Modelling Real GDP and the Price Level in the Short Run Chapter 8 Modelling Real GDP and the Price Level in the Short Run

Copyright © 2005 Pearson Education Canada Inc. Learning Objectives 8.1 Explain the concept of the short-run aggregate supply curve. 8.2 Understand what factors cause shifts in the short-run and long-run aggregate supply curves. 8.3 Evaluate the effects of aggregate demand and supply shocks on the equilibrium real output in the short run. Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Learning Objectives 8.4 Explain the long-run adjustment process. 8.5 Explain how an open economy affects aggregate demand and aggregate supply. 8.6 Explain short-run inflation and economic growth in the economy. Copyright © 2005 Pearson Education Canada Inc.

The Short-Run Aggregate Supply Curve The relationship between aggregate supply and the price level in the short run. Normally positively sloped. Copyright © 2005 Pearson Education Canada Inc.

The Short-Run Aggregate Supply Curve At a higher price level firms make more profits and desire more output. 120 SRAS Price Level 100 100 200 300 400 500 600 700 800 900 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Shifts in the Aggregate Supply Curves LRAS1 LRAS2 SRAS1 SRAS2 Any change that shifts LRAS will also shift SRAS Price Level 1000 1200 1400 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Shifts in the Aggregate Supply Curves LRAS1 SRAS2 A temporary increase in an input price will shift only the SRAS curve. SRAS1 Price Level 1000 1200 1400 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Shifts in the Aggregate Supply Curves Changes That Cause an Increase in Aggregate Supply Discoveries of new raw materials Increased competition A reduction in international trade barriers Fewer regulatory impediments to business An increase in labour supplied Increased training and education A decrease in marginal tax rates A reduction in input prices (SRAS only) Copyright © 2005 Pearson Education Canada Inc.

Shifts in the Aggregate Supply Curves Changes That Cause a Decrease in Aggregate Supply Depletion of raw materials Decreased competition An increase in international trade barriers More regulatory impediments to business A decrease in labour supplied Decreased training and education An increase in marginal tax rates An increase in input prices (SRAS only) Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Equilibrium LRAS 120 SRAS AD At price level 100 AD > AS and the price level increases. Price Level 100 1000 1200 1400 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Equilibrium LRAS SRAS AD 140 At price level 140 AS > AD and the price level falls. Price Level 120 1000 1200 1400 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Equilibrium LRAS SRAS AD At price level 120 AD = AS. Price Level 120 1000 1200 1400 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Equilibrium Aggregate Demand Shock Any shock that causes the aggregate demand curve to shift inward or outward. Aggregate Supply Shock Any shock that causes the aggregate supply curve to shift inward or outward. Copyright © 2005 Pearson Education Canada Inc.

Copyright © 2005 Pearson Education Canada Inc. Equilibrium 1200 LRAS 120 E1 SRAS AD1 AD2 Price Level Recessionary Gap 1180 115 E2 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Equilibrium LRAS SRAS Inflationary AD2 AD1 Inflationary Gap created by an increase in Aggregate Demand 1220 125 E2 Price Level 120 E1 1200 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

The Long-Run Adjustment Process Inflationary and Recessionary gaps will not persist over time. With an inflationary gap, excess demand for resources causes the prices of those resources to increase. This causes the SRAS curve to shift to the left. Copyright © 2005 Pearson Education Canada Inc.

The Long-Run Adjustment Process 125 E3 Excess demand for inputs shifts SRAS left E2 LRAS SRAS Price Level 120 E1 AD1 1200 1220 Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Aggregate Demand and Supply in an Open Economy A stronger dollar increases Aggregate Supply because it reduces the cost of imported inputs. A stronger dollar reduces Aggregate Demand because it makes exports more expensive, and imports less expensive. Copyright © 2005 Pearson Education Canada Inc.

Aggregate Demand and Supply in an Open Economy GDP1 Increase in the value of the dollar reduces the cost of imported inputs SRAS1 AD SRAS2 SRAS increases Price Level E2 P2 GDP2 With AD constant, price level falls, GDP and employment increase Real GDP per Year Copyright © 2005 Pearson Education Canada Inc.

Aggregate Demand and Supply in an Open Economy GDP1 Increase in the value of the dollar makes net exports fall SRAS1 AD1 AD2 AD decreases Price Level E2 P2 GDP2 With SRAS constant, prices, GDP, and employment decrease Real GDP per Year Copyright © 2005 Pearson Education Canada Inc.

Inflation and Growth in the Economy Explaining Inflation: Demand-Pull or Cost- Push? Demand-pull inflation Inflation caused by increases in aggregate demand not matched by increases in aggregate supply. Copyright © 2005 Pearson Education Canada Inc.

Inflation and Growth in the Economy Cost-push inflation Inflation caused by a continually decreasing short-run aggregate supply curve. Copyright © 2005 Pearson Education Canada Inc.

Inflation and Growth in the Economy 1.8 LRAS 133 E1 SRAS ADWorld War I ADprewar 176 E2 2.3 Price Level Real GDP per Year ($ billions) Copyright © 2005 Pearson Education Canada Inc.

Inflation and Growth in the Economy LRAS1 LRAS2 200 SRAS1 SRAS2 AD1 AD2 150 Price Level E1 E2 With economic growth, LRAS1 and SRAS1 shift outward with no inflation 100 50 700 800 Real GDP per Year ( $billions) Copyright © 2005 Pearson Education Canada Inc.