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The Price Level
2
•Up to this point, we have not said much about prices and the price level (P)
• In this chapter we derive the: • Aggregate Demand curve which shows the relation between aggregate expenditure (AE) and the price level (P)
• Aggregate Supply curve shows the relation between aggregate production and the price level (P)
Derivation of Aggregate Demand (AD) Curve
• Start with money demand. An increase in the price level shifts the money demand curve rightward– increasing the equilibrium interest rate (if
the Fed does not increase the money supply)
– causing the aggregate expenditure line to shift downward
– resulting in a lower equilibrium level of GDP.
3
Deriving the Aggregate Demand Curve (a)
4
Interest
Rate
Money ($ billions)
M1d
9%
500
MS
6%A
M2d
B
As the price level, say the CPI, increases from 100 to 140, money demand increases and the interest rate rises.
Deriving the Aggregate Demand Curve (b, c)
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Real Aggregate
Expenditure
($ Trillions)
Real GDP ($ Trillions)
45°
10
AEr=6%E
AEr=9%
6
F
The rise in the interest rate causes real GDP to fall.
Price level
Real GDP ($ Trillions)106
On the AD curve, a higher price level is associated with a lower real GDP.
AD
K
H140
100
The Aggregate Demand Curve
• a curve indicating equilibrium GDP at each price level, with a constant money supply
• its NOT a demand curve at all!
• it is actually an “equilibrium-output-at-each-price-level” curve
6
The Aggregate Demand Curve• Movements along the AD curve
– a change in the price level causes equilibrium GDP to change
7
This inverse relationship between P and Y caused by the change in the interest rate is called the interest rate effect
The Aggregate Demand (AD) Curve
• Another reason for a downward-sloping aggregate demand curve is the Real Wealth Effect• This is the change in consumption
brought about by a change in real wealth that results from a change in the price level.
Nominal and Real Wealth
Nominal Wealth (W) = Assets – Liabilities
Real Wealth is the purchasing power of wealth =
Two things change real wealth: W or P
W
P
As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑
C
Y
450
Y0 Y1
A
BAE0
AE1
As P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓ P and Y move in opposite directions. The AD curve Slopes downward to the right.
What shifts the AD curve ?
• Changes in any of the variables that shift the AE curve: – Government purchases (G)– Planned Investment spending (IP) – Autonomous consumption spending (a)– Taxes (T)– Net exports (NX)– The money supply (M)
11
The Aggregate Demand Curve
• AD curve shifts rightward when: – Government purchases (G) increase– Planned Investment spending (IP) increases– Autonomous consumption spending (a)
increases– Net exports increase– Net taxes decrease – Money supply increases
12
A Spending Change Shifts the AD Curve
13
Real Aggregate
Expenditure
($ Trillions)
Real GDP ($ Trillions)
45°
12.5
AE1
10
E
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
Get the multiplier effect we introduced in chapter 11.
Price level
Real GDP ($ Trillions)12.510
Since real GDP is higher at the given price level, the AD curve shifts rightward.
H to J is the multiplier effect we introduced in chapter 11
AD1
H100
AE2F
AD2
J
Change in Price Level Moves Along the AD Curve (a)
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Price
Level
Real GDP
AD
P3
Price level ↑ moves us leftward along the AD curve
Q3
P1
P2
Q1 Q2
Price level ↓ moves us rightward along the AD curve
Effects of Key Changes on the Aggregate Demand Curve (b, c)
15© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Price Level
Real GDP
AD1
Entire AD curve shifts rightward if:
• a, Ip, G, or NX increases
• Net taxes decrease
• The money supply increases
AD2
Price Level
Real GDP
AD1
Entire AD curve shifts leftward if:
• a, Ip, G, or NX decreases
• Net taxes increase
• The money supply decreases
AD2
The Aggregate Supply Curve
Assumptions:• Firms set the price of their products as a
markup over unit cost of production p = unit cost + mark-up
• Average percentage markup in the economy is determined by competitive conditions in the economy– so we treat the mark-up as stable (fixed)
from year to year• The competitive structure of the economy
changes very slowly16
The Aggregate Supply Curve
• In general, changes in GDP affects unit costs of production– As total GDP(output) increases:
• greater amounts of inputs are needed to produce the greater output
• the prices for non-labor inputs rise • the price of labor, the nominal wage rate,
can also increase (but we make an assumption about this in the short-run!)
