Module 3 (Week 5) - Chapter 8: Real GDP and the Price Level in the Short Run

Changes in the price level result in changes in ______ and changes in ______.

Changes in the price level result in changes in consumption and changes in net exports.

The relationship between the price level and desired consumption involves how changes in the price level lead to changes in household ______, and thus, to changes in desired ______. 

The relationship between the price level and desired consumption involves how changes in the price level lead to changes in household wealth, and thus, to changes in desired spending.

A rise in the price level ______ the real value of money held by the private sector, allowing ______ goods to be purchased. A fall in the price level ______ the real value of money, allowing ______ goods to be purchased.

A rise in the price level lowers the real value of money held by the private sector, allowing fewer goods to be purchased. A fall in the price level increases the real value of money, allowing more goods to be purchased.

Explain the relationship between changes in the price level, consumption, and the AE function.

• Rise in Price Level: AE function shifts downward

  • Reduction in wealth leads to decrease in desired consumption

• Fall in Price Level: AE function shifts upward

  • Rise in wealth leads to increase in desired consumption 

Explain the relationship between changes in the price level, net exports, and the AE function.

• Rise in Domestic Price Level: AE function shifts downward

  • Canadian goods become more expensive (relative to foreign goods), leading to decrease in net exports 

• Fall in Domestic Price Level: AE function shifts upward

  • Canadian goods become less expensive, leading to increase in net exports 

An exogenous rise in the price level causes a(n) ______ shift in the AE function, ______ the equilibrium level of real GDP.

An exogenous rise in the price level causes a(n) downward shift in the AE function, lowering the equilibrium level of real GDP.

An exogenous fall in the price level causes a(n) ______ shift in the AE function, ______ the equilibrium level of real GDP. 

An exogenous fall in the price level causes a(n) upward shift in the AE function, increasing the equilibrium level of real GDP.

The price level and real equilibrium GDP are ______ related, as shown by the ______. 

The price level and real equilibrium GDP are negatively related, as shown by the aggregate demand curve.

Define aggregate demand (AD) curve. 

A curve showing the combinations of real GDP and price level at which desired aggregate expenditure is equal to actual national income

A change in the price level causes a ______ in the AE curve but a ______ along the AD curve. 

A change in the price level causes a shift in the AE curve but a movement along the AD curve.

Explain the relationship between changes in the price level, the AE curve, and the AD curve. 

• Rise in Price Level: AE curve shifts downward, leading to movement upward and to the left along the AD curve 

  • Decrease in equilibrium level of GDP

• Fall in Price Level: AE curve shifts upward, leading to movement downward and to the right along the AD curve

  • Increase in equilibrium level of GDP

Define aggregate demand shock. 

Any event that causes a shift in the aggregate demand (AD) curve

Any change (other than a change in the ______) that causes the AE curve to shift will also cause the AD curve to shift.

Any change (other than a change in the price level) that causes the AE curve to shift will also cause the AD curve to shift.

What are the 4 examples of aggregate demand shocks that shift the AD curve to the right? 

• Increase in desired consumption (C )

• Increase in desired investment (I )

• Increase in government purchases (G )

• Increase in desired exports (X )

What are the 4 examples of aggregate demand shocks that shift the AD curve to the left?

• Decrease in desired consumption (C )

• Decrease in desired investment (I )

• Decrease in government purchases (G )

• Decrease in desired exports (X )

Explain the relationship between changes in autonomous aggregate expenditure, the AE curve, and the AD curve.

• Rise in Autonomous Aggregate Expenditure: AE curve shifts upward, and AD curve shifts to the right

• Fall in Autonomous Aggregate Expenditure: AE curve shifts downward, and AD curve shifts to the left

The simple multiplier measures the ______ shift in the AD curve in response to a change in autonomous desired expenditure. 

The simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous desired expenditure.

Define aggregate supply (AS) curve.

A curve showing the relation between price level and quantity of aggregate output supplied, assuming constant factor prices and technology

Define unit costs.

Cost per unit of output, equal to total cost divided by total output

Explain the relationship between level of output and unit costs.

