AE curve shifts in response to change in price level
Economics Chapter 23 Exogenous Changes in the Price Level - AE curve shifts in response to change in price level; occurs b/c change in price level affects desired consumption and desired net exports Changes in Consumption - Changes in price level lead to changes in household wealth and thus changes in desired spending - What money can buy—its real value—depends on price level - Rise in price level lowers the real value of money; reduction in price level raises value of money - Change in price level change wealth of bondholders and bond issues but b/c changes offset each other there is no change in aggregate wealth - A decrease in wealth leads to decrease in desired consumption and downward shift in AE Change in Net Exports - When price level rises and exchange rate remains unchanged, Canadian goods become more expensive relative to foreign goods which causes a decrease in exports and increase in imports - Rise in price level shifts net export function downward which shifts AE curve down - Fall in price level shifts net ex[ort up and AE up also Changes in Equilibrium GDP - When AE shifts down, equilibrium of real GDP falls A change of Labels - Changing y-axis from actual national income to real GDP—exact same meaning The Aggregate Demand Curve - Price level and real equilibrium GDP are negatively related to each other so we can form the aggregate demand curve out of this - Before price was set, now we let price vary and plot given price levels at various points to construct the aggregate demand (AD) curve—shows relationship between price level and equilibrium level of real GDP - AE and 45 degree line are plotted above AD curve so it can be plotted accordingly - Price level is y axis and real GDP is x axis - A rise in price level causes AE to shift down, a movement upward and to the left along AD curve reflecting a fall in equilibrium level of GDP - Fall in price levels causes AE to shift upward and leads to movement down and right along AD curve - Fall in price level leads to rise in private-sector wealth which increases desired consumption and leads to an increase in equilibrium GDP - A fall in price level leads to a rise in net exports and leads to an increase in equilibrium GDP - Price level goes down, people become relatively richer which increase their consumption which pushes up the AD curve Shifts in the AD curve - Shifts are caused by any event leading to a change in the equilibrium GDP other than price level - Aggregate demand shock: a shift in AD curve - For a given price level, an increase in autonomous aggregate expenditure (gov’t purchase/taxation, consumption, investment, foreign demand for exports) shifts AE curve upward and AD curve to the right. A fall in autonomous aggregate expenditure shifts AE down and AD left The Simple Multiplier of the AD Curve - Simple multiplier measures size of change in equilibrium national income in response to change in autonomous expenditure when price level is held constant; so it also measures size of horizontal shift in the AD curve in response to change in autonomous desired expenditure - If price level is constant and producers supply everything demanded, the simple multiplier also shows the change in equilibrium income that will occur in response to change in autonomous expenditure
23.3 The Supply Side of the Economy The Aggregate Supply Curve - Curve showing the relation between the price level and the quantity of aggregate output supplied for given technology and factor prices The Positive Slope of the AS curve Costs and Output - Unit cost: cost per unit of output equal to total cost divided by total output - Unit cost rises as output rises b/c less efficient plants must be used, less efficient workers have to be hired and existing workers have to be paid more—law of diminishing returns Prices and Output - Price takers: when there’s a lot of small firms who can’t influence market price & must accept price is set by market, when market price changes firms will react by altering level of production - If unit costs rise with output, price taking firms will produce more only if price increases and will produce less if price falls - Price setter: less firms in market, differentiated product that can still be called under one type (like cars) and they have influence over the market price. Will increase price when they expand output into range where unit costs rise and will decrease price if reduction in output lead to reduction in unit cost The increasing slope of the AS Curve - AS curve starts off flat and slowly gets very steep - When output is low (below potential output) firms have excess capacity (plant and equipment are idle), only a small increase in price of their output is needed to induce expansion of production; now output is demand determined up to level at which costs begin to rise - Once output is pushed above normal capacity, cost rises rapidly; higher cost production must be adopted, the more output the more costs rise and larger is rise in price necessary to induce firms to increase output - Increasing slope of AS curve is first asymmetry in behaviour of aggregate supply Shifts in the Aggregate Supply Curve - Anything that changes firms’ production costs cause AS curve to shift - Change in price of inputs and changes in productivity shift AS curve - Input prices change b/c: of things internal to our model like endogenous variables like a rise in production increases demand for inputs and bids up price which shifts AS or it may be exogenous forces like the price of oil going up which makes inputs more expensive - Exogenous forces that shift AS curve are called aggregate supply shocks Changes in Input Prices - If factor price rises, firms find profitability of current production reduced; if prices don’t change firms decrease production, making there be less output for economy as a whole thus shifting AS curve upward and to the left - A fall causes the opposite effect; AS curve shifts downward to the right Changes in Productivity - Productivity is how much each factor of production can produce with given amount of effort and resources - If labour productivity rises (each worker can produce more with given amount of effort and other resources) unit cost falls so it becomes more profitable to produce which means firms increase production which means AS curve as a whole shifts downward to the right because prices go down and output goes up 23.3 Macroeconomic Equilibrium - Macroeconomic equilibrium: where AS and AD curve intersect—combination of real GDP and price level
