PART 3 MACROECONOMIC MODELS AND FISCAL POLICY CHAPTER

PART 3: MACROECONOMIC MODELS AND FISCAL POLICY CHAPTER 10 Aggregate Demand Aggregate Supply Slides prepared by Bruno Fullone, George Brown College © 2010 Mc. Graw-Hill Ryerson Limited 1

In This Chapter You Will Learn: • Learning Objective 10. 1: About aggregate demand (AD) and the factors that cause it to change • Learning Objective 10. 2: About aggregate supply (AS) and the factors that cause it to change • Learning Objective 10. 3: How AD and AS determine an economy’s equilibrium price level and level of real GDP • Learning Objective A 10. 1: (Appendix) How the aggregate demand curve relates to the aggregate expenditure model Chapter 10 2

10. 1 Aggregate Demand • Aggregate demand is a schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level LO 10. 1 3

Figure 10 -1 Aggregate Demand Price Level • Aggregate Quantity Demanded (Real GDP) and the Price Level are inversely related as follows: Figure 10 - 1 AD Real GDP LO 10. 1 4

Aggregate Demand • Slopes downward because of the following effects of a change in price level: 1. Real-balances Effect 2. Interest-rate Effect 3. Foreign Trade Effect Remember: these effects are caused by price level changes LO 10. 1 5

Changes in Aggregate Demand Figure 10 -2 Price level AD Can Increase shift RIGHT AD 1 AD 2 Real domestic output, GDP LO 10. 1 6

Changes in Aggregate Demand Figure 10 -2 Price level AD Can Decrease shift LEFT AD 3 AD 1 Real domestic output, GDP LO 10. 1 7

Determinants of Aggregate Demand • Changes in Consumer Spending – Consumer wealth – Consumer expectations – Household borrowing – Personal taxes LO 10. 1 8

Determinants of Aggregate Demand • Changes in Investment Spending – Interest Rates – Expected Returns • Expectations about future business conditions • Technology • Degree of excess capacity • Business taxes LO 10. 1 9

Determinants of Aggregate Demand • Changes in Government Spending • Changes in Net Export Spending – National Income Abroad – Exchange Rates LO 10. 1 10

10. 2 Aggregate Supply • Aggregate supply is a schedule or curve showing the relationship between the price level of output and the amount of real domestic output that firms in the economy produce • This relationship varies depending on three time horizons: • The immediate short run • The long run LO 10. 2 11

Aggregate Supply in the Immediate Short Run • In the immediate short run, both input prices and output prices are fixed • In the immediate short run, the aggregate supply curve is horizontal at an economy’s current price level • With output prices fixed, firms collectively supply the level of output that is demanded at those prices • As illustrated …. LO 10. 2 12

Figure 10 -3 Aggregate Supply in the Immediate Short Run Price Level ASISR Immediate-shortrun Aggregate Supply Qf 29 -13 Real Domestic Output, GDP

Aggregate Supply in the Short Run • The short run begins after the immediate short run ends • The short run is a period of time during which output prices are flexible but input prices are either totally fixed or highly inflexible. LO 10. 2 14

Aggregate Supply in the Short Run • The upward-sloping aggregate supply curve AS indicates a direct (or positive) relationship between the price level and the amount of real output that firms will offer for sale • The AS curve is relatively flat below the full -employment output • It is relatively steep beyond the fullemployment output • As illustrated … LO 10. 2 15

Figure 10 -4 Short-Run Aggregate Supply Curve Slope not constant: per unit production cost and firm capacity Price Level Aggregate Supply (Short Run) 0 29 -16 Qf Real Domestic Output, GDP

Price level Short-Run Aggregate Supply a 2 P 1 a 1 GDPf GDP 2 LO 10. 2 AS 1 an increase in price level increases profits & output, moving the economy from a 1 to a 2 Real domestic output 17

Short-Run Aggregate Supply Price level AS 1 a 1 P 3 a 3 GDPf a decrease in price level decreases profits & output, moving the economy from a 1 to a 3 Real domestic output LO 10. 2 18

Aggregate Supply in the Short Run • As the economy expands in the short run, per-unit production costs generally rise • The extent of the rise depends on where the economy is operating, relative to its Unless stated otherwise, capacity “aggregate supply” refers to – an economy below AS operating in the short run its fullemployment output has idle capital & labour little upward pressure on production costs – when the economy is operating beyond its full -employment output, most available resources are already employed per-unit production costs increase as economy LO 10. 2 expands 19

Aggregate Supply in the Long Run • For the economy as a whole, it is the time horizon over which all output and input prices are fully flexible • It begins after the short run ends • Price-level changes do not affect firms’ profits and thus they create no incentive for firms to alter their output • Illustrated … LO 10. 2 20