• Rise in Output: rise in unit costs

  • Less efficient standby plants have to be used

  • Less efficient workers are hired

  • Existing workers are paid overtime rates for additional work

The ______ relationship between output and unit costs leads to the ______ slope of the AS curve. Firms who are interested in increasing profits (and avoiding losses) will not produce more output unless they charge ______ prices to cover ______ unit costs. 

The positive relationship between output and unit costs leads to the positive slope of the AS curve. Firms who are interested in increasing profits (and avoiding losses) will not produce more output unless they charge higher prices to cover higher unit costs.

The higher the level of output, the ______ unit costs tend to rise with each extra increment of output. Thus, the AS curve becomes ______ as output rises. 

The higher the level of output, the faster unit costs tend to rise with each extra increment of output. Thus, the AS curve becomes steeper as output rises.

At low levels of output, firms have ______ capacity, and increases in output do not lead to higher unit costs. Thus, the AS curve is ______.

At low levels of output, firms have excess capacity, and increases in output do not lead to higher unit costs. Thus, the AS curve is horizontal (flat).

Define aggregate supply shocks. 

Any shift in the aggregate supply (AS) curve caused by an exogenous force

A shift in the AS curve is caused by changes in 2 exogenous variables: changes in ______ and changes in ______.

A shift in the AS curve is caused by 2 exogenous variables: changes in factor prices and changes in technology.

Explain the relationship between changes in factor prices and the AS curve.

• Rise in Factor Prices (and Other Input Prices): AS curve shifts upward and to the left

  • Firms’ profits at current levels of output are reduced

    • Ex: rise in the prices of raw materials (inputs)

  • In response to the rise in factor prices, aggregate supply falls

• Fall in Factor Prices (and Other Input Prices): AS curve shifts downward and to the right

  • Production becomes more profitable, leading to an increase in aggregate supply

Explain the relationship between changes in technology and the AS curve. 

• Improvement in Technology: AS curve shifts downward and to the right

  • Improvements lead to lower unit costs, allowing output to be sold at lower prices

  • Increase in aggregate supply 

• Deterioration in Technology: AS curve shifts upward and to the left

  • Deterioration leads to higher unit costs

    • Ex: poor weather affecting agricultural production

  • Decrease in aggregate supply

______ occurs at the intersection of the AD and AS curves, determining the equilibrium values of ______ and ______. 

Macroeconomic equilibrium occurs at the intersection of the AD and AS curves, determining the equilibrium values of real GDP and price level. 

The equilibrium values of real GDP and price level occur at the intersection of the AD and AS curves, as shown by Point ______. This is called the ______. 

The equilibrium values of real GDP and price level occur at the intersection of the AD and AS curves, as shown by Point E₀. This is called the macroeconomic equilibrium.

If the price level is equal to P₁, the desired output of firms would be ______. However, at P₁, the level of output demanded is equal to ______. Thus, when the price level is less than P₀ (______), the desired output of firms is ______ than total output demanded.

If the price level is equal to P₁, the desired output of firms would be Y₁. However, at P₁, the level of output demanded is equal to Y₂. Thus, when the price level is less than P₀ (macroeconomic equilibrium), the desired output of firms is less than total output demanded.

When the price level is greater than P₀, the desired output of firms is ______ than total output demanded. 

When the price level is greater than P₀, the desired output of firms is greater than total output demanded. 

What are the 2 types of aggregate demand (AD) shocks? 

• Positive AD Shock: AD curve shifts to the right

  • Increase in desired aggregate spending

  • Increase in equilibrium GDP and price level

• Negative AD Shock: AD curve shifts to the left

  • Decrease in desired aggregate spending

  • Decrease in equilibrium GDP and price level

What are the 2 types of aggregate supply (AS) shocks?

• Positive AS Shock: AS curve shifts to the right

  • Increase in aggregate supply

  • Increase in equilibrium GDP

• Negative AS Shock: AS curve shifts to the left

  • Decrease in aggregate supply

  • Decrease in equilibrium GDP

A rise in aggregate demand ______ the AD curve to the ______, from ______ to ______. Macroeconomic equilibrium moves from ______ to ______. The price level rises from ______ to ______. Real GDP rises from ______ to ______, reflecting a ______ along the AS curve. 

