The Impact of Aggregate Demand on Prices.

This article examines the impact of aggregate demand on prices in the U.S. Differing implicit assumptions regarding the response of the aggregate price level to changes in aggregate demand underlie many of the most important disputes in the field of macroeconomics, both at the abstract level of theoretical discussion and at the practical level of policy recommendation. When aggregate demand shifts in either direction, so does the market-clearing aggregate price level at which output remains fixed. A perfectly flexible actual price level shifts instantaneously to the market-clearing level in response to a shift in demand, but an imperfectly flexible price level changes only gradually toward the market-clearing level, thus allowing real output to vary in the same direction as the demand shift during the transition to complete price adjustment. The resolution of several important issues depends on the speed of price adjustment. Some have applied the theory of rational expectations to stabilization policy to conclude that the monetary authority cannot affect real output by systematic policy reactions if these depend in a regular way on past events and thus can be anticipated by economic agents. When policymakers inherit an inflation rate well above the optimum as in 1969-1970, they must compare the long-term benefits of lower inflation with the short-run costs of the recession required to bring it about. Inflation can be culminated instantaneously without recession when the aggregate price level is perfectly flexible, but the recession that occurs with imperfect flexibility may impose short-run costs sufficient to restrain policy-makers from attempting to reduce inflation all the way to its optimum rate.