Macro Chapter 8-10 Real GDP and the Price Level in the Short Run

Copyright © 2023 Pearson Canada Inc. 8 - 1
9.1 Three Macroeconomic States
• The Short Run
– The assumptions of the model in the short run are:
 Factor prices are assumed to be exogenous; they may
change, but any change is not explained within the
model.
 Technology and factor supplies are assumed to be
constant (and therefore Y* is constant).

The Adjustment of Factor Prices
• The assumptions of the theory of the adjustment
process are:
– Factor prices are assumed to adjust in response to
output gaps.
– Technology and factor supplies are assumed to be
constant (and therefore Y* is constant).

The Long Run
• The assumptions of the model in the long run are:
– Factor prices are assumed to have fully adjusted to any
output gap.
– Technology and factor supplies are assumed to be
changing.

Table 9-1 Three Macroeconomic States
Blank
The Short Run The Adjustment Process The Long Run
Key Assumptions Factor prices are
exogenous.
Factor prices are
flexible/endogenous.
Factor prices are fully
adjusted/endogenous.
Technology and factor
supplies (and thus Y*) are
constant/exogenous.
supplies (and thus Y*) are
constant/exogenous.
supplies (and thus Y*)
are changing.
What Happens Real GDP (Y) is determined
by aggregate demand and
aggregate supply.
Factor prices adjust to output
gaps; real GDP eventually
returns to Y*.
Potential GDP (Y*)
grows over the long run.
Why We Study This
State
To show the effects of AD
and AS shocks on real
GDP.
To see how output gaps cause
factor prices to change and
why real GDP tends to return
to Y*.
To understand the
nature of long-run
economic growth.

8 - 5
Ragan: Macroeconomics
Seventeenth Canadian Edition
Chapter 8
Real GDP and the Price Level
in the Short Run
Copyright © 2023 Pearson Canada Inc.

8.1 The Demand Side of the Economy
• Exogenous Changes in the Price Level
– Changes in Consumption
 Much of the private sector’s total wealth is held in the
form of assets with a fixed nominal value.
 The most obvious example is money.
 What this money can buy—its real value—depends on
the price level.
 A rise in the price level lowers the real value of money
held by the private sector, and a fall in the price level
raises the real value of money held by the private sector.

Changes in Consumption
• Changes in the price level change the wealth of
bondholders and bond issuers, but because the changes
offset each other, there is no change in aggregate wealth.
• In summary, a rise in the price level leads to a reduction
in the real value of the private sector’s wealth.
• A reduction in wealth leads to a decrease in autonomous
desired consumption and to a downward shift in the AE
function.
• A fall in the price level leads to a rise in wealth and desired
consumption and to an upward shift in the AE function.

Changes in Net Exports (1 of 2)
• When the domestic price level rises (and the
exchange rate remains unchanged), Canadian goods
become more expensive relative to foreign goods.
• Canadian consumers reduce their purchases of
Canadian-made goods and increase their purchases
of foreign goods.
• Consumers in other countries reduce their purchases
of Canadian-made goods.

Changes in Net Exports (2 of 2)
• A rise in the domestic price level (with a constant
exchange rate) shifts the net export function
downward, which causes a downward shift in the AE
curve.
• A fall in the domestic price level shifts the net export
function upward and the AE curve upward.

Changes in Equilibrium GDP
• An exogenous increase
in the price level causes
AE0 to shift downward
from to AE1.
• The equilibrium
changes from E0 to E1
and real GDP falls from
Y0 to Y1.
Figure 8-1 Desired Aggregate Expenditure and the Price Level

The Aggregate Demand Curve
• The aggregate demand (AD) curve is a curve showing
combinations of real GDP and the price level that make
desired aggregate expenditure equal to actual national
income.
• A rise in the price level causes the AE curve to shift
downward and leads to a movement upward and to the left
along the AD curve, reflecting a fall in the equilibrium level
of GDP.
• A fall in the price level causes the AE curve to shift upward
and leads to a movement downward and to the right along
the AD curve, reflecting a rise in the equilibrium level of
GDP.

