Aggregate Demand, Aggregate Supply, and Inflation The Aggregate Demand Curve • Aggregate demand is the total demand for goods and services in the economy. • The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level. Deriving the Aggregate Demand Curve P M d r I AE 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. The Aggregate Demand Curve: A Warning • The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. It is a more complex concept. • We cannot use the ceteris paribus assumption to draw the AD curve because when the overall price level rises, many prices (including input prices) rise together. The Aggregate Demand Curve: A Warning • Aggregate demand falls when the price level increases because the higher price level causes the demand for money to rise, which causes the interest rate to rise. • It is the higher interest rate that causes aggregate output to fall. • At all points along the AD curve, both the goods market and the money market are in equilibrium. 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. • The real wealth effect, or real balance, effect: When the price level rises, there is a decrease in consumption brought about by a change in real wealth. Aggregate Expenditure and Aggregate Demand How are aggregate demand and aggregate expenditure related? • 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 Shifts in the Aggregate Demand Curve: A Summary Expansionary monetary policy Ms AD curve shifts to the right Contractionary monetary policy Ms AD curve shifts to the left Expansionary fiscal policy G AD curve shifts to the right T AD curve shifts to the right Contractionary fiscal policy G AD curve shifts to the left 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 (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. Aggregate Supply in the Short Run • 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, 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. • Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment. Shifts of the Short-Run Aggregate Supply Curve Factors That Shift the Aggregate Supply Curve Shifts to the Right Increases in Aggregate Supply Lower costs • lower input prices • lower wage rates Economic growth • more capital • more labor • technological change Public policy • supply-side policies • tax cuts • deregulation Good weather Shifts to the Left Decreases in Aggregate Supply Higher costs • higher input prices • higher wage rates Stagnation •Capital deterioration Public policy • waste and inefficiency • over-regulation 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. • 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 upwardsloping AS curve, but ultimately move with the overall price level. • If costs and the price level move in tandem in the long run, the AS curve is vertical. 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. • 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. Rising costs push the short-run AS curve to the left. • If costs ultimately increase by the same percentage as the price level, the quantity supplied will end up back at Y0. AD, AS, 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. AD, AS, 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. 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. • Sustained inflation is essentially a monetary phenomenon. For the price level to continue to rise period after period, it must be accommodated by an expanded money supply. Causes of Inflation • Demand-pull inflation is • Cost-push, or supplyinflation initiated by an side, inflation is inflation increase in aggregate caused by an increase in demand. costs. Cost-Push, or Supply-Side Inflation • Cost-push inflation is one possible cause of stagflation—a situation in which output is falling at the same time that prices are rising. • 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. • 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 • Hyperinflation is a period of very rapid increases in the price level. • If the Fed tries to prevent crowding out by keeping the interest rate unchanged, 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.