Chapter Twenty Nine
Aggregate Demand,
Aggregate Supply, and
Inflation
Aggregate Demand
Aggregate demand represents
the total demand for all goods
and services in the economy.
The Aggregate Demand Curve
The AD curve 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.
The Aggregate Demand curve is
NOT a market demand curve.
The Aggregate Demand Curve
Price
Level
P2
P1
P0
AD
Y2
Y1
Y0 Aggregate Output, Y
Deriving the AD Curve
Expenditures
C+ I+G=590+0.8*Y
(P=100)
2950
G=50
I=40
450
2950
Income (Y)
Deriving the AD Curve
Price
Level
120
100
80
2700
2950
3200
Aggregate Output, Y
Suppose the price level falls...
Expenditures
C+I+G=590+0.8*Y
(P=100)
2950
G=50
I=40
450
2950
Aggregate Income (Y)
Deriving the AD Curve
Expenditures
C+I+G=640+0.8*Y
(P=80)
C+I+G=590+0.8*Y
(P=100)
3200
2950
G=50
I=40
45o
2950
3200
Income (Y)
Deriving the AD Curve
Price
Level
120
100
80
2700
2950
3200
Aggregate Output, Y
Suppose the price level rises...
Expenditures
C+I+G=590+0.8*Y
(P=100)
2950
G=50
I=40
2950
Aggregate Income (Y)
Suppose the price level rises...
Expenditures
C+I+G=590+0.8*Y
(P=100)
C+I+G=540+0.8*Y
(P=120)
2950
G=50
I=40
2700
2700
2950
Income (Y)
Deriving the AD Curve
Price
Level
120
100
80
2700
2950
3200 Aggregate Output, Y
Deriving the AD Curve
Price
Level
120
100
80
AD
2700
2950
3200
Aggregate Output, Y
Why does AD slope downward?
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.
Other Reasons for a
Downward-Sloping AD Curve
 The
Consumption Link
 The Real Wealth (Real
Balance) Effect
Shifting Aggregate Demand
- Changes in the Money Supply Price
Level
Increase
MS
AD0
AD1
Aggregate Output, Y
Shifting Aggregate Demand
- Changes in the Money Supply Price
Level
Decrease
MS
AD1
AD0
Aggregate Output, Y
Shifting Aggregate Demand
- Changes in the G or T Price
Level
Increase G
or Decease T
AD0
AD1
Aggregate Output, Y
Shifting Aggregate Demand
- A Summary of Policy Changes Expansionary monetary policy:
Contractionary monetary policy:
MS  AD curve shifts to right
MS   AD curve shifts to left
Expansionary fiscal policy:
Contractionary fiscal policy:
G  AD curve shifts to right
G   AD curve shifts to left
T  AD curve shifts to right
T   AD curve shifts to left
Aggregate Supply
Aggregate supply represents the
total supply of all goods and
services in an economy.
Aggregate Supply (AS) Curve
The 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
Price Level
AS
Aggregate Output, Y
Factors That Shift the Short-Run
Aggregate Supply Curve
 Cost
Shocks
 Economics Growth
 Stagnation
 Public Policy
 Natural Disasters
Shifts to the left of AS...
Price Level
0
AS2
AS1
Aggregate Output, Y
Shifts to the left of AS
Decreases in Aggregate Supply
 Higher Costs
- Higher input prices
- Higher wage rates
 Stagnation
- Capital deterioration
 Public Policy
- Waste & inefficiency
- Over regulation
 Bad weather, Natural disasters, destruction
from wars
Shifts to the right of AS...
Price Level
0
AS1
AS2
Aggregate Output, Y
Shifts to the right of AS
Increases in Aggregate Supply
 Lower Costs
- Lower input prices
- Lower wage rates
 Economic Growth
- More capital and/or more labor
- Technological change
 Public Policy
- Supply side policies
- Tax cuts and/or deregulation
 Good Weather
Equilibrium Price Level
AS
Price Level
P0
AD
0
Y0
Aggregate Output, Y
Long-Run Aggregate Supply and
Potential GDP
Potential output or potential GDP
refers to the level of aggregate
output that can be sustained in the
long run without inflation. Usually
associated with full employment.
The Long-Run Aggregate Supply Curve
AS1
LRAS
Price Level
AS0
P2
P1
P0
AD1
AD0
0
Y0
Y1
Aggregate Output, Y
Equilibrium
Price
Level
AS
P0
AD
Y0
Aggregate Output, Y
Equilibrium
Price
Level
AS
short run equilibrium
P0
AD
Y0
Aggregate Output, Y
Equilibrium
LRAS
Price
Level
AS
P0
AD
Y0
Aggregate Output, Y
Equilibrium
LRAS
Price
Level
AS
short run equilibrium
and
long run equilibrium
P0
AD
Y0
Aggregate Output, Y
A shift of AD when the economy is on
the flatter part of the AS curve...
Price
Level
little change
in price
AS
P1
P0
AD0
0
Y0
Y1
AD1
Aggregate Output, Y
A shift of AD when the economy is
operating at or near capacity...
Price
Level
little change in output,
large change in price
AS
P1
P0
AD1
AD0
0
Y0 Y1
Aggregate Output, Y
Causes of Inflation
Inflation: An increase in the overall
price level
 Demand pull inflation is inflation
that is initiated by an increase in
aggregate demand.
 Cost-push (supply-side) inflation
is inflation caused by an increase in
costs.
Demand Pull Inflation
Price Level
AS
P1
P0
AD1
AD0
0
Y0 Y1 Aggregate Output, Y
Cost-Push Inflation
AS1
Price Level
AS0
P1
P0
AD
0
Y1
Y0
Aggregate Output, Y
Review Terms & Concepts
 Aggregate demand
 Equilibrium price level
 Aggregate demand
 Hyperinflation
curve (AD)
 Aggregate supply
 Aggregate supply
curve (AS)
 Cost-push inflation
 Supply shock
 Demand-pull inflation
 Inflation
 Inflationary gap
 Potential GDP
 Real balance effect
 Stagflation
 Sustained inflation