A rise in aggregate demand shifts the AD curve to the right, from AD₀ to AD₁. Macroeconomic equilibrium moves from E₀ to E₁. The price level rises from P₀ to P₁. Real GDP rises from Y₀ to Y₁, reflecting a movement along the AS curve. 

Aggregate demand (AD) shocks cause the price level and real GDP to change in the ______ direction.

Aggregate demand (AD) shocks cause the price level and real GDP to change in the same direction.

• Positive AD Shock: increase in both price level and real GDP

• Negative AD Shock: decrease in both price level and real GDP

Explain why the multiplier is smaller when the AS curve is positively sloped (compared to when the price level is constant). 

• An increase in autonomous expenditure shifts the AE curve upward and the AD curve to the right (horizontal shift)

• A rise in the price level (from P₀ to P₁) causes a decrease in net exports and desired consumption, leading to a downward shift in the AE curve and a movement upward and to the left along the AD curve

  • This counteracts the initial rise in real GDP, reducing the size of the multiplier

The multiplier, adjusted for the effect of the rise in price level, is equal to the ratio of ______. 

The multiplier, adjusted for the effect of the rise in price level, is equal to the ratio of ΔY / ΔA.

• Multiplier = Change in Equilibrium Real GDP / Change in Autonomous Desired Expenditure

If an aggregate demand shock leads to a change in price level, the ultimate change in real GDP will be ______ than what is predicted by the simple multiplier. 

If an aggregate demand shock leads to a change in price level, the ultimate change in real GDP will be less than what is predicted by the simple multiplier.

True or False: A variable price level (non-constant price level) reduces the value of the multiplier.

True

The effect of increases in aggregate demand (AD) is divided between increases in ______ and ______, depending on the slope of the ______ curve.

The effect of increases in aggregate demand (AD) is divided between increases in real GDP and price level, depending on the slope of the aggregate supply (AS) curve.

Explain the effects of a flat AS curve (flat range or Keynesian range) on real GDP, price level, and the multiplier.

• Flat AS Curve: flat range or Keynesian range 

  • Real GDP: any aggregate demand shock leads to a change in real GDP

  • Price Level: no change in the price level

    • Firms with excess capacity can increase output without changing unit costs

  • Simple Multiplier: change in output is determined by the size of the simple multiplier

Explain the effects of a positively sloped AS curve (intermediate range) on real GDP, price level, and the multiplier.

• Positively Sloped AS Curve: intermediate range 

  • Real GDP: shift in AD curve leads to a change in real GDP

  • Price Level: shift in AD curve leads to a change in price level

  • Multiplier: multiplier is positive, but smaller than the simple multiplier

Explain the effects of a steep positively sloped AS curve (steep range) on real GDP, price level, and the multiplier. 

• Steep Positively Sloped AS Curve: steep range

  • Real GDP: change in aggregate demand (AD) leads to little or no change in real GDP

    • Production is close to full capacity

  • Price Level: any change in AD leads to a sharp change in price level

  • Multiplier: multiplier is nearly zero

The steeper the AS curve, the ______ the price effect and the ______ the GDP effect.

The steeper the AS curve, the greater the price effect and the smaller the GDP effect.

A rise in the world price of inputs (such as oil, copper, or iron) is an example of a ______ aggregate supply (AS) shock.

An increase in the world price of inputs (such as oil, copper, or iron) is an example of a negative aggregate supply (AS) shock.

A fall in the world price of inputs (such as oil, copper, or iron) is an example of a ______ aggregate supply (AS) shock.

A fall in the world price of inputs (such as oil, copper, or iron) is an example of a positive aggregate supply (AS) shock.

Aggregate supply (AS) shocks cause the price level and real GDP to change in ______ directions.

Aggregate supply (AS) shocks cause the price level and real GDP to change in opposite directions.

• Positive AS Shocks: decrease in price level and increase in real GDP

• Negative AS Shocks: increase in price level and decrease in real GDP

When the AS curve is flat, shifts in the AD curve primarily affect ______. When the AS curve is steep, shifts in the AD curve primarily affect ______.

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 price level.