notice the data: while potential GDP tends to move upward yr after yr, due to economic growth, actual GDP tends to rise above and fall below potential over shorter periods Date reveals an important fact: Deviations from potential output dont last forever In some of these episodes, government policy-either fiscal or monetary-helped the economy to return to full employment more quickly But even without corrective policies-such as during long parts of Great Ds of the 1930s-the economy shows a remarkable tendency to begin moving back towards potential output What is the mechanism behind? We will study the behavior of a new variable that we have put aside for several chapters: the price level
1
8,000
7,000 6,000 5,000 4,000
3,000
2,000
Figure 1: The Two-Way Relationship Between Output and the Price Level
Aggregate Demand Curve
Price Level
Real GDP
AD and AS
There exist a two-way relationship between price level and output (see diagram 1) Changes in price level cause changes in real GDP illustrated by Aggregate Demand curve Changes in real GDP cause changes in price level illustrated by Aggregate Supply curve
4
Interest Rate
Ms As the price level rises, money demand increases and interest rate rises.
9% 6%
H E
M
500
Money ($ Billions)
6
(c) On the AD curve, a higher price level is associated with a lower real GDP. E
100
AD
10
Opposite sequence of events will occur if price level falls, moving us rightward along AD curve
10
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
11
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
H E AE2 AE1
100
10 13.5
10 13.5
14
P3
P1
P2
AD
Q3
Q1
Q2
Real GDP
16
AD2
AD1 Real GDP
17
AD1
AD2 Real GDP
18
But often, all firms in the economy are affected by the same macroeconomic event
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 Causing prices to rise or fall throughout the economy what interest us in macroeconomics
In any given year, some of these firms will raise their prices, and some will lower them
19
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
A decrease in output affects unit costs through the same three forces, but with opposite result
21
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 23 level
130 100 80 C A
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
6 10 13.5 Real GDP ($ Trillions)
25
26
27
10
P1 P2
Q2
Q1
Q3
Real GDP
29
Real GDP
30
Entire AS curve shifts downward if unit costs for any reason besides an decrease in real GDP
Real GDP
31
Only when economy is at point Eon both curveswill we have reached a sustainable level of real GDP and the price level
32
100
10
14
H J
AD1
AD2
10
13.5 12.5
37
38
39
40
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
AS2
AS1 P4 P3 K J H E AD2 AD1 YFE Y3 Y2 Real GDP
44
P2 P1
45
P1 P2 P3
E N
M
AD1 AD2
Y2
YFE
Real GDP
46