ECO1102 Macroeconomics Chapter 14 PDF

CHAPTER 14 Aggregate Demand and Aggregate Supply ECO1102 Macroeconomics 1 l’Univeristé d’Ottawa / University of Ottawa...

CHAPTER 14 Aggregate Demand and Aggregate Supply ECO1102 Macroeconomics 1 l’Univeristé d’Ottawa / University of Ottawa 16:57 1 Purpose of chapter 14 This chapter we deal with the market for goods and services Real GDP fluctuates, usually growing but at uneven rates – occasionally falling generating recessions The AD-AS model determines equilibrium real GDP and explains its fluctuations – Short to medium term framework ECO1102 Macroeconomics 2 Université d’Ottawa / University of Ottawa 16:57 2 3 key facts regarding economic fluctuations # 1 real GDP has its ups and downs that comprise the business cycle, but this cycle is not regular (like the seasons) – We had experienced about 15 straight years of growth in real GDP in Canada That streak ended in 2008 It resumed half-way through 2009, albeit more slowly than we would have liked Then came the pandemic – Recession = period of contracting real GDP and rising unemployment – Depression = a very severe recession 3 16:57 3  # 2 many macroeconomic aggregates move together, although not necessarily by the same magnitude – usually positive correlations # 3 As real GDP falls even slightly, unemployment skyrockets – I already made this point – By mid-2009, the economy had shrunk about 3.5 % points from its peak, but by mid-2009, the unemployment rate was over 2 % points higher than its trough ECO1102 Macroeconomics 4 Université d’Ottawa / University of Ottawa 16:57 4 Fact 1 - Economic fluctuations are irregular and unpredictable 14-5 5 Figure 14.9 6 16:57 6  Short-Run Economic Fluctuations – I spending 7 FACT 3: As output falls, unemployment rises big time 8 Model of AD and AS Designed to explain short-run fluctuations in equilibrium real GDP Long-run real GDP determined by levels of inputs and productivity – Treated in chapter 7 – The short-run changes around that trend in long-run real GDP is the focus of this model ECO1102 Macroeconomics 9 Université d’Ottawa / University of Ottawa 16:57 9  Aggregate Demand and Aggregate Supply (Figure 14.2) Price Level Aggregate supply Equilibrium price level Aggregate demand ECO1102 0 MacroeconomicsEquilibrium Quantity of output Output 10 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 10 Note that it does generate an equilibrium value for the composite price level P and the aggregate output level – real GDP Somewhat analogous to supply and demand model at the microeconomic level, but the foundations are different – The aggregate demand curve really ought to be called the aggregate expenditure curve ECO1102 Macroeconomics 11 Université d’Ottawa / University of Ottawa 16:57 11 Figure 14.3 The Aggregate-Demand Curve... Price Level P P2 1. A decrease Aggregate in the price demand level... 0 Y Y2 Quantity of Output 2.... increases the quantity of ECO1102 Macroeconomics goods and services demanded. 12 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 12  Why does the AD curve have a negative slope? (sort of hard) There are 3 different reasons If Price – Nothing happens to real GDP, as it is already adjusted for inflation – Real wealth – Consumption spending – GDP = C + I + G + NX 13 Where did we start and end this process? – If P real GDP – If P real GDP – There is the negative slope This shows two points on the AD curve – Figure 14.3 This is called the wealth effect – There was a strong negative wealth effect occurring in the US economy in 2009-2010, as house prices plummeted, thus decreasing consumer wealth, and thus decreasing C independently of Y – There was a positive wealth effect in Canada in 2020 and 2021, as house prices rose a lot and many households had high savings because they could not spend on a lot of items and services 16:57 14 Now for another reason: the real XR effect If Price – Canadian goods and services become less (more) competitive – Net export spending – GDP = C + I + G + NX – This is the real exchange rate effect Interest rate effect mentioned in the text is hard ECO1102 Macroeconomics 15 16:57 15  Interpretation of AD curve AD gives the functional relationship between P and real GDP – This relationship is negative – All of the points are hypothetical – Tells NOTHING about Y (REAL GDP) that actually prevails ECO1102 Macroeconomics 16 Université d’Ottawa / University of Ottawa 16:57 16 Shifts in the AD curve (Table 14.1) Any factor except price which causes an increase in expenditure (I , X, G, C ) will shift AD curve to the right – These are increases in injections Any factor except price which causes a decrease in expenditure (I , X, G, C ) will shift AD curve to the left – These are decreases in injections ECO1102 Macroeconomics 17 16:57 17 Any factor except price which causes (negative) expenditure to decrease (Im, T, S ) will shift AD to the right – These are decreases in withdrawals Any factor except price which causes (negative) expenditure to increase (Im, T, S ) will shift AD to the left – These are increases in withdrawals ECO1102 Macroeconomics 18 Université d’Ottawa / University of Ottawa 16:57 18  Interpretation of shifts – If an injection increases or a withdrawal decreases At each possible price level, there is a higher level of expenditure than before – If an injection decreases or a withdrawal increases At each possible price level, there is a lower level of expenditure than before Any change in P means move along the AD curve. 