GDP and the Price Level

in the Short Run

Chapter 18
LIPSEY & CHRYSTAL
ECONOMICS 12e
 Learning Outcomes

• Aggregate demand is the level of desired real domestic

spending at each price level.
• The aggregate demand curve plots the negative
relationship between GDP and the price level.
• An exogenous change in autonomous spending (a
demand shock) shifts the aggregate demand curve
horizontally by the multiplier times the initial change in
spending.
 Learning Outcomes

• The aggregate supply curve reflects a positive relationship

between output and the price level, for given input prices.
• An exogenous change in input prices or technology (a
supply shock) shifts the short-run aggregate supply curve.
• The equilibrium level of GDP and the price level are
determined where aggregate demand and supply are
equal.
 Aggregate Spending and the Price Level

AE = Y AE0

AE1
Desired Expenditure

E0

E1

45o
0 Y1 Y0 Real National Income [GDP]
 Aggregate Spending and the Price Level

• Changes in the price level cause the AE curve to shift

and equilibrium GDP to change.
• The initial AE curve is AE0 and GDP is at Y1.
• An increase in the price level reduces desired
expenditure and thus causes the AE curve to shift
down to AE1.
• As a result GDP falls to Y1.The reverse happens for a
fall in the price level.
 The AD Curve and the AE Curve

AE = Y
AE0
E0
Desired Expenditure

AE1

E1 AE2

E2

45o
0 Y2 Y1 Y0 Real National Income [GDP]

[i]. Aggregate expenditure

 The AD Curve and the AE Curve

E2
Price Level

P2
E1
E0
P1

P0
AD

0 Y2 Y1 Y0 Real National Income (GDP)

[ii]. Aggregate Demand
 The AD Curve and the AE Curve

E0 AE = Y AE0
Desired Expenditure

AE1
E1
AE2

E2
[i]. Aggregate expenditure

45o
0 Y2 Y1 Y0 Real National Income [GDP]

[ii]. Aggregate Demand

Price Level

E2
P2
E1
P1 E0
AD
P0

Real National Income [GDP]

 The AD curve and the AE curve

• Equilibrium GDP is determined by the AE curve for

each given price level.
• The level of GDP and its associated price level are
then plotted to yield a point on the AD curve.
• When the price level is P0 the AE curve is AE0 and GDP
is Y0. Plotting Y0 against P0 yields the point E0 on the
AD curve.
• An increase in the price level to P1 shifts the AE curve
down to AE1, producing GDP of Y1 and this is
represented by point E1 on the AD curve.
Relationship between AE and AD
curves
AE=Y

e2 AE
E0
Desired spending

e0 AE

e1

45o

0 Y1 Y0 Y2
Real GDP

Desired spending
AD
Price level

less than output

Desired spending
X E0 Z equal output
P0

0 Y1 Y0 Y2 Real GDP
Desired spending
exceeds output
The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Expenditure

Desired Expenditure AE = Y
E1 AE1

AE0

E0

A

45o

0 Y0 Y1 Real GDP

Y1
The Simple Multiplier and Shifts in the AD Curve

[i]. Aggregate Demand

Price Level

E0 E1

P0

Y AD1
AD0

0 Y0 Y1 Real GDP
 The simple multiplier and shifts in the AD curve

• A change in autonomous expenditure changes

equilibrium GDP for any given price level, and the
simple multiplier measures the resulting horizontal
shift in the aggregate demand curve.
 The simple multiplier and shifts in the AD curve

• The original AE curve is at AE0 with equilibrium at E0,

GDP=Y0 and Price level=P0; the yield point E0 on
AD0.
• AE0 shifts to AE1 because of an autonomous
expenditure increase A, and GDP increases to Y1.
• With given price level P0, the AD curve shifts
rightward to E1.
A Short-run Aggregate Supply Curve

SRAS

Y Real GDP
 A Short-run Aggregate Supply Curve

SRAS

P0

Y0 Real GDP
 A Short-run Aggregate Supply Curve

SRAS

P1

P0

Y0 Y1 Real GDP
 The short-run aggregate supply curve

• The SRAS curve is positively sloped.

