Download the aggregate demand curve

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AGGREGATE DEMAND,
AGGREGATE SUPPLY,
AND INFLATION
Chapter 25
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THE AGGREGATE DEMAND CURVE
• One of the most important issues in macroeconomics
is the determination of the overall price level
• Up to now, we took the price level as fixed in our
analysis
• The place to begin our explanation of the price level
is the money market
• Remember that demand for money depends on
income (Y), the interest rate (r) and the price level
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THE AGGREGATE DEMAND CURVE
• Money demand is a function of three variables: the
interest rate (r), the level of real income (Y), and the price
level (P)
• Remember, Y is real output, or income
• It measures the actual volume of output, without regard to changes
in the price level
• Money demand will increase if the real level of output
(income) increases, the price level increases, or the
interest rate declines
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THE AGGREGATE DEMAND CURVE
• aggregate demand The total demand for goods and
services in the economy
• To derive the aggregate demand curve, we examine
what happens to aggregate output (income) (Y) when
the price level (P) changes
• The aggregate demand curve is derived by assuming
that the fiscal policy variables (G and T) and the
monetary policy variable (MS) remain unchanged
• The government does not take any action to affect the
economy in response to changes in the price level
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THE AGGREGATE DEMAND CURVE
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
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THE AGGREGATE DEMAND CURVE
DERIVING THE AGGREGATE DEMAND CURVE
The Aggregate Demand (AD) curve
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THE AGGREGATE DEMAND CURVE
DERIVING THE AGGREGATE DEMAND CURVE
• aggregate demand curve (AD) A curve that shows the
negative relationship between aggregate output (income)
and the price level
• Each point on the AD curve is a point at which both the goods
market and the money market are in equilibrium
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THE AGGREGATE DEMAND CURVE
• An increase in the price level causes the level of
aggregate output (income) to fall
• A decrease in the price level causes the level of
aggregate output (income) to rise
• A lower price level causes money demand to fall, which leads to a
lower interest rate and lower interest rate stimulates planned
investment spending, increasing planned aggregate spending, that
leads to an increase in Y
• Each pair of values of P and Y on the aggregate demand
curve corresponds to a point at which both the goods
market and the money market are in equilibrium
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THE AGGREGATE DEMAND CURVE
THE AGGREGATE DEMAND CURVE: A WARNING
• A demand curve shows the quantity of output demanded
(by an individual) at every price, ceteris paribus
• We assume that other prices and income are fixed
• The reason that the quantity demanded of a particular good falls
when its price rises is that other prices do not rise
• The good therefore becomes more expensive relative to other
goods and households respond by substituting other goods for the
good whose price increased
• Things are different when the overall price level rises
• When the overall price level rises, many prices rise together
• So we can not use the ceteris paribus assumption to draw the AD
curve
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THE AGGREGATE DEMAND CURVE
• Aggregate demand falls when the price level
increases because the higher price level causes the
demand for money (Md) to rise
• With the money supply constant, the interest rate will rise to
reestablish equilibrium in the money market
• It is the higher interest rate that causes aggregate output to
fall
• The AD curve is not the sum of all the market
demand curves in the economy
• It is not a market demand curve
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THE AGGREGATE DEMAND CURVE
OTHER REASONS FOR A DOWNWARD-SLOPING
AGGREGATE DEMAND CURVE
The Consumption Link
• Planned investment does not bear all the burden of providing the
link from a higher interest rate to a lower level of aggregate output
• Decreased consumption brought about by a higher interest rate
also contributes to this effect
• An increase in the price level increases the demand for money,
which leads to an increase in the interest rate, which leads to a
decrease in consumption (as well as planned investment), which
leads to a decrease in aggregate output (income)
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THE AGGREGATE DEMAND CURVE
The Real Wealth Effect
• real wealth, or real balance, effect The change in
consumption brought about by a change in real wealth
that results from a change in the price level
• An increase in the price level lowers the real value of
some types of wealth
• This leads to a decrease in consumption, which leads to a
decrease in aggregate output (income)
• There is a negative relationship between the price level
and output through this real wealth effect
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THE AGGREGATE DEMAND CURVE
AGGREGATE EXPENDITURE AND AGGREGATE
DEMAND
equilibrium condition: C + I + G = Y
At every point along the aggregate demand
curve, the aggregate quantity demanded is
exactly equal to planned aggregate
expenditure, C + I + G.
