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Figure 1a: Potential and Actual
Real GDP, 1960-2001
Actual and Potential Real GDP
7,000
6,000 The green line shows
actual output. During recessions,
output declines.
5,000
4,000 During expansions, output
rises—sometimes rapidly.
3,000
2,000
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Figure 1: The Two-Way Relationship
Between Output and the Price Level
Price Real
Level GDP
Aggregate Supply
Curve
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AD and AS
4
The Aggregate Demand Curve
First step in understanding how price level affects
economy is an important fact
When price level rises, money demand curve shifts
rightward (because purchases become more expensive)
Shift in money demand, and its impact on the economy,
is illustrated in Figure 2
Imagine a rather substantial rise in price level—from
100 to 140
Compared with our initial position, this new equilibrium
has the following characteristics
Money demand curve has shifted rightward
Interest rate is higher
Aggregate expenditure line has shifted downward
Equilibrium GDP is lower
All of these changes are caused by a rise in price level
A rise in price level causes a decrease in equilibrium 5
GDP
Figure 2a: Deriving the Aggregate
Demand Curve
(a)
Interest Rate Ms
M1d M2d
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Figure 2b/c: Deriving the
Aggregate Demand Curve
(b) (c)
a higher price
AEr = 6% level is associated
AEr = 9% 140
H
E with a lower real
($ Trillions)
GDP.
E
The rise in the 100
H interest rate
causes real AD
GDP to fall.
10
Shifts of the AD Curve
When we move along AD curve in Figure 2, we assume that
price level changes
But that other influences on equilibrium GDP are constant
Keep following rule in mind
When a change in price level causes equilibrium GDP to
change, we move along AD curve
Whenever anything other than price level causes equilibrium
GDP to change, AD curve itself shifts
Equilibrium GDP will change whenever there is a change in
any of the following
Government purchases
Autonomous consumption spending
Investment spending
Net exports
Taxes
Money supply
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An Increase in Government
Purchases
Spending shocks initially affect economy by shifting
aggregate expenditure line
In Figure 3, we assume economy begins at a price
level of 100
Let’s increase government purchases by $2 trillion
and ask what happens if price level remains at 100
An increase in government purchases shifts entire AD
curve rightward
AD curve shifts rightward when government
purchases, investment spending, autonomous
consumption spending, or net exports increase, or
when taxes decrease
Analysis also applies in the other direction
AD curve shifts leftward when government
purchases, investment spending, autonomous
consumption spending, or net exports decrease, or
when taxes increase 12
Figure 3: A Spending Shock Shifts
the AD Curve
(a) (b)
At any given price level, an Since real GDP is
Price
Real Aggregate Expenditure
AE2
H AE1
100 H
E
E
AD1 AD2
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Shifts vs. Movements Along the AD
Curve: A Summary
Figure 4 summarizes how some
events in economy cause a
movement along AD curve, and other
events shift AD curve
Panels (b) and (c) of Figure 4 tell us
how a variety of events affect AD
curve, but not how they affect real
GDP
Where will price level end up?
First step in answering that question is to
understand the other side of the 15
P2
AD
Q3 Q1 Q2 Real GDP
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Figure 4b: Effects of Key Changes
on the Aggregate Demand Curve
(b)
Entire AD curve shifts rightward if:
Price Level • a, IP, G, or NX increases
• Net taxes decrease
• The money supply increases
AD2
AD1
Real GDP
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Figure 4c: Effects of Key Changes
on the Aggregate Demand Curve
(c)
Price Level
decreases
Entire AD curve shifts leftward if:
• a, IP, G, or NX decreases
• Net taxes increase
• The money supply decreases
AD1
AD2
Real GDP
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Costs and Prices
Price level in economy results from pricing
behavior of millions of individual business
firms
In any given year, some of these firms will raise
their prices, and some will lower them
But often, all firms in the economy are
affected by the same macroeconomic event
Causing prices to rise or fall throughout the
economy – what interest us in macroeconomics
To understand how macroeconomic events
affect the price level, we begin with a very
simple assumption
A firm sets price of its products as a markup
over cost per unit
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Costs and Prices
Percentage markup in any particular industry will
depend on degree of competition there
In macroeconomics, we are not concerned with how
the markup differs in different industries
But rather with average percentage markup in
economy
Determined by competitive conditions
Competitive structure changes very slowly, so average
percentage markup should be somewhat stable from
year-to-year
But a stable markup does not necessarily mean a
stable price level, because unit costs can change
In short-run, price level rises when there is an
economy-wide increase in unit costs
Price level falls when there is an economy-wide
decrease in unit costs 20
GDP, Costs, and the Price Level
Primary concern here: impact of real GDP on
unit costs and, therefore, on the price level
Why should a change in output affect unit
costs and price level?
