Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
AD & AS in the Short Run 19-Sep-2006 1 of 20 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. AD-AS short run 2 of 20 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. AD-AS short run Macroeconomics 1 AD & AS in the Short Run 19-Sep-2006 3 of 20 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. AD-AS short run 4 of 20 Changes in Equilibrium GDP AE AE =Y E0 • AE0 AE1 •E 1 Y1 Y0 Y An increase in P reduces private-sector wealth and therefore reduces desired aggregate expenditure. This causes the AE curve to shift down, reducing the equilibrium level of real GDP. AD-AS short run Macroeconomics 2 AD & AS in the Short Run 19-Sep-2006 5 of 20 The Aggregate Demand Curve 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. AD-AS short run 6 of 20 AE =Y E0 • AE0 AE1 AE E1 AE2 • E2 • Y2 Y1 Y0 Y Consider a rise in the price level, from P0 to P2: A rise in P causes the AE curve to shift down. This is a movement upward along the AD curve. P P2 • P1 P0 (Conversely, a fall in P causes the AE curve to shift up. This is a movement downward along the AD curve.) • • AD Y2 Y1 Y0 Y AD-AS short run Macroeconomics 3 AD & AS in the Short Run 19-Sep-2006 7 of 20 AE E1 AE =Y AE1 Shifts in the AD Curve • AE0 E0 • Y0 Y1 Y P P0 E0 • E1 • AD1 AD0 Y0 Y1 Any shock that increases equilibrium GDP at a given price level shifts the AD curve to the right. Any shock that reduces equilibrium Y at a given price level shifts the AD curve to the left. The simple multiplier measures the horizontal shift of the AD curve. Y AD-AS short run 8 of 20 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. AD-AS short run Macroeconomics 4 AD & AS in the Short Run 19-Sep-2006 9 of 20 Shifts in the Aggregate Supply Curve Price Level Because unit costs rise with output, both price-taking and price-setting firms will produce more output only if prices increase. The AS curve is therefore upward sloping. A change in either factor prices or productivity will change costs and shift the AS curve. AS1 P1 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. AD-AS short run 10 of 20 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. AD-AS short run Macroeconomics 5 AD & AS in the Short Run 19-Sep-2006 11 of 20 3 Macroeconomic Equilibrium Demand behaviour is only consistent with supply behaviour at the interSec of the AS and AD curves. At P1 there is more output demanded (Y2) than what firms want to produce (Y1). Price Level AD P0 P1 AS E0 • • Y1 • Y0 Y2 Real GDP AD-AS short run 12 of 20 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. AD-AS short run Macroeconomics 6 AD & AS in the Short Run 19-Sep-2006 13 of 20 Aggregate Demand Shocks AD1 Price Level Demand shocks cause P and Y to change in the same direction; both rise with an increase in demand, and both fall with a decrease in demand. AS AD0 P1 P0 • E1 E0 • Y0 Y1 Real GDP AD-AS short run 14 of 20 AE AE =Y E´1 AE´ 1 • AE1 AE0 E1 • ∆A •E0 Y0 Y1 Y´1 Y 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. P AS E1 P1 P0 • E´1 • E0 Y0 AD0 Y1 • AD 1 Y´1 Hence, when the AS curve is upward sloping, the multiplier is smaller than the simple multiplier. Y AD-AS short run Macroeconomics 7 AD & AS in the Short Run 19-Sep-2006 15 of 20 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 AD-AS short run 16 of 20 In the 45 degree model, 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. AD-AS short run Macroeconomics 8 AD & AS in the Short Run 19-Sep-2006 17 of 20 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 Y Y0 AS1 AS0 E1 • • E0 AD Y1 Y0 AD-AS short run 18 of 20 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. AD-AS short run Macroeconomics 9