17
The Aggregate Supply Curve• We assume that in the short-run the
price of labor, nominal wages, are “fixed”, “sticky”– union contracts– can be costly to firms– reputation for paying stable wages– slow-moving bureaucracies
• THIS IS A KEY ASSUMPTION!!!– nominal wage rate is fixed in the short run– changes in output have no effect on the
nominal wage rate in the short run18
The Aggregate Supply Curve
• In the short run, a change in output will affect non-labor costs of production– a rise in real GDP raises firms’ unit costs
• Input requirements increase: coal, oil lumber, copper,…….
• The prices of these non-labor inputs rise
– A decrease in real GDP lowers unit costs • Input requirements decrease• Prices of non-labor inputs fall
19
The Aggregate Supply Curve
• Aggregate Supply (AS) curve– a curve indicating the price level
consistent with firms’ unit costs and markups for any level of output (Y) in the short run
– it is actually a “short-run-price-level-at-each-output-level” curve
– its upward sloping• Price level on the vertical axis• Total output on the horizontal axis
20
The Aggregate Supply Curve
21© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Price
Level
Real GDP
AS
130
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
6
100
80
10 12.5
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
C
A
B
The Aggregate Supply Curve• Movements along the AS curve
– A change in real GDP causes the price level to change
Wages are sticky! Labor costs do not change in the short-run.
Another View of the Aggregate Supply Curve
• In the short run there must be a lag between changes in output prices and changes in input prices, otherwise the aggregate supply (price/output response) curve would be vertical.
• If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.
Slope Matters!Shape of the Short-run Aggregate Supply Curve - Ordinary Conditions
Moderate Levels of :
Unemployment -
Unemployment Rate: 5 -10%
Some excess Capacity -
Ex. Cap Rate: 10-25%
AS exhibits a Positive Slope
Aggregate Supply Curve - Ordinary Conditions Implications
With the positive slope:
Change in output (Y) causes a moderate change in the price level (P)
Shape of the Short-run Aggregate Supply Curve - Slack Conditions
• 26 of 23
High Levels of:
• Unemployment -
Unemployment Rate > 10%
• Lot of excess Capacity - Ex Cap Rate > 25%
• AS is Almost Flat
Shape of the Short-run Aggregate Supply Curve - Slack Conditions - Implications
With a flat slope:
The economy can expand a lot with small increase in P because of the excess capacity.
Shape of the Short-run Aggregate Supply Curve - Tight Conditions
Low Levels of:
Unemployment -
Unemployment Rate < 3%
Little excess Capacity-
Ex Cap Rate < 10%
• AS is Very Steep
Shape of the Short-run Aggregate Supply Curve - Tight Conditions - Implication
• 29 of 23
AS
Large increase in P for a relatively small increase in GDP (Y).
The Aggregate Supply Curve is not a straight line
[--Slack-----] [--Ordinary--] [--Tight--]
Capacity
What Causes the Aggregate Supply Curve to Shift?• Increase in AS means the AS curve shifts downward:
– Lower world oil prices– Good weather – Technological change– Regulation– Lower nominal wages
• Decrease in AS means the AS curve shifts upward: – Higher world oil prices
– Bad weather – Technological change(negative?), stupid pills(?)– Regulation– Higher nominal wages
31
Shift of the Aggregate Supply Curve
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Price
Level
Real GDP
AS1
140 When unit costs rise at any given real GDP—e.g., from an increase in world oil prices or bad weather for farm production—the AS curve shifts upward.
100
10
A
AS2
L
Effects of Key Changes on the Aggregate Supply Curve (a)
33© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Price
Level
Real GDP
AS
Real GDP ↑ moves us rightward along the AS curve
Y3 Y1 Y2
Real GDP ↓ moves us leftward along the AS curveP3
P1
P2
Effects of Key Changes on the Aggregate Supply Curve (b, c)
34
Price Level
Real GDP
AS1
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
AS2
Price Level
Real GDP
AS1
Entire AS curve shifts downward if unit costs ↓ for any reason besides a decrease in real GDP
AS2
AD and AS: Short-Run Equilibrium
• Short-run macroeconomic equilibrium – a combination of price level and GDP
consistent with both the AD and AS curves
35
At point E, the price level of 100 is consistent with an output of $10 trillion along the AD curve. The output level of $10 trillion is consistent with a price level of 100 along the AS curve. At any other combination of price level and output, such as point F or point B, at least one condition for equilibrium will not be satisfied.
