This is a serious gap. Based on the theory we've done up until now, you would tend to raise demand, with the expectation that supply would follow: whether it's by fiscal policy (raise G or lower T to raise C) or monetary policy (raise Ms to lower r and raise Ip). Sometimes that will work, but sometimes it won't.
We are now going to develop a simple theory of the price level, or what causes inflation.
MAJOR CAUTION: We are going to develop a graph in which changes in aggregate demand and supply lead to changes in the price level. At first glance, this will remind you of a simple micro supply and demand model. It is completely different. In the micro model, the "P" referred to the price of that one good, changing while all other prices remained the same. When the price of coffee went up, you substituted toward tea. Here we are talking about all prices rising or falling. In the micro model income also stayed the same. Here income will change as aggregate demand changes -- your expenditures are someone else's income. So the micro reasoning does not work at all.
The aggregate demand curve (AD) describes the total volume of aggregate expenditures in the economy at different price levels. (Given equilibrium in the underlying goods and money markets from which equilibrium levels of expenditure are derived.)
Thus, the AD describes the aggregate expenditure-price outcomes in the economy. At each point on the AD curve, the underlying goods and money markets are in equilibrium for that price level.
That's a lot of abstract words. Let's try a more specific question:
As the price level changes, how does equilibrium aggregate expenditure as determined in goods and money markets change as prices change? We're going to assume that Ms, G, and T are fixed. What we want to know is, with these things fixed, how will AD change as P changes?
What does P (the price level) affect? First, remember that your transactions demand for money depends on Y, r and P. When prices decrease, the demand for money balances decreases, and when prices increase, the demand for money balances increases. (Go back to section 3.2 if you've forgotten this.)
So if P rises Md rises, if P falls Md falls. If Md rises, r rises and Ip falls. If Md falls, r falls and Ip rises.
So we've found a connection through the demand for money balances:
If P increases, Md increases, r rises, Ip falls and hence AD falls.There are two additional reasons that we expect aggregate expenditures in the goods market to increase as the price level drops. Both involve slightly fancier theory than we've been using so far.
If P falls, Md falls, r falls, Ip rises and hence AD rises.
The first additional reason is that as P falls, causing Md to decrease and r to decrease, the impact of a fall in r might be felt not only in planned investment (Ip) but also in consumption (C).
As the interest rate falls, consumers may decide that it is not worth it to save as much at the going income level (since they do not receive as much return when they take these savings to bond markets), or decide that since it is now cheaper to borrow, they will consume more and borrow from credit card companies to finance this consumption. Thus, as r decreases, we might expect to see C rise as well, adding to the increase in expenditures generated by P decreasing. (Obviously now C is not just a function of Y, but is affected by r too, making our model more complicated.)
The second additional reason has to do with "wealth effects." If goods prices fall but the value of your assets don't, you feel wealthier and may start consuming more. Additionally if r falls, the value of any bonds you hold rises, and that will make you feel wealthier, and you'll consume more.
So we've provided three reasons why a fall in the price level might induce a larger amount of aggregate expenditures.
Graphically, this is a way of saying that the AD curve slopes down as a function of the price level.
Having shown that AD slopes down as a function of P, we need to see how it will shift as one of the factors we have held constant (G, T, or Ms) changes.
We already know from our previous analysis that:
a) an increase in G
b) a decrease in T
c) an increase in Ms
Will cause Y to increase at the going price level.
Thus, if G increases, T decreases, or Ms increases, Y increases at the current price level -- graphically, the AD curve shifts out.
Similarly, a decrease in G, an increase in T, or a decrease in Ms will cause AD to shift in.
The aggregate supply curve defines the price-output response of firms. It describes how firms will wish to change total volume of output as prices change.
Caution Again: The Aggregate Demand Curve is not like a market demand curve (or even a whole lot of market demand curves added together). Similarly the Aggregate Supply curve is a macro concept, using totally different reasoning from the micro model.
So why should aggregate supply (the total volume of aggregate output that all firms in the economy together wish to sell) change as prices change?
This turns out to be a really contentious question, and to proceed we need to separate out short-term and long-term responses.
To start with, we will examine short-run price and output responses.
