Macroeconomics Principles (Sayre, Morris, Ghayad) PDF

Principles of Macroeconomics SAYRE // MORRIS // GHAYAD Eleventh Edition CHAPTER 5 Aggregate Demand and Supply Prepared by Ifeanyi Uzoka, Sheridan College ...

Principles of Macroeconomics SAYRE // MORRIS // GHAYAD Eleventh Edition CHAPTER 5 Aggregate Demand and Supply Prepared by Ifeanyi Uzoka, Sheridan College  CHAPTER 5 Aggregate Demand and Supply Learning Objectives: 1. Explain the concepts of potential GDP and the business cycle, and review the source of economic growth 2. Explain the concepts of aggregate supply, aggregate demand, and macroeconomic equilibrium 3. Describe the factors that can affect aggregate demand and aggregate supply © 2024 McGraw Hill 2-2  CHAPTER 5 Aggregate Demand and Supply Learning Objectives: 4. List the causes of recessions and inflationary booms 5. Explain the main points of disagreement between neoclassical and Keynesian economics 6. Explain the modern view of aggregate demand and aggregate supply © 2024 McGraw Hill 2-3  LO1: Potential GDP © 2024 McGraw Hill 2-4  Potential GDP The total amount that an economy is capable of producing when all of its resources are fully utilized as represented by a vertical long-run aggregate supply − Not dependent on line the price level. − What an economy is physically capable of producing; and is not affected by the prices of © 2024 McGraw Hill 2-5  Sources of Long-Term Economic Growth The sources of economic growth for an economy are: – Quantity and quality of labour resources (the level of human capital) – Amount of physical capital available – Rate of technological change – Amount and quality of natural resources © 2024 McGraw Hill 2-6  Economic Growth and Potential GDP A positive change in any of the determinants of economic growth will result in a rightward shift of the potential GDP curve. – Referred to as Economic Growth. – On average, Canada’s potential GDP grew by about 2% per year since the 1990s © 2024 McGraw Hill 2-7  The Business Cycle The Expansionary and Contractionary phases in the growth rate of real GDP. – GDP growth varies year to year © 2024 McGraw Hill 2-8  LO2: Aggregate Supply and Demand © 2024 McGraw Hill 2-9  Aggregate Supply (AS) The total quantity of goods and services produced by all sellers at various price levels, assuming that the prices of factors of production remain constant. – A higher price level (with wages remaining constant) will increase profit for the average firm and will cause a higher level of output – A lower price level implies lower profit and a lower level of output © 2024 McGraw Hill 2-10  Shape of Aggregate Supply (AS) Higher prices result in a greater quantity of aggregate supply © 2024 McGraw Hill 2-11  Real vs. Nominal Wage Real Wage – The amount of goods and services that an employee can buy for a given amount of nominal wage real wage = nominal wage price level Nominal Wage – The present day value of a current © 2024 McGraw Hill 2-12  Aggregate Supply (AS) As prices rise real wages decline – Producers’ real wage cost is declining, resulting in higher profits – Causes an increase in aggregate quantity supplied © 2024 McGraw Hill 2-13 Aggregate Demand (AD) Aggregate Demand (AD): – The total quantity of final goods and services that consumers, businesses, government, and those living outside the country would buy at various price levels. AD = C + I + G + XN © 2024 McGraw Hill 2-14 Aggregate Demand (AD) The AD curve is downward sloping due to: – Real Balances Effect Higher prices results in lower real wealth which causes people to spend less i.e. ↓C – Interest Rate Effect Higher prices cause higher interest rates, which leads to lower investment i.e. ↓I – Foreign-trade Effect Higher prices make Canadian exports less attractive to foreigners, i.e. ↓Xn © 2024 McGraw Hill 2-15  Macroeconomic Equilibrium A situation in which the aggregate quantity demanded equals AD = AS aggregate quantity © 2024 McGraw Hill 2-16  Macroeconomic Equilibrium At a price above