• The positive slope shows that with prices of labour
and other inputs given, total desired output and the
price level will be positively associated.
• A rise in the price level from P0 to P1 will be
associated with a rise in output supplied from Y0 to Y1.
• The slope of the SRAS curve is fairly flat at low levels
of output and very steep at higher levels.
 Macroeconomic Equilibrium

AD
SRAS
Price Level

E0
P0

0 Y0 Real GDP
 Macroeconomic Equilibrium

AD
Price Level

SRAS

E0
P0

P1

0 Y1 Y0 Y2 Real GDP
 Macroeconomic Equilibrium

• Macroeconomic equilibrium occurs at the intersection

of the AD and SRAS curves and determines the
equilibrium values for GDP and the price level.
• Equilibrium occurs at E0 with GDP equal to Y0 and the
price level P0.
 Macroeconomic Equilibrium

• If the price level were P1, below P0, the desired output
of firms would be Y1 but desired demand would be Y2,
so desired spending would exceed desired
production.
• Only at E0 are desired plans of producers and
consumers consistent.
The AE Curve and the Multiplier When the Price Level Varies

AE=Y
Desired Expenditure
E0 AE0 [i]. Aggregate expenditure

45o
Y0 Real GDP

SARS

[i]. Aggregate demand

Price Level

P0
AD0

Y0
Real GDP
The AE Curve and the Multiplier When the Price Level Varies

AE=Y
Desired Expenditure E’1
AE’1
E0 AE0 [i]. Aggregate expenditure
A

45o
Y0 Y’1 Real GDP

SARS

[i]. Aggregate demand

Price Level

E0 E’1
P0
AD0

Y0 Y’1
Real GDP
The AE Curve and the Multiplier When the Price Level Varies

E1 AE=Y
Desired Expenditure E’1
AE’1
E0 AE0 AE1 [i]. Aggregate expenditure
A

Y

45o
Y0 Y1 Y’1 Real GDP

SARS

[i]. Aggregate demand

Price Level

E1
P1 E0 E’1
P0
AD1
AD0
Y0 Y1 Y’1
Real GDP
 The AE curve and the multiplier when the price level varies

• An upward shift in AE is partly offset by the resulting

rise in prices, so the multiplier is smaller than when
prices are constant.
• There is an increase in autonomous expenditure A
creating the initial shift 1.
• But prices then rise so the AE curves shifts part of
the way back down as shown by 2.
• The economy moves from point E0 to E1.
The effects of increases in AD
Demand shocks when the SRAS
curve is vertical
Aggregate supply shocks
Annual % change in input and output
prices for UK manufacturing
Producer prices and unit wages –
annual % change for UK
manufacturing
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Demand
• A change in the price level shifts the AE curve upward
when the price level falls and downward when the price
level rises.
• A new equilibrium level of GDP that results would be the
equilibrium level if it were solely demand-determined.
• The AD curve plots the equilibrium level of GDP that
corresponds to each possible price level.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Demand
• A change in equilibrium GDP following a change in the
price level is shown by a movement along the AD curve.
• A rise in the price level lowers exports and lowers private
consumption spending [because it decreases
consumer’s wealth].
• Both of these changes lower equilibrium GDP and cause
the aggregate demand curve to have a negative slope.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

• The AD curve shifts when any element of autonomous

expenditure changes, and the simple multiplier
measures the magnitude of the shift.
• This multiplier also measures the size of the change in
equilibrium GDP when the price level remains constant
and firms produce everything that is demanded at the
price level.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Supply and Macroeconomic Equilibrium

• The short-run aggregate supply [SRAS] curve, drawn for
given input prices, is positively sloped because unit costs
rise with increasing output and because rising product
prices make it profitable to increase output.
• An increase in productivity or a decrease in input prices
shifts the curve to the right.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

Aggregate Supply and Macroeconomic Equilibrium

• A decrease in productivity or an increase in input prices
has the opposite effect.
• Macroeconomic equilibrium refers to equilibrium values of
real GDP and the price level, as determined by the
intersection of the AD and SRAS curves.
• Shifts in the AD and SRAS curves, called aggregate
demand shocks and aggregate supply shocks, change
the equilibrium values of real GDP and the price level.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

Changes in GDP and the Price Level

• When the SRAS curve is positively sloped, an aggregate
demand shock causes the price level and real GDP to
move in the same direction, the division between these
effects depending on the shape of the SRAS curve.
• The main effect is on real GDP when the SRAS curve is
flat and on the price level when it is steep.
 GDP AND THE PRICE LEVEL IN THE SHORT RUN

• An aggregate supply shock moves equilibrium real GDP

along the AD curve, causing the price level and output to
move in opposite directions.
• A leftward shift in the SRAS curve causes a stagflation -
rising prices and falling output.
• A rightward shift causes an increase in real GDP and a
fall in the price level.
• The division of the effects of a shift in SRAS between a
change in real GDP and a change in the price level
depends on the shape of the AD curve.