This chapter discusses aggregate demand, aggregate supply, and inflation. It introduces the aggregate demand curve, which slopes downward, showing an inverse relationship between the price level and output. The aggregate supply curve can be drawn to represent the economy's price and output responses in both the short run and long run. The intersection of the aggregate demand and supply curves determines the equilibrium price level in the economy. The chapter also examines causes of inflation, including demand-pull inflation and cost-push inflation, and how monetary and fiscal policy can impact price levels and output.

1. Chapter
26
Aggregate Demand,
Aggregate Supply,
and Inflation
Prepared by:
Fernando & Yvonn
Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

2. Aggregate Supply, and Inflation
Aggregate Demand, Aggregate
Supply, and Inflation 26
Chapter Outline
CHAPTER 26: Aggregate Demand,
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
The Equilibrium Price Level
The Long-Run Aggregate Supply Curve
Potential GDP
Aggregate Demand, Aggregate Supply, and
Monetary and Fiscal Policy
Long-Run Aggregate Supply and Policy Effects
Causes of Inflation
Inflation versus Sustained Inflation: A Reminder
Demand-Pull Inflation
Cost-Push, or Supply-Side, Inflation
Expectations and Inflation
Money and Inflation
Sustained Inflation as a Purely Monetary Phenomenon
Looking Ahead
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 23

3. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
aggregate demand The total demand
CHAPTER 26: Aggregate Demand,
for goods and services in the economy.
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.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 23

4. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
DERIVING THE AGGREGATE DEMAND
CURVE
CHAPTER 26: Aggregate Demand,
FIGURE 13.1 The Impact of an Increase in the Price Level on the Economy–
Assuming No Changes in G, T, and M s
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 23

5. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
DERIVING THE AGGREGATE DEMAND
CURVE
aggregate demand curve
(AD) A curve that shows the
CHAPTER 26: Aggregate Demand,
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.
FIGURE 13.2 The Aggregate Demand
(AD) curve
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.
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

6. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
THE AGGREGATE DEMAND CURVE: A
WARNING
CHAPTER 26: Aggregate Demand,
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
a market demand curve.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 23

7. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
OTHER REASONS FOR A DOWNWARD-
SLOPING AGGREGATE DEMAND CURVE
The Consumption Link
CHAPTER 26: Aggregate Demand,
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.
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.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 23

8. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
AGGREGATE EXPENDITURE AND
AGGREGATE DEMAND
CHAPTER 26: 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.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 23

9. Aggregate Supply, and Inflation
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.
CHAPTER 26: Aggregate Demand,
FIGURE 13.3 The Impact of an Increase FIGURE 13.4 The Effect of an Increase
in the Money Supply on the AD Curve in Government Purchases or a Decrease
in Net Taxes on the AD Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 23

10. Aggregate Supply, and Inflation
THE AGGREGATE DEMAND CURVE
SHIFTS OF THE AGGREGATE DEMAND
CHAPTER 26: Aggregate Demand,
FIGURE 13.5 Factors That Shift the Aggregate Demand Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 23

11. Aggregate Supply, and Inflation
THE AGGREGATE SUPPLY CURVE
aggregate supply The total supply of all goods
and services in an economy.
CHAPTER 26: Aggregate Demand,
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” curve—a curve
that traces out the price decisions and output decisions
of all the markets and firms in the economy under a
given set of circumstances.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 23

12. Aggregate Supply, and Inflation
THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
Capacity
Constraints
CHAPTER 26: Aggregate Demand,
Even if firms are not holding excess labor
and capital, the economy may be operating
below its capacity if there is cyclical
unemployment.
Output Levels and
Price/Output Responses
An increase in aggregate demand when the
economy is operating at low levels of output
is likely to result in an increase in output
with little or no increase in the overall price
level. That is, the aggregate supply
(price/output response) curve is likely to be
FIGURE 13.6 The Short-Run Aggregate fairly flat at low levels of aggregate output.
Supply Curve
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

