CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

PowerPoint Lectures for

Principles of Economics,
9e
; ;

By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster

2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

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PART V THE CORE OF MACROECONOMIC THEORY

Aggregate Supply
and the Equilibrium
Price Level

28

Prepared by:
Fernando & Yvonn Quijano
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

PART V THE CORE OF MACROECONOMIC THEORY

Aggregate Supply
and the Equilibrium
Price Level

28
11
CHAPTER OUTLINE
The Aggregate Supply Curve
The Aggregate Supply Curve: A Warning
Aggregate Supply in the Short Run
Shifts of the Short-Run Aggregate Supply Curve

The Equilibrium Price Level

The Long-Run Aggregate Supply Curve
Potential GDP

Monetary and FiscalPolicy Effects

Long-Run Aggregate Supply and Policy Effects

Causes of Inflation
Demand-Pull Inflation
Cost-Push, or Supply-Side, Inflation
Expectations and Inflation
Money and Inflation
Sustained Inflation as a Purely Monetary
Phenomenon

The Behavior of the Fed

Controlling the Interest Rate
The Feds Response to the State of the
Economy
Fed Behavior Since 1970
Inflation Targeting

Looking Ahead

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

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 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
curvea curve that traces out the price decisions
and output decisions of all firms in the economy
under a given set of circumstances.

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The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Aggregate Supply in the Short Run

FIGURE 28.1 The Short-Run

Aggregate Supply Curve
In the short run, the aggregate supply
curve (the price/output response
curve) has a positive slope.
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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The Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Shifts of the Short-Run Aggregate Supply Curve

cost shock, or supply shock A change in costs
that shifts the short-run aggregate supply (AS)
curve.

FIGURE 28.2 Shifts of the Short-Run Aggregate Supply Curve

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Equilibrium Price Level

equilibrium price level The price level at which
the aggregate demand and aggregate supply
curves intersect.

FIGURE 28.3 The Equilibrium Price

Level
At each point along the AD curve, both
the money market and the goods
market are in equilibrium. Each point
on the AS curve represents the price/
output decisions of all the firms in the
economy.
P0 and Y0 correspond to equilibrium in
the goods market and the money
market and to a set of price/output
decisions on the part of all the firms in
the economy.

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Long-Run Aggregate Supply Curve

FIGURE 28.4 The Long-Run

Aggregate Supply Curve
When the AD curve shifts from AD0 to
AD1, the equilibrium price level initially
rises from P0 to P1 and output rises
from Y0 to Y1.
Wages respond in the longer run,
shifting the AS curve from AS0 to AS1.
If wages fully adjust, output will be
back at Y0. Y0 is sometimes called
potential GDP.

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Long-Run Aggregate Supply Curve

The Simple Keynesian

Aggregate Supply Curve
One view of the aggregate
supply curve, the simple
Keynesian view, holds that at
any given moment, the economy
has a clearly defined capacity, or
maximum, output.
With planned aggregate expenditure of AE1
and aggregate demand of AD1, equilibrium
output is Y1.
A shift of planned aggregate expenditure to
AE2, corresponding to a shift of the AD curve
to AD2, causes output to rise but the price
level to remain at P1.

If planned aggregate expenditure and

aggregate demand exceed YF, however,
there is an inflationary gap and the price level
rises to P3.
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The Long-Run Aggregate Supply Curve

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Potential GDP
potential output, or potential GDP The level of
aggregate output that can be sustained in the long
run without inflation.
Short-Run Equilibrium Below Potential Output
Although different economists have different
opinions on how to determine whether an economy
is operating at or above potential output, there is
general agreement that there is a maximum level
of output (below the vertical portion of the shortrun aggregate supply curve) that can be sustained
without inflation.

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

FIGURE 28.5 A Shift of the

Aggregate Demand Curve When the
Economy Is on the Nearly Flat Part of
the AS Curve
Aggregate demand 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.
If the shift occurs when the economy is
on the nearly flat portion of the AS
curve, the result will be an increase in
output with little increase in the price
level from point A to point A.

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Monetary and Fiscal Policy Effects

FIGURE 28.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near
Maximum Capacity
If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be
an increase in the price level with little increase in output from point B to point B.