Figure 8-2 Derivation of the AD Curve
• As the price level rises from
P0 to P1 to P2, the AE curve
shifts downward from AE0 to
AE1 to AE2.
• In the bottom graph, a
movement occurs up along
the AD curve.
• A change in the price level
causes a shift of the AE curve
but a movement along the AD
curve.

Shifts in the AD Curve
• Any change that causes the AE curve to shift will also
cause the AD curve to shift.
• Such a shift is called an aggregate demand shock.
• An increase in autonomous aggregate expenditure shifts
the AE curve upward and the AD curve to the right.
• A fall in autonomous aggregate expenditure shifts the
AE curve downward and the AD curve to the left.
• The simple multiplier measures the horizontal shift in the
AD curve in response to a change in autonomous
desired expenditure.

Figure 8-3 The Simple Multiplier and Shifts in the
AD Curve
• An increase in
autonomous
expenditure shifts AE0
to AE1.
• The size of the
horizontal shift of the
AD curve is equal to the
simple multiplier times
the increase in
autonomous
expenditure.

8.2 The Supply Side of the Economy
• The Aggregate Supply Curve
• The aggregate supply (AS) curve is a curve showing
the relation between the price level and the quantity of
aggregate output supplied, for given technology and
factor prices.
• As output increases, less efficient standby plants may
have to be used, and less efficient workers may have to
be hired, while existing workers may have to be paid
overtime rates for additional work.
• For these reasons, unit cost, which is cost per unit of
output, increases.

Figure 8-4 The Aggregate Supply Curve
• The AS curve is
positively sloped.
• The higher is the level
of output, the faster unit
costs tend to rise, so
the AS curve becomes
steeper as output rises.

Shifts in the AS Curve
• Shifts in the AS curve caused by exogenous forces
are called aggregate supply shocks.
• A rise in factor prices causes the AS curve to shift
leftward.
• A fall in factor prices causes the AS curve to shift
rightward.
• An improvement in technology causes the AS curve to
shift rightward.
• A deterioration in technology causes the AS curve to
shift leftward.

Figure 8-5 Shifts in the AS Curve
• An increase in factor
prices or a
deterioration in
technology shifts the
AS curve leftward
from AS0 to AS1.

8.3 Macroeconomic Equilibrium
• Demand behaviour
is consistent with
supply behaviour
only at the
intersection of the
AS and AD curves.
• E0 is the
macroeconomic
equilibrium.
Figure 8-6 Macroeconomic Equilibrium

Changes in Macroeconomic Equilibrium
• A shift in the AD curve is called an aggregate demand
shock.
• A shift in the AS curve is called an aggregate supply
shock.
• Aggregate demand and aggregate supply shocks are
labelled according to their effect on real GDP.
• Positive shocks increase equilibrium GDP; negative
shocks reduce equilibrium GDP.

Figure 8-7 Aggregate Demand Shocks
• Aggregate demand
shocks cause the price
level and real GDP to
change in the same
direction.
• Both rise with an
increase in aggregate
demand, and both fall
with a decrease in
aggregate demand.

Figure 8-8 The Multiplier When the Price Level
Varies
• An increase in
autonomous
expenditure causes
the AE curve to shift
upward, but the rise
in the price level
causes it to shift part
of the way down
again.

Figure 8-9 The Effects of Increases in Aggregate
Demand
• The effect of any given
shift in AD will be
divided between a
change in Y and a
change in P.
• The steeper the AS
curve, the greater the
price effect and the
smaller the output
effect.

Figure 8-10 Aggregate Supply Shocks
• AS shocks cause P and Y to
change in opposite
directions.
• A negative supply shock
shifts the AS curve leftward,
and the rise in the price level
shifts the AE curve
downward.

