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ECON 209 Chapter 23.docx

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Economics (Arts)
ECON 209
Paul Dickinson

ECON 209 February 5, 2013 Chapter 23 – Output and Prices in the Short Run 23.1 The Demand Side of the Economy Exogenous Changes in the Price Level: Changes in Consumption:  The relationship btwn price level and desired consumption has to do w/ how changes in price level  changes in household wealth  changes in desired spending  Much of private sector’s total wealth is held in the form of fixed assets w/ a nominal val (e.g. MONEY)  What money can actually buy depends on the price level… higher price level = lower purchasing pwr of money  Other fixed assets include gov’t and corporate bonds… changes in the price level change the wealth of bond holders and bond issuers o In dollar terms, the bondholder’s reduction in wealth is directly offset by the issuer’s increase in wealth when price level falls (and vice versa) o NO CHANGE IN AGGREGATE WEALTH results from a change in price level (in terms of bonds)  Rise in price level  reduction in real val of private sector wealth  downward shift in the AE function (and vice versa) Changes in Net Exports:  Rise in domestic price level (w/ a constant exchange rate)  downward shift in the NX function  downward shift in AE curve (and vice versa) Changes in Equilibrium GDP:  Exogenous rise in the price level  downward shifts in both NX function and consumption function  THEREFORE: exogenous rise in the price level  downward shift in AE curve  fall in equilibrium level of real GDP The Aggregate Demand Curve:  Price level and real equilibrium GDP are negatively related  Aggregate demand curve: curve showing combos of real GDP and the price level that make desired aggregate expenditure = actual nat’l income  AD and AE curves can be plotted on the same axis so that levels of GDP can be compared directly  AD curve is negatively sloped 1. Rise in price level  downward shift in AE curve  mvmt upward and to the left along the AD curve (fall in equilibrium level of GDP) 2. Fall in price level  upward shift in AE curve  mvmt downward and to the right along the AD curve (rise in the equilibrium level of GDP)  AD curve is negatively sloped for 2 reasons: 1. Fall in price level  rise in private sector wealth  increased desired consumption  increased equilibrium GDP 2. Fall in price level (for a give exchange rate)  rise in net exports  increased equilibrium GDP  NOTE – B/c AD curve relates equilibrium GDP to price level:  Changes in price level that cause shifts in the AE curve are simply mvmts along the AD curve  A mvmt along the AD curve traces out the response of equilibrium GDP to a change in price level Shifts in the AD Curve: For a given price level, any event that leads to a change in equilibrium GDP will cause the AD curve to shift  Any change other than a change in price level that causes the AE curve to shift will also cause the AD curve to shift – such a shift is called an aggregate demand shock  For a given price level:  Increase in autonomous aggregate expenditure shifts the AE curve upward and the AD curve to the right  Fall in autonomous aggregate expenditure shifts the AE curve downward and the AD curve to the left  IMPORTANT POINT: in order to shift the AD curve, change in autonomous aggregate expenditure must be caused by something other than a change in the domestic price level  A change in aggregate expenditure caused by a change in the domestic price level  mvmt along (not a shift of) the AD curve The Simple Multiplier and the AD Curve:  The simple multiplier msrs the size of the change in equilibrium national income in response to a change in autonomous expenditure when the price level is held constant  The simple multiplier msrs the horizontal shift in the AD curve in response to a change in autonomous desired expenditure 23.2 The Supply Side of the Economy To explain changes in the price level, we need to take acct of the supply decisions of firms The Aggregate Supply Curve:  Aggregate supply: refers to the total output of goods and services that firms would like to produce  Aggregate supply curve: curve showing the relation btwn the price level and the qty of aggregate output supplied, for given technology and factor prices The Positive Slope of the AS Curve:  Unit cost: cost per unite of output, equal to total cost divided by total output  AS curve is drawn on the assumption that technology and prices of all factors of production remain constant… THIS DOES NOT MEAN UNIT COSTS WILL REMAIN CONSTANT  Unit costs tend to rise as output rises  If their unit costs rise w/ output, price-taking firms will produce more only if price increases… they will produce less if price falls  Price-setting firms will increase their prices when they expand their output into the range where unit costs are rising  Price-setting firms will eventually decrease their prices if a reduction in their output leads to a reduction in unit costs (when demand falls, price-setting firms will reduce output; competition among them will tend to cause a reduction in prices whenever unit costs fall)  Actions of both price-taking and price-setting firms cause the price level and the supply of output to be positively related – the AS curve is positively sloped The Increasing Slope of the AS Curve:  At low levels of GDP the AS curve is relatively flat; as GDP rises the AS curve gets progressively steeper… WHY?  Output below potential = firms have excess capacity = OUTPUT IS TRULY DEMAND DETERMINED  The more output is expanded beyond normal capacity, the more unit costs rise, and the larger is the rise in price necessary to induce firms to increase output  Increasing slope of the AS curve: first asymmetry in the behaviour of aggregate supply  Shape of the AS curve is crucial for determining how the effect of an aggregate demand shock is divided btwn a change in price level and a change in real GDP  IN SUMMARY:  AS curve is positively sloped – firms will provide more aggregate output only at a higher price level  The higher the level of output, the faster the unit costs tend to rise w/ each extra increment to output… this explains why the AS curve becomes steeped as output rises Shifts in the Aggregate Supply Curve: For a given level of output, anything that changes firms’ production costs will cause the AS curve to shift… 2 particularly important sources of change are:  Changes in the price of inputs  Can change b/c of ENDOGENOUS or EXOGENOUS forces  Aggregate supply shock: any shift in the AS curve caused by an exogenous force  Changes in productivity Changes in Input Prices:  If factor prices rise:  For any given level of output
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