GDP and the Price Level

in the Short Run

Chapter 18
 Learning Outcomes

 Aggregatedemand 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.
 Anexogenous change in autonomous spending (a
demand shock) shifts the aggregate demand curve
horizontally by the multiplier times the initial
change in spending.
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.
 Aggregate Spending and the Price Level

AE = Y AE0

AE1
Desired Expenditure

E0

E1

45o
0 Y1 Y0 Real National Income [GDP]
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
 The AD Curve and the AE Curve

AE = Y
AE0
E0
Desired Expenditure

AE1

E1 AE2

E2

45o
0 Y2 Y1 Y0 Real National Income [GDP]

[i]. Aggregate expenditure

 The AD Curve and the AE Curve

E2
Price Level

P2
E1
E0
P1

P0
AD

0 Y2 Y1 Y0 Real National Income (GDP)

[ii]. Aggregate Demand
 The AD Curve and the AE Curve

E0 AE = Y AE0
Desired Expenditure

AE1
E1
AE2

E2
[i]. Aggregate expenditure

45o
0 Y2 Y1 Y0 Real National Income [GDP]

[ii]. Aggregate Demand

Price Level

E2
P2
E1
P1 E0
AD
P0

Real National Income [GDP]

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.
Relationship between AE and
AD curves •Points to the left
AE=Y of the AD curve
e2
E0 AE show
Desired spending

AE
e0
combinations of
e1
GDP and the price
level for which
45o
Y1 Y0 Y2
aggregate desired
0 Real GDP
spending exceeds
AD
Desired spending output and vice
Price level

less than output

versa. There is
Desired spending
thus pressure for
P0 X E0 Z equal output output to rise as
0
firms could sell
Y1 Y0 Y2 Real GDP
Desired spending more than their
exceeds output
current output.
The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Expenditure

Desired Expenditure AE = Y
E1 AE1

AE0

E0

A

45o

0 Y0 Y1 Real GDP

Y1
The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Demand

Price Level

E0 E1

P0

Y AD1
AD0

0 Y0 Y1 Real GDP
 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.
 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.
 AE shifts to AE because of an autonomous
0 1
expenditure increase A, and GDP increases to
Y1.
 With given price level P , the AD curve shifts
0
rightward to E1.
A Short-run Aggregate Supply Curve

SRAS

Y Real GDP
 A Short-run Aggregate Supply Curve

SRAS

P0

Y0 Real GDP
 A Short-run Aggregate Supply Curve

SRAS

P1

P0

Y0 Y1 Real GDP
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.
 Macroeconomic Equilibrium

AD
SRAS
Price Level

E0
P0

0 Y0 Real GDP
 Macroeconomic Equilibrium

AD
Price Level

SRAS

E0
P0

P1

0 Y1 Y0 Y2 Real GDP
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 E with GDP equal to Y
0 0
and the price level P0.
Macroeconomic Equilibrium

 Ifthe 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.
The AE Curve and the Multiplier When the Price Level Varies

AE=Y
Desired Expenditure
E0 AE0 [i]. Aggregate expenditure

45o
Y0 Real GDP

SARS

[i]. Aggregate demand

Price Level

P0
AD0

Y0
Real GDP
The AE Curve and the Multiplier When the Price Level Varies

AE=Y
Desired Expenditure E’1
AE’1
E0 AE0 [i]. Aggregate expenditure
A

45o
Y0 Y’1 Real GDP

SARS

[i]. Aggregate demand

Price Level

E0 E’1
P0
AD0

Y0 Y’1
Real GDP
The AE Curve and the Multiplier When the Price Level Varies

E1 AE=Y
Desired Expenditure E’1
AE’1
E0 AE0 AE1 [i]. Aggregate expenditure
A

Y

45o
Y0 Y1 Y’1 Real GDP

SARS

[i]. Aggregate demand

Price Level

E1
P1 E0 E’1
P0
AD1
AD0
Y0 Y1 Y’1
Real GDP
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.
The effect of any given change in demand will be divided between real
output and price level, depending on conditions of supply curve .
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 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.

The effects of increases in AD

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.
Aggregate supply shocks
 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.
 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.
 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.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

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.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

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.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

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.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

 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.