GDP and the Price Level in the Short Run Chapter 18

Learning Outcomes

Aggregate demand is the level of desired real domestic spending at each price level. The aggregate demand curve plots the negative relationship between GDP and the price level. An exogenous change in autonomous spending (a demand shock) shifts the aggregate demand curve horizontally by the multiplier times the initial change in spending.

Learning Outcomes
The aggregate supply curve reflects a positive relationship between output and the price level, for given input prices. An exogenous change in input prices or technology (a supply shock) shifts the short-run aggregate supply curve. The equilibrium level of GDP and the price level are determined where aggregate demand and supply are equal.

Aggregate Spending and the Price Level

AE = Y AE0 AE1

Desired Expenditure

E0

E1

45o 0 Y1 Y0 Real National Income [GDP]

Aggregate Spending and the Price Level Changes in the price level cause the AE curve to shift and equilibrium GDP to change. The initial AE curve is AE0 and GDP is at Y0. An increase in the price level reduces desired expenditure and thus causes the AE curve to shift down to AE1. As a result GDP falls to Y1.The reverse happens for a fall in the price level. An increase in the price level leads to a decrease in purchasing power of residents (decreases consumption and also impacts exports (become more expensive relative to foreign goods) which further decreases aggregate spending

The AD Curve and the AE Curve

AE = Y Desired Expenditure E0 E1

AE0 AE1 AE2

E2

45o 0 Y2 Y1 Y0

Real National Income [GDP]

[i]. Aggregate expenditure

The AD Curve and the AE Curve

E2 P2 P1 P0 AD 0 Y2 Y1 Y0 Real National Income (GDP) E1 E0

[ii]. Aggregate Demand

The AD Curve and the AE Curve

E0 Desired Expenditure E1 AE = Y AE0 AE1 AE2 E2

[i]. Aggregate expenditure

45o 0 Y2 Y1 Y0 Real National Income [GDP]

[ii]. Aggregate Demand

E2
P2 P1 P0

E1

E0

AD
Real National Income [GDP]

The AD curve and the AE curve

Equilibrium GDP is determined by the AE curve for each given price level. The level of GDP and its associated price level are then plotted to yield a point on the AD curve. When the price level is P0 the AE curve is AE0 and GDP is Y0. Plotting Y0 against P0 yields the point E0 on the AD curve. An increase in the price level to P1 shifts the AE curve down to AE1, producing GDP of Y1 and this is represented by point E1 on the AD curve. Rise in domestic price level shifts the net export function downward, which shifts the aggregate spending curve downward.

Relationship between AE and AD curves Points to the left

AE=Y

Desired spending

e2 e0

E0

AE AE

e1

45o 0 Y1 Y0 Y2

Real GDP
Desired spending less than output

AD

P0 0 Desired spending exceeds output

E0

Desired spending equal output

Y1

Y0

Y2

Real GDP

of the AD curve show combinations of GDP and the price level for which aggregate desired spending exceeds output and vice versa. There is thus pressure for output to rise as firms could sell more than their current output.

Price level

The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Expenditure Desired Expenditure
AE = Y AE1 AE0 E0 A

E1

45o 0 Y0 Y1

Real GDP

Y1

The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Demand

E0 P0 Y

E1

AD0
0 Y0

AD1

Y1

Real GDP

The simple multiplier and shifts in the AD curve

A change in autonomous expenditure changes equilibrium GDP for any given price level, and the simple multiplier measures the resulting horizontal shift in the aggregate demand curve.

The simple multiplier and shifts in the AD curve

The original AE curve is at AE0 with equilibrium at E0, GDP=Y0 and Price level=P0; the yield point E0 on AD0. AE0 shifts to AE1 because of an autonomous expenditure increase A, and GDP increases to Y1 . With given price level P0, the AD curve shifts rightward to E1.

A Short-run Aggregate Supply Curve

SRAS

Real GDP

A Short-run Aggregate Supply Curve

SRAS

P0

Y0

Real GDP

A Short-run Aggregate Supply Curve

SRAS

P1

P0

Y0

Y1

Real GDP

The short-run aggregate supply curve

The SRAS curve is positively sloped. The positive slope shows that with prices of labour and other inputs given, total desired output and the price level will be positively associated. A rise in the price level from P0 to P1 will be associated with a rise in output supplied from Y0 to Y 1. The slope of the SRAS curve is fairly flat at low levels of output and very steep at higher levels. Shifts in the SRAS curve are due to changes in input prices and productivity levels. Higher input prices and lower productivity shifts the SRAS curve inwards and vice versa.

Macroeconomic Equilibrium
AD SRAS

E0 P0

Y0

Real GDP

Macroeconomic Equilibrium
AD SRAS

E0 P0 P1

Y1

Y0

Y2

Real GDP

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves and determines the equilibrium values for GDP and the price level. Equilibrium occurs at E0 with GDP equal to Y0 and the price level P0.

