Ch23

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Chapter 23 Output and Prices in the Short Run

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Learning Objectives 1. Explain why an exogenous change in the price level shifts the AE curve and changes the equilibrium level of real GDP. 2. Derive the AD curve and explain why it shifts. 3. Explain the meaning of the AS curve and why it shifts when technology or factor prices change. 4. Define macroeconomic equilibrium. 5. Explain the effects of aggregate demand and aggregate supply shocks on real GDP and the price level.

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23.1 The Demand Side of the Economy Shifts in the AE Curve Consider an exogenous change in the price level, P. What happens to equilibrium GDP? An increase in P reduces the real value of money held by the private sector. A fall in P raises the real value of money holdings. Changes in P also affect the wealth of bondholders and bond issuers, but because the changes offset each other, there is no change in the aggregate wealth.

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In summary, an increase in P reduces private-sector wealth and leads to a fall in desired consumption — this implies a downward shift in the AE curve. Conversely, a fall in P increases private-sector wealth and leads to an increase in desired consumption — this implies an upward shift in the AE curve. There is also an effect on net exports: • A rise in P (with unchanged foreign prices) shifts the NX function downward — this causes a further downward shift in the AE curve. The reverse will occur after a fall in P. Copyright © 2005 Pearson Education Canada Inc.

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Changes in Equilibrium An GDP increase in P reduces AE

AE =Y E0

•

AE0 = C0+ G0 + I0 + NX0 AE1 = C1+ G0 + I0 + NX1

This causes the AE curve to shift down, reducing the equilibrium level of real GDP.

•E

1

Y1

private-sector wealth and therefore reduces desired aggregate expenditure.

Y0

Y

NOTE: for each aggregate price level (P) there is a different level of AE and equilibrium GDP (Y)

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The Aggregate Demand Curve not Aggregate Expenditure (AE) The aggregate demand (AD) curve relates equilibrium real GDP to the price level. For any given price level, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP. Changes in the price level that cause shifts in the AE curve cause movements along the AD curve.

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AE

E0

•

E1

AE =Y AE0 AE1 AE2

•

E2

•

P P2

Y2

Y1

Y0

Y

•

P1 P0

• AD Y1

Y0

A rise in P causes the AE curve to shift down. This is a movement upward along the AD curve. (Conversely, a fall in P causes the AE curve to shift up. This is a movement downward along the AD curve.)

•

Y2

Consider a rise in the price level, from P0 to P1 to P2:

Y

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AE

E0

•

E1

AE =Y AE0 AE1 AE2

•

E2

•

P P2

Y2

Y1

Y0

Y

•

P1 P0

• • AD Y2

Y1

Y0

Y

What is really happening in these diagrams? As the price level increases, Canadians are becoming less wealthy and therefore C falls, also Canadian goods are becoming more expensive on world markets so NX falls, both of which cause the AE curve to shift down.

As the AE curve shifts down firms change production plans and move the economy to new lower levels of output (GDP) (Y). The lower diagram, the AD curve simply traces out the relationship between the price level (P) and equilibrium (Y) depicted in the upper diagram

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AE E1

•

AE =Y AE1 AE0

E0

•

Y0

Y1

Y

P

P0

E0

•

E1

•

AD1 AD0

Y0

Y1

Y

Shifts in the AD Curve Any shock, other than a change in P, that increases equilibrium Y (GDP) at a given price level shifts the AD curve to the right. Any shock, other than a change in P, that reduces equilibrium Y (GDP) at a given price level shifts the AD curve to the left. The simple multiplier measures the horizontal shift of the AD curve.

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AE E1

•

AE =Y AE1 (P0)

Shifts in the AD Curve

AE0 (P0) The shifts depicted in these diagrams might have been caused by any of the following:

E0

•

- decrease in the interest rate Y0

Y1

Y

P

-decrease in the value of the Canadian dollar - an increase in G

P0

E0

•

- increased consumer optimism

E1

•

AD1 AD0

Y0

Y1

Y

Can you explain why the AE curve (and AD curve) shift the way they do in each case? Can you think of other causes for such shifts?

