1. Chapter 8 Modelling Real GDP and the Price Level in the Short Run

2. 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.

3. 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.

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

5. Positive Slope because of Prices a)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 P2P2 Real Wage Number Employed a) Labour Market PF 1 D1D1 LRAS 1 Real GDP/ Year b) c) Real GDP Price Level The Short-Run Aggregate Supply Curve SRAS 1 S1S1 P1P1 Y1Y1 Y2Y2 Y1Y1 Y2Y2 L1L1 L2 W2W2 W1W1

6. 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

7. 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 P2P2 PF 1 LRAS 1 Real GDP/ Year c) Real GDP Price Level The Short-Run Aggregate Supply Curve SRAS 1 P1P1 Y1Y1 Y2Y2

8. 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

9. Production Beyond LRAS? a)Can lay-off workers b)Machines worked less hours P1P1 PF 1 LRAS 1 Real GDP/ Year c) Real GDP Price Level The Short-Run Aggregate Supply Curve SRAS 1 P2P2 Y1Y1 Y2Y2

10. Remember Diminishing Returns? a)Very Steep slope beyond Y 1 -workers get tired if overworked -more workers get in the way of production PF 1 LRAS 1 Real GDP/ Year c) Real GDP Price Level The Shape of the Short-Run Aggregate Supply Curve SRAS 1 P1P1 Y1Y1 Y2Y2

11. Movement Vs. Shift Movements are caused by change in Aggregate Price Levels Shift in SRAS is caused by:

12. 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

13. The SRAS shifts upward (decrease in SRAS) Real output Price level SRAS 0 SRAS 1 1. 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

14. 8.3 Equilibrium P2P2 LRAS 1 Price Level SRAS 1 P1P1 Y1Y1 Y2Y2 SR equilibrium occurs at intersection of AD and SRAS At P 2 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 AD 1 a b

15. AD Shifts While AS is Stable P2P2 LRAS 1 Price Level SRAS 1 P1P1 Y1Y1 Demand/Supply shock: any economic event that causes a shift in demand/supply B) Shift to left is a Recessionary Gap – SR output (Y 2 ) < natural GDP (Y 1 ) AD 2 AD 1 Y2Y2

16. AD Shifts While AS is Stable P2P2 LRAS 1 Price Level SRAS 1 P1P1 Y1Y1 Demand/Supply shock: any economic event that causes a shift in demand/supply B) Shift to right is a Inflationary Gap – SR output (Y 2 ) > natural GDP (Y 1 ) AD 2 AD 1 Y2Y2

17. 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 P1P1 LRAS 1 Price Level SRAS 1 P2P2 Y1Y1 AD 1 Y2Y2 SRAS 2 a b

18. 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 P2P2 LRAS 1 Price Level SRAS 2 P1P1 Y1Y1 AD 1 Y2Y2 SRAS 1 b a

19. 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 USD a) 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 P2P2 LRAS 1 Price Level SRAS 1 P1P1 Y1Y1 AD 2 AD 1 Y2Y2 a b c SRAS 2 Y3Y3 P3P3

20. 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 3:1 a) The US lettuce is expensive for producers to import (input prices higher) b) AS shift inwards, Agg. P increases, UN up c) More expensive imports (M goes down) mean higher NX = (X-M) and AD increases and shifts to right AD = C + I + G + (X-M) 5 = 1 + 2 + 2 6 = 1 + 2 + 3 CAD Weakens P2P2 LRAS 1 Price Level SRAS 2 P1P1 Y2Y2 AD 1 AD 2 Y1Y1 c a SRAS 1 Y3Y3 P3P3

21. 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 P2P2 LRAS 1 Price Level SRAS 1 P1P1 Y1Y1 AD 2 AD 1 Y2Y2 Demand-Pull Inflation Cost-Push Inflation b P2P2 LRAS 1 Price Level SRAS 2 Y2Y2 AD 1 Y1Y1 a SRAS 1 P1P1