principles of macroeconomics: ch. 19 second canadian edition chapter 19 aggregate demand and...
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Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Chapter 19Aggregate Demand and
Aggregate Supply
© 2002 by Nelson, a division of Thomson Canada Limited
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Short-Run Economic Fluctuations
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Three Key Facts About Economic Fluctuations
Economic Fluctuations are Irregular and Unpredictable.– Recessions occur with unpredictable
frequency and duration. Most Macroeconomic Variables
Fluctuate Together.– Most macroeconomic variables are
closely related and move together.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Three Key Facts About Economic Fluctuations
As Output Falls, Unemployment Rises.– Changes in real GDP and the
unemployment rate are inversely related.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Quick Quiz!
List and discuss three key facts about economic fluctuations.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Economic Fluctuations
Although there remains some debate about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Basic Model of Economic Fluctuations
Two variables are used in developing a model to analyze the short-run fluctuations:1. The economy’s output of goods and
services, measured by real GDP
2. The overall price level, measured by the CPI or GDP Deflator
The Model: Aggregate Demand and Aggregate Supply
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Aggregate Demand and Aggregate Supply Model
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
PE
QE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Aggregate Demand and Aggregate Supply
The Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices.
The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Aggregate Demand Curve
The aggregate demand for goods and services may be referred to as:
Y = C + I + G + NXWhy is the aggregate demand curve
downward sloping?1. Pigou’s Wealth Effect2. Keynes’ Interest Rate Effect3. Real Exchange Rate Effect
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Three Reasons for the Downward Slope of the Aggregate Demand
Pigou’s 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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Three Reasons for the Downward Slope of the Aggregate Demand
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Three Reasons for the Downward Slope of the Aggregate Demand
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Factors that might shift the Aggregate Demand Curve
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.”
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Shifts in the Aggregate Demand Curve
Quantity of Output
PriceLevel
AggregateSupply
Aggregate Demand
AD
AD
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Quick Quiz!Explain the three reasons
why the aggregate demand curve slopes downward.
Give an example of an event that would shift the aggregate demand curve. Which way would this event shift the curve?
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Long-Run Aggregate Supply CurveThe 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 economy’s resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Long-Run Aggregate Supply Curve
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
The Long-RunAggregate
Supply Curve
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Long-Run Aggregate Supply Curve
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
Output at Full Employment
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Shifts in the Long-Run Aggregate Supply Curve
Over time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift.– An event that reduces potential output
shifts the schedule to the left.
– Any change that increases the economy’s potential output will shift the curve to the right.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Short-Run Aggregate Supply Curve
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Reasons for the Upward Slope of the Aggregate Supply Curve
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
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Reasons for the Upward Slope of the Aggregate Supply Curve
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Reasons for the Upward Slope of the Aggregate Supply Curve
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Reasons for the Upward Slope of the Aggregate Supply Curve
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
What Might Cause the Aggregate Supply Curve to 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
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Shifts in the Aggregate Supply Curve
Quantity of Output
PriceLevel
AggregateDemand
Aggregate Supply
AS
AS
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
What Might Cause the Aggregate Supply Curve to Shift?
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
What Might Cause the Aggregate Supply Curve to Shift?
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
What Might Cause the Aggregate Supply Curve to Shift?
Legal-institutional environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Quick Quiz!
Explain why the long-run aggregate supply curve is vertical.
Explain three theories for why the short-run aggregate supply curve is upward sloping.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Equilibrium in the Long-Run
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.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Equilibrium in the Long-Run
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Sources of Recession
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 economy’s output of goods and services.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
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
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Demand
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Demand
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Demand
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
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
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Supply
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Supply
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Supply
Quantity of Output
PriceLevel
AggregateSupply
AggregateDemand
QE
PE
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
A Decrease in Aggregate Supply
When the economy falls due to a decrease in the aggregate supply, the price level rises and output decreases. This is called Stagflation.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
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.
– Take action to increase aggregate demand (implement monetary and fiscal policy).
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Quick Quiz!
Suppose that the election of a popular prime ministerial candidate suddenly increases people’s confidence in the future.
Use the model of aggregate supply and aggregate demand to analyze the effect on the economy.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
Overview
Three key factors about economic fluctuations.
The aggregate demand and aggregate supply model.
The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.