MGEA06H3 Chapter Notes - Chapter 6: Canadian Dollar, Exogeny, Aggregate Supply
DepartmentEconomics for Management Studies
Chapter 23 Output and Prices in the Short Run Notes
23.1 The Demand Size of the Economy
Exogenous Changes in the Price Level
x AE curve shifts in response to a change in price level
x this shift occurs because a change in the price level affects desired consumption expenditures and desired net exports
x a rise in the price level lowers the real value of money held by the private sector; a fall in the price level raises the real value of
money held by the private sector
x 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
x a rise in the domestic price level reduces private-sector wealth, which leads to a fall in desired consumption, and thus a
downward shift in the AE curve; a fall in the domestic price level leads to a rise in wealth and desired consumption and thus to
an upward shift in the AE curve
x a rise in the domestic price level 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 and hence the AE curve upward
Changes in Equilibrium GDP
x when the AE curve shifts downward, the equilibrium level of real GDP falls
x as the AE curve shifts upward, the equilibrium level of real GDP rises
The Aggregate Demand Curve
x aggregate demand (AD) curve—a curve showing combinations of real GDP and the price level that make desired aggregate
expenditure equal to actual national income
x for any given price level, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP
x 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 of GDP
x 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
x aggregate demand shock—any shift in the aggregate demand curve
x 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
x the simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure
23.2 The Supply Side of the Economy
The Aggregate Supply Curve
x aggregate supply (AS) curve—a curve showing the relationship between the price level and the quantity of aggregate output
supplied, on the assumption that technology and all factor prices are held constant
x unit cost—cost per unit of output, equal to total cost divided by total output
x if unit costs rise with output, price-taking firms will produce more only if price increases; they will produce less if price falls
x price-setting firms will increase their prices when they expand their output into the range where unit costs are rising; they will
eventually decrease their prices if a reduction in their output leads to a reduction in unit costs
x the actions of both price-taking and price-setting firms cause the price level and the supply of output to be positively related—the
aggregate supply A(S) curve is upward sloping
Shifts in the Aggregate Supply Curve
x aggregate supply shock—any shift in the aggregate supply (AS) curve
x a change in either factor prices or productivity will shift the AS curve because any given output will be supplied at a different
price level than previously; an increase in factor prices or a decrease in productivity shifts the AS curve to the left; an increase in
productivity or a decrease in factor prices shifts the AS curve to the right
23.3 Macroeconomic Equilibrium
x only at the combination of real GDP and price level given by the intersection of the AS and AD curves are demand behaviour
and supply behaviour consistent
Changes in the Macroeconomic Equilibrium
x aggregate demand and supply shocks are labelled according to their effect on real GDP; positive shocks increase equilibrium
GDP; negative shocks reduce equilibrium GDP
Aggregate Demand Shocks
x 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
x when the AS curve is upward sloping, an aggregate demand shock leads to a change in the price level; as a result, the multiplier
is smaller than the simple multiplier
x the effect of any given shift in AD will be divided between a change in real output and a change in the price level, depending on
the conditions of AS; the steeper the AS curve, the greater the price effect and the smaller the output effect
Aggregate Supply Shocks
x aggregate supply shocks cause the price level and real GDP to change in opposite directions; with an increase in supply, the price
level falls and GDP rises; with a decrease in supply, the price level rises and GDP falls
A Word of Warning
x many economic events—especially changes in the world prices 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
two separate effects
23.1 The Demand Side of the Economy
x The AE curve shows desired aggregate expenditure for each level of GDP at a particular price level. Its intersection with the 45°
line determines equilibrium GDP for that price level. Equilibrium GDP that occurs where desired aggregate expenditure equals
actual GDP. A change in the price level changes private-sector wealth and thus causes a shift in the AE curve: upward when the
price level falls and downward when the price level rises. This leads to a new equilibrium level of real GDP.
x The AD curve plots the equilibrium level of GDP that corresponds to each possible price level. A change in equilibrium GDP
following a change in the price level is shown by a movement along the AD curve.
x A rise in the price level lowers exports and lowers autonomous consumption expenditure (because it decreases wealth). Both of
these changes reduce equilibrium GDP and cause the AD curve to have a negative slope.
x The AD curve shifts horizontally when any element of autonomous expenditure changes and the simple multiplier measures the
size of the shift.