The short-run in economics is a situation in which the input markets have not yet had a chance to fully adjust their prices to the changed price level. In particular, we will argue that the short run is a period in which the labor market has not yet managed to fully adjust wages to match the changes in prices.
In the short run, we argue that as P increases, AS increases.
Why may firms wish to increase the total volume of output they supply if prices increase? Again, we have to give a macroeconomic explanation.
The explanation hinges on two ideas:
a) At low levels of output and prices, the economy has a lot of underutilized or unutilized resources. Here, any outward shift of AD (an increase in aggregate demand) can call forth an increased supply of output without requiring much of an increase in prices, since firms do not have to incur too much additional costs to increase supply.
However, as the economy nears full resource utilization at high levels of output, firms do not have the ability to increase output as much as aggregate demand increases. If the economy has drawn all unused resources into production, it has reached full employment level of output or maximum potential GDP.
b) If wages lag behind prices, then as prices rise, firm profits increase. As general profitability increases, firms will want to sell more if they can manage to draw resources into production. Note that as P increases, if wage increases match P, there is no change in profitability, and hence desire to expand output. Thus, the desire to expand output as prices rise can only work if wages lag prices. If input costs (specifically labor costs) do not lag behind price increases, then the AS curve is vertical, since price increases do not change profitability and hence do not generate any desire to expand production on the part of firms.
At low levels of Y, the economy has a lot of unused capacity that it can draw on to increase output. It does not require any big changes in prices to increase output, and if demand were to increase, output would increase easily in such a situation.
As the economy nears full capacity, and it is no longer easy to increase output, only higher prices will induce firms to make more goods (remember that we are assuming that increases in their input costs lag increases in the prices they can charge for goods).
Once the economy physically cannot produce more, price increases may increase firms profitability if wages still lag, but they cannot bring forth any output responses since output is already at the maximum we can produce at full employment.
Note that we have already taken most general macroeconomic conditions into consideration (such as, "does the economy have a lot of unutilized resources") in deriving our as curve.
The only thing we held constant in the short run, was input costs and total level of resources. Thus, these will form our ceteris paribus conditions. Let us take each one in turn:
a) If costs increase suddenly, and prices cannot adapt at once, then profitability decreases, and AS shifts in. Since most "costs" except wages are included in our general price level, the input costs that can create this type of change are usually the costs of inputs that are not produced within the economy: the main costs that we usually see causing sudden shifts in supply are the costs of imported inputs like petroleum.
b) If there is a natural disaster like a flood or an earthquake which eliminates part of our resources, then supply shifts in.
c) If we have an increase in investment or improvement in technology in the longer run, this growth shows up as in increase in our ability to supply output, and the supply curve shifts out.
Now that we have examined what the responses to prices are on the side of expenditures, and on the side of output, we can put this together to find macro equilibrium.
The equilibrium level of P and Y in the macroeconomy will be where the desired total level of expenditures in the goods markets exactly matches the desired total level of output that firms in the economy wish to sell.
Thus, we will get the equilibrium price level and equilibrium y in the economy where AS = AD.
Here, we will not go through usual equilibration process story, since the mechanics of the movement to equilibrium involve too many interacting markets -- the goods market and the money market on the demand side, and questions where the economy is, lags in input costs and profitability on the supply side. We are operating at a very high level of generality. Assessing whether the economy actually reaches equilibrium is difficult, and many economists disagree about the use of this graph since it is not really clear whether and how all these different markets will actually respond and interact in ways that take you to equilibrium.
Run Aggregate Supply
In the long run, wages have enough time to fully catch up with prices, and there are no profit incentives for the firm to expand output. Thus, since there is no lag in wages in the long run, and no increase in profitability, there is no supply response to price increases in the long run. Thus, the long-run AS curve is vertical.
of Fiscal and Monetary Policy
Finally, we can discuss policy in a way that takes into account inflation.
We already know that an effort to increase output can take place through fiscal and monetary policy.
If the government increases G, decreases T, or increases Ms, this should cause aggregate expenditures to increase and hence aggregate demand to shift out. If the economy is slack, this is very effective in increasing Y and hence employment. If the economy is already operating near or at full capacity, however, then the policy will not be very effective in increasing Y.
In the long run, when as is vertical, fiscal and monetary policy efforts to increase output will be ineffective.
