1. Chapter 23: Output and Prices in the Short Run
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2. 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 © 2017 Pearson Canada Inc.

3. 23.1 The Demand Side of the Economy
Exogenous Changes in the Price Level
Changes in Consumption
Much of the private sector’s total wealth is held in the form of assets with a fixed nominal value.
The most obvious example is money.
What this money can buy—its real value—depends on the price level.
A rise in the price level lowers the real value of money held by the private sector, and a fall in the price level raises the real value of money held by the private sector.
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4. Changes in Consumption
Changes in the price level change the wealth of bondholders and bond issuers, but because the changes offset each other, there is no change in aggregate wealth. In summary, a rise in the price level leads to a reduction in the real value of the private sector’s wealth. A reduction in wealth leads to a decrease in autonomous desired consumption and to a downward shift in the AE function. A fall in the price level leads to a rise in wealth and desired consumption and to an upward shift in the AE function.
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5. Changes in Net Exports
When the domestic price level rises (and the exchange rate remains unchanged), Canadian goods become more expensive relative to foreign goods. Canadian consumers reduce their purchases of Canadian-made goods, and increase their purchases of foreign goods. Consumers in other countries reduce their purchases of Canadian- made goods.
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6. Changes in Net Exports
A rise in the domestic price level (with a constant exchange rate) shifts the net export function downward, which causes a downward shift in the AE curve. A fall in the domestic price level shifts the net export function upward and the AE curve upward.
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7. Fig. 23-1 Desired Aggregate Expenditure and the Price Level
An exogenous increase in the price level causes the AE curve to shift downward from AE0 to AE1. The equilibrium changes from E0 to E1 and real GDP falls from Y0 to Y1.
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8. The Aggregate Demand Curve
The aggregate demand (AD) curve is a curve showing combinations of real GDP and the price level that make desired aggregate expenditure equal to actual national income. A rise in the price level causes the AE curve to shift downward and leads to a movement upward and to the left along the AD curve, reflecting a fall in the equilibrium level of GDP. A fall in the price level causes the AE curve to shift upward and leads to a movement downward and to the right along the AD curve, reflecting a rise in the equilibrium level of GDP.
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9. Fig. 23-2 Derivation of the AD Curve
As the price level rises from P0 to P1 to P2, the AE curve shifts downward from AE0 to AE1 to AE2. In the bottom graph, a movement occurs up along the AD curve. A change in the price level causes a shift of the AE curve but a movement along the AD curve.
(i) Aggregate expenditure
(ii) Aggregate demand
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10. Shifts in the AD Curve
Any change—other than a change in the price level—that causes the AE curve to shift will also cause the AD curve to shift. Such a shift is called an aggregate demand shock. For a given price level, an increase in autonomous aggregate expenditure shifts the AE curve upward and the AD curve to the right. A fall in autonomous aggregate expenditure shifts the AE curve downward and the AD curve to the left. The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure.
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11. Shifts in the AD Curve
Any change—other than a change in the price level—that causes the AE curve to shift will also cause the AD curve to shift. Such a shift is called an aggregate demand shock. For a given price level, an increase in autonomous aggregate expenditure shifts the AE curve upward and the AD curve to the right. A fall in autonomous aggregate expenditure shifts the AE curve downward and the AD curve to the left. The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure.
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12. Fig. 23-3 The Simple Multiplier and Shifts in the AD Curve
An increase in autonomous expenditure shifts the AE curve upward from AE0 to AE1. The size of the horizontal shift of the AD curve is equal to the simple multiplier times the increase in autonomous expenditure.
(i) Aggregate expenditure
(ii) Aggregate demand
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13. Determinants of Aggregate Demand (I)
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

14. Determinants of AD (II)
Government spending
Amount of spending on goods, services, or transfer payments to households or firms
Tax rates
Money supply

15. 23.2 The Supply Side of the Economy
The Aggregate Supply Curve
The aggregate supply (AS) curve is a curve showing the relation between the price level and the quantity of aggregate output supplied, for given technology and factor prices.
As output increases, less efficient standby plants may have to be used, and less efficient workers may have to be hired, while existing workers may have to be paid overtime rates for additional work.
For these reasons, unit cost, which is cost per unit of output, increases.
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16. Fig. 23-4 The Aggregate Supply Curve
The AS curve is positively sloped. The higher is the level of output, the faster unit costs tend to rise, so the AS curve becomes steeper as output rises.
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17. Shifts in the AS Curve
Shifts in the AS curve caused by exogenous forces are called aggregate supply shocks. A rise in factor prices causes the AS curve to shift leftward. A fall in factor prices causes the AS curve to shift rightward. An improvement in technology causes the AS curve to shift rightward. A deterioration in technology causes the AS curve to shift leftward.
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18. Fig. 23-5 Shifts in the AS Curve
An increase in factor prices or a deterioration in technology shifts the AS curve leftward from AS0 to AS1.
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19. Determinants of Aggregate Supply
An increase in AS will result from:
A decrease in factor prices
Technological improvement
An improvement in human capital
An increase in the amount of capital
An increase in natural resources

20. 23.3 Macroeconomic Equilibrium
Fig Macroeconomic Equilibrium
Demand behaviour is consistent with supply behaviour only at the intersection of the AS and AD curves. E0 is the macroeconomic equilibrium.
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21. Changes in Macroeconomic Equilibrium
A shift in the AD curve is called an aggregate demand shock. A shift in the AS curve is called an aggregate supply shock. Aggregate demand and aggregate supply shocks are labelled according to their effect on real GDP. Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP.
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22. Aggregate Demand Shocks
Aggregate demand shocks cause the price level and real GDP to change in the same direction. Both rise with an increase in aggregate demand, and both fall with a decrease in aggregate demand.
Fig Aggregate Demand Shocks
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23. Fig. 23-8 The Multiplier When the Price Level Varies
An increase in autonomous expenditure causes the AE curve to shift upward, but the rise in the price level causes it to shift part of the way down again. With an upward sloping AS curve, the multiplier is smaller than the simple multiplier.
(i) Aggregate expenditure
(ii) Aggregate demand
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24. Fig. 23-9 The Effects of Increases in Aggregate Demand
The effect of any given shift in aggregate demand will be divided between a change in real output and a change in the price level. The steeper the AS curve, the greater the price effect and the smaller the output effect.
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25. Aggregate Supply Shocks
Fig A Negative Aggregate Supply Shock
Aggregate supply shocks cause the price level and real GDP to change in opposite directions. A negative supply shock shifts the AS curve leftward, and the rise in the price level shifts the AE curve downward.
(i) Aggregate expenditure
(ii) Aggregate demand and supply
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26. A Word of Warning
Many economic events—especially changes in the world price of raw materials—cause both aggregate demand and aggregate supply shocks in the same economy. The overall effect on real GDP in that economy depends on the relative importance of the two separate effects.
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27. 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
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28. 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
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29. 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.
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