13
Aggregate Demand, Aggregate Supply, and Inflation
Prepared by: Fernando Quijano and Yvonn Quijano
Aggregate demand is the total demand for goods and services in the economy.
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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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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
Principles of Economics, 7/e Karl Case, Ray Fair 4 of 47
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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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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An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right.
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Expansionary fiscal policy G T AD curve shifts to the right AD curve shifts to the right
Contractionary fiscal policy G T AD curve shifts to the left AD curve shifts to the left
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Aggregate supply is the total supply of all goods and services in the economy.
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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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In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.
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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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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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Public policy waste and inefficiency over-regulation Bad weather, natural disasters, destruction from wars
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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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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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Causes of Inflation
CHAPTER 13: Aggregate Demand, Aggregate Supply, and Inflation
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Causes of Inflation
CHAPTER 13: Aggregate Demand, Aggregate Supply, and 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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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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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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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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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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aggregate demand aggregate demand (AD) curve aggregate supply aggregate supply (AS) curve
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