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Chapter 23

Chapter 23- Output and Prices in the Short Run.docx

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University of Toronto Mississauga
Kalina Staub

Chapter 23- Output and Prices in the Short Run 23.1 The Demand Side of the Economy • Understand how an exogenous change in the prove level effects desired aggregate expenditure in order to find out what would happen to equilibrium GDP is there were different price levels Exogenous Changes in the Price Level • AE curve shifts because change in price level affects:  Desired consumption expenditures (Changes in Consumption) o Relationship between price level and desired consumption has to do with how changes in the price level lead to changes in household wealth and thus to changes in desired spending o Most of private sector’s total wealth is held in form of assets with fixed nominal value (money, government and corporate bonds) o A rise in the price level lowers the real value of money held by the private sector ;The higher the price level, the fewer g/s a given amount of money can purchase o A fall in the price level raises the real value of money held by the private sector  Ex. Bondholder’s reduction in wealth is exactly offset by issuer’s increase in wealth; 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  Desired net exports (Changes in Net Exports) o A rise in domestic price level (with constant exchange rate) shifts the net export function downward, which causes a downward shift in the AE curve o A fall in the domestic price level shifts the net export function upward and hence the AE curve upward Changes in Equilibrium GDP • An exogenous rise in price level causes a downward shift in the AE curve and decreases the equilibrium level of real GDP • Fall in price level  Canadian goods become cheaper so net exports rise  Purchasing power of nominal assets increases so households spend more  Resulting increase in desired expenditure on Canadian goods causes AE curve to shift upward  Equilibrium level of GDP therefore rises • A Change of Labels  Horizontal axis is labelled as Real GDP because the price level will now be changing and thus it is necessary to distinguish changes in Nominal GDP from changes in Real GDP The Aggregate Demand Curve • Aggregate demand curve is shown by negative relationship between price level and real equilibrium GDP • Aggregate Demand Curve- A curve showing combinations of real GDP and the price level that make desired aggregate expenditure equal to actual nominal income; Placed under the AE curve • Because AD curve relations equilibrium GDP to the price level, changes in the price level that cause shifts in the AE curve are simply movements along the AD curve • The AD Curve is Not Micro Demand Curve  Information to establish that AD Curve is negatively sloped o A rise in the price level causes the AE curve to shift downward and hence leads to a movement upward and to the left along the AD curve, reflecting a fall in the equilibrium level for GDP o A fall in the price level causes the AE curve to shift upward and hence leads to a movement downward and to the right along the AD curve, reflecting a rise in the equilibrium level of GDP  Micro demand curve describes a situation in which the price of one commodity changes which the prices of all other commodities and consumer’s dollar incomes are constant; negatively sloped for two reasons: 1. As price of commodity falls, purchasing power of each consumer’s income will rise and this rise in real income will lead to more units of the good being purchased o Does not apply to AD curve because $ value of national income is not being held constant as price level changes and we move along the AD curve 2. As the price of the commodity falls, consumers buy more of that commodity and fewer of the now relatively more expensive substitutes o Applies to AD curve but only in a limited way; change in price level does not change relative prices of domestic goods and thus does not cause consumers to substitute between them however change in domestic price level does lead to change in international relative prices and to some substitution between domestic and foreign goods • Shifts in the AD Curve  For a given price level, any event that leads to a change in equilibrium GDP will cause AD curve to shift  Because AD curve plots equilibrium GDP as function of the price level, anything that alters equilibrium GDP at a given price level must shift the AD curve  Aggregate Demand Shock- Any event that causes a shift in the aggregate demand curve  For a given price level, 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  Note: In order to shift the AD curve, the change in autonomous expenditure must be caused by something other than the change in the domestic price level • The Simple Multiplier and the AD Curve  The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure  If price level remains constant and producers are willing to supply everything that is demanded at that price level, the simple multiplier will also show the change in equilibrium income that will occur in response to change in autonomous expenditure 23.2 The Supply Side of the Economy The Aggregate Supply Curve • Aggregate Supply Curve- A curve showing the relation between the price level and the quantity of aggregate output supplied, for two assumptions:  The state of technology is constant  The prices of all factors of production are constant • The Positive Slope of the AS Curve  Unit Cost- Cost per unit of output, equal to total cost divided by total output  Unit costs tend to rise as output rises, even when
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