Production and Prices
Why economies experience economic fluctuations?
How do policy actions by the government and the Federal
Reserve affect output and prices?
To answer the applied questions we need to answer
first the following theoretical questions:
How is GDP determined in the short-run?
How is the price level determined in the short-run?
Determination of GDP and Price level
In the short-run the aggregate price level are
determined by the interaction of the aggregate supply
and the aggregate demand.
Aggregate supply relates aggregate production to the
Aggregate demand relates aggregate expenditure to
the price level
Aggregate Supply Fundamentals
At any given time, the quantity of capital and the state of technology
are fixed but the quantity of labor can vary - GDP = F(K,L,TFP) –
Thus, short-run fluctuations in employment are an important driving
force of short-run fluctuations in GDP.
The wage rate that makes the quantity of labor demanded equal to the
quantity supplied is the equilibrium wage rate and at that wage the
level of employment is the natural rate of unemployment.
Aggregate Supply Fundamentals
Aggregate supply with perfect price flexibility (also called
by the book Long-run AS)
Aggregate supply where prices slowly adjust (the short-
run aggregate supply curve)
The LAS curve is vertical
because potential GDP is
independent of the price level.
Along the LAS curve all prices
and wage rates vary by the
same percentage so that
relative prices and the real
wage rate remain constant
(NEED TO EXPLAIN WHY
THIS IS TRUE AND IT IS NOT
EXPLAINED IN THE BOOK!)
The SAS curve is upward
A rise in the price level
assuming wages fixes
induces firms to hire more
workers and to increase
Can wages continue to be
Along the SAS curve, real
GDP might be above
… or below potential GDP
Because employment can
be above or below the
regular full employment
Changes in Aggregate Supply
When potential GDP increases, both the LAS and SAS
curves shift rightward.
Potential GDP changes, for three reasons
Change in the quantity of capital (physical or human).
Advance in technology.
And, in general, anything that effects equilibrium
The quantity of real GDP demanded, Y, is the total amount
of final goods and services produced in the United States
that people, businesses, governments, and foreigners plan
This quantity is the sum of consumption expenditures, C,
investment, I, government purchases, G, and net exports,
X – M. That is:
Y = C + I + G + X – M.
The Aggregate Demand Curve
Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.
The aggregate demand (AD) curve plots the quantity of
real GDP demanded against the price level.
Buying plans depend on many factors and some of the
main ones are:
The price level
The world economy
The AD curve slopes
downward for two reasons
A wealth effect
Wealth effect A rise in the price level, other things
remaining the same, decreases the quantity of real wealth
(money, bonds, stocks, etc.).
To restore their real wealth, people increase saving and
decrease spending, so the quantity of real GDP demanded
International substitution effect A rise in the price level,
other things remaining the same, increases the price of
domestic goods relative to foreign goods, so imports
increase and exports decrease, which decreases the
quantity of real GDP demanded.
Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs when the
quantity of real GDP demanded equals the quantity of real
GDP supplied at the point of intersection of the AD curve
and the SAS curve.
If total output and the
price level are above
equilibrium GDP, firms will
have to decrease
production and lower
These changes bring a
movement along the SAS
curve toward equilibrium.
In short-run equilibrium,
real GDP can be greater
than or less than potential
Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs when real
GDP equals potential GDP—when the economy is on its
occurs where the AD and
LAS curves intersect and
results when the money
wage has adjusted to put
the SAS curve through the
long-run equilibrium point.