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Aggregate Demand and Supply
Sunday, May 1, 2016

12:41 PM

• Causes of the Great Recession: largest house price bubble in history, financial
panic, oil price shock

Aggregate Demand - Aggregate Supply Model

• Inflation rate on the y axis and current level of output on the x axis
• Aggregate demand curve shows the amount of output consumers, firms,
government, and customers abroad want to purchase at each inflation rate
○ Slopes downward because an increase in the inflation rate causes planned
consumption, investment, and net exports to fall --> PAE and output to
fall
• When inflation rate rises, the Federal Reserve increases the real interest rate
○ Higher real interest rate causes consumption, investment, and net exports
to fall
• Long-Run Equilibrium: a situation in which the AD and AS curves intersect at
potential output Y*
• Short-Run Equilibrium: a situation where the AD and AS curves intersect at a
level of real GDP that is above or below potential
• Demand Shocks: changes in planned spending that are not caused by changes in
output or the inflation rate
• Shifts results from demand shocks, monetary, and fiscal policy
• Aggregate demand shocks do not increase inflationary expectations
• Aggregate supply shocks force a tradeoff between decreased output and
increased inflation

Aggregate Supply Curve

• Aggregate supply curve shows the relationship between the amount of output
firms want to produce and the inflation rate
○ Slopes upward because when firms increase their output, inflation rate
rises
• Inflation seems to be inertial, tending to remain roughly constant as long as the
economy is at potential output and there are no external shocks to the price
level
• The higher the expected rate of inflation, the more nominal wages and costs of
inputs will rise
○ Firms raise prices to cover costs
○ High rate of expected inflation tends to lead to high rate of actual

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level
The higher the expected rate of inflation, the more nominal wages and costs of
inputs will rise
○ Firms raise prices to cover costs
○ High rate of expected inflation tends to lead to high rate of actual
inflation
Shifts result due to available resources, technology, expected inflation rates,
and inflation shocks)
If inflation expectations increase, aggregate supply will decrease
Long-term contracts serve to build in wage and price increases that depend on
inflation expectations at the time the contracts were signed
○ Reinforce inflation inertia
If output gap is zero, the rate of inflation will remain the same
When there is an expansionary gap, the rate of inflation will rise
When there is a recessionary gap, the rate of inflation will fall
Current inflation = expected inflation + change in inflation caused by an output
gap
Resources and technology shift the aggregate supply curve outward
Inflation Shock: a sudden change in the normal behavior of inflation, unrelated
to the nation's output gap
○ Negative: causes an increase in inflation
○ Positive: causes a decrease in inflation
An economy with an expansionary gap sees the bidding up of wages and
production costs
○ Causes a leftward shift in AS which results in higher inflation and
decreased output

Self-Correcting Economy and Stabilization Policy

• Self-Correcting Property: the fact that output gaps will not last indefinitely, but
will be closed by rising or falling inflation
○ Keynesian thinks it can only be done through fiscal/monetary policy
○ Keynesian focuses on the short run period where prices and inflation do
not adjust
• Stabilization policies are most useful when the size of the output gap is large
and the self-correction process is slow
• When firms face menu costs, they face a burden of altering prices
○ Will increase output to take advantage of higher demand and raise prices
later
• When inflation rate increases, household wealth falls, which reduces PAE
○ National income falls --> output decreases
• If the Fed expects second-round effects, it will counteract the inflation (i
...

lower target if high rate) and tighten policy

○ National income falls --> output decreases
• If the Fed expects second-round effects, it will counteract the inflation (i
...

lower target if high rate) and tighten policy



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