equilibrium – a surplus will cause producers to drop prices At a price below equilibrium – a shortage will cause buyers to bid up the price © 2024 McGraw Hill 2-17  Macroeconomic Equilibrium Equilibrium in the macroeconomy might occur at full employment at below full employment and result in a recessionary gap at above full employment result in an inflationary gap © 2024 McGraw Hill 2-18  Full Employment Equilibrium If the equilibrium occurs at the level of long run aggregate supply (LAS), the economy is at full employment equilibrium © 2024 McGraw Hill 2-19  Below Full-Employment Equilibrium If the equilibrium occurs below LAS, there is a Recessionary Gap – which means an output level below potential GDP (the LAS) – If this occurs for two consecutive quarters it is called a Recession © 2024 McGraw Hill 2-20  Above Full-Employment Equilibrium If the equilibrium occurs above LAS, there is an Inflationary Gap – which means an output level greater than potential GDP (the LAS) © 2024 McGraw Hill 2-21  Test Your Understanding Aggregate Aggregate Price Quantity Quantity Index Demanded ($) Supplied ($) 90 $1200 $ 950 95 1150 1025 100 1100 1100 105 1050 1150 110 1000 1190 115 950 1220 a) What is the equilibrium level of prices and real GDP? b) If the price is 95, is there a shortage or surplus? Of how much?© 2024 McGraw Hill 2-22  Test Your Understanding Aggregate Aggregate Price Quantity Quantity Index Demanded ($) Supplied ($) 90 $1200 $ 950 95 1150 1025 100 1100 1100 105 1050 1150 110 1000 1190 115 950 1220 a) What is the equilibrium level of prices and real GDP? Price 100; GDP $1100 © 2024 McGraw Hill 2-23 Test Your Understanding Aggregate Aggregate Price Quantity Quantity Index Demanded ($) Supplied ($) 90 $1200 $ 950 95 1150 1025 100 1100 1100 105 1050 1150 110 1000 1190 115 950 1220 b) If the price is 95, is there a shortage or surplus? Of how much? A shortage of $125 © 2024 McGraw Hill 2-24 LO3: Determinants of Aggregate Demand and Supply © 2024 McGraw Hill 2-25  Determinants of AD Changes in Consumption – Individual consumer wealth – age of consumer durables – consumer confidence © 2024 McGraw Hill 2-26  Determinants of AD Changes in Investment – Changes in interest rates – Changes in the purchase price, installation and maintenance costs of capital goods – Age of capital goods and amount of spare capacity – Business expectations – Government regulations © 2024 McGraw Hill 2-27  Determinants of AD Changes in Net Exports – Value of exchange rate – Income levels abroad – Price of competitive (foreign) goods – Tastes of foreigners Changes in Government Spending, Tax Rates and the money supply © 2024 McGraw Hill 2-28  Shifts in the AD curve Change in any of the determinants of aggregate demand means that at any given price level buyers would be willing to buy more or less goods and services than before. Any change in C or I or G or XN will cause a change in AD, a © 2024 McGraw Hill 2-29 shift to the right or  Increase in Aggregate Demand Table 5.2 Aggregate demand in Canada will increase as a result of: Consumption Investment Net Exports Government ↑ consumer ↓ interest rates ↓ Canadian $ ↑ government wealth spending ↑ age of ↓ price of capital ↑ foreign ↓ tax rates consumer goods incomes durables ↑ consumer ↑ age of capital ↑ foreign ↑ money supply confidence goods prices ↑ business ↑ taste for confidence Canadian products ↓ government regulations © 2024 McGraw Hill 2-30 Decrease in Aggregate Demand Table 5.3 Aggregate demand in Canada will decrease as a result of: Consumption Investment Net Exports Government ↓ consumer ↓ government ↑ interest rates ↑ Canadian $ wealth spending ↓ age of ↑ price of capital ↓ foreign consumer ↑ tax rates goods incomes durables ↓ consumer ↓ age of capital ↓ foreign ↓ money supply confidence goods prices ↓ taste for ↓ business Canadian confidence products ↑ government regulations © 2024 McGraw Hill 2-31 Test Your Understanding 6. Which of the following factors will lead to an increase or decrease in AD (and a shift in the AD curve)? a) A decrease in the stock market index. b) An increase in interest rates. c) A decrease in government spending. d) An increase in foreign incomes. e) A decrease in the exchange rate © 2024 McGraw Hill 2-32 Test Your Understanding 6. Which of the following factors will lead to an increase or decrease in AD (and a shift in the AD curve)? a) A decrease in the stock market index.  