Econ 102 - Chapter 23

Exogenous Changes in the Price Level

The AE curve shifts in response to a change in the price level.

A rise in the domestic price level lowers the real value of money holdings

Similarly a reduction in the price level raises the real value of money holdings

A rise in the price level lowers the real value of money held by the private sector.

A fall in the price level raises the real value of money held by the private sector

Changes in hte price level change the wealth of bondholders and bond issuers,

but because the changes offset each other, there is no change in aggregate wealth.

A rise in the price level leads to

a reduction in the real value of the private sector's wealth

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 upwards and hence the AE curve upwa

Changes in Equilibrium GDP

When the AE curve shift downwaqrd, the equilibrium level of real GDP falls.
conversely, with a fall in the price level, Canadian goods become relatively cheaper internationally, so net exports rises.

A change of labels

We use real GDP rather than national income but these two words have the same meaning.
It is still actual, as opposed to desired, but we leave that off, also for simplicity.
Finally we add real because from this chapter onward the price level will be chan

Aggregate demand curve

A curve showing combinations of real GDP and the price level that make desired aggregate expenditure equal to actual national income
Shows the relationship between the price level and the equilibrium level of real GDP

For any given price level,

The AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP

Because the AD curve relates equilibrium GDP to the price level,

changes in the price level that causes shifts in the AE curve are simply movements along the AD curve
A movement along the AD curve thus traces out the response of equilibrium GDP to a change in the price level

The AD curve is not a Micro Demand Curve!

1) A rise in the price level causes the AE curve to shift downward and hence leads to a movement upward and to the left along the AD curve, reflecting a fall in the equilibrium level of GDP
2) A fall in the price level causes the AE curve to shift upward

A "micro" demand curve desribes a situation in which the price of one commodoity changes while

the prices of all other commodities and consumers' dollar incomes are constant

Such individual demand curve is negatively slope for two reasons

1) As price of the commodity falls, purchasing power of each consumer's income will rise, and this rise in real income will lead to more units of the good being purchased.
2) As price of the commodity falls, consumers buy more of that commodity and fewer

The first reason does not apply to the AD curve

because the dollar value of national income is not being held constant at the price level changes and we move along the AD curve.

The second reasons applies ot the AD curve

but only in a limited way.
A change in the price level does not change the relative prices of domestic goods and thus dues not cause consumers to substitute between them.
However, a change in the domestic price level does lead to ac hange in international

To summarize, the AD curve is negatively sloped for two reasons:

1) A fall in the price level leads to a rise in private sector wealth, which increases desired consumption and thus leads to an increase in equilibrium GDP
2) A fall in the price level (for a given exchange rate) leads to a rise in net exports and thus le

Shifts in the AD curve

Any event that leads to a change in equilibrium GDP will cause the AD curve to shift.
changes could include, government purchases, taxation, households' consumption expenditure, firms' investment behaviour, or foreigner's demand for Canadian exports

Because the AD curve plots equilibrium GDP as a function of the price level,

anything that alters equilibrium GDP at a given price level must shift the AD curve.

Aggregate demand shock

Any shift in the aggregate demand curve.

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

In order to shift the AD curve,

the change in autonomous expenditure must be caused by something other than a change in the domestic price level.

When Price level changes

Leads to a movement along AD curve and shifts AE curve

When Autonomous expenditure changes ( other than change in domestic price level)

leads to a shift of the AE curve and shift of the AD curve

The simple Multiplier and the AD curve

The simple multiplier measure the horizontal shift int he AD curve in response to a change in autonomous desired expenditure.

If the price level remains constant and producers are willing to supply everything that is demanded at the price level,

the simple multiplier will also chow the change in equilibrium income that will occur in response to a change in autonomous expenditure.

The Supply side of the economy

To add an explanation for changes in the price level.
We need to take account of the supply decisions of firms

Aggregate Supply curve

A curve showing the relation between the price level and the quantity of aggregate output supplied, for given technology and factor prices
Relates the price level to the quantity of output that firms would like to produce on the assumption that technology

The positive slope of the AS curve

Costs and Output
Prices and Output

Costs and Output

As output increases, less efficient standby plants may have to be used, and less efficient workers may have to be hired, while existing workers have to paid overtime rates for additional work
For these and other similar reasons, unit costs will tend to ri

Unit Cost

Cost per unit of output, equal to total cost divided by total output

Diminishing Returns

In economics, diminishing returns (also called diminishing marginal returns) refers to how the marginal production of a factor of production starts to progressively decrease as the factor is increased, in contrast to the increase that would otherwise be n

Prices and Output

To consider the relationship between price and output, we need to consider firms that sell in two distinct types of markets:
Those in which firms are price takers
And those in which firms are price setters

If an industry contain many small firms, each firm is too small to influence the market price, which is set by forces of demand and supply.

Each firm must accept whatever price is set by the market and are sadi to be price takers

If their unit costs rise with output, Price -taking firms will produce more only if price increases.

They will produce less if the price falls.

Industries with few enough firms that each can influence the market price of its product.
Most sell products that differ from one another, although similar enough to be thought of as a single product produced by one industry.

Each firm must quote a price at which it is prepared to sell each of its products; that is, the firm is a price setter.

Price-setting firms will increase their prices when they expand their output into the range where unit costs are rising.