Analyzing the 2020 Pandemic
Recession with the AD/AS Model (1 of 2)
• The combined effect of the negative AS shock and the
negative AD shock from the COVID-19 pandemic was
a sharp reduction in output and employment.
• The economy’s ability to combine land, labour and
capital to produce output was severely reduced. There
was a large leftward shift in the AS curve, and real
GDP declined.
• For both businesses and households, the pandemic
led to a significant reduction in demand even for an
unchanged level of income. There was a large
leftward shift of the AD curve, and real GDP fell.

Analyzing the 2020 Pandemic
Recession with the AD/AS Model (2 of 2)
• By the middle of 2021, vaccines for COVID-19 were
becoming available in many countries and most
economies were beginning to recover.
• Once individuals are able to safely return to their
workplaces, the AS shock will reverse relatively
quickly.
• Once stores, restaurants, airlines, and hotels are able
to safely conduct business, households and firms will
return to their normal level of demand. The AD shock
will reverse relatively quickly.

A Word of Warning
• Many economic events ‒ especially changes in the
world price of raw materials ‒ cause both aggregate
demand and aggregate supply shocks in the same
economy.
• The overall effect on real GDP in that economy
depends on the relative importance of the demand-
side and supply-side effects.

8 - 28
Chapter 9
From the Short Run to the
Long Run: The Adjustment of
Factor Prices

9.2 The Adjustment Process
• Potential Output and the Output Gap
Figure 9-1 Output Gaps in the Short Run

Factor Prices and the Output Gap
• Output Above Potential, Y > Y*
– Because firms are producing beyond their normal
capacity output, there is an excess demand for all
factor inputs.
– Workers will find that they have considerable
bargaining power, and they will put upward pressure on
wages.
– The boom that is associated with an inflationary gap
generates conditions ‒ high profits for firms and an
excess demand for labour ‒ that tends to cause wages
to rise.

Output Below Potential, Y < Y*
• Because firms are producing below their normal
capacity output, there is an excess supply of all factor
inputs, including labour.
• Firms will have below-normal sales and not only will
resist upward pressures on wages but also may seek
reductions in wages.
• The slump that is associated with a recessionary gap
generates conditions ‒ low profits for firms and an
excess supply of labour ‒ that tends to cause wages
to fall.

Downward Wage Stickiness
• Both upward and downward adjustments to wages
and unit costs do occur, but there are differences in
the speed at which they typically operate.
• Booms can cause wages to rise rapidly.
• Recessions usually cause wages to fall only slowly.

The Phillips Curve
• A.W. Philips observed that wages tended to fall in
periods of high unemployment and rise in periods
of low unemployment.
• The resulting negative relationship between
unemployment and the rate of change in wages
has been called the Phillips curve ever since.

Potential Output as an “Anchor”
• Following an AD or AS shock, the
short-run equilibrium level of output
may be different from potential
output.
• Any output gap is assumed to cause
wages and other factor prices to
adjust, eventually bringing the
equilibrium level of output back to
potential.
• The level of potential output therefore
acts like an “anchor” for the economy.

9.3 Aggregate Demand and Supply
Shocks
• Positive AD Shocks
Figure 9-2 The Adjustment Process Following a Positive AD Shock

Negative AD Shocks
Figure 9-3 The Adjustment Process Following a Negative AD Shock

Aggregate Supply Shocks
Figure 9-4 The Adjustment Process Following a Negative AS Shock

Long-Run Equilibrium
• Following any AD or AS shocks, the adjustment of
factor prices continues until real GDP returns to Y*.
• The economy is in long-run equilibrium when this
adjustment process is complete and there is no longer
an output gap.
• So the economy is in long-run equilibrium when the
intersection of the AD and AS curves occurs
at Y*.

Figure 9-5 Changes in Long-Run Equilibrium
• In part (i), a shift in the AD
curve raises the price level
but leaves real GDP
unchanged in the long run.
• In part (ii), an increase in
potential output raises real
GDP and lowers the price
level.

The Canadian Wage-Adjustment
Process: Empirical Evidence
• Canadian data confirm
that positive output gaps
tend to drive wages and
costs upward.
• Negative output gaps
tend to drive wages and
costs downward.
Figure 9-6 The Canadian Phillips Curve, 1991–2018
(Source: Author’s calculations using data from the Bank of
Canada and Statistics Canada.)

