Dr. Mitchell/Eco 329/Fall 2000
Lecnot15
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GDP, The Price Level, and the Current Account
Review--AD/AS model
Components of AD
C, I, G, X - M
Why does AD slope downward?
Wealth effect
A higher price level reduces the real value of assets, making households feel poorer and reducing
their desire to purchase new goods & services.
Interest rate effect
Holding the nominal money supply constant, a higher price level reduces the real supply of
money, increasing interest rates and reducing investment and interest-sensitive consumption.
Terms of trade effect
Holding the exchange rate and foreign price levels constant, a higher domestic price level makes
foreign goods more attractive relative to domestic goods, reducing the quantity of domestic
goods demanded.
Shifting AD
Change in C, I, G, X - M unrelated to changes in price level.
Price
Level
AD
Y (GDP)
Aggregate Supply
Determinants of SRAS
Output prices, Input prices, Technology, Expected price level
Dr. Mitchell/Eco 329/Fall 2000
Lecnot15
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Why SRAS slopes upward
Holding input prices constant, an increase in output prices (price level) makes production more
profitable, producers expand output.
Holding the expected price level constant, an increase in the price level results in higher nominal
wages and "fools" workers into temporarily working more.
LRAS
In the LR, all prices and expectations adjust so that we have the natural rate of unemployment
and full-employment output.
LRAS shifts for changes in the size of the labor force, changes in the amounts of other resources,
changes in technology.
Why SRAS may be "asymmetric"
Beyond full-employment output, it is difficult to increase labor hours worked without a
substantial increase in the price level. However, when AD falls, prices and wages do not seem to
adjust downward. Instead, we see reductions in output.
LRAS
Price
Level
SRAS
Y (GDP)
SR macro equilibrium
Quantity demand in aggregate equals quantity supplied in aggregate
LRAS
Price
Level
SRAS
P*
AD
Y*
Y (GDP)
Dr. Mitchell/Eco 329/Fall 2000
Lecnot15
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The multiplier
Recall: An autonomous increase in C, I, G, or X-M of $1 will shift AD by a multiple of the
original change. The multiple depends on the marginal propensity to consume, the marginal
propensity to import, the marginal tax rate, and the slope of the SRAS curve.
LR macro equilibrium
SR equilibrium, plus on LRAS.
SRAS'
LRAS
Price
Level
SRAS
P*
P*
AD
Y*
Y (GDP)
Adjustment to LR equilibrium
From an expansionary (inflationary) gap
Expectations of the price level are revised upwards
Input prices adjust upwards
SRAS shifts left until unemployment rate returns to natural rate.
From a contractionary (deflationary) gap
Expectations of the price level are revised downwards
Input prices (wages) adjust downwards
SRAS shifts right until unemployment rate returns to natural rate.
Typically expect that this takes longer than adjustment from inflationary gap.
The length of time the adjustment takes will depend on the past history of monetary & fiscal
policy. If policy was used to stimulate AD in the past, this may increase the population's
willingness to wait for jobs at their old nominal wages.
How trade affects the analysis
Exports
Determined by our price level, the foreign price level, the exchange rate, and foreign levels of
income.
Dr. Mitchell/Eco 329/Fall 2000
Lecnot15
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Note: A recession abroad will reduce exports, reducing AD and possibly causing a recession at
home.
Depreciation of our currency will stimulate AD since X rises and M falls.
A change in our price level moves us along AD.
A reduction in the foreign price level decreases AD.
Imports
Determined by our price level, the foreign price level, the exchange rate, and domestic level of
income.
Our imports rise as our GDP rises. This is the marginal propensity to import. It reduces the
slope of Aggregate Expenditure and reduces the size of the multiplier. The higher our mpi, the
smaller our multiplier.
Our trade balance thus falls as GDP rises. A trade deficit is more likely when economic times
are good. A trade surplus may be associated with a recession.
$
M
X