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AE E0

•

AE =Y AE0(P0)

Shifts in the AD Curve

AE1(P0) The shifts depicted in these diagrams might have been caused by any of the following:

E1

•

- increase in the interest rate Y1

Y0

Y

P

P0

-increase in the value of the Canadian dollar - an decrease in G

E1

•

- decreased consumer optimism

E0

•

AD0 AD1

Y1

Y0

Y

Can you explain why the AE curve (and AD curve) shift the way they do in each case? Can you think of other causes for such shifts?

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23.2 The Supply Side of the Economy The Aggregate Supply Curve The aggregate supply (AS) curve relates the price level to the quantity of output that firms would like to produce and sell.

The AS curve is drawn on the assumption that technology and factor prices remain constant.

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What does the Aggregate Supply Curve look like? Until this point we have assumed that the aggregate supply (AS) was perfectly elastic (a horizontal straight line) Price Level

Firms would produce any level of output demanded at the existing price level. P0

•

Y1

•

Y0

AS0

Real GDP

Why? Because we assumed that firms had plenty of unused capacity, unemployed workers and resources. Therefore they could expand production without incurring rising costs. This is a purely Keynesian type assumption. Is it true today? Not always.

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Price Level

What does the Aggregate Supply Curve look like? Because unit costs rise with output (Marginal Costs is increasing at most times) both price-taking and price-setting firms will produce more output only if prices increase. The AS curve is therefore upward sloping. AS1 P1

P0

This is straight out of the micro economics of the firm. In the short run firms find that their MC increases as output increase so they will increase production only if they get higher prices.

• •

Y1

Y0

Real GDP

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Shifts in the Aggregate Supply Curve

Price Level

Just as in the micro economics of the firm, if factor prices or productivity change, then the AS (marginal cost curves) shift. An increase in factor prices or a decrease in productivity causes per unit cost of output to increase.

AS1

P0

•

•

Y1

Y0

AS0

Real GDP

An increase in factor prices or a decrease in productivity shifts the AS curve up and to the left.

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Shifts in the Aggregate Supply Curve

Price Level

Just as in the micro economics of the firm, if factor prices or productivity change, then the AS (marginal cost curves) shift. An decrease in factor prices or a increase in productivity causes per unit cost of output to decrease.

AS0

P0

•

•

Y0

Y1

AS1

Real GDP

An decrease in factor prices or an increase in productivity shifts the AS curve down and to the right.

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What does the Aggregate Supply Curve look like?

Price Level

The slope of the AS curve is increasing because when output is low, firms typically have excess capacity (Keynesian section). This means that output can be expanded without causing an significant increase in unit costs. Therefore, only a small increase in price may be needed to induce them to expand production. AS1 P1

P0

But as more and more capacity is used the marginal cost of producing additional units of output go up faster and faster and the AS curve gets steeper.

• •

Y1

Y0

Real GDP

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The Increasing Slope of the AS Curve The slope of the AS curve is increasing because when output is low, firms typically have excess capacity. This means that output can be expanded without causing a large increase in unit costs. Therefore, only a small increase in price may be needed to induce them to expand production. Once output gets closer to capacity, however, increases in output cause larger increases in unit costs. Therefore, larger price increases are needed to induce firms to expand output.

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23.3 Macroeconomic Equilibrium

At P1 there is more output demanded (Y2) than what firms want to produce (Y1).

AD Price Level

Demand behaviour is only consistent with supply behaviour at the intersection of the AS and AD curves.

P0 P1

Therefore prices will rise and output will increase until the excess aggregate demand is eliminated.

AS

E0

•

• Y1

• Y0

Real GDP

Y2

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At P2 there is less output demanded (Y1) than what firms want to produce (Y2).