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Monetary and Fiscal Policy Effects

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Long-Run Aggregate Supply and Policy Effects

It is important to realize that 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 conclusion that policy has no effect on
aggregate output in the long run is perhaps
startling.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Demand-Pull Inflation
demand-pull inflation Inflation that is initiated by
an increase in aggregate demand.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Cost-Push, or Supply-Side, Inflation

cost-push, or supply-side, inflation Inflation

caused by an increase in costs.
FIGURE 28.7 Cost-Push, or SupplySide, Inflation
An increase in costs shifts the AS
curve to the left.
By assuming the government does not
react to this shift, the AD curve does
not shift, the price level rises, and
output falls.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Cost-Push, or Supply-Side, Inflation

stagflation Occurs when output is falling at the
same time that prices are rising.
FIGURE 28.8 Cost Shocks Are Bad
News for Policy Makers
A cost shock with no change in
monetary or fiscal policy would shift
the aggregate supply curve from AS0
to AS1, lower output from Y0 to Y1, and
raise the price level from P0 to P1.
Monetary or fiscal policy could be
changed enough to have the AD curve
shift from AD0 to AD1.
This policy would raise aggregate
output Y again, but it would raise the
price level further, to P2.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Expectations and Inflation

When firms are making their price/output
decisions, their expectations of future prices may
affect their current decisions. If a firm expects that
its competitors will raise their prices, in
anticipation, it may raise its own price.
Given the importance of expectations in inflation,
the central banks of many countries survey
consumers about their expectations.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Money and Inflation

FIGURE 28.9 Sustained Inflation

From an Initial Increase in G and Fed
Accommodation
An increase in G with the money
supply constant shifts the AD curve
from AD0 to AD1. Although not
shown in the figure, this leads to an
increase in the interest rate and
crowding out of planned
investment.
If the Fed tries to keep the interest
rate unchanged by increasing the
money supply, the AD curve will
shift farther and farther to the right.
The result is a sustained inflation,
perhaps even hyperinflation.

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Causes of Inflation

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Sustained Inflation as a Purely Monetary Phenomenon

Virtually all economists agree that an increase in
the price level can be caused by anything that
causes the AD curve to shift to the right or the AS
curve to shift to the left.
It is also generally agreed that for a sustained
inflation to occur, the Fed must accommodate it.
In this sense, a sustained inflation can be thought
of as a purely monetary phenomenon.

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CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Behavior of the Fed

FIGURE 28.10 Fed Behavior

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The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Controlling the Interest Rate

The buying and selling of government securities by
the Fed has two effects at the same time: It
changes the money supply, and it changes the
interest rate.
How much the interest rate changes depends on
the shape of the money demand curve. The
steeper the money demand curve, the larger the
change in the interest rate for a given size change
in government securities.
If the Fed wants to achieve a particular value of
the money supply, it must accept whatever interest
rate value is implied by this choice. Conversely, if
the Fed wants to achieve a particular value of the
interest rate, it must accept whatever money
supply value is implied by this.

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The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Feds Response to the State of the Economy

FIGURE 28.11 The Feds Response

to Low Output/Low Inflation
During periods of low output/low
inflation, the economy is on the
relatively flat portion of the AS
curve. In this case, the Fed is likely
to lower the interest rate (and thus
expand the money supply).
This will shift the AD curve to the
right, from AD0 to AD1, and lead to
an increase in output with very little
increase in the price level.

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The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

The Feds Response to the State of the Economy

FIGURE 28.12 The Feds Response

to High Output/High Inflation
During periods of high output/high
inflation, the economy is on the
relatively steep portion of the AS
curve. In this case, the Fed is likely
to increase the interest rate (and
thus contract the money supply).
This will shift the AD curve to the
left, from AD0 to AD1, and lead to a
decrease in the price level with
very little decrease in output.

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The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Fed Behavior Since 1970

FIGURE 28.13 Output, Inflation, and the Interest Rate 1970 I2007 IV
The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid
1980s on. It aggressively lowered interest rates in the 1990 IV1991 I and 2001 I2001 III recessions.
Output is the percentage deviation of real GDP from its trend. Inflation is the 4-quarter average of the
percentage change in the GDP deflator. The interest rate is the 3- month Treasury bill rate.

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The Behavior of the Fed

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

Inflation Targeting
inflation targeting When a monetary authority
chooses its interest rate values with the aim of
keeping the inflation rate within some specified
band over some specified horizon.

Rising Food Prices

Worry Central Banks
Around the World
Food Prices Worry Central
Bankers
Wall Street Journal

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REVIEW TERMS AND CONCEPTS

CHAPTER 28 Aggregate Supply and the Equilibrium Price Level

aggregate supply
aggregate supply (AS) curve
cost-push, or supply-side, inflation
cost shock, or supply shock
demand-pull inflation
equilibrium price level
inflation targeting
potential output, or potential GDP
stagflation

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