As total output increases
Greater amounts of inputs may be needed to
produce a unit of output
Price of non-labor inputs rise
Nominal wage rate rises
A decrease in output affects unit costs
through the same three forces, but with
opposite result
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The Short Run
All three of our reasons are important in explaining why a
change in output affects price level
However, they operate within different time frames
But our third explanation—changes in nominal wage rate—
is a different story
For a year or more after a change in output, changes in
average nominal wage are less important than other forces
that change unit costs
Some of the more important reasons why wages in many
industries respond so slowly to changes in output
Many firms have union contracts that specify wages for up
to three years
Wages in many large corporations are set by slow-moving
bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying
stable wages 22
The Short Run
Nominal wage rate is fixed in short-run
We assume that changes in output have no
effect on nominal wage rate in short-run
Since we assume a constant nominal
wage in short-run, a change in output
will affect unit costs through the other
two factors
In short-run, a rise (fall) in real GDP, by
causing unit costs to increase (decrease),
will also cause a rise (decrease) in price
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level
Deriving the Aggregate Supply
Curve
Figure 5 summarizes discussion about
effect of output on price level in short-run
Each time we change level of output, there
will be a new price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain
economy’s aggregate supply curve
Tells us price level consistent with firms’ unit
costs and their percentage markup at any level
of output over short-run
A more accurate name for AS curve would
be “short-run-price-level-at-each-output-
level” curve 24
Figure 5: The Aggregate Supply
Curve
26
Shifts of the AS Curve
Figure 5 assumed that a number of important
variables remained unchanged
But in real world, unit costs sometimes change for
reasons other than a change in output
In general, we distinguish between a movement along
AS curve, and a shift of curve itself, as follows
When a change in real GDP causes the price level to
change, we move along AS curve
When anything other than a change in real GDP causes
price level to change, AS curve itself shifts
What can cause unit costs to change at any given
level of output?
Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.
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Figure 6: Shifts of the Aggregate
Supply Curve
AS2
Price Level AS1
L
140
When unit costs rise at any
100 given real GDP, the AS curve
A shifts upward–e.g., an increase
in world oil prices or bad
weather for farm production.
P2
Q2 Q1 Q3 Real GDP
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Figure 7b: Effects of Key Changes
on the Aggregate Supply Curve
(b) AS2
Price Level AS1
Real GDP
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Figure 7c: Effects of Key Changes
on the Aggregate Supply Curve
(c)
Price Level AS1
AS2
Real GDP
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AD and AS Together: Short-Run
Equilibrium
Where will the economy settle in short-
run?
Where is our short-run macroeconomic
equilibrium?
We know that in equilibrium, economy must be at
some point on AD curve
Short-run equilibrium requires economy be
operating on its AS curve
Only when economy is at point E—on
both curves—will we have reached a
sustainable level of real GDP and the
price level 32
Figure 8: Short-Run
Macroeconomic Equilibrium
Price Level AS
B
140
E
100
F
AD
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What Happens When Things
Change?
Now that we know how short-run equilibrium is
determined, and armed with our knowledge of AD and
AS curves, we are ready to put model through its
paces
Our short-run equilibrium will change when either AD
curve, AS curve, or both, shift
An event that causes AD curve to shift is called a
demand shock
An event that causes AS curve to shift is called a
supply shock
In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that
ultimately affects entire economy
Demand shocks and supply shocks are just two
different categories of spending shocks 34
An Increase in Government
Purchases
Shifts AD curve rightward
Can see how it affects economy in short-run:
increases output and rises interest rate in
the money market
Process described is not entirely realistic
Assumes that when government purchases
rise, first output increases, and then price
level rises
In reality, output and price level tend to rise
together
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Figure 9: The Effect of a Demand
Shock
Price Level AS
130
H
115
100 J
E
AD2
AD1
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An Decrease in Government
Purchases
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An Increase in the Money Supply
Although monetary policy stimulates
economy through a different channel than
fiscal policy
Once we arrive at AD and AS diagram, two
look very much alike
Can represent situation as follows
39
Other Demand Shocks
A positive demand shock—shifts AD
curve rightward
Increases both real GDP and price level
in short-run
A negative demand shock—shifts AD
curve leftward
Decreases both real GDP and price level
in short-run
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An Example: The Great Depression
U.S. economy collapsed far more seriously
during 1929 through 1933—the onset of
the Great Depression—than it did at any
other time
What do we know about demand shocks
that caused Great Depression?
Fall of 1929, bubble of optimism burst
Stock market crashed, and investment and
consumption spending plummeted
Demand for products exported by United States
fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward
shift of AD curve
Causing both output and price level to fall 41
Demand Shocks: Adjusting to the
Long-Run
In Figure 9, point H shows new equilibrium
after a positive demand shock in short-
run—a year or so after the shock
But point H is not necessarily where economy
will end up in long-run
In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage
rate will rise, shifting AS curve upward
When output is below full employment, wage
rate will fall, shifting AS curve downward
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Demand Shocks: Adjusting to the
Long Run
Increase in government purchases has no
effect on equilibrium GDP in long-run
Economy returns to full employment, which is
just where it started
This is why long-run adjustment process is often
called economy’s self-correcting mechanism
If a demand shock pulls economy away
from full employment
Change in wage rate and price level will
eventually cause economy to correct itself and
return to full-employment output
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Figure 10: The Long-Run
Adjustment Process
Price Level
AS2
AS1
P4 K
P3 J
P2 H
P1
E
AD2
AD1
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Figure 11: Long-Run Adjustment
After A Negative Demand Shock
Price Level AS1
AS2
P1 E
P2 N
P3 M
AD1
AD2
Real GDP
Y2 YFE
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