Presentation on theme: "AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM"— Presentation transcript:
1 AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM Elements of Economic Analysis in a Canadian Context
2 content Aggregate Demand Factors affecting the Aggregate Demand Aggregate Demand curveAggregate supplyFactors affecting the Aggregate SupplyAggregate Supply curveMacroeconomic equilibrium
3 Agregate DemandConsumption, investment, government purchases of goods and services and net exports are the four components of the aggregate demand (in real terms):AD= C + I + G + (EX - IM)In addition, it is useful to know that aggregate demand is composed of domestic demand or interior demand (DINT = C + I + G) and of the net exterior demand DEXT = EX – IM = NX (net export).
4 Factors affecting the Aggregate Demand Consumption: C = f c (PDI, r, RICH, CONF) PDI: personal disposable income in real terms (also noted Yd ) is defined as household personnal income PI minus taxes (T). PDI = Yd = DI - T In french RPD :revenu personnel disponible réel défini comme le revenu des ménages (RP) après impôts (T); r : real interest rate (cost of financing durable goods); RICH : financial and non-financial wealth of households in real terms (assets minus debts); CONF : psychological factors such as confidence and expectations by consumers' economic conditions
5 C o n s o m m a t i o n r é e l l e e t c o n f i a n c e - Real consumption and confidence for Canada8120261102edsIé4100nnîdaihccen(e2901s9ra8ll7od=1e80ds)drailli-270M-460198019851990199520002005ConsommationréelleConfiance
6 BENR: Real benefits or earnings of corporations Investment:I = f I (BENR, r, CLAFF)BENR: Real benefits or earnings of corporations(bénéfices réels anticipés des sociétés in french)r: Real interest rate as an indicator of the costof capitalCLAFF : Business cycle climate based on the expectations of managers (recession?, durable recovery?, ...).(climat des affaires basé sur l’évaluation et les anticipations des gestionnaires in french )
7 I n v e s t i s s e m e n t r é e l e t b é n é f i c e s r é e l s a pôts-Canada(198-29)802060)%T(ae1040ucxndase20scirooricsseadnxcu-20ea(T-10%)-40-60198019851990199520002005InvestissementréelBénéficesreelsavantimpot
8 G = G In this model, public expenditures are exogeneous; Purchases of goods and services by the goverment:G = GIn this model, public expenditures are exogeneous;they are not a direct function of other variables in the model.G is a discretionary variable because it is determined according to the will of the government in the context of fiscal policy.
9 (EX - IM) = f(EX-IM) (E P*/P, DINT*/DINT) Net exports of goods and services:(EX - IM) = f(EX-IM) (E P*/P, DINT*/DINT)E P*/P : Relative price of foreign goods over that of local goods: ratio of foreign prices (P*) over local ones (P), converted in local currency using the nominal exchage rate (ex. E = #$CA/$US);DINT*/DINT: Ratio of real interior demand of foreign countries (DINT*) over local real interior demand (DINT).
10 E: Nominal Exchange Rate: interpretation Given the weight of our trade with the United States, the nominal exchange rate (E) Canadian is defined as the price of the U.S. dollar in Canadian currency, the value of a U.S. dollar in Canadian dollars. It will be noted as follows:E = # $CA / $US.Thus, an increase of E is interpreted as an increase in the value of the U.S. dollar against the Canadian dollar, then it refers to an appreciation of the U.S. dollar or a depreciation of the Canadian dollar. In the case of a decrease of E, we have a depreciation of the U.S. dollar or an appreciation of the Canadian dollar.
12 Small e: Nominal Exchange Rate WARNING!!!!In canadian news papers we usually observe the small ee = # $US / $CA.e = 1 / EA high value of e means that the Can $ is strongA low value of E means that the Can $ is strongA low value of e means that the Can $ is weakA high value of E means that the Can $ is weak
13 Agreggate demand curve The aggregate demand (AD) curve represents a relationship between real GDP and the price level. This equilibrium relationship is only valid when firms adjust their output perfectly to any fluctuation in the demand.
15 Slope of AD Real money balances effect Effet d’encaisses réelles in french: P (M/P) wealth C YInterest rate effect (r): P households need more money households will sell financial assets r I et C YEffet de substitution internationale : P (E P*/P) Our products are more expensive relatively to foreign goods EX et IM Y
16 Shift of the AD Movements of the AD: While changes in the general price level (P) create a movement along the aggregate demand curve,changes in factors other than the general price level, which affect one or more of the four components of aggregate demand, cause a shift of the entire curve.
