Aggregate demand determines
the actual output of goods and services produced. Given a fixed potential
output for any short-term period, aggregate demand will thus determine the
unemployment rate. In the simple model used above, when aggregate demand
exceeds potential output, an inflationary gap exists and the price level rises.
However, in the real world, inflation occurs at or below full employment.
The inflation rate for a
given time period is the per year change in price level: INFT = (PT+1-PT)/PT.
The price level represents the overall price of all goods and services taken
together. The most commonly cited measure of the average price level is the
Consumer Price Index (CPI). This provides an index of typical consumer products
purchased by average households. However, it does not take into account the
roughly one-third of total output represented by investment expenditure. The
price level index which includes all goods and services in the economy is
called the GDP deflator.
Most firms set their prices
based on the anticipated costs of production and the anticipated demand for the
goods and services produced. These expectations are based on past performance,
economic indicators, and the thought processes of managers. The most recent
level of aggregate demand is one of the key factors determining these
expectations. The higher aggregate demand, the higher the firm’s own recent
demand is likely to have been, and the higher its expectations of future
demand. In addition, the higher the aggregate demand, the higher the firm’s
expectations about the cost of labor, materials and other factor inputs. As a
result, the higher recent aggregate demand has been, the higher a firm is
likely to set its prices. If all firms operate in this fashion, then the rate
of increase of the price level will be directly and positively related to the
level of aggregate demand.
In any short run period,
therefore, aggregate demand will influence both the unemployment rate and the
inflation rate. As a result, there will be an implied relationship between
unemployment and inflation. For each possible level of aggregate demand, there
will be corresponding rate of unemployment and of inflation. The graph of
unemployment against inflation for a varying level of aggregate demand in the short run is called a Phillps
Curve:
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In the real world, the
constraint that Y cannot exceed Q is somewhat relaxed, because of the way we
have defined full employment. Facing demand exceeding Q, some fatories and
workers can work overtime and the average frictional and structural rates of
unemployment will fall because there are so many unfilled vacancies. Thus the economy in the short run can
‘squeeze’ some extra production out of its resources. However, the cost of this
economic ‘boom’ is that factor prices will rise and consequently the price
level will rise at a rate higher than normal. This is represented by the
increasing slope of the Phillips Curve as unemployment goes above UF.
One might expect inflation at
full employment to be zero, because at over-full employment, scarcity of
factors of production will lead to rising demand and thus rising prices; at
under-full employment, abundance of factors of production will lead to reduced
demand and thus reduced prices; and at exact full employment, demand and supply
will be in equilibrium, resulting in stable prices. Empirically, however, the
position of the Phillips Curve has been such that some positive rate of
inflation occurs at the full emploment rate of unemployment. This is caled the
inflationary bias.
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