and actual investment
Investment has three components:
• Plant and equipment -- drill presses, factory buildings, etc.
• Residential investment -- new housing construction
• Inventory investment -- Change in Business Inventories
The first two are consciously planned (although plans can change, and
typically do during a recession);
inventory investment can be unplanned -- if a store fails to sell what it
had expected to, it winds up with more inventory than it had expected.
Stores with unplanned inventory investment will cut back on orders -
- resulting in reduced production at the factory, layoffs and
recession.
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Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Consumption Function: the key to Keynes
Consumption depends on the level of DISPOSABLE INCOME (DPI)
(disposable personal income = income - taxes = Y - T)
Some consumption is autonomous (= “independent” of DPI):
it may depend on other factors such as wealth or stock values.
(even at zero income, Bill Gates would consume something)
The consumption function proposed by Keynes is:
C = C0 + Cy ( Y - T)
C0 = Autonomous consumption
Cy = Marginal propensity to consume
The marginal propensity to consume plays a central role in
the Keynesian system. Keep your eye on the MPC in the following
slides.
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Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Keynesian model: National income identity and equilibrium
The National income identity is:
Y = C + I + G + NX
The Keynesian equilibrium equation is:
Y = C0 + Cy ( Y - T) + Ip + G + NX
Notice that C has been replaced by the consumption function, and
investment by planned investment.
Given values for autonomous consumption = 300
for the marginal propensity to consume = 0.8
for planned investment = 1500
and finally for G = 1200, T = 1000, and NX = 500
the equation can be solved for Y.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Keynesian equilbrium: Solution procedure Start with the equation in
general form:
Y = C0 + Cy ( Y - T) + Ip + G + NX
Substitute in the given numbers:
Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500
Collect all the constant terms:
Y = 3500 + 0.8Y - 800
Y = 2700 + 0.8Y
Subtract 0.8 Y from both sides of the equation:
0.2 Y = 2700
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (2700) = 13, 500
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Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Multiplier
Rerun the previous exercise, raising planned investment by 500.
Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500
Collect all the constant terms:
Y = 4000 + 0.8Y - 800
Y = 3200 + 0.8Y
Subtract 0.8 Y from both sides of the equation:
0.2 Y = 3200
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (3200) = 16, 000
GDP is UP BY 2,500, NOT up by only 500.
Investment spending has a MULTIPLIER EFFECT of 5
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Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Multiplier: Government Spending and Net Exports
Instead of raising planned investment by 500, as on the last slide:
• Raise Government Spending by 500
• Raise Net Exports by 500
• Cut taxes by 500
What happens in each case? You should find that the increases in
government spending and in investment raise income by 2,000 -- that the
multiplier for investment, government spending and net exports is exactly
the same.
Hence the major policy proposals made by Keynes:
-- raise government spending to expand the economy.
-- ensure stability in the world trading system (IMF, WTO)
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Tax Multiplier
Tax cuts have a multiplier effect, but not the same effect as direct
government spending. Reason: part of any tax cut is saved, not spent.
Consider the tax cut of 500:
Y = 300 + 0.8 ( Y - 500) + 1500 + 1200 + 500
Collect all the constant terms:
Y = 3500 + 0.8Y - 400 or Y = 3100 + 0.8Y
Subtract 0.8 Y from both sides of the equation:
0.2 Y = 3100
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (3100) = 15, 500
GDP is UP BY 2,000, NOT up by 2,500 as with investment.
Tax cut has a MULTIPLIER EFFECT of 4.0 ( not 5.0 )
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Karl Case, Ray Fair