Gdp and price level in the short run

1. GDP and the Price Level
in the Short Run
Chapter 18

2. Learning Outcomes
 Aggregate demand is the level of desired real
domestic spending at each price level.
 The aggregate demand curve plots the negative
relationship between GDP and the price level.
 An exogenous change in autonomous spending (a
demand shock) shifts the aggregate demand curve
horizontally by the multiplier times the initial
change in spending.

3. Learning Outcomes
 The aggregate supply curve reflects a positive
relationship between output and the price level, for
given input prices.
 An exogenous change in input prices or technology (a
supply shock) shifts the short-run aggregate supply
curve.
 The equilibrium level of GDP and the price level are
determined where aggregate demand and supply are
equal.

4. AE1
Real National Income [GDP]
0
45o
Y1 Y0
E1
E0
AE0
AE = Y
Desired
Expenditure
Aggregate Spending and the Price Level

5. Aggregate Spending and the Price Level
 Changes in the price level cause the AE curve
to shift and equilibrium GDP to change.
 The initial AE curve is AE0 and GDP is at Y0.
 An increase in the price level reduces desired
expenditure and thus causes the AE curve to
shift down to AE1.
 As a result GDP falls to Y1.The reverse
happens for a fall in the price level.
 An increase in the price level leads to a
decrease in purchasing power of residents
(decreases consumption and also impacts
exports (become more expensive relative to
foreign goods) which further decreases
aggregate spending

6. The AD Curve and the AE Curve
AE1
Desired
Expenditure
0
45o
AE0
Y2 Y1
E2
E1
E0
AE2
Y0
AE = Y
Real National Income [GDP]
[i]. Aggregate expenditure

7. The AD Curve and the AE Curve
0 Y2 Y1 Y0
P2
P1
P0
AD
E0
E1
E2
Real National Income (GDP)
[ii]. Aggregate Demand

8. The AD Curve and the AE Curve
AE1
Desired
Expenditure
0
45o
AE0
Y2 Y1
E2
E1
E0
AE2
Y0
AE = Y
Real National Income [GDP]
[i]. Aggregate expenditure
E2
E1
E0
AD
P2
P1
P0
[ii]. Aggregate Demand
Real National Income [GDP]

9. The AD curve and the AE curve
 Equilibrium GDP is determined by the AE curve for
each given price level.
 The level of GDP and its associated price level are
then plotted to yield a point on the AD curve.
 When the price level is P0 the AE curve is AE0 and
GDP is Y0. Plotting Y0 against P0 yields the point E0
on the AD curve.
 An increase in the price level to P1 shifts the AE
curve down to AE1, producing GDP of Y1 and this is
represented by point E1 on the AD curve.
 Rise in domestic price level shifts the net export
function downward, which shifts the aggregate
spending curve downward.

10. Relationship between AE and
AD curves
Real GDP
Real GDP
Desired
spending
Price
level
45o
AE
AE=Y
E0
e2
e0
e1
Y1 Y0 Y2
AE
Y1 Y0 Y2
P0
0
0
X E0 Z
AD
Desired spending
less than output
Desired spending
equal output
Desired spending
exceeds output
•Points to the left
of the AD curve
show
combinations of
GDP and the price
level for which
aggregate desired
spending exceeds
output and vice
versa. There is
thus pressure for
output to rise as
firms could sell
more than their
current output.

11. AE = Y
The Simple Multiplier and Shifts in the AD Curve
Real GDP
[i]. Aggregate Expenditure
Desired
Expenditure
0
45o
AE0
Y1
E0
Y0
AE1
A
E1
Y1

12. The Simple Multiplier and Shifts in the AD Curve
0 Y1
Y0
P0
AD0
E0 E1
AD1
Y
Real GDP
[i]. Aggregate Demand

13. The simple multiplier and shifts in the AD
curve
 A change in autonomous expenditure changes
equilibrium GDP for any given price level, and the
simple multiplier measures the resulting horizontal
shift in the aggregate demand curve.

14. The simple multiplier and shifts in the AD
curve
 The original AE curve is at AE0 with
equilibrium at E0, GDP=Y0 and Price level=P0;
the yield point E0 on AD0.
 AE0 shifts to AE1 because of an autonomous
expenditure increase A, and GDP increases to
Y1.
 With given price level P0, the AD curve shifts
rightward to E1.

15. Y
SRAS
A Short-run Aggregate Supply Curve
Real GDP

16. Y0
P0
SRAS
Real GDP
A Short-run Aggregate Supply Curve

17. Y0 Y1
P0
P1
SRAS
Real GDP
A Short-run Aggregate Supply Curve

18. The short-run aggregate supply curve
 The SRAS curve is positively sloped.
 The positive slope shows that with prices of labour
and other inputs given, total desired output and
the price level will be positively associated.
 A rise in the price level from P0 to P1 will be
associated with a rise in output supplied from Y0 to
Y1.
 The slope of the SRAS curve is fairly flat at low
levels of output and very steep at higher levels.
 Shifts in the SRAS curve are due to changes in
input prices and productivity levels.
 Higher input prices and lower productivity shifts
the SRAs curve inwards and vice versa.

19. Y0
P0
SRAS
Macroeconomic Equilibrium
AD
E0
0 Real GDP

20. Y0
P0
SRAS
AD
E0
Y2
Y1
P1
0 Real GDP
Macroeconomic Equilibrium

21. Macroeconomic Equilibrium
 Macroeconomic equilibrium occurs at the
intersection of the AD and SRAS curves and
determines the equilibrium values for GDP and
the price level.
 Equilibrium occurs at E0 with GDP equal to Y0
and the price level P0.

