CHAPTER
13
Aggregate Demand,
Aggregate Supply,
and Inflation
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve
• Aggregate demand
is the total demand for
goods and services in
the economy.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Deriving the Aggregate Demand Curve
• To derive the aggregate demand
curve, we examine what happens to
aggregate output (income) (Y) when
the price level (P) changes,
assuming no changes in government
spending (G), net taxes (T), or the
monetary policy variable (Ms).
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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
 P  M d   r   I   AE   Y 
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Deriving the Aggregate Demand Curve
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• The aggregate
demand (AD) curve
is a curve that shows
the negative
relationship between
aggregate output
(income) and the
price level.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve:
A Warning
• The AD curve is not a market
demand curve. It is a more complex
concept.
• We cannot use the ceteris paribus
assumption to draw an AD curve. In
reality, many prices (including input
prices) rise together.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve:
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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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Demand Curve:
A Warning
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• At all points along the
AD curve, both the
goods market and the
money market are in
equilibrium.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Other Reasons for a DownwardSloping Aggregate Demand Curve
• The real wealth effect, or real
balance, effect is the change
in consumption brought about
by a change in real wealth that
results from a change in the
price level.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Expenditure
and Aggregate Demand
• At every point along the
aggregate demand curve, the
aggregate quantity of output
demanded is exactly equal to
planned aggregate
expenditure.
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Y=C+I+G
equilibrium condition
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Aggregate Demand Curve
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• 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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Aggregate Demand Curve
© 2004 Prentice Hall Business Publishing
• An increase in
government purchases
or a decrease in net
taxes shifts the
aggregate demand
curve to the right.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Aggregate Demand Curve
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy
Contractionary monetary policy
Ms
Ms
AD curve shifts to the right
Expansionary fiscal policy
AD curve shifts to the left
Contractionary fiscal policy
G
AD curve shifts to the right
G
AD curve shifts to the left
T
AD curve shifts to the right
T
AD curve shifts to the left
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve
• Aggregate supply is the
total supply of all goods
and services in the
economy.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve
• 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.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve:
A Warning
• The aggregate supply curve is
not a market supply curve or
the sum of all the individual
supply curves in the economy.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve:
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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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve:
A Warning
• When we draw a firm’s 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 the
inputs of other firms.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Aggregate Supply Curve:
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Supply in the Short Run
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• In the short run, the
aggregate supply
curve (the price/output
response curve) has a
positive slope.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Supply in the Short Run
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• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Supply in the Short Run
• Macroeconomists focus on whether
or not the economy as a whole is
operating at full capacity.
• As the economy approaches
maximum capacity, firms respond to
further increases in demand only by
raising prices.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Output Levels and
Price/Output Responses
• When the economy is operating at
low levels of output, an increase in
aggregate demand is likely to result
in an increase in output with little or
no increase in the overall price level.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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 pricelevel increase is fully
anticipated. Most input prices,
however, tend to lag increases
in output prices.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Short-Run
Aggregate Supply Curve
• A cost shock, or supply shock, is a
change in costs that shifts the aggregate
supply (AS) curve.
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Karl Case, Ray Fair
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Shifts of the Short-Run
Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right
Shifts to the Left
Increases in Aggregate Supply
Decreases in Aggregate Supply
Lower costs
lower input prices
lower wage rates
Higher costs
higher input prices
higher wage rates
Economic growth
more capital
more labor
technological change
Stagnation
capital deterioration
Public policy
supply-side policies
tax cuts
deregulation
Public policy
waste and inefficiency
over-regulation
Good weather
Bad weather, natural
disasters, destruction
from wars
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Equilibrium Price Level
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• The equilibrium price
level is the point at
which the aggregate
demand and aggregate
supply curves intersect.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Equilibrium Price Level
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• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
© 2004 Prentice Hall Business Publishing
• Costs lag behind pricelevel changes in the
short run, resulting in
an upward-sloping AS
curve.
• Costs and the price
level move in tandem in
the long run, and the
AS curve is vertical.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
© 2004 Prentice Hall Business Publishing
• Output can be pushed
above potential GDP by
higher aggregate
demand. The
aggregate price level
also rises.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
© 2004 Prentice Hall Business Publishing
• When output is pushed
above potential, there is
upward pressure on costs,
and this causes the shortrun AS curve to the left.
• Costs ultimately increase
by the same percentage as
the price level, and the
quantity supplied ends up
back at Y0.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Long-Run
Aggregate Supply Curve
© 2004 Prentice Hall Business Publishing
• Y0 represents the level
of output that can be
sustained in the long
run without inflation. It
is also called potential
output or potential
GDP.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
© 2004 Prentice Hall Business Publishing
• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy
© 2004 Prentice Hall Business Publishing
• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Long-Run Aggregate
Supply and Policy Effects
© 2004 Prentice Hall Business Publishing
• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
The Simple “Keynesian”
Aggregate Supply Curve
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• 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 an
inflationary gap.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Causes of Inflation
• Demand-pull inflation is
inflation initiated by an
increase in aggregate
demand.
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• Cost-push, or supplyside, inflation is inflation
caused by an increase in
costs.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Cost-Push, or Supply-Side Inflation
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• Stagflation occurs
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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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Cost-Push, or Supply-Side Inflation
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• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• Hyperinflation is a
period of very rapid
increases in the price
level.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Money and Inflation
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• If the Fed tries to prevent
crowding, 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.
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CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
Review Terms and Concepts
aggregate demand
hyperinflation
aggregate demand (AD) curve
inflation
aggregate supply
inflationary gap
aggregate supply (AS) curve
potential output, or potential GDP
cost-push, or supply-side, inflation
real wealth, or real balance, effect
cost shock, or supply shock
stagflation
demand-pull inflation
sustained inflation
equilibrium price level
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