Question

Explain written and graphically, what happens to the short and long term multiplier effect if the general price level changes in the macroeconomic balance.

Answer 1

We know from previous lessons that business cycles are deviations of GDP away from the long run trend. In other words, real GDP is increasing over time, but its a bumpy road along the way with lots of ups and downs.

But why do business cycles exist in the first place? This question continues to fascinate macroeconomists. In our last lesson, we learned how we can use the AD-AS model to describe what real GDP is today. Now, we will use the same model to describe why real GDP might change. Anything that shifts AD or SRAS will create a new macroeconomic equilibrium. We can use the AD-AS model to help explain the business cycle (in other words, the recessions and booms that we have seen in the real world).

When AD or SRAS curves shift, we call these “shocks”. Why a shock? Because the change come as a complete surprise! An unexpected change in the economy will shift either the aggregate demand (AD) or short-run aggregate supply (SRAS) curve. Negative shocks decrease output and increase unemployment. Positive shocks increase production and reduce unemployment. The effect on inflation, however, will depend on whether the shock was a supply shock or a demand shock.

Key Terms

Key term	definition
shock	an unexpected change that will shift either the AD or SRAS curve; if a change is anticipated, that anticipation would already have been incorporated into the curve, so a change must be unexpected in order to cause a change.
demand shock	an unexpected change that shifts AD; a positive demand shock (such as an increase in consumer confidence) increases AD, but a negative demand shock decreases AD.
supply shock	an unexpected change that shifts SRAS; a positive supply shock increases SRAS, but a negative supply shock decreases SRAS.
stagflation	the combination of a stagnating (falling) aggregate output and a higher price level (inflation); stagflation occurs when SRAS decreases.

Key takeaways

AD shocks have a short-run impact on the three macroeconomic variables

We can summarize the impact of an AD shock as described in the table below:

Demand shock	impact on rGDP	impact on unemployment	impact on price level
↑ AD	↑ rGDP	↓ UR	↑ PL
↓ AD	↓ rGDP	↑ UR	↓ PL

A change in any of the components of aggregate demand will cause AD to shift, creating a new short-run macroeconomic equilibrium. In other words, in our AD=C+I+G+NXAD=C+I+G+NXA, D, equals, C, plus, I, plus, G, plus, N, X equation, anything that increases C, I, G, or NX will shift AD to the right. Anything that decreases C, I, G, or NX will shift AD to the left.

For example, suppose an economy is initially in long-run equilibrium. If the economy experiences a positive AD shock, it would be in the expansion phase of the business cycle and have a positive output gap. Increases in AD are the most frequent cause of increases in aggregate output in the business cycle. Positive output gaps are frequently called inflationary gaps because increases in AD also cause an increase in the price level.

We can summarize the impact of a shock to SRAS as described in the table below:

Supply shock	impact on rGDP	impact on unemployment	impact on price level
↑SRAS	↑rGDP	↓ UR	↓ PL
↓SRAS	↓rGDP	↑ UR	↑ PL

Remember the mnemonic “SPITE” to summarize the things that can cause a shift in SRAS: Subsidies for businesses Productivity Input prices Taxes on businesses Expectations about future inflation

For example, suppose an economy is initially in long-run equilibrium (current output is equal to full employment output). If the economy then experiences a positive SRAS shock, such as a decrease in Input prices. Now it would be in the expansion phase of the business cycle and experiences a positive output gap.

On the other hand, if the economy starts in long-run equilibrium and then experiences a negative SRAS shock, it would be in the recession phase of the business cycle and experience a negative output gap. The combination of low output and high inflation that is caused by a decrease in SRAS is so unusual that it gets its a special name: stagflation. This word is a mashup of “stagnation” and “inflation.”

Shifts in SRAS represent the best and the worst outcomes for an economy. If SRAS increases, we end up with lower prices, less unemployment, and more output! On the other hand, decreases in SRAS give us more of what we like the least: less stuff, more unemployment, and higher prices.

