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Chapter 23

Output and Prices in

the Short Run
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Learning Objectives
1. Explain why an exogenous change in the price level shifts
the AE curve and changes the equilibrium level of real
GDP.

2. Derive the AD curve and explain why it shifts.

3. Explain the meaning of the AS curve and why it shifts when

technology or factor prices change.

4. Define macroeconomic equilibrium.

5. Explain the effects of aggregate demand and aggregate

supply shocks on real GDP and the price level.

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23.1 The Demand Side of the Economy

Shifts in the AE Curve
Consider an exogenous change in the price level, P. What
happens to equilibrium GDP?

An increase in P reduces the real value of money held by the

private sector. A fall in P raises the real value of money
holdings.
Changes in P also affect the wealth of bondholders and bond
issuers, but because the changes offset each other, there is
no change in the aggregate wealth.
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In summary, an increase in P reduces private-sector wealth

and leads to a fall in desired consumption — this implies a
downward shift in the AE curve.

Conversely, a fall in P increases private-sector wealth and

leads to an increase in desired consumption — this implies an
upward shift in the AE curve.

There is also an effect on net exports:

• A rise in P (with unchanged foreign prices) shifts the NX
function downward — this causes a further downward
shift in the AE curve. The reverse will occur after a fall in
P.

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Changes in Equilibrium An
GDPincrease in P reduces
private-sector wealth and
therefore reduces desired
AE AE =Y aggregate expenditure.
AE0 = C0+ G0 + I0 + NX0
E0
• AE1 = C1+ G0 + I0 + NX1

This causes the AE curve to

•E shift down, reducing the
1

equilibrium level of real GDP.

Y1 Y0 Y

NOTE: for each aggregate price level (P)

there is a different level of AE and equilibrium GDP (Y)
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The Aggregate Demand Curve

not Aggregate Expenditure
(AE)
The aggregate demand (AD) curve relates equilibrium real
GDP to the price level.

For any given price level, the AD curve shows the level of real
GDP for which desired aggregate expenditure equals actual
GDP.

Changes in the price level that cause shifts in the AE curve

cause movements along the AD curve.
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AE =Y
AE
E0 AE0
•
AE1 Consider a rise in the price
E1 level, from P0 to P1 to P2:
• AE2

E2 A rise in P causes the AE

• curve to shift down. This is
a movement upward along
Y2 Y1 Y0 Y the AD curve.
P
P2 • (Conversely, a fall in P
causes the AE curve to
P1 • shift up. This is a
P0 • AD movement downward along
the AD curve.)
Y2 Y1 Y0 Y
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AE =Y
AE What is really happening in
E0 AE0
• these diagrams?
AE1 As the price level increases,
E1 AE2 Canadians are becoming less
• wealthy and therefore C falls, also
Canadian goods are becoming
E2 more expensive on world markets
• so NX falls, both of which cause
the AE curve to shift down.
Y2 Y1 Y0 Y
P As the AE curve shifts down
firms change production plans
P2 • and move the economy to new
lower levels of output (GDP) (Y).
P1 • The lower diagram, the AD curve
P0 • AD simply traces out the relationship
between the price level (P) and
equilibrium (Y) depicted in the
Y2 Y1 Y0 Y upper diagram
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AE =Y
AE
E1 AE1 Shifts in the AD Curve
•
AE0 Any shock, other than a
change in P, that increases
E0
• equilibrium Y (GDP) at a
given price level shifts the AD
curve to the right.
Y0 Y1 Y Any shock, other than a
P change in P, that reduces
equilibrium Y (GDP) at a
given price level shifts the
E0 E1
P0 • • AD curve to the left.
AD1

AD0 The simple multiplier measures the

Y0 Y1 Y horizontal shift of the AD curve.
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AE =Y
AE
E1 AE1 (P0) Shifts in the AD Curve
•
AE0 (P0)
The shifts depicted in these diagrams
E0 might have been caused by any of the
•
following:
- decrease in the interest rate