They will eventually decrease their prices if a reduction in their output leads to a reduction in unit costs

The actions of both price-taking and price setting firms cause the price level and the supply of output to be positively related -

The aggregate supply (AS) curve is positively sloped

The Increasing slope of the AS curve

At low levels of GDP the AS curve is relatively flat, But as GDP rises the AS curve gets progressively steeper.

When output is low (below potential output),

firms typically have excess capacity- plant and equipment are idle.
only a small increase in the price of their output may be needed to induce them to expand production
if firms have enough excess capacity, they may be willing to sell more at their existi

Shifts in the Aggregate Supply Curve

For a given level of output, anything that changes firms' production costs will cause the AS curve to shift.

Two sources of such change are of particular importance

1) Changes in the price of inputs
2) Changes in productivity

Aggregate supply shock

Any shift in the aggregate supply (AS) curve caused by an exogenous force.

Changes in Input Prices

When factor prices change, the AS curve shifts

The higher is the level of output,

The faster unit costs tend to rise with each extra increment to output. This explains why the AS curve becomes steeper as output rises.

If factor prices rise,

The AS curve shifts upward (and to the left).

A fall in factor prices cause

The AS curve to shift downward (and to the right)

Changes in Prouctivity

If labour productivity rises - that is, each worker can produce more with a given amount of effort and other resources- the unit costs of production will fall

A change in either factor prices or productivity will shift the AS curve because any given output will be supplied at a different price level than previously.

An increase in factor prices or a decrease in productivity shifts the AS curve to the left;
An increase in productivity or a decrease in factor prices shifts the AS curve to the right.

Macroeconomic Equilibrium

The equilibrium values of real GDP and the price level occur at the intersection of the AD and AS curves
The combination of real GDP and price level that is on both the AD curve and the AS curve is called a macroeconomic equilibrium.

Only at the combination of real GDP and the price level given by the intersection of the AS and AD curves

are demand behaviour and supply behaviour consistant

At the prevailing price level,

desired aggregate expenditure must be equal to actual GDP{-
That is, households are just willing to buy all that is produced

Athe AD curve is constructed in such a way that this condition holds everywhere along it.

The second requirement for macroeconomic equilibrium is introduced by consideration of aggregate supply.

At the prevailing price level, firms must want to produce the prevailing level of GDP, no more and no less.

This condition is fulfilled everywhere along the AS curve.
Only where the two curves intersect are both conditions fulfilled simultaneously.

Changes in the macroeconomic equilibrium

The aggregate demand and aggregate supply curves can now be used to understand how various shocks to the economy change both real GDP and the price level

A shift in the AD curve is called an aggregate demand chock

A rightward shift in the AD curve is an increase in aggregate demand
Means that at all price levels, expenditure decisions will now be consistent with a higher level of real GDP
This is called a positive shock.

A leftward shift in the AD curve is a decreased in aggregate demand

That is, at all price levels, expenditure decisions will now be consistent with a lower level of real GDP. This is called a negative shock.

A shift in the AS curve caused by an exogenous force is called an aggregate supply shock.

A rightward shift in the AS curve is an increase in aggregate supply; at any given price level, more real GDP will be supplied.
This is a positive shock

A leftward shift in the AS curve is a decrease in aggregate supply;

At any given price level, less real GDP will be supplied
This is a negative shock

Aggregate demand and supply shocks are labelled according to their effect on real GDP

Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP

Aggregate Demand Shocks

Increase in aggregate demand - a positive AD shock

Aggregate demand shocks cause the price level and real GDP to change in the same direction;

Both rise with an increase in aggregate dmeand, and both fall with a decrease in aggregate demand.

The multiplier when the price level caries

The simple multiplier gives the size of the horizontal shift in hte AD curve in response to a change in atunomous expenditure

If th price level remains constant and firms supply all that is demanded at the exist in price level (as would be the case with a horizontal AS curve),

the simple multiplier gives the increase in equilibrium national income

When the AS curve is positively sloped,

the change in real GDP caused by a change in autonomous expenditure is no longer equal to the size of the horizontal shift in the AD curve.

When the AS curve is upward sloping, an aggregate demand shock lead to a change in the price level.

As a result, the multiplier is smaller than the simple multiplier.

The importance of the shape of the AS curve

The shape of the AS curve has important implications for how the effects of an aggregate demand shock are divided between changes in real GDP and changes in the price level.

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, depending on the conditions of aggregate supply.

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

Aggregate demand shocks typically lead to

changes in both the price level and the level of real GDP

An upward shift in the AE curve shifts the AD curve to the right. However, a positively sloped AS curve means that the price level rises, and this shifts the AE curve back down.

Offsetting some of its initial rise.

Aggregate supply socks

A negative aggregate supply shock, shown by a shift to the left in the AS curve, means that less real output will be supplied at any given price level.

A positive aggregate supply shock, shown by a shift to the right in the AS curve,

means that more real output will be supplied at any given price level.

A positive aggregate supply shock leads to an

increase in real GDP and a decrease in the price level

Aggregate supply shocks causes he price level and real GDP to change in opposite directions.

With an increase in supply, the price level falls and GDP rises; with a decrease in supply, the price level rises and GDP falls.

Many economic events - especially changes in the world prices 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.