9.4 Fiscal Stabilization Policy
• The government may use various fiscal tools to try to
push real GDP back towards potential output.
• The alternatives to using fiscal stabilization policy are
to wait for the recovery of private-sector demand (a
shift in the AD curve) or to wait for the economy’s
adjustment process (a shift in the AS curve).
• Examples of fiscal effects: WWII/Recession 2008

The Basic Theory of Fiscal Stabilization
(1 of 2)
• The effect of any given shift in AD will be divided between
a change in Y and a change in P.
• The steeper the AS curve, the greater the price effect and
the smaller the output effect.
Figure 9-7 The Closing of a Recessionary Gap

The Basic Theory of Fiscal Stabilization
(2 of 2)
• AS shocks cause P and Y to change in opposite
directions.
• A negative supply shock shifts the AS curve leftward, and
the rise in the price level shifts the AE curve downward.
Figure 9-8 The Closing of an Inflationary Gap

Short Run Versus Long Run
• The paradox of thrift—the idea that an increase in
saving reduces the level of real GDP—is true only in
the short run.
• In the long run, the path of real GDP is determined by
the path of potential output.
• The increase in saving has the long-run effect of
increasing investment and therefore increasing
potential output.

Automatic Fiscal Stabilizers (1 of 2)
• Suppose a shock shifts AD right and increases short-run
real GDP.
• As real GDP increases, government tax revenues also
increase.
• With fewer low-income households and unemployed
persons requiring assistance, governments transfers fall.
• The rise in net tax revenues dampens the overall increase
in real GDP caused by the initial shock.
• The tax-and-transfer system reduces the value of the
multiplier and acts as an automatic stabilizer for the
economy.

Automatic Fiscal Stabilizers (2 of 2)
• The marginal propensity to spend on national income is:
z = MPC(1 – t) – m
• The simple multiplier is:
Simple multiplier = 1/ (1 – z)
• The lower the net tax rate (t), the larger the simple
multiplier and thus the less stable is real GDP in
response to shocks to autonomous spending.

Limitations of Discretionary Fiscal
Policy
• Decision and Execution Lags
• Temporary versus Permanent Tax Changes
• Fine Tuning versus Gross Tuning

Fiscal Policy and Growth
• If an increase in government purchases leads to an
increase in potential output (or its growth rate), the
negative effects from the crowding out of private
investment will be reduced.
• Reductions in tax rates generate a short-run
demand stimulus and may also generate a longer-run
increase in the level and growth rate of potential
output.

8 - 49
Chapter 10
Long-Run Economic Growth

Chapter Outline/Learning Objectives
Section Learning Objectives
Blank After studying this chapter, you will be able to
10.1 The Nature of Economic
Growth
1. discuss the costs and benefits of
economic growth.
2. list four important determinants of growth
in potential GDP.
10.2 Economic Growth: Basic
Relationships
3. describe the relationship between
investment, saving, and long-run growth.
4. explain the main elements of Neoclassical
growth theory in which technological
change is exogenous.
10.3 Economic Growth: Advanced
Theories
5. discuss advanced growth theories based
on endogenous technical change and
increasing returns.
10.4 Are There Limits to Growth? 6. explain why resource exhaustion and
environmental degradation may create
serious challenges for public policy
directed at sustaining economic growth.

10.1 The Nature of Economic Growth
Figure 10-1 Three Aspects of Economic Growth

Table 10-1 The Cumulative Effect of
Economic Growth
Annual Growth Rate
Year 1% 2% 3% 5% 7%
0 100 100 100 100 100
10 111 122 134 163 197
30 135 181 243 432 761
50 165 269 438 1 147 2 946
70 201 400 792 3 043 11 399
100 271 725 1 922 13 150 86 772
Small differences in income growth rates make enormous differences in
levels of income over a few decades. Let income be 100 in year 0. At a
growth rate of 3 percent per year, it will be 134 in 10 years, 438 after 50 years,
and 1922 after a century. Notice the difference between 2 percent and 3 percent
growth—even small differences in growth rates make big differences in future
income levels.