Figure 10 -5 Aggregate Supply in the Long Run Price Level ASLR Long-run Aggregate Supply Qf 29 -21 Real Domestic Output, GDP

Determinants of Short-Run Aggregate Supply 1. Change in input prices a. Domestic resource price b. Price of imported resources 2. Change in productivity 3. Change in legal-institutional environment a. Business taxes & subsidies b. Government regulation LO 10. 2 22

Decreases in (short-run) AS Figure 10 -6 AS 2 Price level AS 1 Real GDP LO 10. 2 23

Increases in (short-run) AS Figure 10 -6 AS 1 Price level AS 2 Real GDP LO 10. 2 24

10. 3 Equilibrium and Changes in Equilibrium • Equilibrium occurs at the price level that equalizes the amount of real output demanded & supplied Real Output Demanded (billions) Price Level (index number) Real Output Supplied (billions) $506 108 513 508 104 512 510 100 512 96 505 514 92 502 LO 10. 3 25

Figure 10 -7 The Equilibrium Price Level and Equilibrium Real GDP Price Level AS Equilibrium 100 92 a b AD 502 29 -26 510 514 Real Domestic Output, GDP (Billions of Dollars)

Increases in AD • For any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level • Demand-pull inflation… LO 10. 3 27

Increases in AD Price level Figure 10 -8 P 2 Output does not AS increase all the way to GDP 1 because of inflation P 1 AD 2 GDPf GDP 2 Chapter 8 AD 1 Real GDP 1 28

Inflationary Gap • An inflationary gap is the amount by which equilibrium GDP exceeds potential GDP LO 10. 3 29

Decreases in AD: Recession and Cyclical Unemployment • Deflation, a decline in the price level, is a rarity in the Canadian economy • Real output takes the full brunt of the decline in AD because product prices are “sticky” in the short run – – – – fear of price wars menu costs wage contracts morale, effort, & productivity minimum wage menu costs fear of price wars LO 10. 3 30

Decreases in AD Figure 10 -9 Price level AS prices are sticky downwards P 1 AD 2 GDP 1 GDPf LO 10. 3 AD 1 Real GDP 31

Recessionary Gap • A recessionary is the amount by which equilibrium GDP falls short of potential GDP LO 10. 3 32

Decreases in AS: Cost-push Inflation • Effects of a leftward shift in AS are doubly bad – output decreases – price level increases LO 10. 3 33

Decreases in AS Figure 10 -10 AS 2 Price level AS 1 P 2 P 1 GDP 2 GDPf LO 10. 3 AD 1 Real GDP 34

Increases in AS: Full Employment with Price-Level Stability • Increases in AD should normally lead to inflation • Recently, productivity growth has shifted the long-run AS curve to the right LO 10. 3 35

Increases in AS Figure 10 -11 AS 1 Price level AS 2 P 3 P 2 P 1 AD 2 AD 1 GDP 1 GDP 2 GDP 3 LO 10. 3 Real GDP 36

The Last Word: Has the Impact of Oil Prices Diminished • Aggregate supply shocks • Cost push inflation • Oil prices affected core inflation prior to 1980 • Core inflation unaffected post 1980 – Energy efficiency – Composition of GDP – Bank of Canada vigilance

Chapter 10 Summary 10. 1 Aggregate Demand 10. 2 Aggregate Supply 10. 3 Equilibrium and Changes in Equilibrium Chapter 10 38

Appendix The Relationship of Aggregate Demand Curve to the Aggregate Expenditure Model

Deriving the AD Curve Aggregate Expenditures (billions of dollars) AE 1 (at P 1 ) AE 2 (at P 2 ) AE 3 (at P 3 ) As Price Levels Increases… Price Level 45° P 3 Real GDP Declines P 2 P 1 29 -40 AD GDP 1 GDP 2 GDP 3 Real Domestic Product, GDP

Deriving the AD Curve AE 2 (at P 1 ) Aggregate Expenditures AE 1 (at P 1 ) Increase in Aggregate Expenditures Price Level 45° Increase in Aggregate Demand P 1 AD 2 AD 1 29 -41 GDP 2 Real Domestic Product, GDP

Deriving the AD Curve AE 2 (at P 1 ) Aggregate Expenditures AE 1 (at P 1 ) The Shift in the Aggregate Demand Curve is a Multiple of the initial Change in Aggregate Expenditures Price Level 45° P 1 AD 2 AD 1 29 -42 GDP 1 GDP 2 Real Domestic Product, GDP