17 EXAMPLE: Suppose the government decides to cut taxes for individuals: 1. Consumption is positively connected to personal disposable income (PDI = PI - T). A decrease taxes (T) increases the personal disposable income of households;2. Private consumption is stimulated;3. The aggregate demand is stimulated (rightward shift of the curve).
18 +AD = C(PI-T,…) + I + G +(EX-IM)PAD1(PI-T1,…)AD0(PI-T0,…)YLower income taxes (T0 to T1 ) increases the disposable income of households, this helps boost consumption and thus the aggregate demand. Therefore the curve moves to the right.
19 EXAMPLE: Suppose an increase in the real interest rates in the economy 1. Two components of aggregate demand depend negatively on real interest rates: consumption and investment;2. This increase in interest rates increases the cost of financing purchases of durable goods and therefore discourage consumption;3. This increase also discourages investment projects of companies because it increases their cost of financing.
20 AD = C (r,…) + I (r,…) + G +(EX-IM) P--AD = C (r,…) + I (r,…) + G +(EX-IM)DA0 (r0,…)DA1(r1,…)YRising real interest rate (from r0 to r1) discourages the purchase of durable goods (consumption) and investment by companies. Aggregate demand decreases and aggregate demand curve shifts to the left.
21 EXAMPLE: The government adopted a program of infrastructure spending 1. This transaction represent a purchase of goods and services by the government (increasing the component G).2. The transaction therefore boosts the aggregate demand.3. The aggregate demand curve shifts to the right.
22 AD = C + I + G +(EX-IM) P AD1 (G1) AD0 (G0) Y When the government increases its purchases of goods and services (G0 to G1), aggregate demand is stimulated and the aggregate demand curve shifts to the right.
23 EXAMPLE: The United States is experiencing a strong growth of its domestic demand, while the Canadian domestic demand stagnates.1. This time, it is the component (NX= EX - IM) which changes.2. U.S. growth translates into an increase in the ratio DINT * / DINT. This ratio is positively related to local net exports NX, the ratio will increase because Americans will then consume more domestic goods and imported goods. The increased demand for imported goods in the United States is thus reflected by an increase in exports.3. Because net exports increase, aggregate demand is stimulated and therefore the curve moves to the right.
24 AD = C + I + G + (EX-IM) P AD1 (DINT*1 /DINT,...) YIf U.S. domestic demand grows, Americans import more Canadian goods and services, which translates into an increase in exports and a rightward shift of the aggregate demand curve.
25 Aggregate supplyRelationship between the quantity supplied real GDP and the level of P, ceteris paribusTwo curvesLong Run Aggregate supply (LRAS)Offre agrégée à long terme (OALT)Short Run Aggregate supply (SRAS)Offre agrégée à court terme (OACT)
26 LRASRelationship between the quantity supplied real GDP and the level of P when:firms are at their optimal (not maximum) production capacityresources are used in a sustainable mannerGDP = potential GDP or long run GDP or trend GDPUnemployment rate = natural rate of unemploymentIs vertical: real GDP does not depend on prices in the long run (money neutrality)
28 Shift of the LRASAnything that changes the capacity (potential output) of the economy shifts the OALTLabor forceHuman CapitalCapitalTechnologyProductivity
29 Technological changes PLRAS1YP1LRAS0YP0Real GDP
30 Short Run Aggregate Supply Relationship between the supplied quantity of real GDP and the level of P, where Pf (prices of factors of production) are constantPositive slope: P production (hiring)Potential explanation :Theory of wage rigidity
31 La théorie des salaires rigides Nominal wages adjust slowly (are rigid) in the short runCauses: long-term contracts, notions of fairness, justice, collective agreementP (W/P) unit cost (of production) profits labor and production
33 Shift of the LRAS and SRAS If the LRAS moves the SRAS movesThe two curves move if the production capacity of the economy changesAmount of laborProductivity
34 EXAMPLE: The introduction of computers in the manufacturing process allows workers to perform certain tasks more efficientlyThis example illustrates the effect of increased productivity on the unit cost of labor for companies;In fact, the unit production costs decrease (as wages do not increase);Production capacity increases and the two aggregate supply curves shift to the right.