13. Aggregate Supply, and Inflation
THE AGGREGATE SUPPLY CURVE
AGGREGATE SUPPLY IN THE SHORT RUN
The Response of Input Prices to Changes in the
Overall Price Level
CHAPTER 26: Aggregate Demand,
If input prices changed at exactly the same rate as
output prices, the AS curve would be vertical.
Wage rates may increase at exactly the same rate as
the overall price level if the price level increase is fully
anticipated.
Input prices—particularly wage rates—tend to lag
behind increases in output prices for a variety of
reasons.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 23

14. Aggregate Supply, and Inflation
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.
CHAPTER 26: Aggregate Demand,
FIGURE 13.7 Shifts of the Aggregate Supply Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 23

15. Aggregate Supply, and Inflation
THE AGGREGATE SUPPLY CURVE
SHIFTS OF THE AGGREGATE SUPPLY
CURVE
CHAPTER 26: Aggregate Demand,
FIGURE 13.8 Factors That Shift the Aggregate Supply Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 23

16. Aggregate Supply, and Inflation
THE EQUILIBRIUM PRICE LEVEL
equilibrium price level The price level at
which the aggregate demand and aggregate
supply curves intersect.
CHAPTER 26: Aggregate Demand,
FIGURE 13.9 The Equilibrium Price
Level
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 23

17. Aggregate Supply, and Inflation
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
CHAPTER 26: Aggregate Demand,
potential GDP The
level of aggregate
output that can be
sustained in the long
run without inflation.
FIGURE 13.9 The Long-Run Aggregate Supply Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 23

18. AGGREGATE DEMAND, AGGREGATE SUPPLY,
Aggregate Supply, and Inflation
AND MONETARY AND FISCAL POLICY
CHAPTER 26: Aggregate Demand,
FIGURE 13.11 A Shift of the FIGURE 13.12 A Shift of the
Aggregate Demand Curve When the Aggregate Demand Curve When the
Economy Economy
Is on the Nearly Flat Part of the AS Is Operating at or Near Maximum
Curve Capacity
LONG-RUN AGGREGATE SUPPLY AND POLICY
IfEFFECTS vertical in the long run, neither monetary policy nor fiscal policy has
the AS curve is
any effect on aggregate output in the long run.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 23

19. Aggregate Supply, and Inflation
CAUSES OF INFLATION
INFLATION VERSUS SUSTAINED INFLATION: A
REMINDER
inflation An increase in the overall price level.
CHAPTER 26: Aggregate Demand,
sustained inflation Occurs when the overall
price level continues to rise over some fairly long
period of time.
DEMAND PULL INFLATION
demand-pull inflation Inflation that is initiated
by an increase in aggregate demand.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 23

20. Aggregate Supply, and Inflation
CAUSES OF INFLATION
COST-PUSH, OR SUPPLY-SIDE, INFLATION
cost-push, or
CHAPTER 26: Aggregate Demand,
supply-side,
inflation Inflation
caused by an increase
in costs.
FIGURE 13.13 Cost-Push, or Supply-Side, Inflation
stagflation Occurs when output is falling at the
same time that prices are rising.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 23

21. Aggregate Supply, and Inflation
CAUSES OF INFLATION
EXPECTATIONS AND INFLATION
CHAPTER 26: Aggregate Demand,
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

22. Aggregate Supply, and Inflation
CAUSES OF INFLATION
MONEY AND INFLATION
hyperinflation A period
CHAPTER 26: Aggregate Demand,
of very rapid increases in
the price level
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

23. Aggregate Supply, and Inflation
REVIEW TERMS AND CONCEPTS
aggregate demand equilibrium price level
aggregate demand (AD) hyperinflation
CHAPTER 26: Aggregate Demand,
curve inflation
aggregate supply inflationary gap
aggregate supply (AS) potential output, or potential
curve GDP
cost-push, or supply-side, real wealth, or real balance,
inflation effect
cost shock, or supply shock stagflation
demand-pull inflation sustained inflation
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 23