| | | | | | 2. International forces. A fall in the price level causes our goods to be cheaper to foreigners and foreign goods to be more expensive to us. Consequently, demand for our exports increases, and we shift some of our demand for imports to domestically produced goods and services that compete against imports. | | | | | | | | | 3. The real money supply. A fall in the price level causes the real supply of money in the economy to rise. As we will see in chapter 9, this increase in money serves to increase aggregate demand through several channels. For example, a rise in the real supply of money causes its price, the interest rate, to fall. Lower interest rates, in turn, cause people to increase spending because borrowing costs have fallen. | | | | | | | | | A fall in the price level causes an increase in aggregate demand. The Keynesian multiplier effect is thus invoked, further increasing aggregate demand, so that a modest fall in the price level ends up increasing aggregate demand by a substantial amount, creating the downward-sloping aggregate demand curve AD portrayed in figure 5.1. For those interested, a graphical derivation of this curve appears in appendix 5.1 at the end of this chapter. Appendix A at the end of the book provides a more general overview of this curve and how it relates to other macroeconomic curves. The intersection of AD and AS, point A, is an equilibrium for the economy, so we visualize the economy as being at price level PA and at corresponding output level YA. | | | | | | | | | An increase in aggregate demand for goods and services due to government policy shifts the AD curve horizontally to the right by an amount equal to the multiplier times this increase. A prominent example of such policy shifts is an increase in government spending an expansionary fiscal policy. Tracing the economy's reaction to such a shock can illustrate how the aggregate-supply/aggregate-demand diagram is used. | | | | | | | | | 5.3
Using The Aggregate-Supply/Aggregate-Demand Diagram | | | | | | | | | An increase in government spending of DG increases spending at every price level by DG times the multiplier, so the entire AD curve shifts to the fight by this amount, as shown in figure 5.1 by the shift to AD'. The equilibrium moves to point B, and real income increases from YA to YB. Notice that the new equilibrium position involves a rise in the price level, which, through wealth effects, international effects, and a fall in the real money supply, decreases real aggregate demand, causing the change in income (YB - YA) to be smaller than would have been the case had the price level not risen. The multiplier becomes smaller than the multiplier of the previous chapter. This process is illustrated in figure 5.2, an updated flowchart incorporating the role of the price level. | | | | | | | | | Now the initial excess demand is squeezed off through two sources increases in output and increases in prices so the multiplier in real terms is smaller than when we did not recognize the role of the price level. | | | | |
