Chapter 19 Aggregate Demand and Aggregate Supply

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Chapter 19 Aggregate Demand and Aggregate Supply

• Three key facts about economic fluctuations
• Explaining Short-Run Economic Fluctuations
• The Aggregate-Demand Curve
• The Aggregate-Supply Curve
• Two causes of economic fluctuations

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• Economic activity fluctuates from year to year.
  In some years, the production of goods and
  services rises. In other years normal growth
  does not occur, leading to recession.
• A recession is a situation of declining real GDP,
  falling incomes and rising unemployment for two
  consecutive quarters.
• Depression a severe recession
• Three Key Facts About Economic Fluctuations
• Economic Fluctuations are Irregular and
  Unpredictable.
• Recessions occur with unpredictable frequency and
  duration.
• See Figure 19-1
• Recessions defined here as two or more
  consecutive quarters of negative real GDP growth,
  are shown as the shaded areas.

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• Most Macroeconomic Variables Fluctuate Together.
• Most macroeconomic variables are closely related
  and move together.
• As Output Falls, Unemployment Rises.
• Changes in real GDP and the unemployment rate are
  inversely related.
• Explaining short-run economic fluctuations
• Model of Aggregate Demand and Aggregate Supply
  the model hat most economists use to explain
  short-run fluctuations in economic activity
  around its long-run trend.
• The Aggregate Demand Curve shows the quantity of
  goods and services that households, firms and the
  government are willing to buy at different prices.

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• The Aggregate Supply Curve shows the quantity of
  goods and services that firms would be willing to
  produce and sell at different prices.
• Two variables are used in developing AD-AS model
  to analyze the short-run fluctuations
• 1. The economys output of goods and services,
  measured by real GDP
• 2. The overall price level, measured by the CPI
  or GDP Deflator
• See figure 19-2

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• The Aggregate Demand Curve
• The aggregate demand for goods and services may
  be referred to asY C I G NX
• See figure 19-3 AD curve
• Why is the aggregate demand curve downward
  sloping?
• 1. Pigous Wealth Effect
• 2. Keynes Interest Rate Effect
• Real Exchange Rate Effect
• Pigous Wealth Effect Consumers feel
  wealthier, which stimulates the demand for
  consumption goods.
• A decrease in the price level makes consumers
  feel more wealthy, which in turn encourages them
  to spend more.
• The increase in consumer spending means a larger
  quantity of goods and services demanded.

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• Keynes Interest-Rate Effect The lower the
  price level, the less money households need to
  hold to buy the goods and services they want.
• A lower price level reduces the interest rate,
  encourages greater spending on investment goods,
  and thereby increases the quantity of goods and
  services demanded.
• Real Exchange-Rate Effect When prices of
  Canadian goods go down, foreigners buy more of
  our goods and we purchase less of their goods.
• When a fall in the Canadian price level causes
  the real exchange rate to depreciate, this
  stimulates Canadian net exports, thereby
  increasing the quantity of goods and services
  demanded.

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• Why the AD curve might shift
• The downward slope of the AD curve shows that a
  fall in the price level raises the overall
  quantity of goods and services demanded.
• Many other factors, however, affect the quantity
  of goods and services demanded at a give price
  level. When one of these other factors changes,
  the AD curve shift.
• Shifts in the aggregate demand curve may arise
  because of
• 1. Changes in spending plans by consumers or
  firms.
• 2. Changes in fiscal or monetary policy.
• Anything that causes buyers to want to purchase
  more or less than before will cause the aggregate
  demand schedule to shift.
• See Table 19-1

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• The Aggregate Supply Curve
• Why the AS curve is vertical in the long run
• The Long-Run Aggregate Supply Curve is vertical
  at full-employment GDP with respect to the price
  level.
• In the long-run the quantity of output supplied
  depends on the economys resource endowment,
  technology, and its governing institutions. The
  price level does not affect these variables in
  the long-run.
• See Figure 19-4
• Why the long-run AS curve might shift
• Over time, any change in the factors that
  determine the long-run aggregate supply will
  cause the curve to shift.
• Because output in the classical model depends on
  labour, capital, natural resources and
  technological knowledge, we can categorize shifts
  in the long-run AS as changes from these sources.

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• An event that reduces potential output shifts the
  schedule to the left.
• Any change that increases the economys potential
  output will shift the curve to the right.
• A new way to depict long-run growth and inflation
• See Figure 19-5 Long Run growth and inflation in
  the model of AD-AS
• The LRAS may shift to the right because of
  technological progress.
• At the same time, as the Bank of Canada increases
  the money supply, the AD curve also shifts to the
  right. So price level rises and output grows.
• Thus, AD-AS model provide a new way to depict
  long-run growth and inflation.