19 Aggregate Supply 2 types – Short-run (SRAS) – Long-run (LRAS) This distinction is HARD! The interpretation of this curve: the set of all combinations of P and GDP that firms are willing to produce 20 Figure 14-6 The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply P P2 1. A decrease 2.... reduces the quantity in the price of goods and services level... supplied in the short run. ECO1102 Macroeconomics 0 Y2 Y Quantity of Output21 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 21  Why the SRAS curve has an upward slope Just focus on the ‘sticky-wage’ theory – One of the three reasons that are presented Along any short run aggregate supply curve, physical productivity and input prices are held fixed. As P it’s more (less) profitable to produce, so GDP There is a direct relationship between P and GDP (+ slope) ECO1102 Macroeconomics 22 Université d’Ottawa / University of Ottawa 16:57 22 Warning: Do not ever shift an AS curve due to a change in P ECO1102 Macroeconomics 23 Université d’Ottawa / University of Ottawa 16:57 23 Shifts in SRAS curve (Table 14.2) If productivity falls, and/or if input levels fall, and/or input prices rise, shift SRAS to the left – All of these factors either raise production costs or hamper the production process If productivity rises, and/or input levels rise, and/or input prices fall, shift SRAS to the right – All of these factors either lower production costs or boost the production process 24  Long run AS Is vertical in P-GDP space at ‘the natural rate’ of output, or potential GDP, where production factors are fully employed The vertical form implies that there is no mathematical relationship between the two variables – Slope is undefined ECO1102 Macroeconomics 25 Université d’Ottawa / University of Ottawa 16:57 25 Figure 14-4 The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P P2 2.... does not affect 1. A change the quantity of goods in the price and services supplied level... in the long run. 0 Natural rate Quantity of ECO1102 Macroeconomics of output Output 26 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 26 Why is the LRAS vertical? The long-run equilibrium level for real GDP depends on the factor endowments of land, labor, capital, and the technology of production, which have nothing to do with the price level Input prices, especially wages, eventually catch-up to any change in output prices, and thus the aggregate output level will end up where it started – See page 312 ECO1102 Macroeconomics 27 Université d’Ottawa / University of Ottawa 16:57 27  Shifts in the LRAS curve Natural rate of output also called potential GDP This is thought to be the long-run equilibrium for real GDP Same factors cause the LRAS to shift as the SRAS, except for changes in wages or other input prices ECO1102 Macroeconomics 28 Université d’Ottawa / University of Ottawa 16:57 28 LRAS will expand (contract), and the curve will shift to the right (left), if there is an increase (decrease) in any of the endowments of the factors of production, or if there is an improvement (deterioration) in the technology of production ECO1102 Macroeconomics 29 Université d’Ottawa / University of Ottawa 16:57 29 An expansion in LRAS typically occurs in Canada almost every year. – The productive capacity of the economy expands by 1 - 2 % per year – See figure 14-5 in which this type of expansion is read off the horizontal axis 30 16:57 30  Equilibrium In short-run equilibrium, AD = SRAS, which means that the planned expenditures of consumers, investors, etc. are consistent with the production plans of firms at the equilibrium P. – Anywhere else and there is an imbalance, and we would expect a price adjustment. The intersection of the 2 curves ECO1102 Macroeconomics 31 Université d’Ottawa / University of Ottawa 16:57 31 Short-Run Equilibrium – not from our textbook Price level (GDP deflator, 1992 = 100) 140 Firms cut e' production 130 and prices d' SRAS 120 c' e 110 d Short-run c b' macroeconomic 100 b equilibrium a Firms increase a' 90 production and prices AD 700 750 800 850 900 950 Real GDP (billions of 1992 dollars) 32 Figure 14-7 The Long-Run Equilibrium Price Level Long-run aggregate Short-run supply aggregate supply Equilibrium A price Aggregate demand ECO1102 0 Macroeconomics Natural rate Quantity of of output Output33 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 33  Applications of the AD-AS model: macroeconomic shocks Each time we will start at LR equilibrium, which means potential GDP, also called the ‘natural rate of output’. AD shocks