Aggregate Demand and Supply

• The value of all goods and services demanded by all sectors equals the costs of producing those goods and services
• The economy's equilibrium occurs where the Aggregate Demand (AD) and Aggregate Supply (AS) curves intersect
• Both AD and AS are defined in terms of price level and National Output/Real Gross Domestic Product (RGDP)
• Note: Usually when the AS curve is referenced, it means Short-Run Aggregate Supply (SAS), not Long-Run Aggregate Supply (LAS)

Shifts in AS Curve

• Changes in input costs can shift the AS curve
• Changes in productivity can also shift the AS curve

Shifts in AD Curve

• Alterations in the four sectors of the economy—Consumption (C), Investment (I), Government spending (G), and Net Exports (X – M)—can shift the AD curve

Aggregate Supply

• Aggregate Supply describes the total output of final goods and services that firms in the economy plan to produce
• A nation's total output or GDP depends on the quantity and quality of its production factors, like land, labor, and capital
• Aggregate Supply plots the relationship between the price level and the nation's total output

Short-Run AS (SAS)

• SAS refers to a period where output can change while certain production factors remain fixed
• The SAS curve slopes upward, indicating that higher output correlates with higher prices due to unit costs of production varying directly with output
• It assumes that technology and the prices of all production factors are constant for a given SAS function

Shape of the SAS Curve

• The SAS curve is upward sloping
• Higher output leads to higher per unit costs due to the Law of Diminishing Returns
• The slope of the SAS curve increases as output increases
• Because when output is law, firms typically have excess capacity, output can be expanded without major increases in unit costs
• Only a small price increase may be needed to induce firms to expand production when output is low
• However, increased output leads to larger increases in unit costs as it approaches full capacity
• Due to higher per unit costs, firms produce more only with higher prices for their output
• Price level and national output (real GDP) are, therefore, positively related

Factors Shifting SAS

• A change in the price of factor inputs can shift the SAS curve

• A change in productivity can also shift the SAS curve

• These factors can influence production costs

• An increase in factor prices or a decrease in productivity shifts the SAS curve up and to the left

• A decrease in factor input prices or an increase in productivity shifts the SAS curve down and to the right

Long-Run AS (LAS)

• LAS represents a time frame sufficient for all production factors to become variable

• LAS relates the price level to the output level firms are willing to sell after adjusting factor prices to demand or supply excesses, assuming constant technology

• In the LAS curve, when the economy operates at potential output (Y*), all production factors are fully employed

• Y* is the maximum output an economy can produce when all factor inputs are used at their normal capacity (no overtime or unemployment)

• LAS plots the relationship between the price level and full employment/potential output

• Real GDP is independent of the price level along the LAS

• Short-term deviations from Y* will cause adjustment in wages and factor prices

• At Y*, changes in output prices are matched by equivalent changes in input prices, maintaining constant relative prices and real wage rates

• Assuming Y* is constant in the short run implies that changes in both AD and SAS have no long-term impact on real GDP, since output will eventually revert to potential GDP

• Assuming short-run consistency of Y* does not preclude its potential change

• Increasing potential GDP over time is essential for economic growth

• Any determinant that shifts LAS also affects SAS in the same manner, the reverse is not true

Factors that Shift LAS (Y*)

• Changes in the labor force size can shift the LAS
• Technological advances can shift the LAS
• Changes in the quantity of capital inputs can shift the LAS

Aggregate Demand

• Aggregate Demand (AD) shows the relationship between the total output demanded and the price level (illustrates the relationship between real national output/income and the price level)
• AD plots the quantity of real GDP demanded against the price level

Aggregate Demand Equation

• AD consists of Consumption (C) + Investment (I) + Government spending (G) + (Exports (X) – Imports (M))
• C represents spending by households
• I represents spending by firms
• G represents government spending
• (X – M) represents net exports

Consumption Expenditure

• Disposable income is key to understanding desired consumption spending
• Households save some of their income (Y), with disposable income abbreviated as (Ya)
• Increased C shifts the AD curve to the right

