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AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM 10-800-11 Elements of Economic Analysis in a Canadian Context.

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Presentation on theme: "AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM 10-800-11 Elements of Economic Analysis in a Canadian Context."— Presentation transcript:

1 AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM Elements of Economic Analysis in a Canadian Context

2 1.Aggregate Demand 2.Factors affecting the Aggregate Demand 3.Aggregate Demand curve 4.Aggregate supply 5.Factors affecting the Aggregate Supply 6.Aggregate Supply curve 7.Macroeconomic equilibrium content

3 1. 1.Agregate Demand Consumption, 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 Y d ) is defined as household personnal income PI minus taxes (T). PDI = Y d = 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 Consommation réelleConfiance M i l l i a r d s d e d o l l a r s e n c h a î n é s d e I n d i c e ( = ) Consommation réelle et confiance - Real consumption and confidence for Canada

6 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 cost of capital CLAFF : 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 Investissement réelBénéfices reels avant impot T a u x d e c r o i s s a n c e ( % ) T a u x d e c r o i s s a n c e ( % ) Investissement réel et bénéfices réels avant impôts - Canada ( )

8 Purchases of goods and services by the goverment: G = G In 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 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.

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12 Small e: Nominal Exchange Rate WARNING!!!! In canadian news papers we usually observe the small e e = # $US / $CA. e = 1 / E A high value of e means that the Can $ is strong A low value of E means that the Can $ is strong A low value of e means that the Can $ is weak A high value of E means that the Can $ is weak

13 3. 3.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.

14 Aggregate Demand curve P Y (Real GDP) AD

15 Slope of AD Real money balances effect Effet d’encaisses réelles in french:  P   (M/P)   wealth   C   Y Interest rate effect (r):  P  households need more money  households will sell financial assets   r   I et  C   Y Effet 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 Y P Lower income taxes ( T 0 to T 1 ) increases the disposable income of households, this helps boost consumption and thus the aggregate demand. Therefore the curve moves to the right. AD = C(PI-T,…) + I + G +(EX-IM) AD 0 (PI-T 0,…) AD 1 (PI-T 1,…) +

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 Rising real interest rate (from r 0 to r 1 ) discourages the purchase of durable goods (consumption) and investment by companies. Aggregate demand decreases and aggregate demand curve shifts to the left. DA 0 (r 0,…) Y P DA 1 (r 1,…) AD = C (r,…) + I (r,…) + G +(EX-IM) - -

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 When the government increases its purchases of goods and services (G 0 to G 1 ), aggregate demand is stimulated and the aggregate demand curve shifts to the right. Y P AD 0 (G 0 ) AD 1 (G 1 ) AD = C + I + G +(EX-IM)

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 If 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. Y P AD 0 (DINT* 0 /DINT,...) AD 1 (DINT* 1 /DINT,...) AD = C + I + G + (EX-IM)

25 4. 4.Aggregate supply Relationship between the quantity supplied real GDP and the level of P, ceteris paribus Two curves o Long Run Aggregate supply (LRAS) Offre agrégée à long terme (OALT) o Short Run Aggregate supply (SRAS) Offre agrégée à court terme (OACT)

26 LRAS Relationship between the quantity supplied real GDP and the level of P when: o firms are at their optimal (not maximum) production capacity o resources are used in a sustainable manner GDP = potential GDP or long run GDP or trend GDP Unemployment rate = natural rate of unemployment Is vertical: real GDP does not depend on prices in the long run (money neutrality)

27 LRAS curve LRAS P Real GDP YPYP

28 28 Shift of the LRAS Anything that changes the capacity (potential output) of the economy shifts the OALT o Labor force o Human Capital o Capital o Technology Productivity

29 29 Technological changes LRAS 0 P Real GDP Y P0 LRAS 1 Y P1

30 Short Run Aggregate Supply Relationship between the supplied quantity of real GDP and the level of P, where P f (prices of factors of production) are constant Positive slope:  P   production (hiring) Potential explanation : o Theory of wage rigidity