35 Increase in productivity SRAS0SRAS1LRAS1YP1PLRAS0YP0Real GDP
36 Independent shift of the OACT Variation of Pf Variation of unit cost Variation of the SRASWages: WPrice of other factors of production: PfChanges in price expectations Changes in wages Changes of the SRASThese variations do not change the long run potential output: So the LRAS doesn’t move
37 Increase in oil pricesPSRAS1SRAS0LRASYPReal GDP
38 Macroeconomic equilibrium Short run equilibrium: crossing point of AD and SRASAt a price level that does not equate these two curves, stocks varyFirms change their production and the economy reached the equilibrium
40 Macroeconomic equilibrium and potential output The macroeconomic equilibrium is characterized by one of the following three cases:YE = YPEThe economy is at full employmentor potential employmentYE < YPEThe economy is in recessionary gapYE > YPEThe economy is inflationary gap
41 full employment equilibrium Full employment is characterized by the values of P and Y that will remain in the absence exogenous shocks. This is the position around which the economy is stabilizing in the long run. This balance is therefore compatible with the stability of prices and the long-term maintenance of the natural rate of unemployment.LRASSRASEPEADYE=YPEY
42 recessionary gap scenario The economy is characterized by a recessionary gap when the equilibrium real GDP (YE) is below its full employment level (YPE), the observed unemployment rate is now higher than the natural rate of unemployment. The recessionary gap represents the difference between YPE and YE. We see that the values of P and Y associated with this underemployment equilibrium cannot be maintained in the long run, even in the absence of exogenous shocks.PSRASLRASEPEADYE< YPEY
43 inflationary gap scenario The economy is characterized by an inflationary gap when the equilibrium real GDP (YE) is higher than its full employment level (YPE), the observed unemployment rate is now lower than the natural rate of unemployment. The inflationary gap represents the difference between YPE and YE. We also see in this case that the values of P and Y associated with this over-employment scenario cannot be maintained in the long run, even in the absence of exogenous shocks.PLRASSRASEPEADYPE <YEY
44 macroeconomic equilibrium and the potential of the economy We saw that there may be a macroeconomic equilibrium to the left or right of full employment ni the short run.Is there a mechanism that will bring the economy back to its potential, in the absence of exogenous shocks, including the intervention of the state?This is a fundamental question in macroeconomics. The answer is yes but it depends on the cyclical position of the economy and the flexibility of agents, particularly of the wages in the labor market. This determines the speed with which the economy will return to its potential output.
45 Analysis of macroeconomic shocks The economy is regularly subject to shocks that affect the aggregate demand and / or the aggregate supply. So these shocks affect the macroeconomic equilibrium.If the shock is moving one of the curves, we can make the following observation:Shocks (positive or negative) on aggregate demand lead to changes in real GDP and the price level in the same direction.Shocks (positive or negative) of the SRAS lead to changes in real GDP and the price level in opposite directions.
46 Negative shock to the SRAS A negative supply shock caused by an increase in the prices of the factors of production (wages or Pf), shifts the SRAS curve to the left.Real GDP decreases and the price level rises. In the short run, there is a recessionary gap.
47 Negative shock to the SRAS P1Y1PLRASSRAS0E1E0P0ADYPEReal GDP
48 The economy in a recession The unemployment rate is higher than the natural rateIn the labor market, there is a downward pressure on wages, which reduces the unit costs of production and stimulates the SRAS; while lowering inflation expectations the wages decrease.The short run aggregate supply curve moves back gradually moves to the right;Gradual return to the potential
49 The return to the long run equilibrium Baby I’m coming home! The economy is in an equilibrium state of underemployment in E1 , the recessionary gap observed is equals to Y1 - YPE. The high unemployment exerts downward pressure on wages (W1) and hence on the unit cost of production. The Short Run Aggregate Supply curve moves to the right while the prices go down until the economy stabilizes at full employment (E0)PSRAS1(w1,..)SRAS0E1P1P0ADE0Y1YPEY
50 A positive shock to the aggregate demand A positive demand shock caused by a decline in real interest rates and a strong U.S. growth will shift the AD curve to the right.Real GDP and the price level increase. In the short run there is a inflationary gap
51 Positive shock to the AD (Short run effect) SRASE1P1AD1P0E0LRASAD0YPEY1PIB réel
52 The economy inflationary gap The unemployment rate is lower than the natural rate; labor is scarce.in the labor market, there is an upward pressure on wages, which increases unit costs of production and reduces the SRAS. This increases inflationary expectations.The SRAS curve moves gradually upwards and to the left.Gradual return to full employment
53 Return to the Long run equilibrium The economy is in equilibrium of over-employment E1 , the observed production gap equals to Y1 – YPE > 0. The lowest unemployment rate exerts upward pressure on wages (w0) so that the unit costs of production increase. The SRAS curve moves upward and to the left and will make prices rise until the economy stabilizes at full employment (E0)PSRAS1SRAS0(w0,..)E0P0E1P1AD1YPEY1Y
54 Wage flexibilityThe movement of the SRAS that allows the return to full employment depends on wage flexibility.In real life, we can expect that the natural elimination of a recessionary gap will take longer than for an inflationary gap, as there is a perceived fatalityfor people went they observe a decrease in their wages.