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In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve.
The Aggregate Expenditure Curve and the Aggregate Demand Curve
· Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures.
· Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect).
Equilibrium Real GDP and the Price Level
· An increase in aggregate demand raises the price level and increases real GDP. In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion.
· The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward.
· Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run.
· Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases.
· In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion.
· The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level. As a result, the long-run multiplier is equal to zero.
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III. The Multiplier | | | II. Supply-Side Effects of Fiscal Policy |