22. Macroeconomic Equilibrium
 If the price level were P1, below P0, the
desired output of firms would be Y1 but
desired demand would be Y2, so desired
spending would exceed desired production.
 Only at E0 are desired plans of producers and
consumers consistent.

23. AE=Y
AE0
Desired
Expenditure
[i]. Aggregate expenditure
45o
E0
Y0
SARS
AD0
Real GDP
Real GDP
[i]. Aggregate demand
P0
Y0
The AE Curve and the Multiplier When the Price Level Varies

24. AE=Y
AE0
Desired
Expenditure
[i]. Aggregate expenditure
45o
E0
Y0
SARS
AD0
Real GDP
Real GDP
[i]. Aggregate demand
P0
Y0
The AE Curve and the Multiplier When the Price Level Varies
AE’1
A
E’1
Y’1
E’1
E0
Y’1

25. AE=Y
AE0
Desired
Expenditure
[i]. Aggregate expenditure
45o
E0
Y0
SARS
AD0
Real GDP
Real GDP
[i]. Aggregate demand
P1
P0
Y0
The AE Curve and the Multiplier When the Price Level Varies
AE’1
A
E’1
Y’1
E’1
E0
Y’1
AE1
E1
Y1
Y
E1
Y1
AD1

26. The AE curve and the multiplier when the price level
varies
 An upward shift in AE is partly offset by the
resulting rise in prices, so the multiplier is
smaller than when prices are constant.
 There is an increase in autonomous
expenditure A creating the initial shift 1.
 But prices then rise so the AE curves shifts
part of the way back down as shown by 2.
 The economy moves from point E0 to E1.

27. The effects of increases in AD
The effect of any given
shift in aggregate
demand is split between
a change in real output
and a change in the price
level, depending on
conditions of aggregate
supply. The steeper the
SRAS curve, the greater
is the price effect and the
smaller in the output
effect.
The effect of any given change in demand will be divided between real
output and price level, depending on conditions of supply curve.

28. The effects of increases in AD
The effect of any given change in demand will be divided between real
output and price level, depending on conditions of supply curve.
Over the flat range, any change in aggregate demand leads to no
change in prices and a response of output equal to that predicted
by the simple multiplier.
Over the intermediate range along which the SRAS curve is
positively sloped, a shift in the AD curve gives rise to
appreciable changes in both real GDP and the price level.
Over the steep range, the economy is near its capacity constraint
which will lead to a sharp rise in price and little change in real
GDP. The multiplier in this case is nearly zero.

29. Demand shocks when the SRAS
curve is vertical
In case of demand shocks, if the SRAS curve is vertical, output
remains the same due to demand and supply whilst prices
increase.

30. Aggregate supply shocks

31. GDP AND THE PRICE LEVEL IN THE SHORT
RUN
Aggregate Demand
 A change in the price level shifts the AE curve
upward when the price level falls and downward
when the price level rises.
 A new equilibrium level of GDP that results would
be the equilibrium level if it were solely demand-
determined.
 The AD curve plots the equilibrium level of GDP
that corresponds to each possible price level.

32. GDP AND THE PRICE LEVEL IN THE SHORT
RUN
Aggregate Demand
 A change in equilibrium GDP following a change in the
price level is shown by a movement along the AD
curve.
 A rise in the price level lowers exports and lowers
private consumption spending [because it decreases
consumer’s wealth].
 Both of these changes lower equilibrium GDP and
cause the aggregate demand curve to have a negative
slope.

33. GDP AND THE PRICE LEVEL IN THE SHORT
RUN
 The AD curve shifts when any element of
autonomous expenditure changes, and the
simple multiplier measures the magnitude of the
shift.
 This multiplier also measures the size of the
change in equilibrium GDP when the price level
remains constant and firms produce everything
that is demanded at the price level.

34. Aggregate Supply and Macroeconomic
Equilibrium
 The short-run aggregate supply [SRAS] curve,
drawn for given input prices, is positively sloped
because unit costs rise with increasing output and
because rising product prices make it profitable to
increase output.
 An increase in productivity or a decrease in input
prices shifts the curve to the right.
GDPAND THE PRICE LEVEL IN THE SHORT RUN

35. Aggregate Supply and Macroeconomic
Equilibrium
 A decrease in productivity or an increase in input prices
has the opposite effect.
 Macroeconomic equilibrium refers to equilibrium values
of real GDP and the price level, as determined by the
intersection of the AD and SRAS curves.
 Shifts in the AD and SRAS curves, called aggregate
demand shocks and aggregate supply shocks, change
the equilibrium values of real GDP and the price level.
GDPAND THE PRICE LEVEL IN THE SHORT RUN

36. Changes in GDP and the Price Level
 When the SRAS curve is positively sloped, an
aggregate demand shock causes the price level and
real GDP to move in the same direction, the division
between these effects depending on the shape of the
SRAS curve.
 The main effect is on real GDP when the SRAS curve is
flat and on the price level when it is steep.
GDPAND THE PRICE LEVEL IN THE SHORT RUN

37.  An aggregate supply shock moves equilibrium real
GDP along the AD curve, causing the price level
and output to move in opposite directions.
 A leftward shift in the SRAS curve causes a
stagflation - rising prices and falling output.
 A rightward shift causes an increase in real GDP
and a fall in the price level.
 The division of the effects of a shift in SRAS
between a change in real GDP and a change in
the price level depends on the shape of the AD
curve.
GDPAND THE PRICE LEVEL IN THE SHORT RUN