23.2 The Supply Side of the Economy
x Firms’ unit costs usually rise when their output rises, and thus they are willing to supply more output only at higher prices. As a
result, the AS curve is upward sloping.
x Each AS curve is drawn for given levels of factor (input) prices and productivity.
x An increase in productivity or a decrease in factor prices shifts the AS curve to the right. This is an increase in aggregate supply.
A decrease in productivity or an increase in factor prices shifts the AS curve to the left. This is a decrease in aggregate supply.
23.3 Macroeconomic Equilibrium
x Macroeconomic equilibrium refers to equilibrium values of real GDP and the price level, as determined by the intersection of the
AD and AS curves. Shifts in the AD and AS curves, called aggregate demand and aggregate supply shocks, change the
equilibrium values of real GDP and the price level.
x When the AS curve is upward sloping, an aggregate demand shock causes the price level and real GDP to move in the same
direction. When the AS curve is flat, shifts in the AD curve primarily affect real GDP. When the AS curve is steep, shifts in the
AD curve primarily affect the price level.
x In the usual case with an upward sloping AS curve, a demand shock leads to a change in the price level. As a result, the
multiplier is smaller than the simple multiplier in Chapter 22.
x An aggregate supply shock moves equilibrium GDP along the AD curve, causing the price level and real GDP to move in
opposite directions. A leftward shift in the AS curve causes a reduction in real GDP and an increase in the price level. A
rightward shift causes an increase in real GDP and a fall in the price level.
x Some events are both aggregate supply and aggregate demand shocks. Changes in the world prices of raw materials, for example,
shift the AS curve. If the country (like Canada) is also a producer of such raw materials, there will also be a shift in the AD
curve. The overall effect then depends on the relative sizes of the separate effects.
THE AGGREGATE DEMAND CURVE AND HOW IT SHIFTS: THE LINKED DIAGRAMS APPROACH
Students often have some difficulty working easily with the linked diagram. The key to understanding this is to go over all the algebraic
problems carefully, as this will help you get used to what is a difficult concept. Early in the course, we ignored prices (actually, we held them
constant, but this is equivalent to ignoring them), so that there was no distinction between nominal and real values. Once we introduce prices into
the model, we have to worry about prices might affect the AE-45-degree-line diagram.
With prices in the model, we adopt the convention of having Y stand for “real” output (that is, output corrected for price changes). Real
production generates real income, which generates real aggregate demand. Why then should prices affect AE? There are 3 reasons, all of which
are relatively difficult to understand in the context of an introductory course:
1. The “Real Wealth Effect”—A rise in prices leaves most real assets unaffected (the value of housing tends to go up at the rate of inflation,
so its real value is not affected, for example). But household hold many assets that are denominated in “nominal” terms (that is, are
denominated in dollars). For example, bank accounts and cash are all nominal. A rise in prices eats up the value of these assets and makes
households poorer. The fall in wealth tends to depress the consumption function, as households save in order to restore their wealth. This
causes the AE curve to fall.
2. The “Foreign Sector Effect”—A rise in domestic prices makes out exports less competitive internationally, and this causes X to fall.
Similarly, a rise in domestic prices makes imports more attractive, causing IM to rise. Both cause the AE curve to fall. (However, this can be
complicated in a flexible exchange rate system, since the value of the Canadian dollar might change to compensate for the change in prices,
eliminating this effect.
3. The “Real Money Effect”—A rise in domestic prices means that Canadians need more money to carry out their day-to-day activities. This
increases the transactions demand for money, and other things equal, this causes interest rates to rise, thereby reducing investment. The fall
in I causes the AE curve to fall. The effect is called the real money effect because the rise in domestic prices in effect makes Canada’s
money supply seem smaller (because it does not go as far in terms of buying stuff). In essence, the purchasing power of the money supply
falls, so we sometimes say that the “real money supply” has fallen.
We draw the AD curve by mapping out the different equilibrium points on the AE-45-degree-line curve when price changes. Because a
rise in prices causes the AE curve to fall and Y* to fall, this generates a downward sloping AD curve (see Part (A)).
The Linked Diagram:
How an increase in autonomous expenditure (e.g., an increase in G) shifts AE and AD.
Now we need to know what happens when an exogenous variable changes and shifts the AE curve. Suppose for example that G
increases. Absent any changes in prices, this causes the AE line to shift up vertically by ûG and increases Y* by MûG. What this means on the
linked diagram is that at each price level, AE shifts up vertically by ûG, and AD shifts right by MûG. That is all there is to it, but it takes some
practice and study to get used to this (see Part (B)).