Short-Run Macroeconomic Equilibrium
36
Price
Level
Real GDP
AS
140
6
100
10 14
B
AD
E
F80
Excess Supply
Excess Demand
At point B, AS > AD. Excess Supply.P will fall from 140 to 100 and Y will fall from 14 to 10. As P and Y fall, the interest rate falls which means C and Ip increases causing AD to increase.
Movements along the curves!
Short-Run Macroeconomic Equilibrium
37
Price
Level
Real GDP
AS
140
6
100
10 14
B
AD
E
F80
Excess Supply
Excess Demand
The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories increased.Here, Y, P , money demand, the interest rate(r) and AE all adjust.
At point F, AD > AS. Excess Demand.
P will increase from 80 to 100 and Y will increase from 6 to 10.
As P and Y increase, the interest rate rises which means C and Ip fall causing AD to decrease
Movements along the curves!
Short-Run Macroeconomic Equilibrium
38
Price
Level
Real GDP
AS
140
6
100
10 14
B
AD
E
F80
Excess Supply
Excess Demand
The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories decreased. Here, Y, P , money demand, the interest rate(r) and AE all adjust.
What Happens When Things Change?• Demand shock
– this is any event that causes the AD curve to shift
– for example, a change in government purchases or a change in the money supply
• Supply shock – an event that causes the AS curve to shift– e.g., increase or decrease in world oil
price, regulation, nominal wages.
39
Point J illustrates where the economy would move if the price level remained constant; multiplier = (1/(1-MPC). But, as output increases, the price level rises. Thus, the economy moves along the AS curve from point E to point N.
The Effect of a Demand Shock: Increase G
40
Price
Level
Real GDP
$ Trillions
AS
110
10.0
100
11.5 12.5
AD1
E
AD2
N
J
Starting at point E, an increase in government purchases would shift the AD curve rightward to AD2
Relate back to the Keynesian 450 graph. Multiplier= (1/(1-MPC).
What Happens When Things Change?• Increase in government purchases
Crowding-out of interest-sensitive spending. Multiplier is less than (1/(1-MPC). Inflation and rising interest rates reduce the size of the multiplier.
The Effect of a Demand Shock• As P increases, money demand increases.
If the money supply is constant, the interest rate rises and crowds-out interest sensitive investment and consumer spending. Move up along the AD curve from point J to N.
• Crowding-out of interest-sensitive spending means the size of the multiplier is reduced.
• Inflation and the increase in the interest rate reduce the size of the multiplier.
What Happens When Things Change?• Decrease in government purchases
43
Crowding-in of interest-sensitive spending. Multiplier is larger than (1/(1-MPC). Falling prices and falling interest rates increase the size of the multiplier.
What Happens When Things Change?• Increase in money supply
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To sum up the short-run -• A positive demand shock
– shifts the AD curve rightward– increases both real GDP and the price
level in the short run • A negative demand shock
– shifts the AD curve leftward– decreases both real GDP and the price
level in the short run
45
Demand Shocks: Adjusting to Long Run
• In the short run we treat the wage rate and labor costs as given
• In the long run– the wage rate will change– when output is above full employment
• Wage rate will rise, shifting the AS curve upward
– when output is below full employment• Wage rate will fall, shifting the AS curve
downward
46
Demand Shocks: Adjusting to Long Run
• Self-correcting mechanism – the adjustment process where price and
wage changes return the economy to full-employment output in the long run
• If a demand shock pulls the economy away from full employment– changes in the wages and the price level
will eventually cause the economy to correct itself and return to full-employment output
47
St point E, a positive demand shock would shift the aggregate demand curve to AD2, raising both output and the price level.
In the short-run the economy moves to point N, output is above the full-employment level, YFE.
Firms compete to hire scarce workers, driving up the wage rate. In the long-run the higher wage rate will shift the AS curve to AS2. The economy returns to full-employment output at point L in the long-run.
