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Aggregate Demand,
Aggregate Supply,
and Inflation
Prepared by:
© 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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 23
THE AGGREGATE DEMAND CURVE
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 23
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
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.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 23
THE AGGREGATE DEMAND CURVE
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 23
THE AGGREGATE DEMAND CURVE
OTHER REASONS FOR A DOWNWARD-SLOPING
AGGREGATE DEMAND CURVE
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 23
THE AGGREGATE DEMAND CURVE
AGGREGATE EXPENDITURE AND AGGREGATE
DEMAND
equilibrium condition: C + I + G = Y
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 23
THE AGGREGATE SUPPLY CURVE
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
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.
When the economy is producing at its maximum level of output—that is, at capacity—
the aggregate supply curve becomes vertical.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 23
THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
The Response of Input Prices to Changes in the Overall Price Level
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 23
CAUSES OF INFLATION
INFLATION VERSUS SUSTAINED INFLATION: A REMINDER
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 23
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 13.14 Cost Shocks Are Bad News for Policy Makers
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 23
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
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 23
REVIEW TERMS AND CONCEPTS
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