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• Why the aggregate-supply curve slopes upward in
  the short-run
• See Figure 19-6
• In the short-run, an increase in the overall
  level of prices in the economy tends to raise the
  quantity of goods and services supplied, and a
  decrease in the level of prices tends to reduce
  the quantity of goods and services supplied.
• There are three alternative explanations for the
  upward slope of the short-run aggregate supply
  curve.
• New Classical Misperceptions Theory
• The Keynesian Sticky-Wage Theory
• The New Keynesian Sticky-Price Theory

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• The New Classical Misperceptions Theory A
  higher price level signals to each firm a greater
  demand for their product inducing them to produce
  more.
• Changes in the overall price level can
  temporarily mislead suppliers about what is
  happening in the markets in which they sell their
  output.
• The Keynesian Sticky-Wage Theory The higher
  product prices cause a temporary decrease in real
  wages stimulating employment and output.
• Nominal wages are slow to adjust, or are sticky
  in the short-run, thus a lower price level makes
  employment and production less profitable, which
  induces firms to reduce production.

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• The New Keynesian Sticky-Price Theory Prices
  that do not increase immediately are temporarily
  low thereby stimulating spending and output on
  those goods.
• Prices of some goods and services adjust
  sluggishly in response to changing economic
  conditions.
• Remember Menu Costs.
• Why the short-run AS curve might shift
• Three factors may lead to a shift in the
  short-run aggregate supply curve.
• Changes in Factor (input) Prices
• Changes in Productivity
• Legal-Institutional Environment

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• Changes in factor (input) prices Changes in the
  prices of domestic or imported resources will
  change the cost of producing final goods.
• An increase in input prices will shift the
  supply curve to the left.
• A decrease in input prices will shift the supply
  curve to the right.
• Changes in productivity If changes in the
  resource markets increase factor productivity,
  more goods can be made available at a lower cost.
  New technologies can increase the output per
  unit of labour or capital and hence make
  available more final goods.
• Legal-institutional environment Burdensome
  taxes and counterproductive regulations can
  increase the cost of production and discourage
  firms from producing.
• See Table 19-2

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• Two Causes of Economic Fluctuations
• The long-run equilibrium See Figure 19-7
• Equilibrium output and price level are determined
  by the intersection of the aggregate demand curve
  and the long-run aggregate supply curve.
• Output is at its natural rate and the short-run
  aggregate supply curve passes through the point
  of intersection.
• Two sources from which a recession in the economy
  may occur
• A decrease in aggregate demand
• A decrease in aggregate supply
• Shifts in the aggregate demand or the aggregate
  supply curves result in fluctuations in the
  economys output of goods and services.

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• Source of Recession A Decrease in Aggregate
  Demand
• A decrease in one or more components of the total
  spending function will cause the aggregate demand
  schedule to shift leftward.
• Output will fall below the full employment output
• Unemployment will rise
• See Figure 19-8 Point A and Point B
• Although not shown in the figure, firms respond
  to lower sales and production by reducing
  employment.
• Thus, the pessimism that caused the shift in AD
  is to some extent, self-fulfilling Pessimism
  about the future leads to falling incomes and
  rising unemployment.
• Increase in G or an increase of money supply
  would increase the quantity of goods and services
  demanded at any price and therefore, would shift
  the AD curve back to the right.

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• Even without action by policymakers, the
  recession will remedy itself over a period of
  time. Because of the reduction in AD, the price
  level falls. Eventually, expectations catch up
  with this new reality, and the expected price
  level falls as well. Because the fall in the
  expected price level alters perceptions, wages,
  and prices, it shifts the SRAS to the right from
  AS1 to AS2.
• This adjustment of expectations allows the
  economy over time to approach point C in figure
  19-8.
• In the new long run equilibrium, point C, output
  is back to its natural level.
• Thus, the long-run effect of a shift in AD is a
  nominal change ( the price level is lower) but
  not a real change (output is the same).
• See Figure 19-9 Big shifts in AD in Canada

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• Source of Recession A Decrease in Aggregate
  Supply
• A decrease in short-run aggregate supply will
  result in a new equilibrium along the aggregate
  demand curve below full employment.
• A fall in total output below full output
• An increase in unemployment
• See Figure 19-10 Point A to Point B
• When the economy falls due to a decrease in the
  aggregate supply, the price level rises and
  output decreases. This is called Stagflation.
• Alternatively, policymakers who control monetary
  and fiscal policy might attempt to offset some of
  the effects of the shift in the SRAS curve by
  shifting the AD curve. See Figure 19-11. In this
  case, policymakers are said to accommodate the
  shift in AS because they allow the increase in
  costs to affect the level of prices permanently.

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• Actions by Policy-makers During Periods of
  Recession
• Policy-makers, when faced by decreasing aggregate
  demand or supply could
• Do nothing, assuming that perceptions will adjust
  prices and wages. Example Figure 19-8
• Take action to increase aggregate demand
  (implement monetary and fiscal policy). Example
  Figure 19-11