31 La théorie des salaires rigides Nominal wages adjust slowly (are rigid) in the short run Causes: long-term contracts, notions of fairness, justice, collective agreement  P   (W/P)   unit cost (of production)   profits   labor and production

32 LRAS SRAS LRAS and SRAS curves P Real GDP YPYP

33 Shift of the LRAS and SRAS If the LRAS moves  the SRAS moves The two curves move if the production capacity of the economy changes o Amount of labor o Productivity

34 EXAMPLE: The introduction of computers in the manufacturing process allows workers to perform certain tasks more efficiently This 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 LRAS 0 P Real GDP Y P0 SRAS 1 LRAS 1 Y P1 SRAS 0

36 Independent shift of the OACT Variation of P f  Variation of unit cost  Variation of the SRAS o Wages: W o Price of other factors of production: P f Changes in price expectations  Changes in wages  Changes of the SRAS These variations do not change the long run potential output: So the LRAS doesn’t move

37 LRAS SRAS 0 Increase in oil prices SRAS 1 P Real GDP YPYP

38 Macroeconomic equilibrium Short run equilibrium: crossing point of AD and SRAS At a price level that does not equate these two curves, stocks vary Firms change their production and the economy reached the equilibrium

39 Macroeconomic equilibrium Y P AD SRAS PEPE YEYE E

40 Macroeconomic equilibrium and potential output Y E = Y PE The economy is at full employment or potential employment The macroeconomic equilibrium is characterized by one of the following three cases: Y E < Y PE Y E > Y PE The economy is in recessionary gap The economy is inflationary gap

41 full employment equilibrium Y P PEPE AD LRAS =Y PE E 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. YEYE SRAS

42 recessionary gap scenario Y P PEPE AD SRAS YEYE The economy is characterized by a recessionary gap when the equilibrium real GDP (Y E ) is below its full employment level (Y PE ), the observed unemployment rate is now higher than the natural rate of unemployment. The recessionary gap represents the difference between Y PE and Y E. 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. < Y PE E LRAS

43 inflationary gap scenario P PEPE AD SRAS YEYE The economy is characterized by an inflationary gap when the equilibrium real GDP (Y E ) is higher than its full employment level (Y PE ), the observed unemployment rate is now lower than the natural rate of unemployment. The inflationary gap represents the difference between Y PE and Y E. 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. Y PE < E Y LRAS

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 46 Negative shock to the SRAS A negative supply shock caused by an increase in the prices of the factors of production (wages or P f ), 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 AD LRAS Negative shock to the SRAS SRAS 0 Y PE P0P0 SRAS 1 P1P1 Y1Y1 P Real GDP E0E0 E1E1

48 48 The economy in a recession The unemployment rate is higher than the natural rate In 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 Y P Y PE AD P1P1 Y1Y1 SRAS 1 (w 1,..) P0P0 SRAS 0 E1E1 E0E0 The economy is in an equilibrium state of underemployment in E 1, the recessionary gap observed is equals to Y 1 - Y PE. The high unemployment exerts downward pressure on wages (W 1 ) 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 (E 0 ) The return to the long run equilibrium The return to the long run equilibrium Baby I’m coming home!

50 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 SRAS AD 0 LRAS Positive shock to the AD (Short run effect) AD 1 P PIB réel Y PE Y1Y1 P1P1 P0P0 E1E1 E0E0

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 Y P Y PE AD 1 P1P1 Y1Y1 SRAS 0 (w 0,..) P0P0 SRAS 1 E1E1 E0E0 The economy is in equilibrium of over-employment E 1, the observed production gap equals to Y 1 – Y PE > 0. The lowest unemployment rate exerts upward pressure on wages (w 0 ) 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 (E 0 ) Return to the Long run equilibrium

54 Wage flexibility The 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 fatality for people went they observe a decrease in their wages.


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