Principles of Macroeconomics: Ch. 19 Second Canadian Edition Chapter 19 Aggregate Demand and Aggregate Supply © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview  Three key factors about economic fluctuations.  The aggregate demand and aggregate supply model.  The aggregate demand curve.  The aggregate supply curve.  Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Short-Run Economic Fluctuations  Economic activity fluctuates from year to year. In some years, the production of goods and services rises. In other years normal growth does not occur, leading to recession.  A recession is a situation of declining real GDP, falling incomes and rising unemployment for two consecutive quarters.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Three Key Facts About Economic Fluctuations  Economic Fluctuations are Irregular and Unpredictable. – Recessions occur with unpredictable frequency and duration.  Most Macroeconomic Variables Fluctuate Together. – Most macroeconomic variables are closely related and move together.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Three Key Facts About Economic Fluctuations  As Output Falls, Unemployment Rises. – Changes in real GDP and the unemployment rate are inversely related.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Quick Quiz!  List and discuss three key facts about economic fluctuations.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview Three key factors about economic fluctuations.  The aggregate demand and aggregate supply model.  The aggregate demand curve.  The aggregate supply curve.  Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Economic Fluctuations  Although there remains some debate about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Basic Model of Economic Fluctuations  Two variables are used in developing a model to analyze the short-run fluctuations: 1. The economy’s output of goods and services, measured by real GDP 2. The overall price level, measured by the CPI or GDP Deflator  The Model: Aggregate Demand and Aggregate Supply

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Aggregate Demand and Aggregate Supply Model Quantity of Output Price Level Aggregate Supply Aggregate Demand PEPE QEQE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Aggregate Demand and Aggregate Supply  The Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices.  The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview Three key factors about economic fluctuations. The aggregate demand and aggregate supply model.  The aggregate demand curve.  The aggregate supply curve.  Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Aggregate Demand Curve  The aggregate demand for goods and services may be referred to as: Y = C + I + G + NX  Why is the aggregate demand curve downward sloping? 1. Pigou’s Wealth Effect 2. Keynes’ Interest Rate Effect 3. Real Exchange Rate Effect

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Three Reasons for the Downward Slope of the Aggregate Demand  Pigou’s Wealth Effect: “Consumers feel wealthier, which stimulates the demand for consumption goods.” – A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. – The increase in consumer spending means a larger quantity of goods and services demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Three Reasons for the Downward Slope of the Aggregate Demand  Keynes’ Interest-Rate Effect: “The lower the price level, the less money households need to hold to buy the goods and services they want.” – A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Three Reasons for the Downward Slope of the Aggregate Demand  Real Exchange-Rate Effect: “When prices of Canadian goods go down, foreigners buy more of our goods and we purchase less of their goods.” – When a fall in the Canadian price level causes the real exchange rate to depreciate, this stimulates Canadian net exports, thereby increasing the quantity of goods and services demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Factors that might shift the Aggregate Demand Curve  Shifts in the aggregate demand curve may arise because of: 1. Changes in spending plans by consumers or firms. 2. Changes in fiscal or monetary policy. “Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand schedule to shift.”

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Shifts in the Aggregate Demand Curve Quantity of Output Price Level Aggregate Supply Aggregate Demand AD

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Quick Quiz!  Explain the three reasons why the aggregate demand curve slopes downward.  Give an example of an event that would shift the aggregate demand curve. Which way would this event shift the curve?

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview Three key factors about economic fluctuations. The aggregate demand and aggregate supply model. The aggregate demand curve.  The aggregate supply curve.  Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Long-Run Aggregate Supply Curve  The Long-Run Aggregate Supply Curve is vertical at full-employment GDP with respect to the price level.  In the long-run the quantity of output supplied depends on the economy’s resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Long-Run Aggregate Supply Curve Quantity of Output Price Level Aggregate Supply Aggregate Demand The Long-Run Aggregate Supply Curve

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Long-Run Aggregate Supply Curve Quantity of Output Price Level Aggregate Supply Aggregate Demand Output at Full Employment