AD Price Level

Demand behaviour is only consistent with supply behaviour at the intersection of the AS and AD curves.

Therefore prices will fall and output will decrease until the excess aggregate supply is eliminated.

P2

AS

•

• E0

P0

•

Y1

Y0

Real GDP

Y2

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Changes in the Macroeconomic Equilibrium A demand shock can either be expansionary or contractionary. An expansionary demand shock shifts the AD curve to the right, increasing both P and Y. A supply shock can also be either expansionary or contractionary. An expansionary supply shock shifts the AS curve to the right, increasing Y but decreasing P. Notice that we use the word “expansionary” or “contractionary” to refer to the effect of the shock on the equilibrium level of output.

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Demand shocks cause P and Y to change in the same direction; both rise with an increase in demand.

Price Level

Positive Aggregate Demand Shocks

AD0

AD1

AS

P1 P0

E0

• E1

•

Y0

Y1 Real GDP

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Demand shocks cause P and Y to change in the same direction; both fall with an decrease in demand.

Price Level

Negative Aggregate Demand Shocks

AD1

AD0

AS

P0 P1

E1

• E0

•

Y1

Y0 Real GDP

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Supply shocks cause P and Y to change in opposite directions.

Price Level

Positive Aggregate Supply Shocks

P0

P falls and Y increases with an increase in supply.

AS0

AD0

E0

AS1

•

P1

• E1

Y0

Y1 Real GDP

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Supply shocks cause P and Y to change in opposite directions.

Price Level

Negative Aggregate Supply Shocks

P1

P rises and Y decreases with a decrease in supply.

AS1

AD0

E1

AS0

•

P0

Y1

• E0

Y0

Real GDP

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AE

AE =Y E´1 AE´ 1 • AE1 AE0

E1

•

∆A

•E0 Y0

Y1

Y´1

P

P1 P0

Y

AS E1

•

•

E0

Y0

AD0 Y1

E´1 • AD 1 Y´1

The Mechanics of an AD Shift An increase in autonomous expenditure causes the AE curve to shift upward, but the rise in the price level causes it to shift part of the way down again. Hence, when the AS curve is upward sloping, the multiplier is smaller than the simple multiplier.

Y Copyright © 2005 Pearson Education Canada Inc.

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AD4 AD3

The steeper the AS curve, the greater the price effect and the smaller the output effect.

AS

AD2 P4 Price Level

The effect of any given shift of the AD curve will depend on the slope of the AS curve.

P3

AD1

•

AD0

•

P2 P1 P0

• • Y0

•

Y1

Y2 Y3Y4 Real GDP

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In Chapters 21 and 22, it was shown that shifts in the AE curve always change real GDP. But now we see an extreme case — a vertical AS curve — in which there is no change in real GDP. How can these seemingly contradictory statements be true? The answer is that each AE curve is drawn for a given price level. As the price level changes, the AE curve shifts.

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Aggregate Supply Shocks

E0

AE

Aggregate supply shocks cause P and Y to change in opposite directions.

•

AE =Y AE0 AE1

•E

1

Consider the effects of a negative supply shock. An example of a negative supply shock is an increase in P the price of oil, as happened in the early and late 1970s. P1 P0

Y1

Y0 AS1

Y AS0

E1

•

Y1

• E0

AD

Y0

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Oil Shocks! Price of Oil Sep 1980

120

60 40 20

May 1973 Nov 1974

May 1981

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Oil Shocks! Capacity Utilization file:///C:/Documents and Settings/MFC/Desktop/getSeriesData_pl_files/getSeriesData.png

Q4 1982 Q1 1974

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Oil Shocks! Unemployment Rate file:///C:/Documents and Settings/MFC/Desktop/getSeriesData_png_files/getSeriesData.png

Nov 1982

Aug 1981

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A Word of Warning Many economic events (especially changes in the world prices of raw materials) cause both aggregate demand and aggregate supply shocks. The overall effect on the economy depends on the relative importance of the two separate effects.

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