Macroeconomic Equilibrium

If the price level were P1, below P0, the desired output of firms would be Y1 but desired demand would be Y2, so desired spending would exceed desired production. Only at E0 are desired plans of producers and consumers consistent.

The AE Curve and the Multiplier When the Price Level Varies
AE=Y
Desired Expenditure

E0

AE0

[i]. Aggregate expenditure

45o

Y0

Real GDP SARS [i]. Aggregate demand

P0

AD0
Y0

Real GDP

The AE Curve and the Multiplier When the Price Level Varies
Desired Expenditure E1 A

AE=Y AE1 AE0

[i]. Aggregate expenditure

E0

45o

Y0

Y1

Real GDP SARS [i]. Aggregate demand

E0
P0

E1 AD0

Y0

Y1

Real GDP

The AE Curve and the Multiplier When the Price Level Varies
Desired Expenditure E1 A E1

AE=Y AE1 AE0 AE1

[i]. Aggregate expenditure

E0

Y
45o

Y0

Y1 Y1

Real GDP SARS [i]. Aggregate demand

P1 P0

E0

E1 E1 AD1 AD0

Y0 Y1

Y1

Real GDP

The AE curve and the multiplier when the price level varies

An upward shift in AE is partly offset by the resulting rise in prices, so the multiplier is smaller than when prices are constant. There is an increase in autonomous expenditure A creating the initial shift 1. But prices then rise so the AE curves shifts part of the way back down as shown by 2. The economy moves from point E0 to E1.

The effect of any given change in demand will be divided between real output and price level, depending on conditions of supply curve. The effect of any given shift in aggregate demand is split between a change in real output and a change in the price level, depending on conditions of aggregate supply. The steeper the SRAS curve, the greater is the price effect and the smaller is the output effect.

The effects of increases in AD

The effect of any given change in demand will be divided between real output and price level, depending on conditions of supply curve.

Over the flat range, any change in aggregate demand leads to no change in prices and a response of output equal to that predicted by the simple multiplier. Over the intermediate range along which the SRAS curve is positively sloped, a shift in the AD curve gives rise to appreciable changes in both real GDP and the price level. Over the steep range, the economy is near its capacity constraint which will lead to a sharp rise in price and little change in real GDP. The multiplier in this case is nearly zero.

The effects of increases in AD

Demand shocks when the SRAS curve is vertical

In case of demand shocks, if the SRAS curve is vertical, output remains the same due to demand and supply whilst prices increase.

Aggregate supply shocks

GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Demand

A change in the price level shifts the AE curve upward when the price level falls and downward when the price level rises. A new equilibrium level of GDP that results would be the equilibrium level if it were solely demanddetermined. The AD curve plots the equilibrium level of GDP that corresponds to each possible price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Demand
A change in equilibrium GDP following a change in the price level is shown by a movement along the AD curve. A rise in the price level lowers exports and lowers private consumption spending [because it decreases consumers wealth]. Both of these changes lower equilibrium GDP and cause the aggregate demand curve to have a negative slope.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

The AD curve shifts when any element of autonomous expenditure changes, and the simple multiplier measures the magnitude of the shift. This multiplier also measures the size of the change in equilibrium GDP when the price level remains constant and firms produce everything that is demanded at the price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Supply Equilibrium

and

Macroeconomic

The short-run aggregate supply [SRAS] curve, drawn for given input prices, is positively sloped because unit costs rise with increasing output and because rising product prices make it profitable to increase output. An increase in productivity or a decrease in input prices shifts the curve to the right.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Supply Equilibrium

and

Macroeconomic

A decrease in productivity or an increase in input prices has the opposite effect. Macroeconomic equilibrium refers to equilibrium values of real GDP and the price level, as determined by the intersection of the AD and SRAS curves. Shifts in the AD and SRAS curves, called aggregate demand shocks and aggregate supply shocks, change the equilibrium values of real GDP and the price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

Changes in GDP and the Price Level

When the SRAS curve is positively sloped, an aggregate demand shock causes the price level and real GDP to move in the same direction, the division between these effects depending on the shape of the SRAS curve. The main effect is on real GDP when the SRAS curve is flat and on the price level when it is steep.

GDP AND THE PRICE LEVEL IN THE SHORT RUN

An aggregate supply shock moves equilibrium real GDP along the AD curve, causing the price level and output to move in opposite directions. A leftward shift in the SRAS curve causes a stagflation - rising prices and falling output. A rightward shift causes an increase in real GDP and a fall in the price level. The division of the effects of a shift in SRAS between a change in real GDP and a change in the price level depends on the shape of the AD curve.