Aggregate Supply

and Inflation
By Vishwa Ballabh

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 The Aggregate Supply Curve

• Aggregate supply is the total supply of all

goods and services in the economy.

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 The Aggregate Supply Curve

• 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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 The Aggregate Supply Curve:
A Warning
• The aggregate supply curve is not a market
supply curve or the sum of all the individual
supply curves in the economy.

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 The Aggregate Supply Curve:
A Warning
• Firms do not simply respond to market-
determined prices, but they actually set prices.
Price-setting firms do not have individual supply
curves because these firms are choosing both
output and price at the same time.

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 The Aggregate Supply Curve:
A Warning
• When we draw a firm’s supply curve, we
assume that input prices are constant. In
macroeconomics, an increase in the overall
price level means that at least some input
prices will be rising as well.

• The outputs of some firms are the inputs of

other firms.

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 The Aggregate Supply Curve:
A Warning
• Rather than an aggregate supply curve, what
does exist is a “price/output response” curve
— a curve that traces out the price and output
decisions of all the markets and firms in the
economy under a given set of circumstances.

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Aggregate Supply in the Short Run

• In the short run, the

aggregate supply
curve (the price/output
response curve) has a
positive slope.

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Aggregate Supply in the Short Run

• 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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 Aggregate Supply in the Short Run

• 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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 Output Levels and
Price/Output Responses
• When the economy is operating at low levels of
output, an increase in aggregate demand is
likely to result in an increase in output with little
or no increase in the overall price level.

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 The Response of Input Prices to
Changes in the Overall Price Level

• There must be a lag between changes in

input prices and changes in output prices,
otherwise the aggregate supply (price/output
response) curve would be vertical.

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 The Response of Input Prices to
Changes in the Overall Price Level

• Wage rates may increase at exactly the same

rate as the overall price level if the price-level
increase is fully anticipated. Most input
prices, however, tend to lag increases in
output prices.

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 Shifts of the Short-Run
Aggregate Supply Curve

• A cost shock, or supply shock, is a

change in costs that shifts the aggregate
supply (AS) curve.

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 Shifts of the Short-Run
Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right Shifts to the Left
Increases in Aggregate Supply Decreases in Aggregate Supply
Lower costs Higher costs
lower input prices higher input prices
lower wage rates higher wage rates
Economic growth Stagnation
more capital capital deterioration
more labor
technological change
Public policy Public policy
supply-side policies waste and inefficiency
tax cuts over-regulation
deregulation
Good weather Bad weather, natural
disasters, destruction
from wars
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The Equilibrium Price Level

• The equilibrium price

level is the point at
which the aggregate
demand and aggregate
supply curves intersect.

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The Equilibrium Price Level

• 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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 The Long-Run
Aggregate Supply Curve

• Costs lag behind price-

level changes in the
short run, resulting in
an upward-sloping AS
curve.
• Costs and the price
level move in tandem in
the long run, and the
AS curve is vertical.

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 The Long-Run
Aggregate Supply Curve

• Output can be pushed

above potential GDP by
higher aggregate
demand. The
aggregate price level
also rises.

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 The Long-Run
Aggregate Supply Curve

• When output is pushed

above potential, there is
upward pressure on costs,
and this causes the short-
run AS curve to the left.
• Costs ultimately increase
by the same percentage as
the price level, and the
quantity supplied ends up
back at Y0.

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 The Long-Run
Aggregate Supply Curve

• Y0 represents the level

of output that can be
sustained in the long
run without inflation. It
is also called potential
output or potential
GDP.

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 Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy

• AD 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.
• Expansionary policy works
well when the economy is on
the flat portion of the AS
curve, causing little change
in P relative to the output
increase.
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 Aggregate Demand, Aggregate
Supply, and Monetary and Fiscal Policy

• On the steep portion of the

AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
• When the economy is
operating near full capacity,
an increase in AD will result
in an increase in the price
level with little increase in
output.

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 Long-Run Aggregate
Supply and Policy Effects

• 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
multiplier effect of a change
in government spending or
taxes on aggregate output
is zero.

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The Simple “Keynesian”
Aggregate Supply Curve

• The output of the economy

cannot exceed the maximum
output of YF.

• The difference between

planned aggregate
expenditure and aggregate
output at full capacity is
sometimes referred to as an
inflationary gap.

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 Causes of Inflation

• Inflation is an increase in the overall price

level.

• Sustained inflation occurs when the overall

price level continues to rise over some fairly
long period of time.

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 Causes of Inflation

• Demand-pull inflation is • Cost-push, or supply-

inflation initiated by an side, inflation is inflation
increase in aggregate caused by an increase in
demand. costs.

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Cost-Push, or Supply-Side Inflation

• 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-Push, or Supply-Side Inflation

• 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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 Expectations and Inflation

• 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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Money and Inflation

• Hyperinflation is a
period of very rapid
increases in the price
level.

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Money and Inflation

• 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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Money and Inflation

• If the RBI 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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 Cost of Inflation

• Fall in Purchasing power

• Shoeleather costs

• Menu cost

• Relative Price variability-

misallocation of resources

• Inflation induced tax distortion

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In the presence of zero inflation, a 25 percent tax on interest income
reduces the real interest rate from 4 percent to 3 percent. In the
presence of 8 percent inflation, the same tax reduces the real interest
rate from 4 percent to 1 percent.
Thank You.

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