principles of economics chapter 13

8/13/2019 principles of economics chapter 13

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C

HAPTE

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Prepared by: Fernando Quijano

and Yvonn Quijano

2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair

Aggregate Demand,Aggregate Supply,

and Inflation


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CHAPTER

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2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 47

The Aggregate Demand Curve

Agg regate demand

is the total demand for

goods and services inthe economy.


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Deriving the Aggregate Demand Curve

P M r I AEd Y

The Impact of an Increase in the Price Level on theEconomyAssuming No Changes in G, T, and Ms


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Deriving the Aggregate Demand Curve

The aggregatedemand (AD) cu rveis a curve that shows

the negativerelationship betweenaggregate output(income) and the

price level.


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The Aggregate Demand Curve:

A Warning

TheADcurve is not a market

demand curve. It is a more complex

concept.

We cannot use the ceteris paribus

assumption to draw anADcurve. In

reality, many prices (including input

prices) rise together.


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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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A Warning

At all points along the

ADcurve, both the

goods market and the

money market are in

equilibrium.


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Other Reasons for a Downward-

Sloping Aggregate Demand Curve

The consumption link: The

decrease in consumption

brought about by an increasein the interest rate contributes

to the overall decrease in

output.


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Other Reasons for a Downward-

Sloping Aggregate Demand Curve

The real wealth effect, or real

balance, effectis the change

in consumption brought aboutby a change in real wealth that

results from a change in the

price level.


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Aggregate Expenditure

and Aggregate Demand

At every point along the

aggregate demand curve, the

aggregate quantity of outputdemanded is exactly equal to

planned aggregate

expenditure.

Y = C + I + G

equilibrium condition


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CHAPTER




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.


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Shifts of the Aggregate Demand Curve

Factors That Shift the Aggregate Demand Curve

Expansionary monetary policyMs ADcurve shifts to the right

Contractionary monetary policy

Ms ADcurve shifts to the left

Expansionary fiscal policyG ADcurve shifts to the right

Contractionary fiscal policyG ADcurve shifts to the left

T ADcurve shifts to the right T ADcurve shifts to the left


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The Aggregate Supply Curve

Aggregate supplyis the

total supply of all goods

and services in theeconomy.


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The Aggregate Supply Curve

The agg regate supp ly(AS)

curveis a graph that shows

the relationship between theaggregate quantity of output

supplied by all firms in an

economy and the overall price

level.


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The Aggregate Supply Curve:

A Warning

The aggregate supply curve is

not a market supply curve or

the sum of all the individualsupply curves in the economy.


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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.


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A Warning

When we draw a firms 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 theinputs of other firms.


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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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Aggregate Supply in the Short Run

In the short run, the

aggregate supply

curve (the price/output

response curve) has a

positive slope.


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Aggregate Supply in the Short Run

At low levels of

aggregate output, the

curve is fairly flat. As

the economyapproaches capacity,

the curve becomes

nearly vertical. At

capacity, the curve is

vertical.


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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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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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Shif f h Sh R


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Shifts of the Short-Run

Aggregate Supply Curve

Bad weather, natural

disasters, destruction

from wars

Good weather

Public policywaste and inefficiency

over-regulation

Public policysupply-side policies

tax cuts

deregulation

Stagnation

capital deterioration

Economic growth

more capital

more labor

technological change

Higher costs

higher input priceshigher wage rates

Lower costs

lower input priceslower wage rates

Shifts to the LeftDecreases in Aggregate Supply

Shifts to the RightIncreases in Aggregate Supply

Factors That Shift the Aggregate Supply Curve


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The Equilibrium Price Level

The equ i l ibr ium price

levelis the point at

which the aggregate

demand and aggregatesupply curves intersect.


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The Equilibrium Price Level

P0and Y0correspond to

equilibrium in the goods

market and the money

market and a set ofprice/output decisions

on the part of all the

firms in the economy.

Th L R


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The Long-Run


Costs lag behind price-

level changes in the

short run, resulting in

an upward-slopingAScurve.

Costs and the price

level move in tandem inthe long run, and the

AScurve is vertical.

Th L R


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The Long-Run


Output can be pushed

above potential GDPby

higher aggregate

demand. Theaggregate price level

also rises.

Th L R


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The Long-Run


When output is pushed

above potential, there is

upward pressure on costs,

and this causes the short-runAScurve to the left.

Costs ultimately increase

by the same percentage as

the price level, and thequantity supplied ends up

back at Y0.

Th L R


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The Long-Run


Y0represents the level

of output that can be

sustainedin the long

run without inflation. Itis also called potent ial

output orpotent ial

GDP.

A t D d A t


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Aggregate Demand, Aggregate

Supply, and Monetary and Fiscal Policy

Expansionary policy works

well when the economy ison the flat portion of theAS

curve, causing little change

in Prelative to the output

increase.

ADcan shift to the right for

a number of reasons,

including an increase in the

money supply, a tax cut, oran increase in government

spending.


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L R A t


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Long-Run Aggregate

Supply and Policy Effects

If theAScurve is vertical in

the long run, neither

monetary policy nor fiscal

policy has any effect onaggregate output.

In the long run, the

multiplier effect of a change

in government spending ortaxes on aggregate output

is zero.

The Simple Ke nesian


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The Simple Keynesian


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 aninf lat ionary gap.


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Causes of Inflation

Inf lat ionis an increase in the

overall price level.

Sustained inf lat ionoccurs

when the overall price level

continues to rise over some

fairly long period of time.


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Causes of Inflation

Demand-pul l inf lat ionisinflation initiated by anincrease in aggregatedemand.

Cost-push, or supp ly -side, inf lationis inflationcaused by an increase incosts.


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Cost-Push, or Supply-Side Inflation

Stagflat ionoccurs

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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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 intothe system.

In terms of theAD/ASdiagram, an

increase in inflationary expectationsshifts theAScurve to the left.


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Inflation


Money and Inflation

Hyperinf lat ionis a

period of very rapid

increases in the price

level.


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Inflation


Money and Inflation

An increase in Gwith

the money supply

constant shifts theAD

curve fromAD0toAD1. This leads to an

increase in the interest

rate and crowding out

of planned investment.


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Inflation


Money and Inflation

If the Fed tries to prevent

crowding, it will increase

the money supply and

theADcurve will shiftfarther and farther to the

right. The result is a

sustained inflation,

perhaps hyperinflation.


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Inflation

Review Terms and Concepts

hyperinflation

inflation

inflationary gap

potential output, or potential GDP

real wealth, or real balance, effect

stagflation

sustained inflation

aggregate demand

aggregate demand (AD) curve

aggregate supply

aggregate supply (AS) curve

cost-push, or supply-side, inflation

cost shock, or supply shock

demand-pull inflation

equilibrium price level

principles of economics chapter 13

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