Econ 1221

Chapter 23

Short Run Macro Model (Endogenous Price)

The AD-AS Model
• Now that we solved our first macroeconomic model, let’s make the model
a little more realistic by getting rid of the most unrealistic assumption of
constant output prices.

• In this new model, prices are no longer constant.

- Rather prices are determined endogenously (within the model).

• So we are going to look at the simultaneous determination of output (Y)

and prices in the economy.
• Note that, price in macroeconomics refers to a price index, in this model
the GDP Deflator.
- Also note, prices here refers to the prices of final goods and services.
- Factor prices (like wage, interest rate) are still assumed to be constant (exogenous)

2
The AD-AS Model
• After introducing price as a variable in the model, we are going to rewrite
the Aggregate Expenditure – Income model by taking into consideration
the effect of prices on planned expenditure and production.
• At a given price, if all output demand is met, then the economy’s output
should be at AE = Y (The Keynesian Cross).
- We are going to see that AE depends on price. So as price changes we should see
different levels of Y satisfying AE (P) = Y. This gives us a relationship between P and Y.
We are going to call it the Aggregate Demand (AD) relationship.

- AD is derived using the Keynesian Cross with changing prices.

• Then we introduce the supply side of the economy, where higher output
can only be produced at higher prices. This gives us another relationship
between P and Y, and we call it the Aggregate Supply (AS) relationship.

• The interaction between AD and AS determines the P and Y in equilibrium.

3
The Aggregate Demand Relationship
• To establish the relationship between P and Y from the demand
(expenditure) side of the economy, we first need to see how P might
affect AE.

• Recall AE = C + I + G +NX

- Note that, these variables are real variables, not nominal. So an increase in
price of everything would not normally affect any of these variables. [Think
about adding an extra zero to every price]

- Yet, there are at least two ways in which a change in aggregate price level
might affect the planned aggregate expenditure.

4
How price affects Aggregate Expenditure
1. Through Wealth: People hold a part of their wealth in liquid assets like cash, current account
deposits etc. If aggregate price level in the economy rises, those assets lose purchasing power.
As a result, overall value of wealth goes down when price level increases.

- This would…………………………..AE by ……………………………………….

- What do you think happens to the real value of non-liquid assets like houses when price level rises?

2. Through Export and Import: An increase in overall price level makes domestic goods and
services more expensive compared to foreign goods and services. As a result:

- Planned exports will ……………………..

- Planned imports will ………………………..

- And Net Exports will ………………………..

5
How price affects Aggregate Expenditure
An increase in aggregate price (say from 𝑃0 to 𝑃1 ) will shift the AE
curve………………

6
AE = Y to Aggregate Demand (AD) Curve
From the Aggregate Expenditure – Income graph above, an increase in
aggregate price from 𝑃0 to 𝑃1 will reduce Y from 600 to 300.

7
Shifts in the Aggregate Demand (AD) Curve
• Since the AD curve is derived from the AE = Y condition, any change in
AD must be understood through changes in the AE function.

• We have already seen how a change in price would affect the AD

curve.
- An increase in price would shift the AE curve downward so that equilibrium Y
would be lower and will cause a resulting leftward movement along the AD
curve.
• If AE shifts for any reason other than P, we will see a shift of the AD
curve as well.
- For an illustration, consider government increases planned spending by 40.

8
Shifts in the Aggregate Demand (AD) Curve

9
Shifts in the Aggregate Demand (AD) Curve

10
Shifts in the Aggregate Demand (AD) Curve
• So, an increase in G will shift the aggregate expenditure curve upward
which will increase equilibrium Y at any price and shift the AD curve
rightward.

• We can actually say more than this about the shift of the AD curve.
- Notice that, a given change in government spending, ∆𝐺, causes the
equilibrium Y to change by ∆𝑌 = ∆𝐺 𝑋 (𝑠𝑖𝑚𝑝𝑙𝑒 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟)

- At a given price, the horizontal shift of the AD curve is also

∆𝑌 = ∆𝐺 𝑋 (𝑠𝑖𝑚𝑝𝑙𝑒 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟)

- That is, for any given change in autonomous spending (∆𝐴), we can measure
the exact horizontal shift of the AD curve using the simple multiplier.
11
Supply Side of the Economy: Aggregate Supply
• Aggregate Supply relationship looks at how much output (in aggregate) the
producers in the economy are willing to produce at different prices.
• We consider that there is diminishing returns to using the economy’s
resources.
-To produce more and more output, producers need to use resources that are less
productive or are difficult to use/acquire.
For example: overtime work, transform jungle into cultivable land, use space for park to build
high-rise apartment etc.