Long-Run Adjustment after a Positive Demand Shock
49
Price
Level
Real GDP
AS1
YFE
P1
AD1
EAD2
Y2
P2 N
AS2
L
P4
Starting from point E, a negative demand shock shifts the AD curve to AD2, lowering GDP and the price level. In the short-run, output is below the full-employment level at point N. With unemployed labor available, wages and unit costs will fall, causing firms to lower their prices. The AS curve shifts downward until full employment is regained at point M, with a lower price level in the long-run.
Long-Run Adjustment after a Negative Demand Shock
51
Price
Level
Real GDP
AS1
YFE
P3 AD1
E
AD2
Y2
P2 N
AS2
P1
M
Demand shock : The self-correcting mechanism in the long-run• When output exceeds its full-employment
level– Wages will eventually rise– Causing a rise in the price level and a drop in
GDP until full employment is restored• When output is less than its full-employment
level– Wages will eventually fall– Causing a drop in the price level and a rise in
GDP until full employment is restored
52
Long-run Aggregate Supply Curve• Long-run aggregate supply curve
– A vertical line – Indicating all possible output and price-
level combinations at which the economy could end up in the long run
• The self-correcting mechanism– Shows us that, in the long run, the
economy will eventually behave as the classical model predicts
53
This figure illustrates a positive demand shock, but focuses on the long-run effects. The initial equilibrium is at point E, with output at full employment (YFE) and price level P1. After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE). The long-run AS curve—a vertical line—shows all possible combinations of price level and output for the economy, skipping over the short-run changes. The vertical, long-run AS curve shows that in the long run, demand shocks can affect the price level but not output.
The Long-Run AS Curve
54
Price
Level
Real GDP
AS1
YFE
P1
AD1
EAD2
Y2
P2 N
AS2
LP4
Long-Run AS Curve
Supply Shocks• Negative supply shock. In the short run
– the AS curve shifts upward• Decreasing output and increasing the price
level
– causes stagflation (falling output and rising prices)
• Positive supply shock. In the short run– the AS curve shifts downward
• Increasing output and decreasing the price level
55
A negative supply shock would shift the AS curve upward from AS1 to AS2.
In the short-run, equilibrium is at point R, the price level is higher and output (Y2) is below YFE.
Eventually, wages will fall, causing unit costs to fall, and the AS curve will shift back down to its original position.
The Effect of a Negative Supply Shock
56
Price
Level
Real GDP
AS1
P1
AD
E
Y2
P2
AS2
YFE
Long-Run AS Curve
R
A positive supply shock would shift the AS curve down from AS1 to AS2. In the short-run equilibrium at point R, the price level is lower and output is above YFE.
Eventually, wages will rise, causing unit costs to rise, and the AS curve will shift back up to its original position.
The Effect of a Positive Supply Shock
57
Price
Level
Real GDP
AS1
P1
AD
E
Y2
P2
AS2
YFE
Long-Run AS Curve
R
Supply Shocks• In the long run
– The economy self-corrects after a long-lasting supply shock
– When output differs from its full-employment level• The wage rate changes• AS curve shifts until full employment is
restored
58
The Story of Two Recessions• The recession of 1990-91
– a supply-shock recession– caused by a reduction in oil supply
• Price of oil doubled
• The recession of 2008-09– a powerful, negative demand shock
• Home prices – falling• Stock prices – plunged
59
An AD and AS Analysis of Two Recessions: 1990-91Recession
60
Price
Level
Real GDP
AS1990
YFE
AD1990
E
Y2
P2
AS1991
P1
R
1. In 1990, a supply shock
from higher oil prices shifted the AS curve leftward …
2. causing output to fall…
3. and the price level to rise
An AD and AS Analysis of Two Recessions: 2008-09 Recession
61
Price
Level
Real GDP
AS2007
YFE
AD2007
E
Y2
P2
P1
4. In 2008-09, a demand shock from several factors caused the AD curve to shift leftward …
5. causing output to fall…
6. and the price level to fall
AD2009
R
GDP and the Price Level in Two Recessions
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The Aggregate Supply Curve is not a straight line
[--Slack-----] [--Ordinary--] [--Tight--]
CapacityAD1
AD2
AD3
AD4
P1
P2
P3
P4Expansionary policy is inflationary and has small impact on aggregate output (Y)
Expansionary policy is not inflationary and has relatively large impact on aggregate output (Y)