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If price is below equilibrium, desired output of firms is less than desired aggregate expenditure so there’s excess demand - If price is above equilibrium there is excess supply Changes in Macroeconomic Equilibrium - Aggregate demand shocks: positive shocks (if AD shifts right), negative shock (if AD shifts left) - Aggregate supply shocks: positive shock (AS shifts right), negative shock (AS shifts left) - Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP Aggregate Demand Shocks - Aggregate demand shocks cause price level and real GDP to change in the same direction ; both rise w/ an increase in AD and both fall with decrease in AD The Multiplier when the Price Level Varies - Instead of having horizontal supply, now it slopes upward so simple multiplier no longer calculates the magnitude of change in AE, now this is dissipated by the AS curve - When AS curve is upward sloping, an AD shock leads to a change in price level. So multiplier is smaller than simple multiplier - First, there is an increase in AE, this causes the AD curve to shift right which causes a rise in price level which affects net exports and desired consumption which then brings down AE curve not completely back to where it was but somewhere in between The importance of the Shape of the AS curve - Has 3 distinct ranges - Over the flat range: change in AD leads to no change in price (demand-determined and simple multiplier shows magnitude of AD shifting) - Over intermediate range: where AS is positively sloped a shift in AD gives rise to appreciable changes in real GDP and price level. The multiplier is positive but smaller than the simple multiplier - Over steep range: little more can be produced. Economy is near capacity constraints and any change in AD leads to a sharp change in price level and little or no change in GDP which means multiplier is nearly zero - The steeper the AS curve, the greater price effect and smaller output effect Reconciliation with Previous Analysis - AD shocks typically lead to change in both price level and level of real GDP - But when AS curve is very steep, shock to AD changes price but no level of real GDP - AE curve is drawn on assumption there is constant price level but with an increasing AS curve, some of the shock is cancelled out and the AE curve moves back down, if it is vertical then all the shock is cancelled out and only price will increase Aggregate Supply Shocks - Negative AS shock means less real output, higher price - Positive AS shock means more real output, lower price - AS shocks cause price level and real GDP to change in opposite direction - Many economic events—esp. changes in world prices of raw materials—cause both AD and AS shocks in the same economy. Overall effect on real GDP in that economy depends on the relative importance of the two separate effects The Keynesian AS Curve - When real GDP is below potential GDP individual firms operate with excess capacity then respond to changes in demand by altering output while keeping price constant will supply whatever they can sell at existing prices as long as they are producing below normal capacity - When demand rises enough, firms cost rises and so will their price The Asian Crisis and the Canadian Economy - When Asian economies stopped needing as much raw materials, the AD curve in Canada felt the shock b/c of decreased exports (leftward shifting AD curve)
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Canada also produces a lot of things using raw materials so when price of raw materials fell these companies’ unit costs went down s they produced more (AS curve shifts right) Overall effect on Canadian economy? Since Canada is a net exporter of raw materials (exports more raw materials than it imports) it must experience decrease in national income when prices fall. Net effect of negative demand shock and positive supply shock reduces Canadian GDP so the shock to the AD is larger than shock to the AS making equilibrium level lower
23.3 The Supply Side of the Economy The Aggregate Supply Curve - Curve showing the relation between the price level and the quantity of aggregate output supplied for given technology and factor prices The Positive Slope of the AS curve Costs and Output - Unit cost: cost per unit of output equal to total cost divided by total output - Unit cost rises as output rises b/c less efficient plants must be used, less efficient workers have to be hired and existing workers have to be paid more—law of diminishing returns Prices and Output - Price takers: when there’s a lot of small firms who can’t influence market price & must accept price is set by market, when market price changes firms will react by altering level of production - If unit costs rise with output, price taking firms will produce more only if price increases and will produce less if price falls - Price setter: less firms in market, differentiated product that can still be called under one type (like cars) and they have influence over the market price. Will increase price when they expand output into range where unit costs rise and will decrease price if reduction in output lead to reduction in unit cost The increasing slope of the AS Curve - AS curve starts off flat and slowly gets very steep - When output is low (below potential output) firms