GDP and price level in short run

What is GDP?
• Gross domestic product is the monetary value of all
final goods and services produced within the
geographical boundaries of a country irrespective
of whoever is producing it, in one year.
• GDP= P1*Q1+P2*Q2+P3*Q3
 AD curve has traditional negative slope.
 AD is the total demand (total spending) for a
country’s goods and services at a given price level
in a given time period.

AD = C + I + G + ( X – M)
 TheAD curveshowstherelationshipbetweenthe averagepriceleveland
realoutput.
Price level

0 Real GDP/National Income/

y
National output/Real output
Components of AD
• Consumption
• Investment
• Government spending
• Net Exports(X-M)
Whenpriceintheeconomyfallsfromptop1, C+I+G+(X-M)
increasesfromYtoY1.
P

P1

AD = C+I+G+(X-M)

Y Y1 Real output
Changes in AD:

 Changes in price causes a movement along the AD

curve, from one level of real output to another

 Changes in the components of AD will cause a shift in

the demandcurve.
◦ An increase in government spending ,which may
occur in a deliberate attempt to increaseAD;

◦ An increase in consumption arising from an increase in

wealth, an increase in the money supply, a cut in taxation,
a rise in population, increased optimism (‘feel- good
factor’) etc.
◦ An increase in investment due to change in
technology, a rise in expectation, a fall in the rate of
interest;

◦ An increase in export because of a rise in quality, a fall

in the country’s exchange rate, a rise in income abroad.
Government policies affecting AD:

 Fiscal policy – taxes

 Expansionary fiscal policy
 Monetary policy – interestrates
 Aggregatesupplyisthetotalquantityofgoods andservicesfirmsarewiling
andabletosellata givenpricelevelinagivenperiodoftime.
The Short Run Aggregate Supply (SRAS) Curve
 The Short Run Aggregate Supply (SRAS) curve is
drawn on the assumption that the prices of all
factors of production are fixed;

 The curve slopes up from left to right, this is

because higher output is likely to raise the cost
per unit produced and therefore to supply more,
firms have to charge a higher price;
 Macroeconomic equilibrium occurs where
AggregateDemandmeetsAggregateSupply.
 Only at the combination of GDP and price level
given by the intersection the AD and AS curves
are spending behavior (demand) and
production (supply) activityconsistent.
 A shift in either the AD or the AS curve leads to
changes in the equilibrium values of the price
level and real GDP.
Pric

AS
e

P0 e

AD
Real output
Y0

If the price level deviates from this equilibrium (P0), pressures on business and
consumerswilmovetheeconomybacktowardpointe.
 Two conditions should be satisfied to attain
macroeconomic equilibrium: (1) at the prevailing price
level, desired expenditure must be equal to national
output. The idea is agents are willing to buy all that is
produced. The AD curve is constructed in such a way
that this condition holds everywhere on it. (2) at the
prevailing price level, firms must wish to produce the
prevailing level of national output, no more and no less.
This is introducedby theconsideration of AS.
 Although the economy is self-correcting in the long-run,
this process can take up to a decade or more.
 Particularly, if outputis belowpotential output, the economy
can suffer an extended period of depressed aggregate
output an high unemployment during this period of self-
correction.
 JohnMaynard Keynes: “In the long run weare all dead.”
He recommended that governments not wait for
the economy to correct itself, but use fiscal policy to
get the economy back to potential output more quickly.
 This is the rationale for active stabilization policy ,
whichis theuse of governmentpolicytoreducethe severity
of recessions and controlexcessively strong expansions.
 However, the ability to improve the economy’s performance
is not always guaranteed; it depends on the kinds of
shocksthe economyfaces.
 This is the rationale for active stabilization policy ,
whichis theuse of governmentpolicytoreducethe severity
of recessions and controlexcessively strong expansions.
 However, the ability to improve the economy’s performance
is not always guaranteed; it depends on the kinds of
shocksthe economyfaces.
Short run equilibrium
• At p2 there is excess supply
• At p1 there is shortage
• At p0 there is equilibrium
THANK YOU..
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