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  • The Changing Price Level. Aggregate Demand and Aggregate Supply

    TEACHER: Hello, Student. In this Module we will refine our model of national income (GDP), making it more realistic and sophisticated.

    STUDENT: Let me guess. We are going to abandon the assumption that the price level is constant, right?

    TEACHER: Right. Because practically every situation affecting the economy will affect both the real GDP and the price level.

    STUDENT: Do you mean to say that there will be changes in the GDP measured at constant prices (the real GDP) as well as changes in the nominal GDP (the GDP at current prices)?

    TEACHER: Exactly. And to do that we need to abandon our assumption that national output depends exclusively on demand. This will permit analyzing situations where the economy is working close to full employment (potential GDP). And to this end we need more tools. Since we will have to study how aggregate demand and supply react to price changes, we will need the help of the aggregate demand and the aggregate supply curves.
    Now, do you have one of your intelligent questions at this point?

    STUDENT: Sure. What happens to equilibrium GDP when there is a change in the price level?

    TEACHER: Good question. We will assume that the changes in the price level are exogenous, that they are caused by factors external to our economy, like the rise in price of imported products.

    Changes in Consumption

    Changes in the price level will necessarily affect desired consumption. If the price level increases, people will tend to consume less, and vice-versa.

    STUDENT: Sounds like an obvious situation. As products and services become more expensive and if disposable income remains fixed, people will have less purchasing power and spend less.

    TEACHER: Not exactly. They could still spend the same money for less products. The desired expenditure curve is not a function of prices, but a function of national income and of the propensity to spend.

    The main reason why an increase in prices drives the desired expenditure curve downwards is the wealth effect. People save for long-term goals like retirement. A rise in the price level reduces the real value of their assets and savings. In order to recover these losses, people will tend to save more. The propensity to save will increase and obviously the propensity to spend will diminish. Thus, the desired consumption function will move to the right, causing the same movement in the aggregate expenditure curve.

    STUDENT: Will you show me one of your nice pictures with a graphic representation of what happens to the Aggregate Expenditure when there is a change in the price level?

    TEACHER: Sure, here it is:
    In Figure B204_1 we see the line representing Aggregate Expenditure at initial price level. We also see that at an increased price level, the line shifts to the right and intersects with the 45° line at a lower level of GDP.
    Now, can you tell me what happens if the price level diminishes?

    STUDENT: Easily. The AE line shifts to the left and intersects the 45° line at a higher level of equilibrium GDP.

    TEACHER: Very well. Now we will discuss what happens to net exports when the domestic price level changes.

    Changes in Net Exports

    When goods produced locally in country A become more expensive, consumers will demand more imported substitutes. By the same token, foreigners will be less inclined to purchase goods imported from country A since they will have increased in price.

    Can you tell me what will happen to net exports when the domestic price level rises, and how this will influence the aggregate expenditure curve?

    STUDENT: Yes, I guess I can. Exports will fall, imports will rise; in consequence, net exports will fall. This will cause the aggregate expenditure to shift downwards (to the right).

    TEACHER: Very well. We can conclude that an increase in domestic prices will negatively affect the desired consumption curve and net exports. The sum of both individual effects will be reflected in the Aggregate Expenditure curve, which will intersect with the 45° line at a lower equilibrium level of GDP. A decrease in domestic prices will cause the opposite to happen.

    STUDENT: May I add the usual proviso, "if all other exogenous variables are constant"?

    TEACHER: You are already speaking like a macroeconomist. You are right, in economics we usually analyze each variable while assuming the rest to be constant.

    Now let us begin to discuss the Aggregate Demand curve.

    STUDENT: Just a second, please. What is the difference between the aggregate expenditure and the aggregate demand curve?

    TEACHER: The desired expenditure curve is related to national income (GDP) at a given price level. The aggregate demand curve relates each combination of equilibrium GDP with different price levels.

    Please take a look at this picture:
    In Figure B204_2i we see how equilibrium GDP is determined by the Aggregate Expenditure AE curve at price levels 1, 2 and 3. The resulting equilibrium GDP values are GD1, GD2 and GD3.

    In Figure B204_2ii we have plotted the same three GDP levels and the corresponding price levels 1, 2 and 3. The points of intersection define the Aggregate Demand AD curve.

    STUDENT: By looking at both parts of Figure B204_2 I notice that a change in the price level causes:

    1. a shift of the AE curve and,
    2. a movement along the AD curve.

    Am I right?

    TEACHER: That is correct. The AD curve shows, for each price level, the associated equilibrium GDP. For instance, in our Figure B204_2, at price level 2 the equilibrium level of GDP would be GDP 2.

    STUDENT: And the AD curve slopes downward and to the right for the same reason that the demand curve of any good has this shape: higher price, less demand. Right?

    TEACHER: Wrong. That would be a fallacy of composition. The case of particular goods can not be applied to the aggregate prices and output of the economy.

    STUDENT: I see, but the AD curve slopes downward and to the right anyway.

    TEACHER: Yes, but for different reasons. The basic one is that increases in the price level will push interest rates up while the quantity of money in the economy is fixed. And increases in the interest rate tend to reduce output as people and businesses restrict borrowing for investments or purchases.

    Changes in the AD Curve

    You mentioned yourself, rightly, that changes in the price level produce movements along the AD curve.

    But if something alters the equilibrium GDP at a given price level, the result will be a shift of the AD curve.

    In general, we can say that a change in the amount of autonomous desired consumption, investment, government or net export expenditure at a given price level, will cause a shift of the AD curve.

    STUDENT: And it will shift to the right if the changes are increases, and to the left if the changes are decreases. True?