Y0 Y1 -decrease in the value of the

Y
Canadian dollar
P
- an increase in G
- increased consumer optimism
E0 E1
P0 • •
AD1 Can you explain why the AE
curve (and AD curve) shift the
AD0 way they do in each case?
Can you think of other causes
Y0 Y1 Y for such shifts?
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AE =Y
AE
E0 AE0(P0) Shifts in the AD Curve
•
AE1(P0)
The shifts depicted in these diagrams
E1 might have been caused by any of the
• following:
- increase in the interest rate
-increase in the value of the
Y1 Y0 Y Canadian dollar
P
- an decrease in G
- decreased consumer optimism
E1 E0
P0 • • Can you explain why the AE
AD0 curve (and AD curve) shift the
way they do in each case?
AD1
Can you think of other causes
Y1 Y0 Y for such shifts?
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23.2 The Supply Side of the Economy

The Aggregate Supply Curve

The aggregate supply (AS) curve relates the price level to the
quantity of output that firms would like to produce and sell.

The AS curve is drawn on the assumption that technology

and factor prices remain constant.

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What does the Aggregate Supply Curve look

like?
Until this point we have assumed that the aggregate supply
(AS) was perfectly elastic (a horizontal straight line)

Firms would produce Why?

Price Level

any level of output Because we assumed

demanded at the that firms had plenty of
unused capacity,
existing price level. unemployed workers and
resources.
AS0 Therefore they could
P0 • • expand production
without incurring rising
costs.
This is a purely Keynesian
Y1 Y0 type assumption. Is it true
Real GDP
today? Not always.
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What does the Aggregate Supply Curve look

like?
Because unit costs rise with output (Marginal Costs is
increasing at most times) both price-taking and price-setting
firms will produce more output only if prices increase. The AS
curve is therefore upward sloping.
Price Level

AS1
This is straight out of the
P1 • micro economics of the
firm. In the short run
firms find that their MC
P0 • increases as output
increase so they will
increase production only
if they get higher prices.
Y1 Y0
Real GDP
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Shifts in the Aggregate Supply Curve

Just as in the micro economics of the firm, if factor prices or
productivity change, then the AS (marginal cost curves) shift.

An increase in factor
prices or a decrease in
Price Level

AS1
productivity causes per
unit cost of output to
increase.
AS0
P0 • • An increase in factor
prices or a decrease
in productivity shifts
Y1 Y0
the AS curve up and
Real GDP to the left.
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Shifts in the Aggregate Supply Curve

Just as in the micro economics of the firm, if factor prices or
productivity change, then the AS (marginal cost curves) shift.

An decrease in factor prices

or a increase in productivity
Price Level

AS0 causes per unit cost of output

to decrease.

AS1
P0 • • An decrease in factor
prices or an increase
in productivity shifts
the AS curve down
Y0 Y1 and to the right.
Real GDP
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What does the Aggregate Supply Curve look

like?
The slope of the AS curve is increasing because when output is low,
firms typically have excess capacity (Keynesian section). This means
that output can be expanded without causing an significant increase
in unit costs. Therefore, only a small increase in price may be
needed to induce them to expand production.
Price Level

AS1
But as more and more
P1 • capacity is used the
marginal cost of
producing additional
P0 • units of output go up
faster and faster and the
AS curve gets steeper.
Y1 Y0
Real GDP
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The Increasing Slope of the AS Curve

The slope of the AS curve is increasing because when output

is low, firms typically have excess capacity. This means that
output can be expanded without causing a large increase in
unit costs. Therefore, only a small increase in price may be
needed to induce them to expand production.

Once output gets closer to capacity, however, increases in

output cause larger increases in unit costs. Therefore, larger
price increases are needed to induce firms to expand output.
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23.3 Macroeconomic Equilibrium

Demand behaviour is
AD
only consistent with AS
supply behaviour at the

Price Level
intersection of the AS
and AD curves.
E0
At P1 there is more P0 •
output demanded (Y2) P1 • •
than what firms want
to produce (Y1).
Y1 Y0 Y2
Therefore prices will rise
and output will increase Real GDP
until the excess aggregate
demand is eliminated.
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Demand behaviour is
only consistent with
supply behaviour at the
AD
intersection of the AS AS
and AD curves.

