CHAPTER 23 OUTPUT AND PRICES IN THE SHORT RUN

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1 CHAPTER 23 OUTPUT AND PRICES IN THE SHORT RUN Expand model to make price level endogenous variable. LEARNING OBJECTIVES - Why exogenous change in price level shifts AE curve and changes equilibrium level of real GDP - How to derive AD curve and what causes it to shift - AS and why it shifts - How to define macroeconomic equilibrium - How aggregate demand and aggregate supply shocks affect equilibrium real GDP and the price level 23.1 THE DEMAND SIDE OF THE ECONOMY AE curve shows desired AE for each level of GDP at particular price level. Equilibrium GDP occurs where desired aggregate expenditure equals actual GDP where it intersects with the 45 degree line. Exogenous changes in the Price Level AE curve shifts in response to a change in the price level. This occurs because a change in the price level affects desired consumption expenditures and desired net exports. Upward when price level falls, downward when price level rises. Changes in Consumption Relationship between the price level and desired consumption has to do with how change in the price level lead to changes in household wealth and thus to changes in desired spending. Much of private sector s total wealth is held in form of assets with fixed nominal value. (ex: money, government and corporate bonds). The real value of this money depends on the price level. A rise in the price level lowers the real value of money held by the private sector. A fall in the price level raises the real value of money held by the private sector. Bonds if there is a rise in the price level, the repayment to the bondholder is lower in real value than it otherwise would be; decline in wealth for bondholder. Issuer of bond makes repayment of lower real value; experienced experience in wealth. Changes in the price level change the wealth of bondholders and bond issuers, but because the changes offset each other, there is no change in aggregate wealth. Summary: - Rise in price level leads to reduction in real value of private sector s wealth. Reduction in wealth leads to a decrease in autonomous desired consumption and thus a downward shift in the AE function. - Fall in price level leads to rise in wealth and desired consumption and thus upward shift in the AE curve. Changes in Net Exports When domestic price level rises, Canadian goods become more expensive relative to foreign gods. Causes Canadian consumers to reduce their purchases of Canadian-made goods and increase purchases of foreign goods. At same time, consumers in other countries reduce purchases of now relatively more expensive Canadian-made goods.

2 A rise in the domestic price level (with a constant exchange rate) shifts the net export function downward, which causes a downward shift in the AE curve. A fall in the domestic price level shifts the net export function upward and hence the AE curve upward. Changes in Equilibrium GDP Exogenous rise in price level causes downward shift in AE curve. Equilibrium level of real GDP falls. Fall in price level, upward shift in AE and rise in equilibrium level of real GDP. The aggregate demand curve Negative relationship price level and real equilibrium GDP aggregate demand curve Aggregate demand (AD) curve: a curve showing combinations of real GDP and the price level that make desired aggregate expenditure equal to actual national income For any given price level, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP. Shifts in AE are just movements along the AD curve The AD curve is not a micro demand curve 1. A rise in the price level causes AE curve to shift downward and leads to movement upward and to the left along AD, reflecting fall in equilibrium level of GDP 2. Fall in the price level causes the AE curve to shift upward and hence leads to a movement downward and to the right along the AD curve, reflecting a rise in the equilibrium level of GDP. Micro demand curve describes a situation in which the price of one commodity changes while the prices of all other goods and incomes are constant. Negatively sloped because: 1. As price falls, purchasing power of consumer s income increases and more will be purchased 2. As price of commodity falls, consumers buy more of that and less of more expensive substitutes First does not apply to AD because dollar value of national income is not being held constant. Also: change in price level does not change the relative prices of domestic goods and thus does not cause substitution effect. Does lead to international substitution effect. AD curve is negatively sloped for two reasons: 1. Fall in the price level leads to a rise in private-sector wealth, which increases desired consumption and leads to increase in equilibrium GDP 2. Fall in the price level (for given exchange rate) leads to a rise in net exports and thus leads to an increase in equilibrium GDP Shifts in the AD curve Any event that leads to change in equilibrium GDP will cause the AD curve to shift - Change in government policy (purchases or taxation) - Change in household s expenditure - Firms investment behaviour - Foreigners demand for Canadian exports Rise in price level lowers exports and lowers autonomous consumption expenditure. Both changes reduce equilibrium GDP and cause AD curve to have negative slope.