    TEACHER: True. These shifts are called aggregate demand shocks. For instance a large lowering of tax rates while government spending is maintained will cause an expansionary demand shock and create a boom (inflationary gap) in the economy.

    The Aggregate Supply Curve

    The aggregate supply (AS) curve indicates the level of GDP that will be supplied at price level. We have two types of AS curves: the short-run and the long-run curve. In the short run prices of all inputs (labor and materials) are fixed, while in the long run they will adjust to the new general level of prices.

    Let me show you another picture:
    Now, would you mind describing what you see in Figure B204_3?

    STUDENT: I’ll try. First of all I observe that the curve slopes upward and to the right (other things being equal, of course!). And this time I will avoid the fallacy of composition, and will not tell you that this is so for the same reason that an individual good’s AS curve has this shape. So, you tell me why, Teacher.

    TEACHER: The curve has this shape because since we assume that in the short run prices of inputs are unchanged, firms will make a higher profit by supplying a higher output if the price level of their produce goes up. But what else do you notice about the AS curve in the figure?

    STUDENT: Well, I see that the short-run AS curve gets steeper as output rises. It is close to the horizontal on relatively low levels of output and gets steeper and steeper as output increases. Why, I do not know.

    TEACHER: Your observation is correct. And the reason is that at lower levels of output it is likely that idle capacity is called into production. As output increases more and more, firms finally have employed most idle capacity and it becomes more and more expensive to increase production, no matter how much prices rise. Eventually the curve will get close to vertical.

    STUDENT: Just a second! Didn’t you say before that prices of all inputs where stable in the short run?

    TEACHER: Right. But this does not mean that unit prices remain unchanged. The average price level does not change, but as output increases less efficient machinery and workers are utilized, and this increases marginal unit costs.

    Anyway, let me tell you that the shape of the AS curve is a somewhat controversial subject. Some economist, as the ones belonging to the "New classical economists" school founded by Lucas, Sargent and Wallace, maintains that the short-run AS curve is always vertical.

    STUDENT: There is always a bunch of economists hoping to win a Nobel prize by inventing something obvious. To me, there is no difference: it depends on the point of the curve you start with. If the level of prices starts to rise when there is idle capacity, the curve will have the shape shown in Figure B204_3. If prices start to rise close to full capacity, then the slope will be vertical. It’s that simple.

    TEACHER: I’ll nominate you, dear Student, to the Nobel Prize. You are probably right Now, let us continue.

    National Output and the Price level

    We will now combine the AS and the AD curves in the same graphic:
    What can you deduce from Figure B204_4?

    STUDENT: Well, what I can see is that the equilibrium level of prices and GDP are at the intersection of the AS and the AD curves.

    TEACHER: Good observation. Now that we understand the use off aggregate supply and demand curves, we can take a look at specific examples and analyze them.

    First let’s discuss the "Great Crash" of 1929. The US and the developed world economies prospered in 1928 and part of 1929. There was low unemployment and an investment boom, especially for equipment to manufacture in quantity new products such as autos, trucks, radios, electricity generating equipment, etc. In October 1929 the stock market collapsed and the economy in the US fell into a deep depression, with unemployment rate reaching a staggering 25%. The depression was mainly the result of a fall in gross domestic investment.

    STUDENT: Well, I read that there was also a fall in consumer demand. This is a natural consequence of unemployment, people consume less if they lose their jobs, or are afraid of losing them.

    TEACHER: Correct. There also was a widespread failure of banks, and many people lost their savings. Plus people who had invested in stocks saw their paper wealth disappear. Understanding the concept of aggregate demand and supply you can see why the economy fell into a deep depression, since the AD curve shifted violently to the left and the new equilibrium level of the GDP was much lower.

    As we have already mentioned, the government of the US did not act wisely (Keynes had not published his theory yet). Nor did the government of other countries; the US and all developed countries implemented tariff barriers for imports. Each country tried to protect local producers. The aggregate result of these ultra-protectionist measures was a collapse of international trade and as a result all economies suffered still more. When F.D.Roosevelt became President he succeeded in implementing some Keynesian policies, against a strong resistance from traditional politicians and businessmen. But although there was some improvement, the US did not completely emerge from depression until after the beginning of World War II.

    In preparation and during the war, the government spent huge amounts of money and the economy was over-stimulated. Can you tell me using AD and AS curves what happened?

    STUDENT: The AD curve shifted to the right, and this must have created a strong upward pressure on the price level.

    TEACHER: Very well. To resist the inflationary pressure the government implemented price controls. This policy may work in the short run to keep prices from rising, but the underlying "repressed" inflation eventually takes its course. Between 1945 and 1948 the consumer price index rose 34%.

    STUDENT: Can we discuss unemployment now? Because after all, one of the main objectives of policymakers is keeping unemployment as low as possible.

    TEACHER: Certainly, but first let me tell you that we can identify three types of unemployment:

    * Frictional unemployment is the result of some people working only part of the year, young people looking for their first job, or workers who quit or are fired and are looking for a new position.
    * Structural unemployment is the result of:

    1. A part of the potential labor force not being skilled enough to do the jobs for which there is demand, and
    2. The economy being stuck for long periods at an equilibrium GDP level below potential.

    * Cyclical unemployment, due to short or medium term business cycle fluctuations.

    Unemployment imposes high costs to an economy. We can speak of economic costs, like the goods and services lost forever during the "deflationary gap" periods when equilibrium GDP is below potential. And of course, there are important non-economic human costs. Unemployed people and their families are under strong emotional pressure in the industrialized world where holding a job is not only an economic question but also a measure of social prestige and self-image, and of course material hardship is also a very probable occurrence.

    Very well, let’s stop here.


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