AGGREGATE DEMAND, AGGREGATE SUPPLY, AND INFLATION. Chapter 25

Transcription

1 1 AGGREGATE DEMAND, AGGREGATE SUPPLY, AND INFLATION Chapter 25

2 2 One of the most important issues in macroeconomics is the determination of the overall price level Up to now, we took the price level as fixed in our analysis The place to begin our explanation of the price level is the money market Remember that demand for money depends on income (Y), the interest rate (r) and the price level

3 3 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 increases, or the interest rate declines

4 4 aggregate demand The total demand for goods and services in the economy To derive the aggregate demand curve, we examine what happens to aggregate output (income) (Y) when the price level (P) changes The aggregate demand curve is derived by assuming that the fiscal policy variables (G and T) and the monetary policy variable (M S ) remain unchanged The government does not take any action to affect the economy in response to changes in the price level

5 5 DERIVING The Impact of an Increase in the Price Level on the Economy Assuming No Changes in G, T, and M s

6 6 DERIVING The Aggregate Demand (AD) curve

7 7 DERIVING 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 market are in equilibrium

8 8 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 A lower price level causes money demand to fall, which leads to a lower interest rate and lower interest rate stimulates planned investment spending, increasing planned aggregate spending, that leads to an increase in Y 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

9 9 : A WARNING A demand curve shows the quantity of output demanded (by an individual) at every price, ceteris paribus We assume that other prices and income are fixed The reason that the quantity demanded of a particular good falls when its price rises is that other prices do not rise The good therefore becomes more expensive relative to other goods and households respond by substituting other goods for the good whose price increased Things are different when the overall price level rises When the overall price level rises, many prices rise together So we can not use the ceteris paribus assumption to draw the AD curve

10 10 Aggregate demand falls when the price level increases because the higher price level causes the demand for money (M d ) 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 a market demand curve

11 11 OTHER REASONS FOR A DOWNWARD-SLOPING AGGREGATE DEMAND CURVE The Consumption Link Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output Decreased consumption brought about by a higher interest rate also contributes to this effect An increase in the price level increases the demand for money, which leads to an increase in the interest rate, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output (income)

12 12 The Real Wealth Effect real wealth, or real balance, effect The change in consumption brought about by a change in real wealth that results from a change in the price level An increase in the price level lowers the real value of some types of wealth This leads to a decrease in consumption, which leads to a decrease in aggregate output (income) There is a negative relationship between the price level and output through this real wealth effect

13 13 AGGREGATE EXPENDITURE AND AGGREGATE DEMAND equilibrium condition: C + I + G = Y At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G.

14 14 When the price level rises (M D increases, ED for money, interest rate increases, planned investment decreases) it is planned aggregate expenditure that decreases (hence aggregate output decreases), moving us up the aggregate demand At every point along the aggregate demand curve, the aggregate quantity demanded is exactly equal to planned aggregate expenditure, C + I + G

15 15 SHIFTS OF Consider an increase in the quantity of money supplied If the quantity of money is expanded at any given price level (ES of money), the interest rate will fall, causing planned investment spending (and planned aggregate expenditure) to rise The result is an increase in output at the given price level An increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right

16 16 SHIFTS OF An increase in the quantity of money supplied at a given price level shifts the aggregate demand curve to the right. An increase in government purchases or a decrease in net taxes shifts the aggregate demand curve to the right. The Impact of an Increase in the Money Supply on the AD Curve The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve

17 17 SHIFTS OF Consider an increase in the government purchases or a decrease in net taxes An increase in government purchases directly increases planned aggregate expenditure, which leads to an increase in output A decrease in net taxes results in a rise in consumption, which increases planned aggregate expenditure, which also leads to an increase in output Remember that some of the increase will be crowded out if the money supply is held constant An increase in government purchases or a decrease in net taxes at a given price level shifts the aggregate demand curve to the right

18 18 SHIFTS Factors That Shift the Aggregate Demand Curve