Aggregate Supply:

Inflation is a raise in the general overall price level. A raise in the price of any one particular good--even a large raise in the price of any one particular good— isn’t inflation. Inflation subsequently is an increase in the price of just about everything. Together the prices of all or nearly all goods as well as incomes rise by approximately the same proportional amount.

When real GDP is greater than potential output inflation is probable to be higher than people had previously anticipated. Therefore inflation is likely to accelerate. Conversely when the level of real GDP is below potential output then inflation is probable to be lower than people had previously anticipated. The inflation rate is probable to fall toward zero--and perhaps prices will begin to fall in deflation.

Economists call this correlation among real GDP (relative to potential output) and the rate of inflation (relative to its previously-expected value) the short-run aggregate supply curve. One manner to write the short-run aggregate supply curve is as:

i.e., the relative deviation of real GDP Y from potential output Y* is equivalent to the parameter ? (the Greek letter “theta”) which represents the slope of the short-run aggregate supply function times the proportional deviation of the price level P from its anticipated level Pe. However since the inflation rate π is simply the proportional rate of change of the price level we are able to replace the expression ((P-Pe)/Pa) with the actual inflation rate π minus the expected inflation rate π^e:

Output Relative to Potential and the Inflation Rate:

Legend: When production is higher in comparison of potential output, prices will be higher comparison of consumers, businesses and workers had anticipated--and inflation will be higher than expected inflation.

The aggregate supply curve slopes upward for the reason that a higher inflation rate calls forth the more intensive use of resources and thus a higher level of production. A higher inflation rate either decreases the real money stock by raising the price level directly and thus increases the real interest rate or induces the central bank to elevate the real interest rate and thus cuts aggregate demand. Where aggregate supply as well as aggregate demand are equal—where the two curves cross--is the current level of real GDP and the current inflation rate.

Aggregate Supply and Aggregate Demand:

Legend: Where aggregate supply equals collective demand determines not just real GDP but also the price level and the inflation rate.

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