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Chapter 23: Output and Prices in the Short Run Copyright © 2014 Pearson Canada Inc. Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 23.1 The Demand Side of the Economy 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 aggregate demand (AD) curve and understand what causes it to shift. 23.2 The Supply Side of the Economy 3. describe the meaning of the aggregate supply (AS) curve and understand why it shifts when technology or factor prices change. 23.3 Macroeconomic Equilibrium 4. explain how AD and AS shocks affect equilibrium real GDP and the price level. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 2 23.1 The Demand Side of the Economy Exogenous Changes in the Price Level 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 also affect the wealth of bondholders and bond issuers • but there is no change in aggregate wealth* *Only if bonds are not held by foreigners. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 3 Exogenous Changes in the Price Level An increase in P thus reduces private-sector wealth: • reduction in desired consumption • downward shift in AE curve There is also an effect on net exports: • the NX function shifts downward • further downward shift in AE curve Conversely for a fall in P. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 4 Fig. 23-1 Desired Aggregate Expenditure and the Price Level An increase in P reduces desired aggregate expenditure: AE shifts down, equilibrium Y falls. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 5 The Aggregate Demand Curve The aggregate demand (AD) curve relates equilibrium real GDP to the price level. For any given P, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP. Changes in the price level cause movements along the AD curve. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 6 Fig. 23-2 Derivation of the AD Curve Consider a rise in the price level, from P0 to P2: The AE curve shifts down, but we move along the AD curve. (i) Aggregate expenditure (ii) Aggregate demand Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 7 Fig. 23-3 The Simple Multiplier and Shifts in the AD Curve Shifts in the AD Curve (aggregate demand shocks) Any shock that increases equilibrium GDP at a given price level shifts the AD curve to the right. (i) Aggregate expenditure The horizontal shift of the AD curve is the simple multiplier times the change in autonomous spending. (ii) Aggregate demand Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 8 Determinants of Aggregate Demand (I) 1. 2. 3. Consumption – Changes in wealth, age of consumer durables and consumer expectations will change aggregate demand Investment – Changes in interest rates, age of capital goods, business expectations and government policies will change aggregate demand Net exports – Change in the value of exchange rate, income levels abroad and price of competitive foreign goods 9 Determinants of AD (II) 3. 4. 5. Government spending – Amount of spending on goods, services, or transfer payments to households or firms Tax rates Money supply 10 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 As unit costs rise with output, firms will produce more output only if prices increase: AS curve is upward sloping Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide11 The Aggregate Supply Curve 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 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 12 Shifts in Aggregate Supply Curve Aggregate Supply Shocks Fig. 23-5 Shifts in the AS Curve Anything that increases firms' costs causes the AS curve to shift up: • factor prices • technology Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 13 23.3 Macroeconomic Equilibrium Demand behaviour is consistent with supply behaviour only at the intersection of the two curves. Fig. 23-6 Macroeconomic Equilibrium E0 is the macroeconomic equilibrium. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 14 Determinants of Aggregate Supply An increase in AS will result from: 1. A decrease in factor prices 2. Technological improvement 3. An improvement in human capital 4. An increase in the amount of capital 5. An increase in natural resources 15 Changes in Macroeconomic Equilibrium Demand shocks can either be expansionary or contractionary. • direction of AD shift Supply shocks can either be expansionary or contractionary. • direction of the AS shift In both cases, "expansionary" or "contractionary" refers to the effect on equilibrium output. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 16 Aggregate Demand Shocks Demand shocks cause P and Y to change in the same direction. Fig. 23-7 Aggregate Demand Shocks Possible causes: • ΔG > 0 • ΔI > 0 • ΔX > 0 • ΔC > 0 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 17 Fig. 23-8 The Multiplier When the Price Level Varies The Mechanics of an AD Shift The shock causes the AE curve to shift upward, but the rise in the price level causes it to shift down. With an upward sloping AS curve, the multiplier is smaller than the simple multiplier. (i) Aggregate expenditure (ii) Aggregate demand Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 18 Fig. 23-9 The Effects of Increases in Aggregate Demand The effect of any given shift of the AD curve will depend on the slope of the AS curve. The steeper the AS curve, the greater the price effect and the smaller the output effect. Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 19 Aggregate Supply Shocks Fig. 23-10 A Negative Aggregate Supply Shock Aggregate supply shocks cause P and Y to change in opposite directions. (i) Aggregate expenditure Possible causes: • Δ price of inputs • Δ wages • Δ technology Copyright © 2014 Pearson Canada Inc. (ii) Aggregate demand and supply Chapter 23, Slide 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. LESSONS FROM HISTORY 23-1 The Asian Crisis and the Canadian Economy Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide 21 Review 1. Which of the following will cause a positive aggregate supply shock? A) an increase in the price of raw materials B) a decrease in productivity C) a decrease in the price of oil D) a decrease in the price of foreign output E) an increase in the price of foreign output © 2014 Pearson Education Canada Inc. 22 Review Refer to Figure on the left. Suppose that an increase in government purchases by 50 causes the AD curve to shift to the right, as shown. The simple multiplier is ________ and the multiplier is ________. A) 4; 3.2 B) 4; 1.2 C) 2.8; 1.2 D) 4; 2.8 E) 6; 1.2 © 2014 Pearson Education Canada Inc. 23 Review Suppose firms are currently producing beyond their normal capacity. A change in AD leads to a relatively A) small change in price level and a small change in real GDP. B) no change in both price and output. C) large change in price level and a large change in real GDP. D) large change in price level and a small change in real GDP. E) small change in price level and a large change in real GDP. © 2014 Pearson Education Canada Inc. 24