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Chapter 8

Real GDP and the Price Level in the Short Run

8.1 The Demand Side of the Economy

• Exogenous Changes in the Price Level

– Changes in Consumption

 Much of the private sector’s total wealth is held in the form of assets with a fixed nominal value.

 The most obvious example is money.

 What this money can buy—its real value—depends on the price level.

 A rise in the price level lowers the real value of money held by the private sector, and a fall in the price level raises the real value of money held
by the private sector.

Changes in Consumption

• Changes in the price level change the wealth of bondholders and bond issuers, but because the changes offset each other, there is no change in
aggregate wealth.

• In summary, a rise in the price level leads to a reduction in the real value of the private sector’s wealth.

• A reduction in wealth leads to a decrease in autonomous desired consumption and to a downward shift in the AE function.

• A fall in the price level leads to a rise in wealth and desired consumption and to an upward shift in the AE function.

Changes in Net Exports

• When the domestic price level rises (and the exchange rate remains unchanged), Canadian goods become more expensive relative to foreign
goods.

• Canadian consumers reduce their purchases of Canadian-made goods and increase their purchases of foreign goods.

• Consumers in other countries reduce their purchases of Canadian-made goods.

• 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 upward and the AE curve upward.

Changes in Equilibrium GDP

• An exogenous increase in the price level causes AE0 to shift downward from to AE1 .

• The equilibrium changes from E0 to E1 and real GDP falls from Y0 to Y1 .

Figure 8-1 Desired Aggregate Expenditure and the Price Level

The Aggregate Demand Curve

• The aggregate demand (AD) curve is a curve showing combinations of real GDP and the price level that make desired aggregate expenditure equal
to actual national income.

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

• A fall in the price level causes the AE curve to shift upward and leads to a movement downward and to the right along the AD curve, reflecting a
rise in the equilibrium level of GDP.
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Figure 8-2 Derivation of the AD Curve

• As the price level rises from P0 to P1 to P2 , the AE curve shifts downward from AE0 to AE1 to AE2 .

• In the bottom graph, a movement occurs up along the AD curve.

• A change in the price level causes a shift of the AE curve but a movement along the AD curve.

Shifts in the AD Curve

• Any change that causes the AE curve to shift will also cause the AD curve to shift.

• Such a shift is called an aggregate demand shock.

• 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.

• The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure
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Figure 8-3 The Simple Multiplier and Shifts in the AD Curve

• An increase in autonomous expenditure shifts AE0 to AE1 .

• The size of the horizontal shift of the AD curve is equal to the simple multiplier times the increase in autonomous expenditure.

8.2 The Supply Side of the Economy

The Aggregate Supply Curve

• The aggregate supply (AS) curve is a curve showing the relation between the price level and the quantity of aggregate output supplied, for given
technology and factor prices.

• As output increases, less efficient standby plants may have to be used, and less efficient workers may have to be hired, while existing workers may
have to be paid overtime rates for additional work.

• For these reasons, unit cost, which is cost per unit of output, increases.
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Figure 8-4 The Aggregate Supply Curve

• The AS curve is positively sloped.

• The higher is the level of output, the faster unit costs tend to rise, so the AS curve becomes steeper as output rises.

Figure 8-5 Shifts in the AS Curve

• An increase in factor prices or a deterioration in technology shifts the AS curve leftward from AS0 to AS1 .

Shifts in the AS Curve

• Shifts in the AS curve caused by exogenous forces are called aggregate supply shocks.

• A rise in factor prices causes the AS curve to shift leftward.

• A fall in factor prices causes the AS curve to shift rightward.

• An improvement in technology causes the AS curve to shift rightward.

• A deterioration in technology causes the AS curve to shift leftward.

8.3 Macroeconomic Equilibrium

• Demand behaviour is consistent with supply behaviour only at the intersection of the AS and AD curves.

• E0 is the macroeconomic equilibrium.

Figure 8-6 Macroeconomic Equilibrium

Changes in Macroeconomic Equilibrium

• A shift in the AD curve is called an aggregate demand shock.

• A shift in the AS curve is called an aggregate supply shock.

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

• Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP.

Figure 8-7 Aggregate Demand Shocks

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

• Both rise with an increase in aggregate demand, and both fall with a decrease in aggregate demand.
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Figure 8-8 The Multiplier When the Price Level Varies

• 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.

Figure 8-9 The Effects of Increases in Aggregate Demand

• The effect of any given shift in AD will be divided between a change in Y and a change in P.

• The steeper the AS curve, the greater the price effect and the smaller the output effect.
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Figure 8-10 Aggregate Supply Shocks

• AS shocks cause P and Y to change in opposite directions.

• A negative supply shock shifts the AS curve leftward, and the rise in the price level shifts the AE curve downward.

Analyzing the 2020 Pandemic Recession with the AD/AS Model

• The combined effect of the negative AS shock and the negative AD shock from the COVID-19 pandemic was a sharp reduction in output and
employment.

• The economy’s ability to combine land, labour and capital to produce output was severely reduced. There was a large leftward shift in the AS
curve, and real GDP declined.

• For both businesses and households, the pandemic led to a significant reduction in demand even for an unchanged level of income. There was a
large leftward shift of the AD curve, and real GDP fell.
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• By the middle of 2021, vaccines for COVID-19 were becoming available in many countries and most economies were beginning to recover.

• Once individuals are able to safely return to their workplaces, the AS shock will reverse relatively quickly.

• Once stores, restaurants, airlines, and hotels are able to safely conduct business, households and firms will return to their normal level of
demand. The AD shock will reverse relatively quickly.

A Word of Warning

• Many economic events ‒ especially changes in the world price 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 demand-side and supply-side effects.