Chapter 8

Modelling Real GDP and the Price Level in the Short Run

8.1 The Short-Run Aggregate Supply

• The aggregate supply curve (SRAS) shows the relationship between the aggregate price level and the quantity of aggregate output.

Aggregate Supply Curve• Aggregate Supply is the amount of real GDP

that will be made available by sellers at various price levels.

• Aggregate Supply looks different in the Long Run and the Short Run:– In the Long Run, classical economists assume the

economy operates at full employment (maximum output), independent of the price level.

– In the Short Run, businesses will increase supply if the price level increases.

Positive Relationship

• There is a positive relationship in the short run between price level and the quantity of aggregate output supplied.

• Positive Slope because of Pricesa) ALL Prices increase > suppliers costs in wages

are sticky so real wages fall

b) So suppliers hire more workers and produce more

c) Real GDP increases

P2

Rea

l Wag

e

Number Employed

a) Labour MarketPF1

D1

LRAS1

Real GDP/ Year

b) c) Real GDP

Pric

e Le

vel

The Short-Run Aggregate Supply Curve

SRAS1S1

P1

Y1 Y2

Y1

Y2

L1 L2

W2

W1

The SAS is positively sloped because:• Eg. Chocolate bar $2, workers paid $5, real

wage is $3• Now,

1. prices go up to $3 and so real wage goes down to $2

2. Producers sell Chocolate bar for more money ($3) therefore make more profit so they hire more workers and expand production

• Production Beyond LRAS? a) Can push current workers to produce more, or

call up laid-off workers

b) Machines worked more hours

c) Hired more workers

P2

PF1

LRAS1

Real GDP/ Year

c) Real GDP

Pric

e Le

vel

The Short-Run Aggregate Supply Curve

SRAS1

P1

Y1 Y2

The SAS is positively sloped because:• Eg. Chocolate bar $2, workers paid $5, real

wage is $3• Now,

1. prices go down to $1.50 and so real wage goes up to $3.50

2. Producers sell Chocolate bar for less money ($1.50) therefore make less profit so they hire less workers and produce less

• Production Beyond LRAS?

a) Can lay-off workers

b) Machines worked less hours

P1

PF1

LRAS1

Real GDP/ Year

c) Real GDP

Pric

e Le

vel

The Short-Run Aggregate Supply Curve

SRAS1

P2

Y1Y2

• Remember Diminishing Returns?a) Very Steep slope beyond Y1

-workers get tired if overworked

-more workers get in the way of production

PF1

LRAS1

Real GDP/ Year

c) Real GDP

Pric

e Le

vel

The Shape of the Short-Run Aggregate Supply Curve

SRAS1

P1

Y1 Y2

Movement Vs. Shift

• Movements are caused by change in Aggregate Price Levels

• Shift in SRAS is caused by:

8.2 Shift in the SRAS

• Changes in: – Input prices eg. Lettuce, tomato, dressing – nominal wages, and – productivity

• lead to changes in producers’ profits and shift the short-run aggregate supply curve

• Result of change in producers’ DESIRE to supply not ABILITY to supply

The SRAS shifts upward (decrease in SRAS)

Real output

Pri

ce

lev

el

SRAS0

SRAS11. Increases in input prices Eg. wages

3. Increases in sales and excise taxes

2. Expectations of higher future inflation

4. Decreases in productivity

5. Increase in import prices

8.3 Equilibrium

P2

LRAS1

Pric

e Le

vel

SRAS1

P1

Y1 Y2

• SR equilibrium occurs at intersection of AD and SRAS

• At P2 there is an excess of goods in the market so prices fall

• Demand/Supply shock: any economic event that causes a shift in demand/supply

• A) Inflationary Gap – output > natural GDP• B) Recessionary Gap – output < natural GDP

AD1

a

b

AD Shifts While AS is Stable

P2

LRAS1

Pric

e Le

vel

SRAS1

P1

Y1

• Demand/Supply shock: any economic event that causes a shift in demand/supply

B) Shift to left is a Recessionary Gap – SR output (Y2) < natural GDP (Y1)

AD2

AD1

Y2

AD Shifts While AS is Stable

P2

LRAS1

Pric

e Le

vel

SRAS1

P1

Y1

• Demand/Supply shock: any economic event that causes a shift in demand/supply

B) Shift to right is a Inflationary Gap – SR output (Y2) > natural GDP (Y1)

AD2

AD1

Y2

8.4 The Long-Run Adjustment Process

• Demand/Supply shock: any economic event that causes a shift in demand/supply causing a inflationary or recessionary gap

• At “a” the economy is at full employment/production (6 salads)

• At “b” firms are operating at beyond natural production rates • There is excess demand for inputs (that go into producing goods eg

lettuce) and prices for inputs rise• Higher input prices shift the SRAS to left from “b” to “a” again

P1

LRAS1

Pric

e Le

vel

SRAS1

P2

Y1

AD1

Y2

SRAS2

ab

The Long-Run Adjustment Process

• Demand/Supply shock: any economic event that causes a shift in demand/supply causing a inflationary or recessionary gap

• At “a” the economy is at full employment/production (6 salads)

• At “b” firms are operating at below natural production rates • There is surplus inputs in the market (that go into producing goods eg

lettuce) and prices for inputs fall• Lower input prices shift the SRAS to right from “b” back to “a” again

P2

LRAS1

Pric

e Le

vel

SRAS2

P1

Y1

AD1

Y2

SRAS1

ba

8.5 AD and AS in an Open Economy

• How does a stronger CAD affect aggregate supply? CAD buy 3 USD, or 1:3

-if CAD stronger compared to other currencies: CAD now buy 4 USDa) The US lettuce is cheaper for producers to import (input prices lower) b) AS shift outward, Agg. P lowers, UN down c) Cheaper imports (lower M) mean lower NX = (X-M) and AD lowers and shifts to left AD = C + I + G + (X-M) 5 = 1 + 2 + 2 4 = 1 + 2 + 1

CAD Increases

P2

LRAS1

Pric

e Le

vel

SRAS1

P1

Y1

AD2

AD1

Y2

ab

c

SRAS2

Y3

P3

b

AD and AS in an Open Economy

• How does a weaker CAD affect aggregate supply? CAD buy 4 USD or 4:1

-if CAD stronger compared to other currencies: CAD now buy 3 USD, or 3:1a) The US lettuce is expensive for producers to import (input prices higher) b) AS shift inwards , Agg. P increases, UN upc) More expensive imports (M goes down) mean higher NX = (X-M) and AD increases and shifts to rightAD = C + I + G + (X-M) 5 = 1 + 2 + 2 6 = 1 + 2 + 3

CAD Weakens

P2

LRAS1

Pric

e Le

vel

SRAS2

P1

Y2

AD1

AD2

Y1

c

a

SRAS1

Y3

P3

8.6 Inflation in the Short-Run

• Demand-pull inflation: increases in AD not matched by increases in AS• WWI, government spending on making weapons, labour

• Cost-Push inflation: decreases in AS not matched by decreases in AD

P2

LRAS1

Pric

e Le

vel

SRAS1

P1

Y1

AD2

AD1

Y2

Demand-Pull Inflation Cost-Push Inflation

bP2

LRAS1

Pric

e Le

vel

SRAS2

Y2

AD1

Y1

a

SRAS1

P1