Key graphs

Positive demand shocks

PLPLrGDPrGDPSRASSRASADADAD_2AD2​PL_1PL1​Y_1Y1​Y_fYf​LRASLRASPL_2PL2​Y_2Y2​

Figure 1: A positive demand shock

This economy was initially at long-run equilibrium, so its current output (Y_1Y1​Y, start subscript, 1, end subscript) was equal to its full employment output (Y_fYf​Y, start subscript, f, end subscript). As the result of an increase in one of the components of AD, the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL_2PL2​P, L, start subscript, 2, end subscript) and higher output (Y_2Y2​Y, start subscript, 2, end subscript). Because output has increased, the unemployment rate has decreased.

Positive supply shocks

PLPLrGDPrGDPSRAS_1SRAS1​ADADPL_1PL1​Y_1Y1​Y_fYf​LRASLRASPL_2PL2​Y_2Y2​SRAS_2SRAS2​

Figure 2: A positive supply shock

This economy was initially at long-run equilibrium, and its current output (Y_1Y1​Y, start subscript, 1, end subscript) was equal to its full employment output (Y_fYf​Y, start subscript, f, end subscript). Something has changed in the economy making output cheaper for producers, such as a decrease in the cost of labor. At the old price level, SRAS would exceed AD. This surplus output puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level (PL_2PL2​P, L, start subscript, 2, end subscript) and higher output (Y_2Y2​Y, start subscript, 2, end subscript). Because output has increased, the unemployment rate has decreased.

Shifts in SRAS are caused by things that impact the ability to produce goods and services in the short run. The most common factor that affects SRAS is an economy-wide change in factor prices. Some things that impact an economy’s ability to produce are so profound that they have not just a short-run impact, but a long-run impact, which means both the SRAS and LRAS will shift. For example, if more resources become available (like an entirely new form of energy is discovered), then this would shift the LRAS curve to the right. We will develop this idea more in a future lesson, however. For now, focus on the immediate impact a change in the cost of production has on SRAS alone.

Negative demand shocks

PLPLrGDPrGDPSRASSRASADADAD_2AD2​PL_1PL1​Y_1Y1​Y_fYf​LRASLRASPL_2PL2​Y_2Y2​

Figure 3: A negative demand shock

This economy was initially at long-run equilibrium, and its current output (Y_1Y1​Y, start subscript, 1, end subscript) was equal to its full employment output (Y_fYf​Y, start subscript, f, end subscript). As the result of a decrease in one of the categories of AD, the entire AD curve has decreased (shifted to the left). At the old price level, SRAS would exceed AD. This puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level (PL_2PL2​P, L, start subscript, 2, end subscript) and lower output (Y_2Y2​Y, start subscript, 2, end subscript). Because output has decreased, the unemployment rate has increased.

Negative supply shocks

PLPLrGDPrGDPSRAS_1SRAS1​ADADPL_1PL1​Y_1Y1​Y_fYf​LRASLRASPL_2PL2​Y_2Y2​SRAS_2SRAS2​

Figure 4: A negative supply shock

This economy was initially at long-run equilibrium, and its current output (Y_1Y1​Y, start subscript, 1, end subscript) was equal to its full employment output (Y_fYf​Y, start subscript, f, end subscript). Something has changed in the economy making output more costly for producers, such as increased regulation. At the old price level, AD would exceed SRAS. This puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL_2PL2​P, L, start subscript, 2, end subscript) and lower output (Y_2Y2​Y, start subscript, 2, end subscript). Because output has decrease, the unemployment rate has increased.

Common misperceptions

-Some people get confused about changes in the price level versus changes in expectations in the price level. A change in the price level leads to movement along the SRAS or AD curve, but changes in expectations shift the entire curve itself. If something happens that makes firms believe that inflation is coming, they will adjust their plans accordingly.

For example, if firms expect they will have to pay higher wages in the future because of inflation, they start cutting back production today in anticipation of that inflation. As a result, the SRAS curve will decrease, even before any inflation has occurred. Expectations of inflation are, in effect, self-fulfilling prophecies!