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THE AGGREGATE DEMAND CURVE
• When the price level rises (MD increases, ED for
money, interest rate increases, planned
investment decreases) it is planned aggregate
expenditure that decreases (hence aggregate
output decreases), moving us up the aggregate
demand
• At every point along the aggregate demand
curve, the aggregate quantity demanded is
exactly equal to planned aggregate expenditure,
C+I+G
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THE AGGREGATE DEMAND CURVE
SHIFTS OF THE AGGREGATE DEMAND CURVE
• Consider an increase in the quantity of money
supplied
• If the quantity of money is expanded at any given price level
(ES of money), the interest rate will fall, causing planned
investment spending (and planned aggregate expenditure) to
rise
• The result is an increase in output at the given price level
• 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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THE AGGREGATE DEMAND CURVE
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.
The Impact of an Increase in the Money
Supply on the AD Curve
An increase in government purchases or a
decrease in net taxes shifts the aggregate
demand curve to the right.
The Effect of an Increase in Government
Purchases or a Decrease in Net Taxes on the
AD Curve
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THE AGGREGATE DEMAND CURVE
SHIFTS OF THE AGGREGATE DEMAND CURVE
• Consider an increase in the government purchases or a
decrease in net taxes
• An increase in government purchases directly increases planned
aggregate expenditure, which leads to an increase in output
• A decrease in net taxes results in a rise in consumption, which
increases planned aggregate expenditure, which also leads to an
increase in output
• Remember that some of the increase will be crowded out if the
money supply is held constant
• An increase in government purchases or a decrease in
net taxes at a given price level shifts the aggregate
demand curve to the right
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THE AGGREGATE DEMAND CURVE
SHIFTS THE AGGREGATE DEMAND CURVE
Factors That Shift the Aggregate Demand Curve
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THE AGGREGATE SUPPLY CURVE
• aggregate supply The total supply of all goods and
services in an economy
• aggregate supply (AS) curve 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: A WARNING
• A supply curve shows the quantity of output an individual
firm would supply at every price, ceteris paribus
• We assume that input prices, including wage rates, are constant
• A individual firm’s supply curve shows what would happen to the
firm’s output if the price of its output changes with no
corresponding increase in costs
• Things are different when the overall price level rises
• The outputs of some firms are the inputs of other firms
• If output prices rise, there will be an increase in at least some input
prices
• Because all input prices (including wage rates) are not constant as
the overall price level changes, individual firms’ supply curve shift
as the overall price level changes, so we can not sum them to get
an aggregate supply curve
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THE AGGREGATE SUPPLY CURVE
• Because input prices change when the overall price level changes
and because many firms in the economy set prices as well as
output
• An “aggregate supply curve” in the traditional sense of the word
supply does not exist
• What does exist is what we might call a “price/output response”
curve—a curve that traces out the price decisions and output
decisions of all the markets and firms in the economy under a
given set of circumstances
• The AS curve is not the sum of all the individual supply curves in
the economy
• It is not a market supply curve
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THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
• Many argue that the aggregate supply curve has a positive slope,
at least in the short-run
• To understand the shape of the AS curve, consider the output and
price response of markets and firms to an increase in aggregate
demand brought about by an expansionary fiscal or monetary
policy
• The reaction of firms to such an expansion is likely to depend on
two factors:
• How close the economy is to capacity at the time of expansion
• How rapidly input prices respond to increases in the overall price
level
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THE AGGREGATE SUPPLY CURVE
Capacity Constraints
• Short run describes the time in which firms’ decisions are
constrained by some fixed factor of production
• A firm is producing at full capacity if it is fully utilizing the
capital and labor it has on hand
• Firms may have excess capital and excess labor on hand
• Even if firms are not holding excess labor and capital, the
economy may be operating below its capacity if there is
cyclical unemployment (people willing to work but can not
find jobs)
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THE AGGREGATE SUPPLY CURVE
Output Levels and Price/Output Responses