Inflation is a general rise in the price level. That is, inflation occurs when P increases.
Thus, in your AS-AD graph, when the equilibrium changes and P increases from the old to the new equilibrium, you have inflation.
Note that the AS-AD graph gives you the overall price level. It is the equivalent of your implicit gdp deflator. The inflation rate needs to be found by finding out the percentage change in prices. We'll simply focus on why P may increase here, and not discuss the inflation rate for now.
Causes of inflation:
A. Demand pull inflation
Demand pull inflation occurs when prices rise because something (either an increase in G, a decrease in T, or an increase in Ms) causes AD to increase. The increase in AD causes prices to rise.
The extent of demand pull inflation will depend on where the economy is operating: at low levels of Y, increases in AD do not generate much inflation, but when the economy is booming and near full capacity, increases in AD will generate lots of inflation.
B. Cost push inflation
Cost push inflation occurs when something--like a sudden increase in the price of oil- causes the supply curve to shift inwards. Cost push inflation usually signals stagflation (stagnation of output plus inflation): prices rise even as income falls.
Stagflation is very troublesome for policy makers. Here, they simultaneously face inflation and recession. If they choose to tackle the recession and try to increase output, they have to increase AD. But this will cause P to increase further, and worsen inflation. If instead they want to bring the prices down and curb inflation, they can only do this by cutting demand and reducing AD. This will only cause the recession to worsen and cause Y to shrink even further.
In extreme cases, policy makers may resort to direct cost and price control, since these can help reduce inflation without reducing Y. But these measures are politically unpopular, plus if the measures are used for too long they can generate inefficiency in production.
C. Expectations-driven inflation
Once inflation starts, and continues for a while (such as may happen with a cost shock), it is very hard to control. This is because when firms expect prices to continue to rise, they will raise their prices in line with these expectations, which will then create price increases as everyone does this. The inflationary-expectations then get built into the pricing decisions and will generate increased prices in itself. thus, inflationary expectations become a self-fulfilling prophesy.
D. Long run sustained inflation:
In the long run, if inflation persists so that prices keep rising, then this must be because something keeps increasing AD and causing prices to rise. We will be working with our long-run AS curve here.
There are two reasons this can happen:
i) wage-price spirals.
In effect, if for some reason the agreed upon social distribution of output breaks down, or the social compact of how output will be shared between wages and profits breaks down, this can show up as an unstable macroeconomic inflationary spiral.
If workers find that even at full employment, they are not getting high wages, they will start to push for higher wages and a better share of the output in the economy. Since the labor market is tight and the economy is operating near full employment, workers can push for better wages.
As they succeed in getting a better distribution of income by raising wages, prices have not yet had a chance to increase. Since workers spend more of their income than profit-makers do (since those earning profits tend to be richer and hence do not spend as great a proportion of their extra income), consumption increases and so ad increases.
As AD increases, Y increases and P increases.
But, in the longer run, since wages have increased, firms face a "profit squeeze," their profits decrease. So the sort-run AS shifts inwards, causing Y to fall and P to rise yet further.
Then workers find that as prices have risen, the gains they made in increasing their wages were wiped out. So again, they push for higher wages, which causes consumption to increase and ad to increase. Then, as firms adjust to higher wages, the short-run AS shifts in.
Thus, when the social agreement on how to divide up total output between wage earners and profits breaks down, one can have inflationary wage-price spirals.
ii) sustained monetary or fiscal expansion
If for some reason the government tries to increase Y beyond full potential output, and if the federal reserve tries to accommodate this increase by maintaining the interest rate at a low level, then you can have sustained inflation.
Say the economy is at full capacity.
The government tries to increase employment beyond this level by increasing G, and hence increasing AD.
This causes P to increase.
As P increases, Md increases. Now, if Md increases, r will increase.
If the Fed wishes to maintain interest rates at the old level, it will increase Ms to try and hold r down. But the increase in Ms causes AD to increase further and hence causes P to increase. This in turn increases Md and causes r to increase. To hold down r, the Fed will increase Ms, which will in turn increase AD and P, and so on. The result of trying to maintain the interest rate at an unsustainably low level by increasing Ms can cause a persistent inflation in the economy in the long run.