[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Demand
Figure 29.6
Output
Inflation
Cyclical
unemployment
AGGREGATE DEMAND AND INFLATION
The four fundamental keys to understanding short-run
fluctuations serve to link together demand, output,
cyclical unemployment, and inflation. The next three
chapters examine these links.
2. Sticky prices: When the labor market does not clear, shifts in the
demand for goods and services in the product market lead firms
to adjust production rather than simply change prices (see
Chapter 30).
3. Short-run inflation–unemployment trade-off: A fall in cyclical unemployment
leads to an increase in inflation—increases in cyclical
unemployment reduce inflation. This relationship implies that
policymakers face a trade-off in the short run between lower
unemployment and higher inflation (see Chapters 31 and 33).
4. Inflation, monetary policy, and spending: As inflation rises, monetary
policy works to reduce aggregate spending. When inflation
falls, monetary policy acts to boost aggregate spending. This relationship
between monetary policy, inflation, and aggregate spending
can vary over time as the central bank’s policy goals change
(see Chapters 31 and 32).
LINKING THE FOUR KEY CONCEPTS
The four key concepts work together to explain how output and inflation are determined
when the economy is not at full employment. Figure 29.6 shows how. We can
start at any one of the boxes and use the key concepts to travel around the circle. For
example, let’s suppose something causes demand to drop. It might be a financial
crisis in Asia or Latin America that reduces sales of U.S. goods in those countries.
The drop in demand causes U.S. firms to scale back production—output falls. With
production now at lower levels, firms do not need as many workers, so layoffs occur
and cyclical unemployment rises. Wages fail to adjust quickly enough to keep the economy
at full employment. High cyclical unemployment leads to slower wage growth,
and inflation declines. In the face of a decline in inflation, the Fed acts to boost some
types of spending, helping to offset some of the initial drop in demand that started
the process.
Over the next few chapters, we will examine each of these links in detail, learning
about how they operate and how they help us understand the causes of economic
fluctuations.
656 ∂ CHAPTER 29 INTRODUCTION TO MACROECONOMIC FLUCTUATIONS