Benefits of Economic Growth
• Rising Average Living Standards
– Economic growth is a powerful means of improving
average material living standards.
– Economic growth that raises average income tends to
change the whole society’s consumption patterns,
shifting away from tangible goods toward services.
– Economic growth provides the higher incomes that
often lead to a demand for a cleaner environment.

Addressing Poverty and Income
Inequality
• In recent years, the majority of aggregate income
growth in many countries, including Canada, has been
accruing to the top earners in the income
distribution.
• While average per capital incomes have been rising,
there has also been a rise in income inequality
• Poverty and income inequality are important
challenges for public policy.

APPLYING ECONOMIC CONCEPTS (1 of 2)
10-2 A Case Against Economic Growth
– Presents a case against continued economic growth,
especially in the developed countries
– Growth is not sustainable
– Growth may not increase overall well-being

Costs of Economic Growth
• Forgone Consumption
– Economic growth, which promises more goods and
services in the future, is achieve by consuming fewer
goods today. This sacrifice of current consumption is
an important cost of growth.
• Social Costs
– The process of economic growth is disruptive for some
businesses and workers. There are social costs from
workers’ skills becoming obsolete.

Sources of Economic Growth
• Four major determinants of growth are:
1. Growth in the labour force
2. Growth in human capital
3. Growth in physical capital
4. Technological improvement
• Different theories or economic growth emphasize
different sources of growth.

10.2 Economic Growth: Basic
Relationships
• A Long-Run Analysis
– In the simplest short-run macro model, the equilibrium
level of real GDP is such that real GDP equals desired
consumption plus desired investment:
Y = C + I
Y – C = I or S = I
– In the short-run, real GDP adjusts to determine
equilibrium, in which desired saving equals desired
investment.
– In the model’s long-run version, real GDP is equal to Y*
and the interest rate adjusts to determine equilibrium.

Investment, Saving, and Growth (1 of 2)
• We now add a government sector that purchases goods
and services (G) and collects taxes net of transfers (T).
• With real GDP equal to Y* in the long run, desired
private saving is equal to:
Private saving = Y* − T − C
• Public saving is equal to the combined budget surpluses
of the federal, provincial, and municipal governments.
Public saving = T – G

Investment, Saving, and Growth (2 of 2)
National saving = NS = Y*−T − C + (T − G)
NS = Y* − C − G
• So for a given level of real GDP in the long run (Y*),
an increase in household consumption or government
purchases implies a reduction in national saving.
• The supply curve for national saving and the
investment demand curve make up the economy’s
market for financial capital.

Figure 10-2 Investment and Saving in the Long
Run
In the long run, the condition that desired national saving equals desired investment determines the equilibrium
real interest rate.

Increases in Investment Demand and
the Supply of National Saving (1 of 4)
• An increase in the supply of national saving (NS)
reduces the real interest rate and encourages more
investment.
• The higher rate of investment leads to a higher growth
rate of potential output.

Figure 10-3(i) Increases in Investment Demand
and the Supply of National Saving (2 of 4)
Changes in the supply of national saving or the demand for investment will change the equilibrium real interest
rate and the rate of growth of potential output.

Increases in Investment Demand and
the Supply of National Saving (3 of 4)
• An increase in the demand for investment (I) pushes
up the real interest rate and encourages more saving
by households.
• The higher rate of saving (and investment) leads to a
higher growth rate of potential output.

Figure 10-3(ii) Increases in Investment Demand
and the Supply of National Saving (4 of 4)
Changes in the supply of national saving or the demand for investment will change the equilibrium real interest
rate and the rate of growth of potential output.

Figure 10-4 Cross-Country Investment and Growth
Rates, 1961‒2019
• The figure shows a positive relationship between investment
rates and growth rates, as predicted by our model.
(Source: Based on author’s calculations using data from the World Bank, www.worldbank.org.)