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Shifts in the Long-Run Aggregate Supply Curve  Over time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift. – An event that reduces potential output shifts the schedule to the left. – Any change that increases the economy’s potential output will shift the curve to the right.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition The Short-Run Aggregate Supply Curve  In the short-run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Reasons for the Upward Slope of the Aggregate Supply Curve  There are three alternative explanations for the upward slope of the short-run aggregate supply curve. – New Classical Misperceptions Theory – The Keynesian Sticky-Wage Theory – The New Keynesian Sticky-Price Theory

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Reasons for the Upward Slope of the Aggregate Supply Curve  The New Classical Misperceptions Theory: “A higher price level signals to each firm a greater demand for their product inducing them to produce more.” – Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their output.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Reasons for the Upward Slope of the Aggregate Supply Curve  The Keynesian Sticky-Wage Theory: “The higher product prices cause a temporary decrease in real wages stimulating employment and output.” – Nominal wages are slow to adjust, or are “sticky” in the short-run, thus a lower price level makes employment and production less profitable, which induces firms to reduce production.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Reasons for the Upward Slope of the Aggregate Supply Curve  The New Keynesian Sticky-Price Theory: “Prices that do not increase immediately are temporarily low thereby stimulating spending and output on those goods.” – Prices of some goods and services adjust sluggishly in response to changing economic conditions. – Remember Menu Costs.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition What Might Cause the Aggregate Supply Curve to Shift?  Three factors may lead to a shift in the short-run aggregate supply curve. – Changes in Factor (input) Prices – Changes in Productivity – Legal-Institutional Environment

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Shifts in the Aggregate Supply Curve Quantity of Output Price Level Aggregate Demand Aggregate Supply AS

Principles of Macroeconomics: Ch. 19 Second Canadian Edition What Might Cause the Aggregate Supply Curve to Shift?  Changes in factor (input) prices: Changes in the prices of domestic or imported resources will change the cost of producing final goods. – An increase in input prices will shift the supply curve to the left. – A decrease in input prices will shift the supply curve to the right.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition What Might Cause the Aggregate Supply Curve to Shift?  Changes in productivity: If changes in the resource markets increase factor productivity, more goods can be made available at a lower cost. New technologies can increase the output per unit of labour or capital and hence make available more final goods.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition What Might Cause the Aggregate Supply Curve to Shift?  Legal-institutional environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Quick Quiz!  Explain why the long- run aggregate supply curve is vertical.  Explain three theories for why the short-run aggregate supply curve is upward sloping.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview Three key factors about economic fluctuations. The aggregate demand and aggregate supply model. The aggregate demand curve. The aggregate supply curve.  Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Equilibrium in the Long-Run  Equilibrium output and price level are determined by the intersection of the aggregate demand curve and the long- run aggregate supply curve.  Output is at its natural rate and the short-run aggregate supply curve passes through the point of intersection.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Equilibrium in the Long-Run Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Sources of Recession  Two sources from which a recession in the economy may occur: – A decrease in aggregate demand – A decrease in aggregate supply  Shifts in the aggregate demand or the aggregate supply curves result in fluctuations in the economy’s output of goods and services.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Source of Recession A Decrease in Aggregate Demand  A decrease in one or more components of the total spending function will cause the aggregate demand schedule to shift leftward. – Output will fall below the full employment output – Unemployment will rise

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Demand Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Demand Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Demand Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Source of Recession A Decrease in Aggregate Supply  A decrease in short-run aggregate supply will result in a new equilibrium along the aggregate demand curve below full employment.  A fall in total output below full output – An increase in unemployment

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Supply Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Supply Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Supply Quantity of Output Price Level Aggregate Supply Aggregate Demand QEQE PEPE

Principles of Macroeconomics: Ch. 19 Second Canadian Edition A Decrease in Aggregate Supply  When the economy falls due to a decrease in the aggregate supply, the price level rises and output decreases. This is called Stagflation.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Actions by Policy-makers During Periods of Recession  Policy-makers, when faced by decreasing aggregate demand or supply could: – Do nothing, assuming that perceptions will adjust prices and wages. – Take action to increase aggregate demand (implement monetary and fiscal policy).

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Quick Quiz!  Suppose that the election of a popular prime ministerial candidate suddenly increases people’s confidence in the future.  Use the model of aggregate supply and aggregate demand to analyze the effect on the economy.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition Overview Three key factors about economic fluctuations. The aggregate demand and aggregate supply model. The aggregate demand curve. The aggregate supply curve. Equilibrium in the long-run.