Chapter 10 Aggregate Supply and Aggregate Demand

Aggregate Supply

• Real GDP supplied: the total quantity that firms plan to produce during a period.
• Aggregate supply: the relationship between real GDP supplied & price level.
• Time frames associated with labour market states are long-run and short-run.

Long-Run Aggregate Supply

• The relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP is long-run aggregate supply.
• Potential GDP is independent of the price level.
• The long-run aggregate supply curve, LAS, is vertical at potential GDP.

Short-Run Aggregate Supply

• Short-run aggregate supply is the relationship between real GDP supplied & price level when money wage rate, prices of other resources, & potential GDP remain constant.
• With no change in the money wage rate and other factor prices, a rise in the price level increases the quantity of real GDP supplied.
• The short-run aggregate supply curve, SAS, is upward sloping.

Aggregate Supply Curves

• The long run: the quantity of real GDP supplied is potential GDP.
• When the price level rises and money wage rate changes by the same percentage, quantity of real GDP supplied remains at potential GDP.
• The short-run: the quantity of real GDP supplied increases if the price level rises.
• The SAS curve slopes upward.
• If the price level rises with no change in the money wage rate, firms increase production.
• With a given money wage rate, the SAS curve intersects the LAS curve at potential GDP.
• The price level is 110 here.
• At a given money wage rate, when the price level falls below 110, real GDP supplied decreases along the SAS curve.
• The quantity of real GDP supplied increases along the SAS curve when the price level rises above 110 with a given money wage rate.
• Real GDP exceeds potential GDP.

Changes in Aggregate Supply

• Aggregate supply changes if something other than the price level affects production plans.
• These influences include changes in potential GDP and changes in money wage rate, as well as other factor prices.

Changes in Potential GDP

• Both the LAS and SAS curves shift rightward when potential GDP increases.
• If any of the following increase, potential GDP increases:
  • Full-employment quantity of labour
  • Quantity of capital, both physical and human
  • An advance in technology

Changes in the Money Wage Rate

• A rise in the money wage rate affects short-run, but not long-run, aggregate supply.
• The SAS curve shifts leftward, decreasing short-run aggregate supply.

Aggregate Demand

• Y, the quantity of real GDP demanded, is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy.
• This equates to the sum of consumption expenditures (C), investment (I), government expenditure (G), and net exports (X – М), or: Y = C + I + G + X – M.
• Buying plans hinge on many factors, but there is focus on the relationship between the quantity of real GDP demanded and the price level.
• The main question is: How does the quantity demanded of real GDP demanded vary as the price level varies?

The Aggregate Demand Curve

• Aggregate demand: the relationship between the quantity of real GDP demanded and the price level.
• The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price level.

Aggregate Demand Curve Slope

• The AD curve slopes downward for two reasons:
  • Wealth effect
  • Substitution effects

Wealth Effect

• A rise in the price level decreases the quantity of real wealth, which in turn causes people to increase saving and decrease spending.
• Overall, the quantity of real GDP demanded decreases.
• Similarly, a fall in the price level increases both the quantity of real wealth and the quantity of real GDP demanded.

Substitution Effects

• Intertemporal substitution effect: a rise in the price level decreases the real value of money and raises the interest rate.
• When interest rates rise, people borrow and spend less, decreasing the quantity of real GDP demanded.
• When interest rates fall, people borrow and spend more, increasing the quantity of real GDP demanded, due to the increased real value of money and lowered interest rate with a fall in price level.
• International substitution effect: a rise in the price level increases the price of domestic goods relative to foreign goods.
• The quantity of real GDP demanded decreases, as imports increase and exports decrease.
• Similarly, with a fall in the price level, the quantity of real GDP demanded, increases.

Changes in Aggregate Demand

• Aggregate demand changes when an influence on buying plans other than the price level changes.
• Main aggregate demand influences:
  • Expectations
  • Fiscal policy
  • Monetary policy
  • The world economy

Expectations

• Aggregate demand changes depending on expectations about future income, future inflation, and future profits.
• Aggregate demand increases when expected future income increases, as people's consumption rises today.
• Aggregate demand increases when the expected inflation rate rises, which makes buying goods cheaper today.
• Aggregate demand rises when expected future profits increase, which boosts firms’ investment.