• In periods of low output, there is likely to be excess
capacity in the economy as a whole
• There will be cyclical unemployment in the economy in
periods of low output
• It is likely that firms will respond to an increase in demand
by increasing output much more than they increase prices
• Firms are below capacity, so the extra cost of producing more
output is likely to be small
• Firms can get more labor (from the ranks of the unemployed)
without much increase in wages rates
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THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
The Short-Run Aggregate Supply Curve
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THE AGGREGATE SUPPLY CURVE
• An increase in aggregate demand when the economy is operating at
low levels of output is likely to result in an increase in output with little
or no increase in the overall price level
• That is, the aggregate supply (price/output response) curve is
likely to be fairly flat at low levels of aggregate output
• Aggregate output is higher at B than at A, but the price level at B is
only slightly higher than it is at A
• If aggregate output continues to expand, firms begin to move closer to
capacity and their response to an increase in demand is likely to
change form increasing output to increasing prices
• As firms continue to increase output, so the economy will be
approaching its capacity
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THE AGGREGATE SUPPLY CURVE
• As aggregate output rises, the prices of labor and capital (input costs)
will begin to rise, leading firms to increase their output prices
• At some level of output, all sectors will be fully utilizing their
equipment
• In addition, there is little or no cyclical unemployment
• At this point, firms will respond to any further increases in demand
only by raising prices
• When the economy is producing at its maximum level of
output—that is, at capacity— the aggregate supply curve
becomes vertical
• Moving from C to D results in no increase in aggregate output
but a large increase in the price level
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THE AGGREGATE SUPPLY CURVE
The Response of Input Prices to Changes in the Overall Price Level
• The time lag between changes in input prices and changes in
output prices is another reason for the aggregate supply
(price/output response) curve to slope upward
• If input prices changed at exactly the same rate as output prices,
the AS curve would be vertical
• Wage rates may increase at exactly the same rate as the overall
price level if the price level increase is fully anticipated
• Input prices—particularly wage rates—tend to lag behind
increases in output prices for a variety of reasons
• This point has led to an important distinction between the AS
curve in the long run and the AS curve in the short run
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THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY CURVE
• Anything that affects individual firm decisions also can
shift the AS curve
• Cost shocks, economic growth, stagnation, public policy
and natural disasters
• cost shock, or supply shock A change in costs that shifts the
aggregate supply (AS) curve
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THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY CURVE
Shifts of the Aggregate Supply Curve
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THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY CURVE
Factors That Shift the Aggregate Supply Curve
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THE EQUILIBRIUM PRICE LEVEL
• equilibrium price level The price level at which the
aggregate demand and aggregate supply curves intersect
• The point at which the AS and AD curves intersect
corresponds to equilibrium in the goods and money
markets and to a set of price/output decisions on the part
of all the firms in the economy
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THE EQUILIBRIUM PRICE LEVEL
The Equilibrium Price Level
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THE LONG-RUN AGGREGATE SUPPLY CURVE
• For the AS curve not to be vertical, some costs must
lag behind increases in the overall price level
• If all prices change at the same rate, the level of
aggregate output does not change
• We have assumed that in the short run at least some
cost changes lag behind price-level changes
• However, some costs like wage rates tend to move
very closely with the price level over time
• If wage rates and other costs fully adjust to changes in
prices in the long run, then the long-run AS curve is
vertical
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THE LONG-RUN AGGREGATE SUPPLY CURVE
POTENTIAL GDP
The Long-Run Aggregate Supply Curve
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THE LONG-RUN AGGREGATE SUPPLY CURVE
• The economy is initially in equilibrium at P0 and Y0 (point
A)
• A shift in the AD curve from AD0 to AD1
• Both the price level and aggregate output rise in the short
run to P1 and Y1(at point B)
• As costs fully adjust to prices in the long run, increase in
