GDP and the Price Level in the Short Run Chapter 18 LIPSEY & CHRYSTAL ECONOMICS 12e

Learning Outcomes Aggregate demand is the level of desired real domestic spending at each price level. The aggregate demand curve plots the negative relationship between GDP and the price level. An exogenous change in autonomous spending (a demand shock) shifts the aggregate demand curve horizontally by the multiplier times the initial change in spending.

Learning Outcomes The aggregate supply curve reflects a positive relationship between output and the price level, for given input prices. An exogenous change in input prices or technology (a supply shock) shifts the short-run aggregate supply curve. The equilibrium level of GDP and the price level are determined where aggregate demand and supply are equal.

Aggregate Spending and the Price Level AE = Y AE0 AE1 E0 Desired Expenditure E1 45o Y1 Y0 Real National Income [GDP]

Aggregate Spending and the Price Level Changes in the price level cause the AE curve to shift and equilibrium GDP to change. The initial AE curve is AE0 and GDP is at Y1. An increase in the price level reduces desired expenditure and thus causes the AE curve to shift down to AE1. As a result GDP falls to Y1.The reverse happens for a fall in the price level.

The AD Curve and the AE Curve AE = Y AE0 E0 AE1 E1 AE2 Desired Expenditure E2 45o Y2 Y1 Y0 Real National Income [GDP] [i]. Aggregate expenditure

The AD Curve and the AE Curve P2 Price Level E1 E0 P1 P0 AD Y2 Y1 Y0 Real National Income (GDP) [ii]. Aggregate Demand

The AD Curve and the AE Curve AE = Y AE0 AE1 E1 Desired Expenditure AE2 E2 [i]. Aggregate expenditure 45o Y2 Y1 Y0 Real National Income [GDP] [ii]. Aggregate Demand E2 Price Level P2 E1 E0 P1 AD P0 Real National Income [GDP]

The AD curve and the AE curve Equilibrium GDP is determined by the AE curve for each given price level. The level of GDP and its associated price level are then plotted to yield a point on the AD curve. When the price level is P0 the AE curve is AE0 and GDP is Y0. Plotting Y0 against P0 yields the point E0 on the AD curve. An increase in the price level to P1 shifts the AE curve down to AE1, producing GDP of Y1 and this is represented by point E1 on the AD curve.

Relationship between AE and AD curves AE=Y e2 AE E0 AE e0 Desired spending e1 45o Y1 Y0 Y2 Real GDP Desired spending less than output AD Price level Desired spending equal output E0 X Z P0 Y1 Y0 Y2 Real GDP Desired spending exceeds output

The Simple Multiplier and Shifts in the AD Curve [i]. Aggregate Expenditure AE = Y E1 AE1 AE0 Desired Expenditure E0 A 45o Y0 Y1 Real GDP Y1

The Simple Multiplier and Shifts in the AD Curve [i]. Aggregate Demand Price Level E0 E1 P0 Y AD1 AD0 Y0 Y1 Real GDP

The simple multiplier and shifts in the AD curve A change in autonomous expenditure changes equilibrium GDP for any given price level, and the simple multiplier measures the resulting horizontal shift in the aggregate demand curve.

The simple multiplier and shifts in the AD curve The original AE curve is at AE0 with equilibrium at E0, GDP=Y0 and Price level=P0; the yield point E0 on AD0. AE0 shifts to AE1 because of an autonomous expenditure increase A, and GDP increases to Y1. With given price level P0, the AD curve shifts rightward to E1.

A Short-run Aggregate Supply Curve SRAS Y Real GDP

A Short-run Aggregate Supply Curve SRAS P0 Y0 Real GDP

A Short-run Aggregate Supply Curve SRAS P1 P0 Y0 Y1 Real GDP

The short-run aggregate supply curve The SRAS curve is positively sloped. The positive slope shows that with prices of labour and other inputs given, total desired output and the price level will be positively associated. A rise in the price level from P0 to P1 will be associated with a rise in output supplied from Y0 to Y1. The slope of the SRAS curve is fairly flat at low levels of output and very steep at higher levels.

Macroeconomic Equilibrium AD SRAS Price Level E0 P0 Y0 Real GDP

Macroeconomic Equilibrium AD SRAS Price Level E0 P0 P1 Y1 Y0 Y2 Real GDP

Macroeconomic Equilibrium Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves and determines the equilibrium values for GDP and the price level. Equilibrium occurs at E0 with GDP equal to Y0 and the price level P0.