b) An increase in interest rates. c) A decrease in government spending. d) An increase in© 2024 foreign McGraw Hill incomes. 2-33 Test Your Understanding 6. Which of the following factors will lead to an increase or decrease in AD (and a shift in the AD curve)? a) A decrease in the stock market index.  b) An increase in interest rates.  c) A decrease in government spending.  d) An increase in foreign incomes.  © 2024 McGraw Hill 2-34  Determinants of Aggregate Supply Economic growth is due to: – A change in human capital – A change in the amount of capital – Technological change – A change in natural resources © 2024 McGraw Hill 2-35 Determinants of both LAS and AS © 2024 McGraw Hill 2-36  Determinants of both LAS and AS An improvement in any of the 4 economic growth determinants shifts both AS and LAS to the right. © 2024 McGraw Hill 2-37 Determinant of AS only © 2024 McGraw Hill 2-38 Determinants of AS only A change in the price of a resource shifts only AS (LAS not affected) © 2024 McGraw Hill 2-39  Test Your Understanding What effect will the following changes have on aggregate supply and on potential GDP (LAS)? a) an increase in the price of imported crude oil b) an increase in the number of immigrants entering Canada c) the discovery of extensive oil deposits in northern Canada d) a substantial increase in wage settlements © 2024 McGraw Hill 2-40  Test Your Understanding What effect will the following changes have on aggregate supply and on potential GDP (LAS)? a) a) an increase in the price of imported crude oil  AS b) b) an increase in the number of immigrants entering Canada c) the discovery of extensive oil deposits in northern Canada d) a substantial increase in wage settlements © 2024 McGraw Hill 2-41  Test Your Understanding What effect will the following changes have on aggregate supply and on potential GDP (LAS)? a) an increase in the price of imported crude oil  AS b) an increase in the number of immigrants entering Canada  AS and LAS c) the discovery of extensive oil deposits in northern Canada  AS and LAS d) a substantial increase in wage settlements  AS e) the introduction of a microchip that reduces computer processing time by 80 percent  AS and LAS © 2024 McGraw Hill 2-42  Test Your Understanding Suppose the LAS (potential GDP) for the country of Taymar is $1100 and the aggregate supply is as shown in the table. a) Plot the aggregate supply curve, and draw in the LAS. b) Assume that the aggregate supply changed by $100 as a result of increased Price Index productivity. Plot the Aggregate new Supplied Quantity AS curve,($)and show the new90LAS. 950 95 1025 100 1100 105 1150 110 1190 115 1220 120 1240 © 2024 McGraw Hill 2-43 Test Your Understanding © 2024 McGraw Hill 2-44  LO4: Determinants of Real GDP and the Price Level © 2024 McGraw Hill 2-45  A Change in AD - The Multiplier When spending independently changes, total income changes more, as some of that income is spent again © 2024 McGraw Hill 2-46  Increase in AD One person’s spending becomes another person’s income An increase in AD will increase both real GDP and the price level © 2024 McGraw Hill 2-47  Increase in AS A decrease in the price of a factor of production will shift the AS curve right resulting in an increase in GDP but a fall in the price © 2024 McGraw Hill 2-48 : Determinants of Increase in AS The following factors will increase aggregate supply: Potential GDP Factor Aggregate Supply (long-run aggregate supply) ↓ wages ↑ / ↓ factor prices ↑ / ↑ quantity/quality of human capital ↑ ↑ ↑ quantity/quality of physical capital ↑ ↑ ↑ technology ↑ ↑ ↑ quantity/quality of natural resources ↑ ↑ © 2024 McGraw Hill 2-49 : Determinants of Decrease in AS The following factors will decrease aggregate supply: Potential GDP Factor Aggregate Supply (long-run aggregate supply) ↑ wages ↓ / ↑ factor prices ↓ / ↓ quantity/quality of human capital ↓ ↓ ↓ quantity/quality of physical capital ↓ ↓ ↓ technology ↓ ↓ ↓ quantity/quality of natural resources ↓ ↓ © 2024 McGraw Hill 2-50 Increase in LAS (and AS) Recall that a shift in LAS will also shift AS © 2024 McGraw Hill 2-51 Test Your Understanding The following table shows the aggregate demand and aggregate supply schedules for the economy of Zee. a) What are the equilibrium values of price and real GDP? Aggregate Aggregate Quantity Quantity Price Index Supplied ($) Demanded ($) 1950 90 1620 1900 95 1700 1850 100 1760 1800 105 1800 1750 110 1830 1700 115 1850 © 2024 McGraw Hill 2-52  Test Your Understanding Aggregate Aggregate Quantity Quantity Price Index Supplied ($) Demanded ($) 1950 90 1620 1900 95 1700 1850 100 1760 1800 105 1800 1750 110 1830 1700 115 1850 a) What are the equilibrium values of price and real GDP? Price 105; GDP $1800 © 2024 McGraw Hill 2-53 Test Your Understanding Aggregate Aggregate Quantity Quantity Price Index Supplied ($) Demanded ($) 1950 90 1620 1900 95 1700 1850 100 1760 1800 105 1800 1750 110 1830 1700 115 1850 b) Assume that aggregate demand decreases by $200 at every price level. What will be the new equilibrium values of price and real GDP? © 2024 McGraw Hill 2-54 Test Your Understanding Aggregate Aggregate Quantity Quantity Price Index Supplied ($) Demanded ($) 1950 90 1620 1900 95 1700 1850 100 1760 1800 105 1800 1750 110 1830 1700 115 1850 b) Assume that aggregate demand decreases by $200 at every price level. What will be the new equilibrium values of price and real GDP? Price 95; GDP $1700 © 2024 McGraw Hill 2-55  Causes of Inflation Inflation can be caused by an increase in AD (demand-pull) or by a decrease in AS (cost-push). © 2024 McGraw Hill 2-56  Causes of Recessions A recession might be caused by a decrease in AD or by a decrease in AS (as shown in the last slide). © 2024 McGraw Hill 2-57 LO5: Two Schools of Thought © 2024 McGraw Hill 2-58  Keynesian vs. Neoclassical Neoclassical assumptions: – The market is competitive and efficient – Prices and wages adjust rapidly to a surplus or shortage – Economy always remains at full © 2024 McGraw Hill 2-59 The Neoclassical View © 2024 McGraw Hill 2-60  Keynesian vs. Neoclassical Keynesian assumptions: – The market is not very competitive due to market power of big corporations and unions – Prices and wages are sticky; adjust slowly – Government intervention is sometimes © 2024 McGraw Hill 2-61 The Keynesian View © 2024 McGraw Hill 2-62  LO6: The Modern View © 2024 McGraw Hill 2-63  The Modern View The impact of an increase in AD depends on the condition of the economy – In big recessions, there is a big effect on GDP – At close to potential GDP, the effect © 2024 McGraw Hill 2-64 The Modern View of AD Curve © 2024 McGraw Hill 2-65  The Modern View In a recession, the economy acts Keynesian Close to potential GDP, the economy acts Neoclassical © 2024 McGraw Hill 2-66  Is the Economy Self- Adjusting? In a Recessionary Gap – wages fall and AS shifts right until natural full employment is reached Real GDP is higher Prices are lower © 2024 McGraw Hill 2-67  Is the Economy Self- Adjusting? In an Inflationary Gap, – wages rise and AS shifts left until eventually natural full employment is reached Real GDP is lower Prices are higher © 2024 McGraw Hill 2-68  CHAPTER 5 SUMMARY Key Concepts to Remember 1. What is potential GDP 2. Sources of economic growth 3. Ideas of aggregate demand and aggregate supply, and how they generate macroeconomic equilibrium 4. Determinants of aggregate demand and aggregate supply, and the Multiplier 5. Causes of recessions and inflationary booms 6. Keynesian, Neoclassical, and Modern views of the economy © 2024 McGraw Hill 2-69