1. Output and Prices in the Short Run1
Chapter 23
Output and Prices in the Short Run
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2. In this chapter you will learn...2
In this chapter you will learn...
1. …why an exogenous change in the price level shifts the AE curve and changes the equilibrium level of real GDP.
2. …how to derive the aggregate demand (AD) curve and what causes it to shift.
3. …the meaning of the aggregate supply (AS) curve and why it shifts when technology or factor prices change.
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3. In this chapter you will learn...3
In this chapter you will learn...
4. …how to define macroeconomic equilibrium.
5. …how aggregate demand and aggregate supply shocks affect equilibrium real GDP and the price level.
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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.
For the private sector - Money and Government Bonds
Changes in P also affect the wealth of private bond holders and private bond issuers
- but there is no change in aggregate private wealth
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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 and gets flatter
- further downward shift in AE curve
Conversely for a fall in P.
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Changes in Equilibrium GDP AE
AE =Y
An increase in P reduces desired aggregate expenditure:
- AE shifts down
- equilibrium Y falls
AE0 E0 •
AE1 • E1 Y1 Y0 Y
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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.
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AE =Y AE E0
AE0 ( at P0) •
AE1 (at P1 > P0) E1 •
AE2 (at P2 > P1)
Consider a rise in the price level, from P0 to P2: E2 • Y2 Y1 Y0 Y P
The AE curve shifts down, but we move along the AD curve. • P2 P1 • P0 • AD Y2 Y1 Y0 Y
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AE =Y AE
AE1 E1 •
Shifts in the AD Curve
AE0 E0
Any shock that increases equilibrium GDP at a given price level shifts the AD curve to the right. • Y0 Y1 Y P
The horizontal shift of the AD curve is the simple multiplier times the change in autonomous spending. E0 E1 P0 • •
AD1
AD0 Y0 Y1 Y
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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
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Shifts in the Aggregate Supply Curve
Anything that increases firms’ costs causes the AS curve to shift up:
- factor prices
- technology
- regulation
Price Level
AS1 P1 •
AS0 P0 • •
Why does AS get steeper as output rises? Y1 Y0
Real GDP
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12. What does the Aggregate Supply Curve look like?
Until this point we have assumed that the aggregate supply (AS) was perfectly elastic (a horizontal straight line)
Why?
Firms had plenty of unused capacity, unemployed workers and resources.
Firms could expand production without incurring rising marginal costs.
Price Level
Firms would produce any level of output demanded at the existing price level.
AS0 P0 • •
This is a purely Keynesian type assumption. Is it true today? Maybe in some industries. Y1 Y0
Y (GDP)
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

13. What does the Aggregate Supply Curve look like?
Unless, the economy is in a serious recession and firms have a lot of unused capacity, unit costs rise with output (Marginal Costs generally increases as output increases) firms will produce more output only if prices increase The AS curve is therefore upward sloping (except at very levels of output).
Price Level
AS1
This is straight out of the microeconomics of the firm.
In the short run firms generally find that MC increases as output increases so they will increase production only if they get higher prices. P1 • P0 • Y0 Y1
Y (GDP)
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

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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
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Macroeconomic Equilibrium
Demand behaviour is consistent with supply behaviour only at the intersection of the two curves. AD
Price Level AS E0 P0 • P1 • •
E0 is the macroeconomic equilibrium. Y1 Y0 Y2
Real GDP
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Changes in the 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.
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Aggregate Demand Shocks
Price Level
Demand shocks cause P and Y to change in the same direction.
Possible causes:
- ΔG > 0
- ΔI > 0
- ΔX > 0
- ΔC > 0
AD1 AS
AD0 P1 • E1 E0 P0 • Y0 Y1
Real GDP
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18. Shifts in the AD Curve when P is constant *
AE =Y AE
Shifts in the AD Curve when P is constant *
AE1 (P0) E1 •
AE0 (P0)
Any shock that increases equilibrium GDP at a given price level shifts the AD curve to the right.
Recall - interest rates
- wealth (non P related)
- confidence (expectations)
- foreign incomes
- exchange rates
- change in G
- etc. E0 • Y0 Y1 Y P E0 E1 P0 • •
AD1
The horizontal shift of the AD curve is the simple multiplier times the change in autonomous spending.
AD0 Y0 Y1 Y
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

19. Copyright © 2011 Pearson Canada Inc.19 AE
AE =Y
E´1
AE´1 •
The Mechanics of an AD Shift
AE1 E1
AE0 •
The shock causes the AE curve to shift upward, but the rise in the price level causes it to shift down. A • E0 Y0 Y1
Y´1 Y P AS
With an upward sloping AS curve, the multiplier is smaller than the simple multiplier. E1 P1 •
E´1 P0 • •
AD1 E0
AD0 Y0 Y1
Y´1 Y
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The effect of any given shift of the AD curve will depend on the slope of the AS curve. AS
AD2 P4
AD1 •
Price Level
AD0 P3 • P2 • P1 •
The steeper the AS curve, the greater the price effect and the smaller the output effect. P0 • Y0 Y1 Y2 Y3 Y4
Real GDP
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21. AD5
General case *
AD4 AS
AD3 P5
The effect of any given shift of the AD curve will depend on the slope of the AS curve.
AD2 P4
AD1 •
Price Level
AD0 P3 • P2 • P0 • •
The steeper the AS curve, the greater the price effect and the smaller the output effect. Y0 Y1 Y2 Y3 Y4
Y (GDP)

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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
- Δ regulation P
AS1
AS0 E1 P1 • E0 P0 • AD Y1 Y0
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23. Offsetting changes in wages and productivity*
Offsetting changes in wages and productivity
If wage rise at the same rate as productivity increases then there is no net effect
An increase in wages causes a negative supply shock
An increase in productivity causes a positive supply shock P
Negative supply shock if wages rise faster than productivity
Positive supply shock if wages rise more slowly than productivity
AS0 E0 P0 • AD Y0
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

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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
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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.
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