3 Any change other than a change in the price level that cause the AE curve to shift will also cause the AD curve to shift. Aggregate demand shock: any shift in the aggregate demand curve. For a given price level, an increase in autonomous aggregate expenditure shifts the AE curve upward and the AD curve to the right. A fall in autonomous aggregate expenditure shifts the AE curve downward and the AD curve to the left. Important: in order to shift AD, change in autonomous expenditure must be caused by something other than a change in the domestic price level. Change in AE dues to change in domestic price level leads to movement along AD (not shift). Simple Multiplier and the AD Curve The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure. AD shifts horizontally when any element of autonomous expenditure changes, and the simple multiplier measures the size of the shift THE SUPPLY SIDE OF THE ECONOMY The Aggregate Supply Curve Aggregate supply curve (AS): a curve showing the relation between the price level and the quantity of aggregate output supplied, for given technology and factor prices. Positive Slope of the AS curve Costs and output Unit cost: cost per unit of output, equal to total cost divided by total output What will increasing output do to unit costs? AS curve drawn on assumption that technology and prices of all factors of production remain constant. Does not mean unit costs will be constant. As output increases, less efficient standby plants may have to be used, less efficient workers may have to be hired, while existing workers may have to be paid overtime rates for additional work. Unit costs tend to rise as output rises. (law of diminishing returns also) Prices and output Price takers vs price setters Price takers many individual firms, each too small to influence market price. If their unit costs rise with output, price-taking firms will produce more only if price increases. They will produce less if the price falls. Price setters few enough firms that each can influence the market price of its product. Differentiated products. Price-setting firms will increase their prices when they expand their output into the range where unit costs are rising. They will eventually decrease their prices if a reduction in their output leads to a reduction in unit costs. The actions of both price-taking and price-setting firms cause the price level and the supply of output to be positively related the aggregate supply (AS) curve is positively sloped. Firms unit costs rise when output rises, and thus they are willing to supply more output only at higher prices.

4 The Increasing Slope of the AS Curve At low levels of GDP the AS curve is relatively flat, but as GDP rises the AS curve gets progressively steeper. When output is low firms typically have excess capacity. Only a small increase in price of output may be needed to induce them to expand production. May even have enough excess capacity that they may be willing to sell more at existing prices when demand for product increases output truly demand determined in that situation. Once output is above normal capacity, unit costs tend to rise rapidly. Higher-cost production methods may have to be adopted. The more output is expanded beyond normal capacity, the more that unit costs rise and hence the larger is the rise in price that is necessary to induce firms to increase output. First asymmetry AS curve positively sloped indicates firms will provide more aggregate output only at a higher price level. Shifts in the Aggregate Supply Curve Anything that changes firms production costs will cause the AS curve to shift. Two particularly important sources: 1. Changes in the prices of inputs 2. Changes in productivity Two reasons for change in input: - Endogenous input prices change because of things internal to model. Ex: rise in production increases demand for inputs and bids up their prices. - Exogenous forces unconnected to model. Ex: rise in world oil price. Aggregate supply shock: any shift in the aggregate supply (AS) curve cause by an exogenous force Changes in Input Prices When factor prices change, the AS curve shifts. If they rise, firms will find the profitability of their current production reduced. For any given level of output to be produced, an increase in the price level will be required. If prices do not rise, firms will react by decreasing production. For economy as a whole, there will be less output supplied at each price level than before the increase in factor prices. If factor prices rise, AS curve shifts upward and to the left. Changes in productivity If labour productivity rises, the unit costs of production will fall. Lead to lower prices. Same output can now be sold at lower price. Causes shift in AS down and to the right. A change in either factor prices or productivity will shift the AS curve because any given output will be supplied at a different price level than previously. An increase in factor prices or a decrease in productivity shifts the AS curve to the left; an increase in productivity or a decrease in factor prices shifts the AS curve to the right MACROECONOMIC EQUILIBRIUM

5 Equilibrium values of real GDP and price level occur at intersection of AD and AS curves. Macroeconomic equilibrium. Lower price level than equilibrium the desired output of firms is less than desired aggregate expenditure. Only at the combination of real GDP and price level given by the intersection of the AS and AD curves are demand behaviour and supply behaviour consistent. Two conditions for equilibrium: 1. At price level, AE must be equal to actual GDP (always true along AD) 2. At price level, firms must want to produce the prevailing level of GDP, no more and no less. (always true along AS) Only where they intersect are both conditions fulfilled. Changes in the Macroeconomic Equilibrium Shift AD curve aggregate demand shock - Positive to the right/increase - Negative to the left/decrease Shit AS curve caused by exogenous force aggregate supply shock - Positive to the right/increase - Negative to the left/decrease Aggregate demand and supply shocks are labelled according to their effect on real GDP. Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP. Aggregate Demand Shocks Increase in AD increased I, G, X, C, or transfer payments Increase in AD means that more domestic output is demanded at any given price level. Increase in AD causes both price level and real GDP t rise. Aggregate demand shocks cause the price level and real GDP to change in the same direction; both rise with an increase in AD, and both fall with a decrease in AD. The Multiplier when the Price Level Varies the simple multiplier gives the size of the horizontal shift in the AD curve in response to a change in autonomous expenditure. If price level remains constant, the simple multiplier gives the increase in equilibrium national income. But the AS curve slopes upward. When the AS curve is positively sloped, the change in real GDP caused by a change in autonomous expenditure is no longer equal to the size of the horizontal shift. Part of expansionary impact of increase in demand is dissipated by rise in price level. When the AS curve is upward sloping, an aggregate demand shock leads to a change in the price level. As a result, the multiplier is smaller than the simple multiplier. The Importance of the shape of the AS Curve Over flat range any change in AD leads to no change in prices and a response of output equal to that predicted by simple multiplier. Intermediate range shifts in AD gives rise to appreciable changes in both real GDP and price level. Multiplier is positive, but smaller than simple multiplier.

