1Inflation and Aggregate SupplyInflation and Aggregate SupplyPrinciples of Macroeconomics Dr. Gabriel X. MartinezAve Maria UniversityChapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Inflation and Aggregate SupplyInflation and Aggregate SupplyWhere does inflation come from?Where does inflation come from?––If people, businesses and government demand If people, businesses and government demand more goods, their prices will rise.more goods, their prices will rise.––But if firms produce more goods, their prices will But if firms produce more goods, their prices will fall.fall.Inflation is determined by the interaction of Inflation is determined by the interaction of Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply for goods and services.for goods and services.The Aggregate Demand The Aggregate Demand CurveCurveChapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply44Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Aggregate Demand (Aggregate Demand (ADAD) Curve) Curve––Shows theShows therelation betweenrelation betweenshortshort--run equilibrium output run equilibrium output Y Y and the rate of inflation, and the rate of inflation, ππ..––For AD, changes in For AD, changes in ππcause changes in cause changes in YY..Inflation, Spending, and Output: The Inflation, Spending, and Output: The Aggregate Demand CurveAggregate Demand CurveChapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply55Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Aggregate Demand (Aggregate Demand (ADAD) Curve) Curve––The name of the curve reflects the fact that The name of the curve reflects the fact that shortshort--run equilibrium run equilibrium outputoutputis determined by, is determined by, and and equalsequals, total planned , total planned spendingspendingin the in the economy.economy.––Increases in inflation reduce planned spendingIncreases in inflation reduce planned spendingand shortand short--run equilibrium output, so the run equilibrium output, so the aggregate demand curve is downwardaggregate demand curve is downward--sloping.sloping.Inflation, Spending, and Output: The Inflation, Spending, and Output: The Aggregate Demand CurveAggregate Demand CurveChapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply66Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Inflation and the Inflation and the ADADCurveCurve––The Keynesian model assumes output adjusts The Keynesian model assumes output adjusts to demand at preset prices in the short run.to demand at preset prices in the short run.––Prices do not remain fixed indefinitely: this Prices do not remain fixed indefinitely: this means there can be inflation.means there can be inflation.Inflation, Spending, and Output: The Inflation, Spending, and Output: The Aggregate Demand CurveAggregate Demand Curve2The Aggregate Demand CurveThe Aggregate Demand CurveThe IncomeThe Income--Expenditures Model (chapter 26) Expenditures Model (chapter 26) told us that equilibrium output is given bytold us that equilibrium output is given byand that, including the effect of interest rates on and that, including the effect of interest rates on C and I (chapter 27)C and I (chapter 27)This means real interest rates and equilibrium This means real interest rates and equilibrium output are inversely related.output are inversely related.[]XNGITcCcY +++−⎟⎠⎞⎜⎝⎛−=11[]rbaXNGITcCcY )(11+−+++−⎟⎠⎞⎜⎝⎛−=Eq 1Chapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply88Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Aggregate Demand CurveThe Aggregate Demand CurveWhere does Where does rrcome from?come from?It is the It is the realrealopportunity cost of holding aopportunity cost of holding arealrealstock of moneystock of money––That is, holding an X amount of purchasing That is, holding an X amount of purchasing power in the form of money.power in the form of money.Chapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply99Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Aggregate Demand CurveThe Aggregate Demand Curverraffects I and Caffects I and Crrtypically moves very closely with typically moves very closely with ii, the , the nominal interest rate.nominal interest rate.The nominal interest rate, The nominal interest rate, ii, is determined by , is determined by the equality of real money supply (M/P) and the equality of real money supply (M/P) and real money demand (Mreal money demand (MDD).).Chapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply1010Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Aggregate Demand CurveThe Aggregate Demand CurvePeoplePeople’’s Real Money Holdings are.s Real Money Holdings are.LetLet’’s think in terms of growth rates.s think in terms of growth rates.––M rises at M rises at ““the rate of money growth,the rate of money growth,””..––P rises at P rises at ““the rate of inflationthe rate of inflation””, , ππ..MM∆PMChapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply1111Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. Inflation and Inflation and Real BalancesReal BalancesIf If > > ππ, , Real Money HoldingsReal Money Holdingsrise.rise.––PeoplePeople’’s money has more value, so spending s money has more value, so spending rises.rises.If If π π > > , , Real Money HoldingsReal Money Holdingsfall.fall.––PeoplePeople’’s money has less value, so spending s money has less value, so spending falls.falls.Inflation, Spending, and Output: The Inflation, Spending, and Output: The Aggregate Demand CurveAggregate Demand CurvePMMM∆MM∆Chapter 28: Inflation and Chapter 28: Inflation and Aggregate SupplyAggregate Supply1212Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved. The Aggregate Demand CurveThe Aggregate Demand CurveHigher inflation reduces the real money Higher inflation reduces the real money supply,