Macroeconomic Equilibrium If the price level were P1, below P0, the desired output of firms would be Y1 but desired demand would be Y2, so desired spending would exceed desired production. Only at E0 are desired plans of producers and consumers consistent.

The AE Curve and the Multiplier When the Price Level Varies AE=Y E0 AE0 [i]. Aggregate expenditure Desired Expenditure 45o Y0 Real GDP SARS [i]. Aggregate demand Price Level P0 AD0 Y0 Real GDP

The AE Curve and the Multiplier When the Price Level Varies AE=Y E’1 AE’1 E0 AE0 [i]. Aggregate expenditure A Desired Expenditure 45o Y0 Y’1 Real GDP SARS [i]. Aggregate demand Price Level E0 E’1 P0 AD0 Y0 Y’1 Real GDP

The AE Curve and the Multiplier When the Price Level Varies AE=Y E1 E’1 AE’1 AE1 E0 AE0 [i]. Aggregate expenditure A Desired Expenditure Y 45o Y0 Y1 Y’1 Real GDP SARS [i]. Aggregate demand Price Level E1 P1 E0 E’1 P0 AD1 AD0 Y0 Y1 Y’1 Real GDP

The AE curve and the multiplier when the price level varies An upward shift in AE is partly offset by the resulting rise in prices, so the multiplier is smaller than when prices are constant. There is an increase in autonomous expenditure A creating the initial shift 1. But prices then rise so the AE curves shifts part of the way back down as shown by 2. The economy moves from point E0 to E1.

The effects of increases in AD

Demand shocks when the SRAS curve is vertical

Aggregate supply shocks

Annual % change in input and output prices for UK manufacturing

Producer prices and unit wages – annual % change for UK manufacturing

GDP AND THE PRICE LEVEL IN THE SHORT RUN Aggregate Demand A change in the price level shifts the AE curve upward when the price level falls and downward when the price level rises. A new equilibrium level of GDP that results would be the equilibrium level if it were solely demand-determined. The AD curve plots the equilibrium level of GDP that corresponds to each possible price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN Aggregate Demand A change in equilibrium GDP following a change in the price level is shown by a movement along the AD curve. A rise in the price level lowers exports and lowers private consumption spending [because it decreases consumer’s wealth]. Both of these changes lower equilibrium GDP and cause the aggregate demand curve to have a negative slope.

GDP AND THE PRICE LEVEL IN THE SHORT RUN The AD curve shifts when any element of autonomous expenditure changes, and the simple multiplier measures the magnitude of the shift. This multiplier also measures the size of the change in equilibrium GDP when the price level remains constant and firms produce everything that is demanded at the price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN Aggregate Supply and Macroeconomic Equilibrium The short-run aggregate supply [SRAS] curve, drawn for given input prices, is positively sloped because unit costs rise with increasing output and because rising product prices make it profitable to increase output. An increase in productivity or a decrease in input prices shifts the curve to the right.

GDP AND THE PRICE LEVEL IN THE SHORT RUN Aggregate Supply and Macroeconomic Equilibrium A decrease in productivity or an increase in input prices has the opposite effect. Macroeconomic equilibrium refers to equilibrium values of real GDP and the price level, as determined by the intersection of the AD and SRAS curves. Shifts in the AD and SRAS curves, called aggregate demand shocks and aggregate supply shocks, change the equilibrium values of real GDP and the price level.

GDP AND THE PRICE LEVEL IN THE SHORT RUN Changes in GDP and the Price Level When the SRAS curve is positively sloped, an aggregate demand shock causes the price level and real GDP to move in the same direction, the division between these effects depending on the shape of the SRAS curve. The main effect is on real GDP when the SRAS curve is flat and on the price level when it is steep.

GDP AND THE PRICE LEVEL IN THE SHORT RUN An aggregate supply shock moves equilibrium real GDP along the AD curve, causing the price level and output to move in opposite directions. A leftward shift in the SRAS curve causes a stagflation - rising prices and falling output. A rightward shift causes an increase in real GDP and a fall in the price level. The division of the effects of a shift in SRAS between a change in real GDP and a change in the price level depends on the shape of the AD curve.