Fiscal Policy

• Fiscal policy: government's attempt to influence the economy through setting and changing taxes, making transfer payments, and purchasing goods/services.
• Disposable income increases with a tax cut or an increase in transfer payments.
• Aggregate demand increases alongside increased consumption expenditure from an increase in disposable income.
• Because government expenditure on goods and services is one component of aggregate demand, an increase in government expenditure increases aggregate demand.

Monetary Policy

• Changes in interest rates and the quantity of money in the economy is monetary policy.
• Aggregate demand increases as buying power increases from increased quantity of money.
• Aggregate demand also increases from a cut in interest rates, promoting expenditure.

The World Economy

• The world economy affects aggregate demand in two ways:
• Aggregate demand increases when a fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services, increasing exports while decreasing imports.
• Aggregate demand also increases when foreign income increases, which raises the demand for Canadian exports.

Shifting the AD Curve

• Increases shift it to the right.
• Decreases shift it to the left.

Short-Run Macroeconomic Equilibrium

• Short-run macroeconomic equilibrium: the quantity of real GDP demanded equals the quantity of real GDP supplied; where the AD and SAS curves intersect.

Real GDP Above or Below Equilibrium

• If real GDP is above equilibrium GDP, firms decrease production and lower prices, bringing a movement along the SAS curve towards equilibrium.
• If real GDP is below equilibrium GDP, firms increase production and raise prices, bringing a movement along the SAS curve towards equilibrium.
• In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-Run Macroeconomic Equilibrium

• Long-run macroeconomic equilibrium: real GDP equals potential GDP, positioning the economy on its LAS curve.
• Long-run equilibrium is at the intersection of the AD and LAS curves.

Economic Growth

• Economic growth is illustrated through potential GDP increases because the quantity of labour grows, capital is accumulated, and technology advances.
• The LAS curve shifts rightward.

Relationship Between Economic Growth and Inflation

• Inflation is also illustrated on the same graph as economic growth.
• Aggregate demand increases at a higher rate than long-run aggregate supply, if the quantity of money grows faster than potential GDP.
• The AD curve shifts farther than the LAS curve.
• Both inflation and economic growth occur at the same time.

The Business Cycle in the AS-AD Model

• The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.
• An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP.
• A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP.
• A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP.
• The amount by which potential GDP exceeds real GDP is an inflationary gap.
• When real GDP is less than potential GDP, the gap is called a recessionary gap.
• Real GDP fluctuates around potential GDP in a business cycle, shifting from one short-run equilibrium to another.

Fluctuations in Aggregate Demand

• Shows the effects of an increase in aggregate demand.
• The AD curve shifts rightward with an increase in aggregate demand.
• Production rises and the price level is in the short run.
• There is an inflationary gap at the short-run equilibrium.
• The money wage rate then begins to rise and the SAS curve shifts leftward.
• The price level rises and real GDP decreases until it equals potential GDP.

Fluctuations in Aggregate Supply

• Shows the effects of a rise in the price of oil.
• The SAS curve shifts leftward.
• Real GDP decreases and the price level rises.
• The economy experiences stagflation.

Macroeconomic Schools of Thought

• Macroeconomists are divided into three broad schools of thought:
  • Classical
  • Keynesian
  • Monetarist

The Classical View

• Classical macroeconomist: believes the economy is self-regulating and always at full employment.
• The term "classical" is derived from the founding school of economics, which includes Adam Smith, David Ricardo, and John Stuart Mill.
• New classical view: business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change.

The Keynesian View

• Keynesian macroeconomist: believes that the economy would rarely operate at full employment if left alone, and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required.
• The term "Keynesian" is derived from the name of the economist John Maynard Keynes.
• New Keynesian: wage rates, but also prices of goods are sticky.

The Monetarist View

• A monetarist: macroeconomist who believes that the economy is self-regulating and will normally operate at full employment, provided that monetary policy isn't erratic and the pace of money growth is kept steady.
• The term "monetarist" was coined by Karl Brunner, to describe his own views and those of Milton Friedman.