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Chapter 23
Output and
Prices in the Short Run
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In this chapter you will learn
1. why an exogenous change in the price level shifts the AE
curve and changes the equilibrium level of real GDP.
2. how to derive the aggregate demand (AD) curve and what
causes it to shift.
3. the meaning of the aggregate supply (AS) curve and why it
shifts when technology or factor prices change.
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In this chapter you will learn
4. how to define macroeconomic equilibrium.
5. how aggregate demand and aggregate supply shocks affect
real GDP and the price level.
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23.1 THE DEMAND SIDE
OF THE ECONOMY
Exogenous Changes in the Price Level – what are they?
Exogenous means ‘from outside the system’
– something not explained in our model (eg. G, interest rates,
exchange rates, the weather)
Endogenous means ‘from within our system’
– something explained in our model (eg. Y, AE, C, M)
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What do we mean by an exogenous increase or
decrease in prices ?
The Canadian price level (P) increases for some reason not
explained as part of our macroeconomic story.
Example - natural resource prices in world markets increase
causing Canadian natural resources prices to rise and this feeds
through to production costs and ultimately P (the general price
level).
Or - a new Gov’t safety regulation causes all prices to go up.
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Exogenous Changes in the Price Level
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– why do they matter?
An increase in P reduces the real value of money holdings.
A fall in P raises the real value of money holdings.
Changes in P affect the wealth of both private bondholders
and private bond issuers - but there is no change in aggregate
wealth of the private sector.
BUT
What about government debt? - Changes in P make the
Gov’t debt worth less – this does affect the wealth of the
private sector
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An increase in P thus reduces private-sector wealth:
- causing a reduction in desired consumption
- resulting in a downward shift in AE curve
There is also an effect on net exports (recall relative prices in Canada
in in foreign countries):
- the NX function shifts downward and steepens
- resulting in a further downward shift in AE curve
The opposite happens for a fall in P.
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Changes in Equilibrium GDP
AE
AE =Y
E0
•
AE0 (P0)
AE1 (P1)
An increase in P reduces
desired aggregate
expenditure (C and NX
shift downward):
- AE shifts down
- equilibrium Y falls
•E
1
Y1
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Y0
Y
where P1 > P0
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Changes in Equilibrium GDP
AE
AE =Y
E1
•
A decrease in P increases
desired aggregate expenditure
(C and NX shift upwards):
AE1 (P1)
AE0 (P0)
- AE shifts up
- equilibrium Y increase
•E
0
Y0
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Y1
Y
where P1 < P0
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The Aggregate Demand Curve
The aggregate demand (AD) curve relates equilibrium real
GDP (Y) to the price level.
For any given P, the AD curve shows the level of real GDP (Y)
for which desired aggregate expenditure equals actual GDP
(Y).
Changes in the price level cause movements along the AD
curve.
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AE =Y
E0
• AE0 ( at P0)
AE1 (at P1 > P0)
AE
E1
AE2 (at P2 > P1)
•
Consider a rise in the price
level, from P0 to P2:
E2
•
Y2
Y1
Y0
Y
P
P2
•
P1
P0
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The AE curve shifts down
as P rises, but we move
along the AD curve.
•
• AD
Y2
Y1
Y0
Y
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AE
E1
•
•
Y1
Y
P
P0
E0
•
E1
•
AD1
AD0
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Y0
Shifts in the AD Curve*
when P is constant
AE0 (P0) Any shock that increases
equilibrium GDP at a given price
level shifts the AD curve to the
right.
E0
Y0
AE =Y
AE1 (P0)
Y1
Y
Recall - interest rates
- wealth (non P related)
- confidence (expectations)
- foreign incomes
- exchange rates
- change in G
- etc.
The horizontal shift of the AD
curve is the simple multiplier
times the change in
autonomous spending.
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23.2 THE SUPPLY SIDE OF THE ECONOMY
The Aggregate Supply Curve
The AS curve relates the price level to the quantity of output
that firms would like to produce and sell.
The AS curve is drawn for a given
- level of technology
- set of factor prices.
Since unit costs (Marginal Costs) rise with output, firms will
produce more output only if prices increase.
 AS curve is upward sloping
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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
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•
Y0
AS0
Y (GDP)
Why?
Firms had plenty of unused
capacity, unemployed workers
and resources.
Firms could expand
production without incurring
rising marginal costs.
This is a purely Keynesian
type assumption. Is it true
today? Maybe in some
industries.
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What does the Aggregate Supply Curve look like?
Because unit costs rise with output (Marginal Costs generally increases as
output increases) firms will produce more output only if prices increase.
Price Level
The AS curve is therefore upward sloping.
AS1
•
P1
P0
In the short run firms
generally find that MC
increases as output increases
so they will increase
production only if they get
higher prices.
•
Y0
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This is straight out of the
microeconomics of the firm.
Y1
Y (GDP)
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What does the Aggregate Supply Curve look like?
Price Level
The slope of the AS curve is relatively flat when output is low, firms
typically have excess capacity (Keynesian section). This means that
output can be expanded without causing a significant increase in unit
costs.
AS1
•
P1
P0
•
Y0
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Y1
But as more and more
capacity is used the marginal
cost of producing additional
units of output goes up faster
and faster and the AS curve
gets steeper.
Y (GDP)
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Price Level
Shifts in the Aggregate Supply Curve
Anything that increases firms’
costs causes the AS curve to
shift up:
AS1
•
P1
AS0
- increases in factor prices
- reversal in technology
P0
•
•
- increased regulation
- weather, etc.
Y0
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Y1
Y (GDP)
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Price Level
Shifts in the Aggregate Supply Curve
Anything that decreases
firms’ costs causes the AS
curve to shift down:
AS0
•
P0
AS1
- decrease in factor prices
- improved technology
P1
•
•
- less regulation
- weather, etc.
