Output and Prices in the Short Run

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CHAPTER 25
Output and Prices in the Short Run
The Economic Problem
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What happens to the equilibrium national income
when the price level changes ?

• There is a negative relationship between the
  price level and the Aggregate Expenditure .
• An exogenous change in the price level have an
  effect on consumption , C, and on net exports
  which in turn affect Aggregate Expenditure. Thus,
  the equilibrium GDP will change.

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I. Change in Consumption

• An increase in domestic price level lowers the
  real value of wealth or income which in turn
  decreases consumption, so AE function shifts
  downward .
• So as P rises , real W falls , C decreases, and
  AE Function shift downward .
• A fall in the price level has an opposite effect.

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II. Change in Net Exports

• When domestic price level rises, then domestic
  goods become more expensive relative to foreign
  goods. Therefore,
• Domestic consumers will buy less of domestic
  goods and more of foreign goods, so imports will
  rise .
• Foreign countries will reduce their purchases of
  our domestic goods so Exports will decrease and
  as a result Net Exports ( X- M ) will fall .

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Change in Equilibrium National Income

• Change in the price level change both Consumption
  and Net export .
• A rise in the price level will decrease both C
  and ( X-M ) so AE function shift down and Y will
  decrease .
• A fall in the price level has the opposite effect
  so as P falls, Y rises.

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Figure 25-1 Aggregate Expenditure and the Price
LevelAn increase in the price level reduces
aggregate expenditure and thus the equilibrium
GDP falls to Y1
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The Aggregate Demand

• The negative relationship between the price level
  and National income is called Aggregate Demand ,
  AD.
• AD curve is negatively slopped which means that
  
• As Price level decrease, Income will rise and as
  price level rises, Income will falls.
• The change in price level ,P, causes a movement
  along the AD curve.

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Figure 25-2Derivation of the AD Curve
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• At any point on the AD curve, desired aggregate
  expenditure is exactly equal to the output (real
  GDP).
• Points on the left of the AD curve show
  combinations of GDP and the price level that
  cause aggregate expenditure to exceed output, and
  vice versa.

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Figure 25-3The Relationship Between the AE and
AD Curves
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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 example, an increase in the amount of
  consumption, investment, government purchases, or
  net exports associated with each level of
  national income will shift the AD curve to the
  right. This is an expansionary demand shock.

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Figure 25-4The Simple Multiplier and Shifts in
the AD CurveThe simple multiplier measures the
horizontal shift in the AD curve
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The Aggregate Supply Curve

• Shows the relationship between the quantity
  supplied by all firms and the price level .
• Short-run Aggregate Supply, SRAS curve relates
  the price level to quantity supplied by all firms
  with the assumption that technology and prices of
  all factors of production remain constant.
• Long-run aggregate supplied curve, LRAS relates
  the price level to quantity supplied by all firms
  after the economy has fully adjusted to the
  change in the price level .

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Short-Run Aggregate Supply

• Price-taking firms will produce more only if
  price increases.
• Price-setting firms will increase their prices
  when they expand their output because their
  marginal cost is rising.
• The SRAS curve shows a positive relationship
  between the price level and the total output
  produced by all firms in the economy.
• A change in the price level causes a movement
  along the SRAS curve from one point to another .

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Shift in SRAS Curve or Aggregate Supply Shock

• There are two reasons for SRAS curve to shift
• 1. Change in prices of inputs or cost of
  production .
• 2. Increase in productivity

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Figure 25-5The Short-Run Aggregate Supply
CurveNote that the slope of the AS curve
increases as GDP increases
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I. Change in Prices of Inputs

• If prices of inputs rise .. Cost of production
  will rise .. profit will decrease, therefore, for
  the same output to be produced , an increase in
  the price level is required, otherwise firms will
  cut production and this shifts the SRAS curve to
  the left .
• If prices of inputs fall it will have the
  opposite effect . (shift SRAS to the right )

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II. Increase in Productivity

• If labor productivity rises .. Unit cost of
  production will fall as long as the wage rate
  does not rise sufficiently to offset the
  productivity rise . This will shift the SRAS
  curve to the right .
• If labor productivity falls it will have the
  opposite effect which means it will shift the
  SRAS curve to the left .

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Macroeconomic Equilibrium

• The intersection between the AD and SRAS curves
  give us the macroeconomic equilibrium of national
  income and the price level .
• Any shift in either the AD or SRAS curves leads
  to change in the equilibrium value of the
  national income and the price level .

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Figure 25-6Macroeconomic EquilibriumAt E0, the
demand behavior and supply behavior are consistent
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Changes in the Macroeconomic Equilibrium

• Aggregate Demand Shock
• An increase in AD shifts the AD curve to the
  right, and this increases both the equilibrium
  national income and the price level . This
  increase in AD is called Expansionary Demand
  Shock.
• A fall in AD shifts AD curve to the left, and
  this decreases both equilibrium national income
  and the price level . This is called
  Contractionary Demand Shock.

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Figure 25-7Aggregate Demand Shocks
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• Aggregate Supply Shock
• An increase in aggregate supply will shift the
  SRAS curve to the right or downward and this will
  lead to an increase in the equilibrium national
  income and a decrease in equilibrium price level.
• A decrease in aggregate supply will shift the
  SRAS curve to the left or upward. This decreases
  equilibrium national income and increases the
  price level.

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The Multiplier when the price level Varies

• When the SRAS is upward slopping (and the price
  level is allowed to vary), the multiplier would
  be smaller than the simple multiplier.
• This is because an increase in the autonomous
  expenditure shifts the AD curve to the right
  which will result in an initial increase in
  national income. But because there will be a
  shortage in output, the price level will rise in
  order to reach the equilibrium between AD and AS.
  This will result in a reduction in the national
  income.

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Figure 25-8Multiplier When the Price Level Varies
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Keynesian SRAS Curve

• Keynesian SRAS curve is horizontal as the price
  level is assumed to be held constant.
• Based on the Keynesian SRAS curve, firms will
  supply whatever they can sell at the existing
  price as long as they are operating below the
  normal capacity.
• Therefore, based on the Keynesian SRAS curve,
  real national income is determined by changes in
  AD curve.

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The Importance of the Shape of SRAS curve

• Over the horizontal part of SRAS curve any change
  in AD will change the equilibrium national income
  only.
• Over the middle part of SRAS any change in AD
  will change both the equilibrium price level and
  national income .
• Over the steeper part of the SRAS curve any
  change in AD will cause large change in
  equilibrium price level and a small change in
  equilibrium national income .

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Figure 25-9The Effects of Increases in Aggregate
DemandAs the slope of the AS curve increases,
changes in AD curve will have a greater effect on
the price compared with the effect on output.
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The Effect of Demand Shock when the SRAS curve is
Vertical

• When the SRAS curve is vertical, then any change
  in AD will change the price level only with no
  change in equilibrium national income.
• The multiplier in this case is zero .

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Figure 25-10Demand Shocks When the SRAS Curve is
Vertical
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Aggregate Supply Shocks

• Aggregate supply shocks cause the price level and
  real GDP to change in opposite direction.
• A decrease in supply will result in an increase
  in the price level which will lead to a decrease
  in real GDP, and vise versa.

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Figure 25-11Aggregate Supply Shocks