The “Neoclassical” Growth Model
• The aggregate production function:
GDP = FT (L, K, H)
– L = labour
– K = physical capital
– H = human capital
– T = technology
• The notation FT indicates that the function relating L,
K, and H to GDP depends on the state of technology.

Properties of the Aggregate Production
Function
• Key assumptions:
– the aggregate production function displays
diminishing marginal returns when any one of the
factors is increased on its own.
– constant returns to scale when all factors are
increased together.
• For simplicity, we will assume that human capital and
physical capital can be combined into a single variable
called capital and that technology is held constant.

Figure 10-5(i) The Aggregate Production Function
and Diminishing Marginal Returns (1 of 2)
With one input held constant, the other input has a declining average and marginal product.

Figure 10-5(ii) The Aggregate Production Function
and Diminishing Marginal Returns (2 of 2)
With one input held constant, the other input has a declining average and marginal product.

Economic Growth in the Neoclassical
Model (1 of 3)
1. Labour-Force Growth
– In the Neoclassical model with diminishing marginal
returns, increases in population (with fixed capital) lead
to increases in GDP but an eventual decline in material
living standards.
2. Physical and Human Capital Accumulation
– Capital accumulation leads to improvements in material
living standards, but because of the law of diminishing
returns, these improvements become smaller with each
additional increment of capital.

Model (2 of 3)
3. Balanced Growth with Constant Technology
– If capital and labour grow at the same rate, GDP will
increase.
– In the Neoclassical growth model with constant returns
to scale, such balanced growth will not lead to
increases in per capita output and therefore will not
generate improvements in material living
standards.

Model (3 of 3)
4. The Importance of Technological Change
– Technological change is assumed to be exogenous.
– New knowledge can contribute to the growth of
potential output, even without capital accumulation or
labour-force growth.
– Embodied technical change ‒ technological
improvements are contained in the new capital goods.

Should Workers Be Afraid of
Technological Change?
• Fear of widespread unemployment caused by technical
change is unfounded.
• As long as labour markets continue to adjust to changes
in the demand and supply for labour, the overall level of
employment will grow in line with the population,
independent of the rate of technological change.
• If overall technological progress leads to an increased
demand for skilled workers, the workers most able to
adapt to changing economic conditions are the ones
most likely to prosper unlike those without requisite
skills.

10.3 Economic Growth: Advanced
Theories
• Endogenous Technological Change
– Research has established that technological change is
responsive to economic signals (prices and profits); it is
endogenous to the economic system.
– Growth is achieved through costly, risky, innovative
activity that often occurs in response to economic
signals.
 Learning by Doing
 Knowledge Transfer
 Market Structure and Innovation
 Shocks and Innovation

Increasing Marginal Returns
• Neoclassical theories of economic growth assume
that investment in capital is subject to diminishing
marginal returns.
• Some research suggests the possibility of increasing
returns that remain for considerable periods of time.
• The sources of increasing returns fall into one of two
categories:
– Market-development costs
– The Economics of Ideas

10.4 Are There Limits to Growth?
• Resource Exhaustion
– The years since WWII have seen a rapid acceleration
in the consumption of the world’s resources,
particularly fossil fuels and basic minerals.
– The world’s current resources and its present capacity
to cope with pollution and environmental degradation
are insufficient to accomplish the rise in global living
standards with present technology.
– Most economists agree that absolute limits to growth,
based on the assumptions of constant technology and
fixed resources, are not relevant.

Resource Exhaustion
• Technology changes continually, as do available
stocks of resources.
• Advances in technological knowledge bring can
increase resource efficiency.
• Technology is constantly advancing, and many things
that seemed impossible a generation ago will be
commonplace a generation from now.
• Such technological advance makes any absolute
limits to economic growth less likely.

Environmental Degradation
• Conscious management of pollution was unnecessary
when the world’s population was 1 billion people, but
such management has now become a pressing
matter.
• Conclusion
– Growth can help the world address many problems.
But further growth must be sustainable growth, which
should be based on knowledge-driven technological
change.

Macro Chapter 8-10 Real GDP and the Price Level in the Short Run

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