Price Level
At P2 there is less P2 • •
output demanded (Y1)
E0
than what firms want P0 •
to produce (Y2).

Therefore prices will fall

Y1 Y0 Y2
and output will decrease
until the excess aggregate Real GDP
supply is eliminated.
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Changes in the Macroeconomic

Equilibrium
A demand shock can either be expansionary or
contractionary. An expansionary demand shock shifts the AD
curve to the right, increasing both P and Y.

A supply shock can also be either expansionary or

contractionary. An expansionary supply shock shifts the AS
curve to the right, increasing Y but decreasing P.

Notice that we use the word “expansionary” or

“contractionary” to refer to the effect of the shock on the
equilibrium level of output.

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Positive Aggregate Demand Shocks

AD1

Price Level
Demand shocks cause AD0 AS
P and Y to change in
the same direction;
both rise with an
increase in demand. P1
• E1
E0
P0 •

Y0 Y1 Real GDP
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Negative Aggregate Demand Shocks

AD0

Price Level
Demand shocks cause AD1 AS
P and Y to change in
the same direction;
both fall with an
decrease in demand. P0
• E0
E1
P1 •

Y1 Y0 Real GDP
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Positive Aggregate Supply Shocks

AS0
AD0

Price Level
Supply shocks cause AS1
P and Y to change in
opposite directions.
P0 E0 •
P1 • E1
P falls and Y
increases with an
increase in supply.

Y0 Y1 Real GDP
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Negative Aggregate Supply Shocks

AS1
AD0

Price Level
Supply shocks cause AS0
P and Y to change in
opposite directions.
P1 E1
•
P0 • E0
P rises and Y
decreases with a
decrease in supply.

Y1 Y0 Real GDP
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AE AE =Y
E´1 AE´ The Mechanics of an AD
• 1
Shift
AE1
E1 AE0
• An increase in autonomous
expenditure causes the AE
∆A curve to shift upward, but
•E0 the rise in the price level
causes it to shift part of the
Y0 Y1 Y´1 Y way down again.
P
AS
Hence, when the AS curve
E1 is upward sloping, the
P1 • multiplier is smaller than
E´1
P0 • • AD the simple multiplier.
E0 1
AD0
Y0 Y1 Y´1 Y
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AD4
AD3
The effect of any given AD2 AS
shift of the AD curve will P4 AD1 •
depend on the slope of
AD0

Price Level
the AS curve. P3 •
The steeper the AS P2 •
curve, the greater the
P1
price effect and the •
P0 •
smaller the output
effect.
Y0 Y1 Y2 Y3Y4
Real GDP

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In Chapters 21 and 22, it was shown that shifts in the AE

curve always change real GDP. But now we see an
extreme case — a vertical AS curve — in which there is
no change in real GDP.

How can these seemingly contradictory statements be true?

The answer is that each AE curve is drawn for a given price

level. As the price level changes, the AE curve shifts.

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AE =Y
Aggregate Supply AE0
E0
Shocks AE • AE1
Aggregate supply shocks
cause P and Y to change in •E
1

opposite directions.
Consider the effects of a
negative supply shock.
Y1 Y0 Y
An example of a negative
supply shock is an increase in P AS1
the price of oil, as happened in AS0
the early and late 1970s. E1
P1 •
P0 • E0
AD

Y1 Y0
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Oil Shocks! Price of Oil

Sep May 1981

120 1980

May
60 1973

40
Nov 1974
20
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Oil Shocks! Capacity Utilization

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Q4 1982

Q1 1974
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Oil Shocks! Unemployment Rate

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Nov 1982

Aug 1981
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A Word of Warning
Many economic events (especially changes in the world prices
of raw materials) cause both aggregate demand and
aggregate supply shocks.

The overall effect on the economy depends on the relative

importance of the two separate effects.

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