• As production gets costlier the more output the economy produces, a high
output can only be produced at higher prices.
[Note that, factor prices are constant in this model. So the higher cost of production is
not due to higher factor prices, rather due to less productive resources]
⟹ Aggregate Supply curve is upward sloping.
12
Supply Side of the Economy: Aggregate Supply
• AS curve is upward sloping
- because per unit cost of production rises as
more output is produced.
• Notice, the AS curve is not only upward
sloping, the slope increases as we move
right.
- That is, price rises faster as we move right
along the AS curve.
- The argument is that, as the economy
produces more and more, it gets closer to
its capacity and it becomes increasingly
hard to find resources to produce more.
Summary:
- Producing below capacity (with excess
capacity) ⟹ relatively flat AS

- Producing at or above
capacity ⟹ relatively steep AS

13
Macroeconomic Equilibrium
Intersection of AD and AS simultaneously determines the aggregate
price level (P) and output (Y) in the economy.

14
Changes in the short run output of an economy
• Now we have a complete (and somewhat realistic) model of the short
run output determination in an economy. And we would like this
model to be able to explain fluctuations in output, i.e. business cycles.
• Looking at the equilibrium, it is easy to see that in this model output
can change if:
- Something happens that shifts the AD curve. We will call them Aggregate
Demand (AD) shocks. If a shock shifts the AD curve to the right, equilibrium
output will increase and we will call it a Positive AD Shock. If something shifts
the AD curve to the left, equilibrium output will decrease and we will call it a
Negative AD Shock.
- Alternatively, equilibrium output can change if something shifts the AS curve.
If something shifts the AS curve to the right (or down), equilibrium Y will
increase and we will call it a Positive AS Shock. The opposite case will be a
Negative AS Shock.
15
A positive AD shock

• Suppose planned government

spending increases.
- This would shift the AE curve
upward.
- As a result, AD curve will shift
rightward.
- In equilibrium Y and P increases.

• Why might government adopt a

policy like this?

16
The Multiplier
• An important consideration is quantifying the effect of an increase in
autonomous spending like G. That is, how big of a change in output a
given change in government expenditure brings?
- In previous model, we saw that it is more than one for one, and the multiplier
effect is calculated using the “Simple Multiplier”.
- Is it still the case when introduce price into the model?
• What we are going to see is that, the change in output brought about
by a given change in autonomous spending now (allowing prices to
change) is smaller than what the simple multiplier would imply.
- In other words, changing prices weakens the multiplier effect.
- Or, The Multiplier (in the model with endogenous price) is smaller than The
Simple Multiplier (in the model with fixed prices)

17
Multiplier vs Simple Multiplier (AE-Y graph)
• Suppose, we have a short run equilibrium (𝑌0 , 𝑃0 ) shown in the next
slide and 𝐴𝐸0 𝑃0 is the associated AE curve at that point.

18
Multiplier vs Simple Multiplier (AD-AS graph)

19
What makes the multiplier larger or smaller
• So, we established that the multiplier is smaller than the simple multiplier.
- And that’s because the counteracting effect of price changes.

• How large can the multiplier be?

- Equal to simple multiplier.
- Happens if AS curve is …………………

• How small can the multiplier be?

- Zero.
- Happens when AS curve is ………………

• So if an economy is operating very close to its capacity, the multiplier will

be ……………………….

- If an economy is operating with a lot of excess capacity, the multiplier will be

…………………………..

20
AS Shock
• Now that we looked at a case of AD
shock in detail, let’s see what might
happen due to an AS shock.
• Let’s say oil price rises in the
international market, and we are
looking at an economy that is
primarily an importer of oil.
• Since many industries use oil as an
input, unit cost of production rises.
- AS curve shifts up/left.
- Equilibrium Y and P both falls.
• A situation where output and price
are both falling is called a
Stagflation.

21
Practice
2. Wage increases. [note that this is an
1. National income in China exogenous change in wage, which is different
from the wage adjustments we will discuss in
increases. As a result: next chapter]
- Per unit cost of production increases.
- NX increases.
- AS shifts up/left.
- AE shifts up.
- Both Y and P decreases in
- AD shifts right. equilibrium.
- This is a negative AS shock.
- Both Y and P increases in equilibrium.
3. Exogenous improvement in
- This is a positive AD shock. technology.
- Positive AS shock.

22