6 Steep range very little more can be produced, no matter how large the demand increase. Change in AD leads to sharp change in price level and little to no change in real GDP. Multiplier in this case is nearly zero. The effect of any given shift in aggregate demand will be divided between a change in real output and a change in price level, depending on the conditions of aggregate supply. The steeper the AS curve, the greater the price effect and the smaller the output effect. Steeper AS greater price effect, smaller output effect. Reconciliation with previous analysis AD shocks typically lead to changes in both PL and rgdp. Vertical AS curve AD shocks will result in no change in rgdp, only in PL. But before shifts in AE always change rgdp. Answer: each AE curve is drawn on assumption of constant price level. Upward shift in AE curve shifts AD to the right. Positively sloped AS curve means that the price level rises, and this rise shifts the AE curve back down. Example: vertical AS curve. AE shift upward raises amount demanded. Vertical AS curve means output cannot be expanded. Extra demand merely forces prices up, and as prices rise, the AE curve shifts down again. Thus, rise in prices offsets expansionary effect of original shift and eventually leaves both AE and equilibrium real GDP unchanged. The Keynesian AS Curve Not Keynes s actual views but version his early followers used in attempt to express his work in a formal model. When real GDP < potential GDP, individual firms are operating with excess capacity. Respond to changes in demand by altering output while keeping prices constant. Will supply whatever they can sell at their existing prices as long as they are producing below their normal capacity. Economy has horizontal AS curve any output up to potential output will be supplied at the going price level. Real GDP is demand determined. Only applies to levels of GDP below potential GDP. Also applies to macro model assuming constant price level that we used before. Aggregate Supply Shocks Negative shift left; less real output at given PL Positive shift right; more real output at given PL Changes can be due to, for example, world price of important inputs. Aggregate supply shocks cause the price level and real GDP to change in opposite directions. With an increase in supply, the price level falls and GDP rises; with a decrease in supply, the price level rises and GDP falls. Economy especially sensitive to changes in price for oil. 70s created cartel and restricted output f oil. Increase in price caused leftward shifts in AS curve. Real GDP fell while price level rose.

7 90s Southeast Asian countries plunged into major recession and world demand for raw materials fell, and thus price of goods fell. Was a positive aggregate supply shock for countries that used raw materials as inputs for production. The Asian crisis and the Canadian economy Asian demand for raw materials fell. Leftward shift in Canadian AD curve; demand for Canadian raw materials had fallen. Rightward shift of Canadian AS curve as dramatic reduction in prices of raw materials implies reduction in costs for manufacturing firms. Both cause lower price level. Real GDP AD reduces it, AS increases it. Since Canada is a net exporter, it must experience a decrease. Net effect of negative demand shock and positive supply shock is to reduce Canadian GDP. A word of warning World price of oil prices negative supply shock and positive demand shock. For countries producing positive AD shock Many economic-events especially changes in the world prices of raw materials cause both aggregate demand and aggregate supply shocks in the same economy. The overall effect on real GDP in that economy depends on the relative importance of the two effects. KEY CONCEPTS EFFECTS OF AN EXOGENOUS CHANGE IN THE PRICE LEVEL RELATIONSHIP BETWEEN THE AE AND AD CURVES NEGATIVE SLOPE OF THE AD CURVE POSTIIVE SLOPE OF THE AS CURVE MACROECONOMIC EQUILIBRIUM AGGREGATE DEMAND SHOCKS THE MULTIPLIER WHEN THE PRICE LEVEL VARIES AGGREGATE SUPPLY SHOCKS

Chapter 23. Aggregate Supply and Aggregate Demand in the Short Run. In this chapter you will learn to. The Demand Side of the Economy

Chapter 23. Aggregate Supply and Aggregate Demand in the Short Run. In this chapter you will learn to. The Demand Side of the Economy Chapter 23 Aggregate Supply and Aggregate Demand in the Short Run In this chapter you will learn to 1. Explain why an exogenous change in the price level shifts the AE curve and changes the equilibrium