Question

Use an aggregate supply-and-demand diagram to show that multiplier effects are smaller when the aggregate supply curve is steeper. Which case gives rise to more inflation-the steep aggregate supply curve or the flat one? What happens to the multiplier if the aggregate supply curve is vertical?

Short answer

Answer: The steepness of the aggregate supply curve affects the multiplier effect and inflation in such a way that a steeper aggregate supply curve results in a smaller multiplier effect and more inflation. This is because, with a steeper aggregate supply curve, an increase in spending leads to a smaller increase in output and a larger increase in the price level. If the aggregate supply curve is vertical, the multiplier effect on output is zero, and all changes in spending result in changes to the price level, leading to full inflation.

Step-by-step solution

Understanding Aggregate Supply and Demand Curves

Aggregate Supply (AS) curve shows the relationship between the quantity of output firms are willing to produce and the overall price level. The Aggregate Demand (AD) curve shows the relationship between the real output (Gross Domestic Product) and the price level, reflecting the total quantity of goods and services demanded by the economy. In general, a steeper AS curve suggest that changes in the price level result in relatively smaller changes in output.

Understanding the Multiplier Effect

The multiplier effect refers to the change in real output (Gross Domestic Product) resulting from an initial change in spending (such as government spending or investment) that leads to increased income, consumption, and thus further increases in output. The larger the multiplier, the greater the impact of the initial change in spending on the overall output of the economy.

Draw an Aggregate Supply-and-Demand Diagram

Draw an aggregate supply-and-demand diagram, with the price level on the vertical axis and real GDP (output) on the horizontal axis. Plot a downward sloping Aggregate Demand (AD) curve and an upward sloping Aggregate Supply (AS) curve. Label the intersection of these curves as the equilibrium point.

Illustrating the Multiplier Effects with Different Steepness of AS Curve

Now, consider an increase in government spending or investment, causing the AD curve to shift to the right. Draw two different AS curves: one with a flatter slope (AS1) and another with a steeper slope (AS2). The new equilibrium points for each AS curve (E1 for AS1, and E2 for AS2), represent the resulting change in output and price level due to the increased spending and thus the multiplier effect.

Examine the Changes in Output and Price Level

Observe the differences in the changes of output (ΔY) and price level (ΔP) for each AS curve: - With a flatter AS curve (AS1), the increase in output (ΔY1) is higher, and the increase in the price level (ΔP1) is smaller. - With a steeper AS curve (AS2), the increase in output (ΔY2) is smaller, and the increase in the price level (ΔP2) is higher.

Answering Questions about Inflation and the Multiplier Effect

1. The steep aggregate supply curve (AS2) gives rise to more inflation because the increase in the price level (ΔP2) is higher compared to the case with a flat aggregate supply curve (ΔP1). 2. If the aggregate supply curve is vertical, it indicates that output is fixed and does not change with a change in the price level. In this case, the multiplier effect on output is zero since any change in spending does not result in any change in output. Instead, all the changes will be reflected in the price level, leading to full inflation.

Key concepts

Multiplier Effect

The multiplier effect is an essential economic concept that helps us understand how initial spending in the economy leads to a larger change in overall economic output. Think of it like a ripple; when an initial chunk of spending is thrown into the economy, it starts a cycle of income and consumption that spreads wider across the economy.

The basic idea is that when a government, business, or consumer spends, it doesn't just sit in one spot. This spending creates income for others, who in turn, spend part of that income, creating more income for others. The cycle continues, multiplying the initial spending impact. Here's why it matters:

• An increase in government expenditure, for instance, doesn't just result in an equivalent increase in national income.
• Instead, it leads to a cycle of further spending, as those receiving income from this expenditure spend part of it.
• This process continues, creating a ripple effect that expands throughout the economy, increasing total output more than the initial spending amount.

However, the multiplier's size may change depending on certain conditions. One important determinator is the slope of the aggregate supply curve. A steeper curve typically means smaller multiplier effects, as we'll explore next.

Inflation

Inflation is the general increase in prices over time, and it usually leads to a decrease in the purchasing power of money. In our context of aggregate supply and demand, the slope of the aggregate supply curve has profound implications for inflation.

When the aggregate supply curve (AS) is steep, any shift in the aggregate demand curve (due to increased spending, for example) causes considerable changes in the price level with only a minor change in output. This scenario often leads to more inflation. Let's uncover why:

• A steeper AS curve means that firms have limited capacity to increase output in response to increased demand. So, they raise prices instead.
• This scenario results in more substantial inflationary pressures when aggregate demand increases.
• In contrast, when the AS curve is flatter, businesses respond by increasing output more readily, keeping prices steadier and reducing inflationary pressures.

Thus, a steep AS curve leads to higher inflation due to price level increases, making it important for governments and policymakers to manage demand carefully to prevent excessive inflation.

Aggregate Supply Curve

The aggregate supply curve is a fundamental construct in macroeconomics, depicting the total quantity of goods and services that firms in an economy are willing and able to produce at a given overall price level. Its shape has a significant influence on economic outcomes, like output and inflation.

**Understanding the Aggregate Supply Curve:**

• An upward sloping curve illustrates that as the price level increases, firms are incentivized to produce more because higher prices typically mean higher revenues.
• The curve's steepness indicates how responsive output is to changes in the price level.
• A flat aggregate supply curve suggests a high responsiveness, meaning firms can quickly adjust output with little change in prices.
• Conversely, a steep curve suggests a limited ability for output change, requiring significant price adjustments.

The most extreme case is a vertical aggregate supply curve, seen in the long run, where output is fixed, reflecting factors like full employment. In such cases, the economy's output is not affected by price level changes, and the full effect of any demand changes is reflected in prices, leading to pure inflationary impact. Understanding these dynamics is crucial for economic planning and policy decisions.