take the form of shifts in AD curve AS shocks take the form of shifts in SRAS curve ECO1102 Macroeconomics 34 Université d’Ottawa / University of Ottawa 16:57 34 positive shock to AD Suppose an expansion in AD caused by a stock market boom or by a housing market boom (that is what we have big time) At each possible price level, spending goes up, so AD Equilibrium P, Q Economy grows nicely and we reach a short-run equilibrium ECO1102 Macroeconomics 35 Université d’Ottawa / University of Ottawa 16:57 35 Due to great times, there is upward pressure on wages (called ‘over-heating’) This causes SRAS Equilibrium P , Q Eventually, we end up back at potential GDP The fact that we started at the natural rate of output but also ended up there is consistent with the fact that the LRAS curve is vertical 36 16:57 36  negative shock to AD – Figure 14- 8 Suppose a contraction in AD, due to a stock market crash, a major terrorist attack, or a pandemic – In 2008 and part of 2009, a HUGE negative shock to AD caused by clogged-up, dysfunctional credit markets – In 2014-2015 in Canada, the near collapse in crude oil prices – In 2020, the COVID-19 pandemic At each possible price level, spending goes down, so AD Equilibrium P, Q Economy enters a recession 37 16:57 37 Figure 14-8 Contraction in Aggregate Demand 2.... causes output to fall in the short run... Price Level Long-run Short-run aggregate aggregate supply, AS supply AS2 3.... but over time, the short-run P A aggregate-supply curve shifts... P2 B 1. A decrease in aggregate demand... P3 C Aggregate demand, AD AD2 0 Macroeconomics ECO1102 Y2 Y Quantity of 4.... and output returns Output to its natural rate. 38 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 38 Due to hard times, after a long adjustment period, there is downward pressure on wages This causes SRAS Equilibrium P , Q Eventually, the recession ends, and real GDP grows back to its natural rate ECO1102 Macroeconomics 39 Université d’Ottawa / University of Ottawa 16:57 39  Case of a negative shock to AS Suppose a contraction of SRAS, due to an energy price shock – 2008 in the US (oil prices very high) – Japanese earthquake – Nine-eleven terrorist attack – The 2019 Corona virus At each possible price, production costs rise, causing SRAS Equilibrium P, Q Called stagflation 40 16:57 40 An Adverse Shift in Aggregate Supply - figure 14-10 1. An adverse shift in the short- run aggregate-supply curve... Price Level Long-run Short-run aggregate AS2 aggregate supply supply, AS B P2 A P 3.... and the price level to rise. Aggregate demand ECO1102 0Macroeconomics Y2 Y Quantity of 2.... causes output to fall... Output 41 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 41 The classical and neo-classical approaches both recommend that the economy be allowed to right itself – Hard times cause wages and input prices to fall – SRAS expands – After a long, painful adjustment period, P and Q ECO1102 Macroeconomics 42 Université d’Ottawa / University of Ottawa 16:57 42  One way to remedy the situation is for the government to cause an increase in AD AD Equilibrium P ,Q End up with even higher prices than before, but the economy is back to its natural rate of output ECO1102 Macroeconomics 43 Université d’Ottawa / University of Ottawa 16:57 43 Accommodating an Adverse Shift in Aggregate Supply – figure 14-11 1. When short-run aggregate supply falls... Price Level Long-run Short-run aggregate AS2 aggregate supply supply, AS P3 C 2.... policymakers can P2 accommodate the shift A by expanding aggregate 3.... which P demand... causes the price level to rise 4.... but keeps output AD2 further... at its natural rate. Aggregate demand, AD ECO1102 0Macroeconomics Natural rate Quantity of of output Output 44 Université d’Ottawa / University of Ottawa 16:57 Copyright © 2004 South-Western 44 Summary of shocks and their impacts See Table 14.3 – Determine which side of the output market is affected Could be both – Determine the direction of the shift Think of the underlying pressures – Use the diagram to determine the short-run equilibrium – Use the diagram to determine the long-run equilibrium 45 16:57 45  S and D shocks have opposing effects on P – Positive AD shock will raise equilibrium P – Positive AS shock will lower equilibrium P – Negative AD shock will lower equilibrium P – Negative AS shock will raise equilibrium P ECO1102 Macroeconomics 46 Université d’Ottawa / University of Ottawa 16:57 46 S and D shocks have the same effects on Q (real GDP) – Positive AD shock will raise equilibrium Q – Positive AS shock will raise equilibrium Q – Negative AD shock will lower equilibrium Q – Negative AS shock will lower equilibrium Q ECO1102 Macroeconomics 47 Université d’Ottawa / University of Ottawa 16:57 47 Temporary supply shocks (involving only SRAS) affect both P and Q, but not in the long run permanent shocks impact only LRAS – From a change in factor endowments – From a change in productivity ECO1102 Macroeconomics 48 Université d’Ottawa / University of Ottawa 16:57 48