Output and Prices in the Short Run

1
Output and Prices in the Short Run

• Lecture 8

2
Overview

• Aggregate Expenditure and the Price Level
• Aggregate Demand
• Aggregate Supply
• Short-run Macroeconomic Equilibrium with Price
  Adjustment
• Aggregate Demand and Aggregate Supply Shocks

3
Demand-Determined Output

• In our Short-run Macro Model we (mplicitly assume
  that firms are willing and able to supply any
  amount of output at the given price level without
  requiring any changes in price. We therefore
  assume national income to be demand determined.
• There are two situations under which the
  assumption that output is demand determined is
  most reasonable.
• Excess Capacity in production
• Firms are price-setters

4
Excess Capacity in Production
When there are unemployed resources in the
economy, so that output is below potential and
firms have excess capacity.
Firms are Price-Setters
When firms price setters this means that firms
have some influence over price, either because of
there are relatively few firms in the market, or
because products are differentiated.
If the economys resources are fully employed and
firms are price takers, then the assumption of
demand-determined output may not be reasonable.
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Aggregate Expenditure and the Price Level
Consider an exogenous change in the price level,
P. What happens to equilibrium GDP?
An increase in P reduces the real value of money
held by the private sector. A fall in P raises
the real value of money holdings.
Changes in P also affect the wealth of
bondholders and bond issuers, but because the
changes offset each other, there is no change in
the aggregate wealth.
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In summary, an increase in P reduces
private-sector wealth and leads to a fall in
desired consumption this implies a downward
shift in the AE curve.
Conversely, a fall in P increases private-sector
wealth and leads to an increase in desired
consumption this implies an upward shift in the
AE curve.

• There is also an effect on net exports
• A rise in P (with unchanged foreign prices)
  shifts the NX function downward this causes a
  further downward shift in the AE curve. The
  reverse will occur after a fall in P.

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Price Level and Equilibrium National Income
An increase in P reduces private-sector wealth
and therefore reduces desired aggregate
expenditure.
AE
AE Y
AE0
E0

AE1

This causes the AE curve to shift down, reducing
the equilibrium level of real GDP.
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 price level, the AD curve shows the
level of real GDP for which desired aggregate
expenditure equals actual GDP.
Changes in the price level that cause shifts in
the AE curve cause movements along the AD curve.
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AE Y
E0
AE0

AE
Consider a rise in the price level, from P0 to P2
AE1
E1
AE2

A rise in P causes the AE curve to shift down.
This is a movement upward along the AD curve.
E2

Y2
Y1
Y0
Y
P

P2
(Conversely, a fall in P causes the AE curve to
shift up. This is a movement downward along the
AD curve.)
P1

P0

AD
Y2
Y1
Y0
Y
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AE Y
Shifts in the AD Curve
AE
AE1
E1

AE0
Any shock that increases equilibrium GDP at a
given price level shifts the AD curve to the
right.
E0

Any shock that reduces equilibrium Y at a given
price level shifts the AD curve to the left.
Y1
Y0
Y
P
E1
E0
P0


The simple multiplier measures the horizontal
shift of the AD curve.
AD1
AD0
Y1
Y0
Y
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Exercise 1
AE 350 0.8Y 0.1 (M/P)
Autonomous Expenditure
Marginal Propensity to Spend out of National
Income
Real value of assets held. M nominal value P
Price level
12
A rise in the price level reduces the real value
of those assets (M/P) and, through this reduction
in wealth, leads to less desired aggregate
expenditure.
M 6000
AE 350 0.8Y 0.1(6000)
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(No Transcript)
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Equilibrium national income is that level of
income where Y AE. In general form we have Y
AE ? Y A 0.8Y ? Y(1 0.8) A ? Y
A/(0.2) In the six specific cases we
get P1 Y 950/0.2 4750 P2 Y 650/0.2
3250 P3 Y 550/0.2 2750 P4 Y
500/0.2 2500 P5 Y 470/0.2 2350 P6 Y
450/0.2 2250
Note that each successive increase in the price
level has a smaller effect on wealth and
equilibrium national income than the previous
increase.
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P 6, Y 2250
P 5, Y 2350
P 4, Y 2500
P 3, Y 2750
P 2, Y 3250
P 1, Y 4750
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Deriving AD from AE
General Form AE A zY F(P)

• Step 1

Replace AE and Y with YAD
F(P) decreases with P
YAD A z YAD F(P)