have excess capacity (plant and equipment are idle), only a small increase in price of their output is needed to induce expansion of production; now output is demand determined up to level at which costs begin to rise - Once output is pushed above normal capacity, cost rises rapidly; higher cost production must be adopted, the more output the more costs rise and larger is rise in price necessary to induce firms to increase output - Increasing slope of AS curve is first asymmetry in behaviour of aggregate supply Shifts in the Aggregate Supply Curve - Anything that changes firms’ production costs cause AS curve to shift - Change in price of inputs and changes in productivity shift AS curve - Input prices change b/c: of things internal to our model like endogenous variables like a rise in production increases demand for inputs and bids up price which shifts AS or it may be exogenous forces like the price of oil going up which makes inputs more expensive - Exogenous forces that shift AS curve are called aggregate supply shocks Changes in Input Prices - If factor price rises, firms find profitability of current production reduced; if prices don’t change firms decrease production, making there be less output for economy as a whole thus shifting AS curve upward and to the left - A fall causes the opposite effect; AS curve shifts downward to the right Changes in Productivity - Productivity is how much each factor of production can produce with given amount of effort and resources - If labour productivity rises (each worker can produce more with given amount of effort and other resources) unit cost falls so it becomes more profitable to produce which means firms increase production which means AS curve as a whole shifts downward to the right because prices go down and output goes up 23.3 Macroeconomic Equilibrium - Macroeconomic equilibrium: where AS and AD curve intersect—combination of real GDP and price level
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If price is below equilibrium, desired output of firms is less than desired aggregate expenditure so there’s excess demand - If price is above equilibrium there is excess supply Changes in Macroeconomic Equilibrium - Aggregate demand shocks: positive shocks (if AD shifts right), negative shock (if AD shifts left) - Aggregate supply shocks: positive shock (AS shifts right), negative shock (AS shifts left) - Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP Aggregate Demand Shocks - Aggregate demand shocks cause price level and real GDP to change in the same direction ; both rise w/ an increase in AD and both fall with decrease in AD The Multiplier when the Price Level Varies - Instead of having horizontal supply, now it slopes upward so simple multiplier no longer calculates the magnitude of change in AE, now this is dissipated by the AS curve - When AS curve is upward sloping, an AD shock leads to a change in price level. So multiplier is smaller than simple multiplier - First, there is an increase in AE, this causes the AD curve to shift right which causes a rise in price level which affects net exports and desired consumption which then brings down AE curve not completely back to where it was but somewhere in between The importance of the Shape of the AS curve - Has 3 distinct ranges - Over the flat range: change in AD leads to no change in price (demand-determined and simple multiplier shows magnitude of AD shifting) - Over intermediate range: where AS is positively sloped a shift in AD gives rise to appreciable changes in real GDP and price level. The multiplier is positive but smaller than the simple multiplier - Over steep range: little more can be produced. Economy is near capacity constraints and any change in AD leads to a sharp change in price level and little or no change in GDP which means multiplier is nearly zero - The steeper the AS curve, the greater price effect and smaller output effect Reconciliation with Previous Analysis - AD shocks typically lead to change in both price level and level of real GDP - But when AS curve is very steep, shock to AD changes price but no level of real GDP - AE curve is drawn on assumption there is constant price level but with an increasing AS curve, some of the shock is cancelled out and the AE curve moves back down, if it is vertical then all the shock is cancelled out and only price will increase Aggregate Supply Shocks - Negative AS shock means less real output, higher price - Positive AS shock means more real output, lower price - AS shocks cause price level and real GDP to change in opposite direction - Many economic events—esp. changes in world prices of raw materials—cause both AD and AS shocks in the same economy. Overall effect on real GDP in that economy depends on the relative importance of the two separate effects The Keynesian AS Curve - When real GDP is below potential GDP individual firms operate with excess capacity then respond to changes in demand by altering output while keeping price constant will supply whatever they can sell at existing prices as long as they are producing below normal capacity - When demand rises enough, firms cost rises and so will their price The Asian Crisis and the Canadian Economy - When Asian economies stopped needing as much raw materials, the AD curve in Canada felt the shock b/c of decreased exports (leftward shifting AD curve)
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Canada also produces a lot of things using raw materials so when price of raw materials fell these companies’ unit costs went down s they produced more (AS curve shifts right) Overall effect on Canadian economy? Since Canada is a net exporter of raw materials (exports more raw materials than it imports) it must experience decrease in national income when prices fall. Net effect of negative demand shock and positive supply shock reduces Canadian GDP so the shock to the AD is larger than shock to the AS making equilibrium level lower