Determinants of Consumption Expenditure

• Disposable income (Ya)
• Wealth
• Interest rate (r)
• Expected future income
• Expected future prices
• Debt

Disposable Income

• Disposable income is most influential regarding consumer spending
• It entails the after-tax income available to households
• There will be a positive shift in AD, since Ya and consumption expenditure are directly correlated
• Shifts in the AD curve are caused by changes in Ya

Wealth

• Sum of all valuable assets the household owns
• Increased wealth tends to reduce the incentive to save, leading to a larger fraction of disposable income being spent
• Increased consumption and a shift in the AD curve to the right will result from increased wealth

Interest Rate

• Increased interest rates can raise the borrowing costs for funds, resulting in people postponing big purchases
• When ‘r’ is higher, servicing existing debts increases, discretionary household income decreases, and consumption expenditure decreases
• Increased “r” can increase opportunity costs since we forgo higher potentials earnings and lower consumption

Expected Future Income

• Increasing expected future income increases household consumption today
• Increasing expected future income will shift the AD to the right, since a higher proportion of current income is spent and a smaller fraction is saved

Expected Future Price

• With a one-time price increase, purchases increase before this anticipated increase
• Continuous price increases lead to more saving and less consumption
• Spending depends on the price changes being permanent

Debt

• Debt and consumption correlate negatively
• Consumers that accumulate a debt load are less inclined to spend freely, and their spending also tends to be postponed
• AD will shift inward with accumulating debts

Investment Expenditure

• Investment expenditure is defined as spending by firms to increase inventories, purchases of new buildings and plants, and new capital equipment
• Residential housing also constitutes I
• Increased investment shifts to AD curve to the right

Determinants of Investment Expenditure

• Interest rate (r)
• Expected input and output prices
• Business confidence

Interest Rate

• Interest rate can be a crucial determinant to investment spending
• Firms will maximize profits, leading to a maximized ideal rate of return for each investment decision
• Firms will ensure that they have an expected rate of return that is greater than/equal to the market interest rate

Expected Input and Output Prices

• Decreased investment spending occurs with increased input cost when little revenue is available
• Increased investment spending occurs when the profit margin increases with increased output prices

Business Confidence

• Generally investments take time to develop, so investment spending is usually based on the future consumer demand
• As 'r' increases, opportunity cost for investing is capital goods increases, thus decreasing investment opportunities
• Firms will generally finance their capital income, so existing debt burdens for firms increase with increased interests, drawing down firms existing income, thus reducing the company's abilities to invest

Government Expenditure

• Expenditure will involve goods and services and will exclude the purchases of durable goods for the military and transfer payments
• Transfer payments indirectly affect AD, by increasing national disposable income
• The interest payment on national debt is also excluded
• Discretionary Fiscal Policy means that the government implemented tax and spending changes
• Influence will involve the aggregate level of spending within an economy

Net Exports

• Imports are a negative AD component because AD will account for which goods/services are produced domestically

• Imports will entail for leaving money

• Exports are a positive AD component because it involves goods/services produced that have been purchased from abroad

• AD to the left will shift when national income increases & imports will increase

• Forty percent of output is exported

• Eighty five percent goes to the U.S.

• Canada's economy is sensitive to economic health with trading partners

• Multiplier effect and initial X adjustments causes more economical volatility

Determinants of Exports and Imports

• Exchange rate
• Domestic vs. foreign prices
• Tariffs
• Foreign income

Exchange Rates

• Exchange rate are the price of one unit of currency
• Supply and demand create flexibility
• Calculated value of the Currency (A) = 1/Currency (B)
• Canadian exports will increase when the Canadian rate is decreased, and imports will be decreased

Domestic vs Foreign Prices

• Imports will increase and exports decrease with increased competition
• The opposite is true

Tariffs

• Import Tariffs involves taxes on goods being entered into the country
• Export Tariffs involves taxes on goods being left within the country

Foreign Income

• Foreign income is the highest influencer of exports
• Export expenditure increases with foreign income increases