Y1
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Y0
Y (GDP)
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The slope of the AS curve is increasing as output rises:
- when output is low, firms typically have excess
capacity  costs do not rise quickly
- when output is nearer Y*, costs rise as output rises
 firms need higher prices
EXTENSIONS IN THEORY 23-1
The Keynesian AS Curve
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23.3 MACROECONOMIC EQUILIBRIUM
Aggregate Supply (AS) what Canadian firms want to
sell at a given P
AD is equal to AS only at the
intersection of the two
curves.
AD
E0
P0
E0 is the macroeconomic
equilibrium.
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AS
Price Level
Aggregate Demand (AD) what consumers, investors,
governments and foreigners
want to buy from Canadian
firms at a given P
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Y0
Y (GDP)
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Demand behaviour is only
consistent with supply
behaviour at the intersection
of the AS and AD curves.
Therefore prices will rise
and output will increase
until the excess aggregate
demand is eliminated.
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Price Level
At P1 there is more output
demanded (Y2) than what
firms want to produce (Y1).
AD
AS
E0
P0
P1
•
•
Y2
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•
Y0
Y1
Y (GDP)
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At P2 there is less output
demanded (Y1) than what
firms want to produce (Y2).
Price Level
Therefore prices will fall
and output will decrease
until the excess aggregate
supply is eliminated.
AD
P2
AS
•
•
E0
•
P0
Y2
Y0
Y1
Y (GDP)
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Changes in the Macroeconomic Equilibrium
Demand shocks can either be expansionary or contractionary
- direction of AD shift
AD shifts out - expansionary
AD shifts in - contractionary
Supply shocks can either be expansionary or contractionary
- direction of the AS shift
AS shifts out - expansionary
AS shifts in - contractionary
In both cases, “expansionary” or “contractionary” refers to the
effect on equilibrium output.
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Aggregate Demand Shocks – Positive shock
Possible causes:
AD1
Price Level
Demand shocks cause P
and Y to change in the
same direction.
- ΔG > 0
AS
AD0
P1
- ΔI > 0 eg. r
P0
• E1
E0
•
- ΔX > 0 eg. exchange rate
- ΔC > 0 eg. confidence
P increases and Y increases
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Y0
Y1 Y (GDP)
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Aggregate Demand Shocks- Negative shock
Possible causes:
AD0
Price Level
Demand shocks cause P
and Y to change in the
same direction.
- ΔG < 0
AS
AD1
P0
- ΔI < 0 eg. r
P1
• E0
E1
•
- ΔX < 0 eg. exchange rate
- ΔC < 0 eg. confidence
Y1
P decreases and Y decreases
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Y0 Y (GDP)
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If the AS curve is flat, then
firms are willing to
produce more output at
current prices (Chapter 21
and 22). We get the
simple multiplier effect.
But with an upward
sloping AS curve, the
multiplier is smaller than
the simple multiplier.
P
AS2
E2
P2
P0
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AS1
•
E1
•
•
E0
Y0
AD1
AD0
Y2
Y1
Y
WHY? Because firms are
operating in the rising
portion of their Marginal
Cost Curve – costs are
rising with additional
output.
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AD4
The steeper the AS
curve, the greater the
price effect and the
smaller the output effect.
*
AS
AD3
P5
AD2
P4
Price Level
The effect of any given
shift of the AD curve will
depend on the slope of
the AS curve.
AD5
P3
•
AD1
AD0
•
•
P2
P0
•
•
Y0
Y1
Y2 Y3Y4
Y (GDP)
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Aggregate Supply Shocks
- Positive shock
Aggregate supply shocks
cause P and Y to change in
opposite directions.
Possible causes:
- decrease price of nonwage inputs
P
- decrease in wages
- improvement in technology
- decreased regulation
P0
P decreases and Y increases
NICE!
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AS0
AS1
E0
•
P1
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• E1
AD
Y0
Y1
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Aggregate Supply Shocks
- Negative shock
Aggregate supply shocks
cause P and Y to change in
opposite directions.
Possible causes:
- increase price of nonwage inputs
- increase in wages
- reversal in technology
- increased regulation
P increases and Y decreases
OUCH!
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P
AS1
AS0
P1
P0
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E1
•
• E0
AD
Y1
Y0
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Offsetting changes in wages
and productivity
An increase in wages
causes a negative supply
shock
An increase in productivity
causes a positive supply
shock
If wage rise at the same rate as
productivity increases then there
is no net effect
AS’0
P
Negative supply shock if wages
rise faster than productivity
Positive supply shock if wages rise
more slowly than productivity
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AS0
P0
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• E0
AD
Y0
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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.
LESSONS FROM HISTORY 23-1
The Asian Crisis and the Canadian
Economy
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The Canadian Economy is being
‘shocked’ all the time.
Many of these AD and AS shocks
are relatively small and cancel out.
Consider an increase
in energy prices which
Increase costs to firms
and the wealth of
Canadians
To make real world predictions
about the future level of P and Y we
would need to keep track of many
possible changes (G, r, exchange
rates, confidence levels, input
prices, technology, etc., etc.)
Y1
Y0
P
The overall outcome for the
economy depends on the relative
importance of the two separate
effects.
AS1
E1 AS0
P1
•
P0
Y
E0
AD1
•
AD0
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Y0 Y1
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The increase in the world price of oil from 2002 to 2006
was dramatic, but many observers were surprised at its
modest impact on the Canadian economy. For more
information on how changes in oil prices affect Canada,
and for why the negative AS effect is smaller now than
in the 1970s, look for “Oil Prices and the Canadian
Economy” in the Additional Topics section of this book’s
MyEconLab.
www.myeconlab.com
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