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 23.1The 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. 23.2The 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. 23.3Macroeconomic Equilibrium 4.explain how AD and AS shocks affect equilibrium real GDP and the price level. Copyright © 2014 Pearson Canada Inc. 2 Chapter 23, Slide

23.1The 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. 3 Chapter 23, Slide

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. 4 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide

Fig Desired Aggregate Expenditure and the Price Level An increase in P reduces desired aggregate expenditure: AE shifts down, equilibrium Y falls. 5 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide

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. 6 The Aggregate Demand Curve Chapter 23, Slide Copyright © 2014 Pearson Canada Inc.

Fig Derivation of the AD Curve Consider a rise in the price level, from P 0 to P 2 : The AE curve shifts down, but we move along the AD curve. 7 Copyright © 2014 Pearson Canada Inc. (i) Aggregate expenditure (ii) Aggregate demand Chapter 23, Slide

Fig 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. The horizontal shift of the AD curve is the simple multiplier times the change in autonomous spending. 8 Copyright © 2014 Pearson Canada Inc. (i) Aggregate expenditure (ii) Aggregate demand Chapter 23, Slide

23.2The 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. 9 Chapter 23, Slide

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 10 Copyright © 2014 Pearson Canada Inc. EXTENSIONS IN THEORY 23-1 The Keynesian AS Curve Chapter 23, Slide

Fig Shifts in the AS Curve Aggregate Supply Shocks Anything that increases firms' costs causes the AS curve to shift up: factor prices technology 11 Shifts in Aggregate Supply Curve Chapter 23, Slide Copyright © 2014 Pearson Canada Inc.

23.3Macroeconomic Equilibrium Demand behaviour is consistent with supply behaviour only at the intersection of the two curves. E 0 is the macroeconomic equilibrium. 12 Copyright © 2014 Pearson Canada Inc. Fig Macroeconomic Equilibrium Chapter 23, Slide

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. 13 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide

Aggregate Demand Shocks Demand shocks cause P and Y to change in the same direction. Possible causes: ΔG > 0 ΔI > 0 ΔX > 0 ΔC > 0 14 Fig Aggregate Demand Shocks Chapter 23, Slide Copyright © 2014 Pearson Canada Inc.

Fig The Multiplier When the Price Level Varies 15 Copyright © 2014 Pearson Canada Inc. 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 Chapter 23, Slide

Fig. 23-9The 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. 16 Copyright © 2014 Pearson Canada Inc. Chapter 23, Slide

Aggregate Supply Shocks Aggregate supply shocks cause P and Y to change in opposite directions. Possible causes: Δ price of inputs Δ wages Δ technology 17 Copyright © 2014 Pearson Canada Inc. (i) Aggregate expenditure (ii) Aggregate demand and supply Fig A Negative Aggregate Supply Shock Chapter 23, Slide

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. 18 Copyright © 2014 Pearson Canada Inc. LESSONS FROM HISTORY 23-1 The Asian Crisis and the Canadian Economy Chapter 23, Slide

19 Copyright © 2014 Pearson Canada Inc. MyEconLab The increase in the world price of oil from 2002 to 2008 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 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. Chapter 23, Slide