-John Maynard Keynes
Aggregate Demand, Aggregate Supply, and Inflation
(Part A)
by
Charles Lamson
One of the most important issues in macroeconomics is the determination of the overall price level. Recall that inflation---an increase in the overall price level---is one of the key concerns of macroeconomists and government policymakers. Understanding the factors that affect the price level is essential to understanding macroeconomics.
In earlier posts, we discussed how inflation is measured and the costs of inflation, but made no mention of the causes of inflation. For simplicity, our analysis in earlier posts took the price level as fixed. This allowed us to discuss the links between the goods market and the money market without the complication of a changing price level. Having considered how the two markets work, we are now ready to take up flexible prices. We begin by discussing the aggregate demand curve and the aggregate supply curve. We then put the two curves together and discuss how the equilibrium price level is determined in the economy. This analysis allows us to see how the price level affects the economy and how the economy affects the price level. Finally, we consider monetary and fiscal policy effects and the causes of inflation. The Aggregate Demand Curve The place to begin our exploration of the price level is the money market. People's demand for money depends on income (Y), the interest rate (r), and the price level (P).  It is not hard to understand why the price level affects the demand for money. Suppose you plan to purchase a one pound bag of chocolate, one bag of potato chips, and a Hostess Twinkie. If these items cost $2.00, $1.00, and $0.50, respectively, you would need $3.50 in cash or in your checking account to make your purchases. Suppose that the price of these goods doubles. To make the same purchases you will need $7.00. In general, the amount of money required to make a given number of transactions depends directly and proportionately on the average price of those transactions. As prices and wages rise, households will want to keep more money in their wallets and in their checking accounts, firms will need more in their cash drawers, and so forth. If prices and wages are rising at 6 percent per year, we can expect the demand for money to increase at about 6 percent per year, ceteris paribus. 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. Deriving the Aggregate Demand Curve Recall that aggregate demand is 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. Does it increase, decrease, or remain constant when the price level increases? Our discussions of the goods market and the money market provide the tools to answer this.   An increase in the price level increases the demand for money and shifts the money demand curve to the right, as illustrated in Figure 1(a). At the initial interest rate of 6 percent, an increase in the price level leads to an excess demand for money. Because of the higher price level, households and firms need to hold larger money balances than before. However, the quantity of money supplied remains the same. [Remember, we are assuming that the Federal Reserve (Fed) takes no action to change the money supply.] The money market is now out of equilibrium. Equilibrium is reestablished at a higher interest rate, 9 percent.
 An increase in the price level causes the level of aggregate output (income) to fall. The situation is reversed when the price level declines. A lower price level causes money demand to fall, which leads to a lower interest rate. A lower interest rate stimulates planned investment spending, increasing planned aggregate expenditure, which leads to an increase in Y.  A decrease in the price level causes the level of aggregate output (income) to rise. This negative relationship between aggregate output (income) and the price level is called the aggregate demand (AD) curve, shown in Figure 2   Each point on the aggregate demand curve represents equilibrium in both the goods market and the money market. 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. The Aggregate Demand Curve: A Warning It is very important that you realize what the aggregate demand curve represents. The aggregate demand curve is much more complex than a simple individual or market demand curve. The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. To understand why, recall the logic behind a simple downward-sloping household demand curve. A demand curve shows the quantity of output demanded (by an individual household or in a single market) at every possible price, ceteris paribus. In drawing a simple demand curve, we are assuming that other prices and income are fixed. From these assumptions, it follows that one reason the quantity demanded of a particular good falls when its price rises is that other prices do not rise. The good in question therefore becomes more expensive relative to other goods, which leads households to substitute other goods for the good whose price increased. In addition, if income does not rise when the price of a good does, real income falls. This may also lead to a lower quantity demanded of the good whose price has risen.  Things are different when the overall price level rises. When the overall price level rises many prices including many wage rates (many people's income) rise together. For this reason, we cannot use the ceteris paribus assumption to draw the AD curve. The logic that explains why a simple demand curve slopes downward fails to explain why the AD curve also has a negative slope.  You do not need to understand anything about the money market to understand a simple individual or market demand curve. However, to understand what the aggregate demand curve represents, you must understand the interaction between the goods market and the money market. The AD curve in Figure 2 embodies everything we have learned about the goods market and the money market up to now. The AD curve is not the sum of all the market demand curves in the economy. It is not a market demand curve.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 533-536* end |
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