• Step 2

Solve for YAD
YAD A F(P) 1 - z
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Exercise 2
AE 350 0.8Y 0.1 (M/P)
To find aggregate demand, set AE Y YAD,
solve for YAD
YAD 350 0.8 YAD 0.1 (M/P)
YAD - 0.8YAD 350 0.1(M/P) 0.2YAD 350
0.1(M/P) YAD 1750 0.5 (M/P)
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Aggregate Supply
The aggregate supply (AS) curve relates the price
level to the quantity of output that firms would
like to produce and sell.
The AS curve is drawn on the assumption that
technology and factor prices remain
constant. Because unit costs rise with output,
both price-taking and price-setting firms will
produce more output only if prices increase. The
AS curve is therefore upward sloping.
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Shifts in Aggregate Supply
Price Level
AS0
A change in either factor prices or productivity
will change costs and shift the AS curve.
AS1

P1
An increase in factor prices or a decrease in
productivity shifts the AS curve up and to the
left.
P0


Y0
Y1
Real GDP
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The Slope of the Aggregate Supply Curve
The slope of the AS curve is increasing because
when output is low, firms typically have excess
capacity. This means that output can be expanded
without causing a large increase in unit costs.
Therefore, only a small increase in price may be
needed to induce them to expand production.
Once output gets closer to capacity, however,
increases in output cause larger increases in
unit costs. Therefore, larger price increases are
needed to induce firms to expand output.
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Short-run Macroeconomic Equilibrium with Price
Adjustment
AD
AS
Demand behaviour is only consistent with supply
behaviour at the intersection of the AS and AD
curves.
Price Level
E0
P0

P1


At P1 there is more output demanded (Y2) than
what firms want to produce (Y1).
Y0
Y1
Y2
Real GDP
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Exercise 3
Induced Expenditure
Autonomous Expenditure
Effect of Price level
We can derive Aggregate Demand (AD) by setting
this AE function equal to Y and solving for
equilibrium Y in terms of A and P.
Simple Multiplier for Autonomous Expenditure
23
Now suppose that Aggregate Supply can be
expressed as the following function
Technological advance
Short run macroeconomic equilibrium can be found
by equating and .
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To get the level of national income in the short
run, we would substitute P for P in either
aggregate demand or aggregate supply functions.
New Multiplier for Autonomous Expenditure
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AD and AS Shocks

• A shock is expansionary if it results in an
  increase in Y.
• A shock is contractionary if it results in a
  decrease in Y.
• An expansionary demand shock shifts the AD curve
  to the right, increasing both P and Y. A
  contractionary demand shock shifts the AD curve
  to the left, decreasing both P and Y.
• An expansionary supply shock shifts the AS curve
  to the right, increasing Y but decreasing P. A
  contractionary supply shock shifts the AS curve
  to the left, decreasing Y but increasing P.

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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.
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AD Shocks
Price Level
AD1
Demand shocks cause P and Y to change in the same
direction both rise with an increase in demand,
and both fall with a decrease in demand.
AS
AD0
P1

E1
E0
P0

Y0
Y1
Real GDP
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AE Y
E1
AE
AE1

AE1
E1
AE0
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.

?A

E0
Y
Y0
Y1
Y1
P
AS
Hence, when the AS curve is upward sloping, the
multiplier is smaller than the simple multiplier.
E1
P1

E1
P0


AD1
E0
AD0
Y
Y0
Y1
Y1
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AD4
AD3
The effect of any given shift of the AD curve
will depend on the slope of the AS curve.
AS
AD2

AD1
P4
Price Level
AD0

P3
The steeper the AS curve, the greater the price
effect and the smaller the output effect.
P2

P1

P0

Y1
Y2
Y3
Y4
Y0
Real GDP
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Vertical AS Curve
AS
AD2
AD1
Price Level
AD0
P2
P1
P0
Y0
Real GDP
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In previous classes, it was shown that shifts in
the AE curve always change real GDP. But now we
see an extreme case a vertical AS curve in
which there is no change in real GDP.
How can these seemingly contradictory statements
be true?
The answer is that each AE curve is drawn for a
given price level. As the price level changes,
the AE curve shifts.
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AE Y
AS Shocks
AE0
E0
AE

AE1
Aggregate supply shocks cause P and Y to change
in opposite directions.

E1
Consider the effects of a negative supply shock.
Y
Y1
Y0
An example of a negative supply shock is an
increase in the price of oil, as happened in the
early and late 1970s.
P
AS1
AS0
E1
P1

E0
P0

AD
Y0
Y1