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Chapter

26
Aggregate Demand,
Aggregate Supply,
and Inflation

Prepared by:

Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Aggregate Demand, Aggregate
Supply, and Inflation 26
Chapter Outline
The Aggregate Demand Curve
Deriving the Aggregate Demand Curve
The Aggregate Demand Curve: A Warning
Other Reasons for a Downward-Sloping Aggregate
Demand Curve
Aggregate Expenditure and Aggregate Demand
Shifts of the Aggregate Demand Curve
The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning
Aggregate Supply in the Short Run
Shifts of the Short-Run Aggregate Supply Curve
dna, yl ppuS et ager gg A

The Equilibrium Price Level


The Long-Run Aggregate Supply Curve
Potential GDP
Aggregate Demand, Aggregate Supply, and
Monetary and Fiscal Policy
Long-Run Aggregate Supply and Policy Effects
Causes of Inflation
Inflation versus Sustained Inflation: A Reminder
Demand-Pull Inflation
Cost-Push, or Supply-Side, Inflation
Expectations and Inflation
P A HC

Money and Inflation


Sustained Inflation as a Purely Monetary Phenomenon
Looking Ahead

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THE AGGREGATE DEMAND CURVE

aggregate demand The total demand


for goods and services in the economy.

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
dna, yl ppuS et ager gg A

increases, or the interest rate declines.


P A HC

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THE AGGREGATE DEMAND CURVE
DERIVING THE AGGREGATE DEMAND CURVE
dna, yl ppuS et ager gg A

FIGURE 13.1 The Impact of an Increase in the Price Level on the Economy–Assuming No
P A HC

Changes in G, T, and Ms

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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
dna, yl ppuS et ager gg A

market are in equilibrium.


FIGURE 13.2 The Aggregate Demand (AD) 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.
P A HC

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

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
dna, yl ppuS et ager gg A

a market demand curve.


P A HC

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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.

The Real Wealth Effect


real wealth, or real balance, effect The change
dna, yl ppuS et ager gg A

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.
P A HC

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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.
dna, yl ppuS et ager gg A
P A HC

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THE AGGREGATE DEMAND CURVE
SHIFTS OF THE AGGREGATE DEMAND
An increase in the quantity of money supplied An increase in government purchases or a
at a given price level shifts the aggregate decrease in net taxes shifts the aggregate
demand curve to the right. demand curve to the right.
dna, yl ppuS et ager gg A

FIGURE 13.3 The Impact of an Increase in FIGURE 13.4 The Effect of an Increase in
P A HC

the Money Supply on the AD Curve 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
dna, yl ppuS et ager gg A

FIGURE 13.5 Factors That Shift the Aggregate Demand Curve


P A HC

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THE AGGREGATE SUPPLY CURVE

aggregate supply The total supply of all goods


and services in an economy.

THE AGGREGATE SUPPLY CURVE: A WARNING


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
dna, yl ppuS et ager gg A

price level.
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
P A HC

given set of circumstances.


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THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN

Capacity Constraints
Even if firms are not holding excess labor
and capital, the economy may be operating
below its capacity if there is cyclical
unemployment.

Output Levels and Price/Output


Responses
An increase in aggregate demand when the
dna, yl ppuS et ager gg A

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
FIGURE 13.6 The Short-Run Aggregate Supply fairly flat at low levels of aggregate output.
Curve
P A HC

When the economy is producing at its maximum level of output—that is, at capacity—
the aggregate supply curve becomes vertical.
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THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
The Response of Input Prices to Changes in the Overall Price Level

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.
dna, yl ppuS et ager gg A

Input prices—particularly wage rates—tend to lag


behind increases in output prices for a variety of
reasons.
P A HC

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THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY CURVE
cost shock, or supply shock A change in costs
that shifts the aggregate supply (AS) curve.
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.7 Shifts of the Aggregate Supply Curve


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THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY CURVE
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.8 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.
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.9 The Equilibrium Price Level

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THE LONG-RUN AGGREGATE SUPPLY CURVE
If wage rates and other costs fully adjust to changes in prices in the long run, then the
long-run AS curve is vertical.

POTENTIAL GDP
potential output, or
potential GDP The
level of aggregate
output that can be
sustained in the long
run without inflation.
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.9 The Long-Run Aggregate Supply Curve

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AGGREGATE DEMAND, AGGREGATE SUPPLY,
dna, yl ppuS et ager gg A
AND MONETARY AND FISCAL POLICY

FIGURE 13.11 A Shift of the Aggregate FIGURE 13.12 A Shift of the Aggregate
Demand Curve When the Economy Demand Curve When the Economy
Is on the Nearly Flat Part of the AS Curve Is Operating at or Near Maximum Capacity

LONG-RUN AGGREGATE SUPPLY AND POLICY EFFECTS


If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has
P A HC

any effect on aggregate output in the long run.

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CAUSES OF INFLATION
INFLATION VERSUS SUSTAINED INFLATION: A REMINDER

inflation 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.
DEMAND PULL INFLATION
dna, yl ppuS et ager gg A

demand-pull inflation Inflation that is initiated by


an increase in aggregate demand.
P A HC

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CAUSES OF INFLATION
COST-PUSH, OR SUPPLY-SIDE, INFLATION

cost-push, or supply-
side, inflation Inflation
caused by an increase
in costs.
dna, yl ppuS et ager gg A

FIGURE 13.13 Cost-Push, or Supply-Side, Inflation

stagflation Occurs when output is falling at the


P A HC

same time that prices are rising.


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CAUSES OF INFLATION
EXPECTATIONS AND INFLATION
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.14 Cost Shocks Are Bad News for Policy Makers

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CAUSES OF INFLATION
MONEY AND INFLATION

hyperinflation A period
of very rapid increases in
the price level
dna, yl ppuS et ager gg A
P A HC

FIGURE 13.15 Sustained Inflation from an Initial Increase in G and Fed Accommodation

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REVIEW TERMS AND CONCEPTS

aggregate demand equilibrium price level


aggregate demand (AD) hyperinflation
curve inflation
aggregate supply inflationary gap
aggregate supply (AS) potential output, or potential
curve GDP
cost-push, or supply-side, real wealth, or real balance,
inflation effect
dna, yl ppuS et ager gg A

cost shock, or supply shock stagflation


demand-pull inflation sustained inflation
P A HC

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