How Output Is Determined in the Short Run

How Output Is Determined in the Short Run
Having discussed the factors that influence the demand for an open economy’s output,
we now study how output is determined in the short run. We show that the output
market is in equilibrium when real domestic output, , equals the aggregate demand for
domestic output:
(17-1)
The equality of aggregate supply and demand therefore determines the short-run equilibrium
output level.5
Y = D(EP*/P, Y - T, I, G).
Y
Y
Y
Y
Y
5 Superficially, equation (17-1), which may be written as looks like
the GNP identity we discussed in Chapter 13, . How do the two equations differ? They
differ in that (17-1) is an equilibrium condition, not an identity. As you will recall from Chapter 13, the investment
quantity I appearing in the GNP identity includes undesired or involuntary inventory accumulation by
firms, so the GNP identity always holds as a matter of definition. The investment demand appearing in equation
(17-1), however, is desired or planned investment. Thus, the GNP identity always holds, but equation (17-1)
holds only if firms are not unwillingly building up or drawing down inventories of goods.
Y = C + I + G + CA
Y = C(Yd) + I + G + CA(EP*/P, Yd),
CHAPTER 17 Output and the Exchange Rate in the Short Run 427
Our analysis of real output determination applies to the short run because we assume
that the money prices of goods and services are temporarily fixed. As we will see later in
the chapter, the short-run real output changes that occur when prices are temporarily fixed
eventually cause price level changes that move the economy to its long-run equilibrium. In
long-run equilibrium, factors of production are fully employed, the level of real output is
completely determined by factor supplies, and the real exchange rate has adjusted to
equate long-run real output to aggregate demand.6
The determination of national output in the short run is illustrated in Figure 17-2,
where we again graph aggregate demand as a function of output for fixed levels of the
real exchange rate, taxes, investment demand, and government spending. The intersection
(at point 1) of the aggregate demand schedule and a 45-degree line drawn from the origin
(the equation ) gives us the unique output level at which aggregate demand
equals domestic output.
Let’s use Figure 17-2 to see why output tends to settle at in the short run. At an output
level of , aggregate demand (point 2) is higher than output. Firms therefore increase
their production to meet this excess demand. (If they did not, they would have to meet the
excess demand out of inventories, reducing investment below the desired level, .) Thus,
output expands until national income reaches .
At point 3 there is an excess supply of domestic output, and firms find themselves involuntarily
accumulating inventories (and involuntarily raising their investment spending
above its desired level). As inventories start to build up, firms cut back on production; only
when output has fallen to will firms be content with their level of production. Once
again, output settles at point 1, the point at which output exactly equals aggregate demand.
In this short-run equilibrium, consumers, firms, the government, and foreign buyers of domestic
products are all able to realize their desired expenditures with no output left over.
Y1
Y1
I
Y2
Y1
D = Y Y1
6 Thus, equation (17-1) also holds in long-run equilibrium, but the equation determines the long-run real exchange
rate when Y is at its long-run value, as in Chapter 16. (We are holding foreign conditions constant.)
Aggregate
demand, D
Y 2 Y1 Output, Y
1
2
Aggregate demand =
aggregate output, D = Y
Aggregate demand
3
Y 3
45°
D1
Figure 17-2
The Determination of Output in
the Short Run
In the short run, output settles
at Y1(point 1), where aggregate
demand, D