costs cause the AS curve to shift to left from AS0 to AS1
• If costs and prices have risen by exactly the same
percentage, aggregate output will be back at Y0 (at point
C)
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THE LONG-RUN AGGREGATE SUPPLY CURVE
POTENTIAL GDP
• The vertical portion of the short-run AS curve exists because there
are limits to the amount that an economy can produce in any given
time period
• The vertical portions of the short-run AS curve is to the right of Y0
• If the vertical portions of the short-run AS curve represents
“capacity”, Y0 represents the level of aggregate output that can
be sustained in the long run without inflation
• potential output, or potential GDP The level of aggregate output
that can be sustained in the long run without inflation
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THE LONG-RUN AGGREGATE SUPPLY CURVE
• If output is above Y0, there is upward pressure on
costs
• As the economy approaches short-run capacity, wage
rates tend to rise as firms try to attract more people
into the labor force
• Rising costs shift the short-run AS curve to the left
and drive output back to Y0
• If short-run AS and AD curves intersect to the right of Y0,
wages and other input prices will rise, causing the short-run
AS curve to shift to the left and pushing GDP back down to
Y0
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• Two fiscal policy variables, G and T
• The monetary policy tool, MS (money supply)
• An expansionary policy aims at stimulating the economy
through an increase in G or MS or a decrease in T
• A contractionary policy aims at slowing down the
economy through a decrease in G or MS or an increase in
T
• An expansionary policy shifts the AD curve to the right
• A contractionary policy shifts the AD curve to the left
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• How do these policies affect the equilibrium values of the
price level (P) and the level of aggregate output?
• We must be careful to note where along the (short-run)
AS curve the economy is at the time of the change
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• If the economy is initially on the flat portion of the AS
curve, then an expansionary policy, which shifts the AD
curve to the right, results in a small price increase relative
to the output increase:
• The increase in equilibrium Y is much greater than the
increase in equilibrium P
• The expansionary policy works well
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• If the economy is initially on the steep portion of the
AS curve, then an expansionary policy, which shifts
the AD curve to the right, results in a small increase
in equilibrium output and a large increase in the
equilibrium price level:
• The increase in equilibrium P is much greater than
the increase in equilibrium Y
• The expansionary policy does not work well
• Output is initially close to capacity and attempts to increase it
further lead mostly to a higher price level
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
A Shift of the Aggregate Demand Curve
When the Economy
Is on the Nearly Flat Part of the AS Curve
A Shift of the Aggregate Demand Curve
When the Economy
Is Operating at or Near Maximum Capacity
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
LONG-RUN AGGREGATE SUPPLY AND POLICY
EFFECTS
• Flat part of AS curve
• Firms producing below capacity
• Firms respond to an increase in demand by increasing
output much more than they increase prices
• Steep part of AS curve
• Firms are close to capacity
• Firms respond to an increase in demand by increasing
prices much more than they increase output
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• Assume the economy is on the steep part of AS
curve
• Increase in G with no change in money supply
• An unanticipated decline in firms’ inventories
• As firms are very close to capacity output when the economy
is on the steep part of the AS curve, they can not increase
their output very much
• There is a substantial increase in price level
• The increase in price level increases the demand for money,
which leads to an increase in the interest rate, decreasing
planned investment
• There is nearly complete crowding out of investment
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AGGREGATE DEMAND, AGGREGATE SUPPLY,
AND MONETARY AND FISCAL POLICY
• What is the effect of monetary and fiscal policy in the long run?
• If the long-run AS curve is vertical, as monetary and fiscal
policy shift the AD curve, output always comes back to initial Y
• Policy affects only the price level in the long run
• The multiplier effect of a change in G on aggregate output in
the long run is zero
• 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
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CAUSES OF INFLATION
• inflation An increase in the overall price level
• demand-pull inflation Inflation that is initiated by an
increase in aggregate demand
• cost-push, or supply-side, inflation Inflation caused by
an increase in costs
• 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