Chapter Six: Aggregate Supply 90min

6.1 Aggregate Supply Curve Aggregate Supply is the amount of real GDP that will be made available by sellers at various price levels. Aggregate Supply looks different in the Long Run and the Short Run: –In the Long Run, classical economists assume the economy operates at full employment (maximum output), independent of the price level. –In the Short Run, businesses will increase supply if the price level increases.

Modeling Production and Real GDP The aggregate production function shows the relationship between inputs (labour) to production and the quantity of aggregate total output (GDP) supplied Real GDP Number of People Working Production Function

A Range for Potential Output and the LAS Curve The position of the long-run aggregate supply curve is determined by potential output. Eg. On the PPF Potential output – the amount of goods and services an economy can produce when both labor and capital are fully employed. Only one level of production possible! Eg one machine, one pencil

A Range for Potential Output and the LRAS Curve Potential output – Only one level of production possible! Eg one machine, one pencil, one minute, sell for $1 Add worker will slow down production – Diminishing Marginal Returns: additional output from worker less than previous in SR –In LR, lay off worker and reach equilibrium input/output in production and prices

A Range for Potential Output and the LAS Curve –In LR, lay off worker and reach equilibrium input/output in production and prices –LR assumes full information! –If sell pencil for more money then supplier of wood charge more and workers demand more wages more immediately bring back in equilibrium with no change of output –In the SR no full info., employee and supplier get paid same and owner makes profit so production expands LR supply curve tilts over

A Range for Potential Output and the LAS Curve –LR assumes full information! Supplier Sell $0.5 > Worker pay $0.5 > Owner Sell $2 = $1 profit Owner Sell $3 for $2 profit but then > Supplier Sell $1 > Worker pay $1 Profit back down to $1 no incentive to produce more –SR Supplier sell $0.5 > Worker pay $0.5 > Owner Sell $2 = $1 profit Owner Sell $3 for $2 profit but supplier and worker don’t know so profit stays at $2 and there is an incentive to produce more

The Labour Market

6.2 Shifts in the LRAS Curve Real output Price Level LAS The LAS curve shows the long- run relationship between output and the price level. Economic growth eg. New tech, more human and physical capital, more resources shifts the LRAS to the right. The position of the LAS curve depends on potential output – the amount of goods and services an economy can produce when both capital and labor are fully employed. Potential output LAS 1

Shifts in the LRAS Curve Economic growth eg. New tech, more human and physical capital, more resources shifts the LRAS to the right. Productivity Increases Demand for the more productive labour increases and wages follow PF 1 PF 0 Real Wage Number Employed Labour Market D1D1 D0D0 S0S0

6.3 Aggregate Demand The LRAS curve describes the Real GDP trend The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate domestic output demanded by households, businesses, and the government

The Aggregate Demand Curve The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy. It shows the level of expenditures that would take place at every price level in the economy. ie. willingness to spend

The Aggregate Demand Curve

Downward Sloping It is downward-sloping for two reasons: –The first is the Real Balance Effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. –The second is the interest rate effect of a change in aggregate the price level—a higher aggregate price level reduces the purchasing power of households’ money holdings, the BofC rises interest rates to cool the economy (also have less commercial deposits too banks raise r to attract more deposits) leading to a fall in investment spending and consumer spending

The Real Balance Effect Real Balance Effect– a fall in the price level will make the holders of money and other financial assets richer, so they buy more. Most economists accept the logic of the wealth effect, however, they do not see the effect as strong.

The Interest Rate Effect The interest rate effect works as follows: a decrease in the price level  increase of real cash  banks have more money to lend  interest rates fall  investment expenditures increase

The Open Economy Effect Works as follows: NX = X-M Decrease in the CDN price level  CDN goods less expensive  Foreigners buy more CDN goods  Foreigners buy less of own goods  Canadians buy more CDN goods (X>M) = NX?  Increase in real goods purchased (expenditures) in Canada

The Slope of the AD Curve The AD is a downward sloping curve. Aggregate demand is composed of the sum of aggregate expenditures. Expenditures = C + I + G +(X - M)

The Aggregate Demand Curve Aggregate Demand is the total value of real GDP that all sectors of the economy (C + I + G + X n ) are willing to purchase at various price levels. When the price level increases, (inflation), people purchase less output.

AD Shift Factors The aggregate demand curve shifts because of –Changes in expectations eg gas prices –Changes in wealth eg lottery, r through I) –Changes in the stock of physical capital –NOT through price changes Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve Not in this chapter but will be in future chapters

Shifts of the Aggregate Demand Curve – Rightward Shift

Shifts of the Aggregate Demand Curve – Leftward Shift

AD and the Multiplier The change in total expenditures = 300 ($100+($100+$100)) 1. Initial effect = $100 increase in X (exports) => $100 increase in AD (shift) + 2. Workers who make goods get $100 increase in income => SPEND!! + 3. Bar owners get $100 increase in income Multiplier effect = 200

AD and the Multiplier Change in total expenditures = 300 Price level Real output AD 0 P0P0 Initial effect = 100 increase in exports AD Multiplier effect =

6.4 LR Equilibrium, the price Level and Economic Growth The AS/AD model is fundamentally different from the microeconomic supply/demand model.

The AS/AD Model Microeconomic supply/demand curves concern the price and quantity of a single good.

The AS/AD Model In the AS/AD model the price of everything is on the vertical axis and aggregate output is on the horizontal axis. So there is no substitution Equilibrium occurs when AD=AS ie. Planned Expenditures = Planned Production

Long-Run Macroeconomic Equilibrium LR equilibrium of $6 trillion in real GDP and price level of 100. AD>AS => Sales?? L?? W?? P?? Supply Creates Its Own Demand!

Deflation Deflation is a decline in the general level of prices for a period of years –This last occurred between

Growth and Deflation Secular Deflation: persistent decline in prices from economic growth Avoided price decrease by increasing aggregate demand What if AD shifts out faster than LRAS? D1D1 D0D0 LRAS 0 LRAS 1 AD LRAS 0 LRAS 1 Real GDP/ Year Price Level

6.5 Causes of Inflation Defining inflation –This is the OPPOSITE of deflation –Generally, we consider inflation to be a sustained rise in the average price level over a period of years When the overall price level is rising, the prices of some goods and services are going down [e.g., TV prices in the 1970s and the 1980s, the price of VCRs, and more recently the price of cellular phones]

Theories of the Causes of Inflation Demand-Side Inflation Cost-Push (Supply Side) inflation

Demand-Side Inflation When there is excessive demand for goods and services, we have demand- pull inflation –This occurs when people are willing and able to buy more output than our economy can produce because our economy is already operating at full capacity

Demand-Side Inflation Demand-pull inflation is often summed up as “too many dollars chasing too few goods” –Just where did all of this money come from”?

Cost-Push Inflation There are three variants of cost- push inflation –The wage-price spiral –Profit-push inflation –Supply-side cost shocks

Cost-Push Inflation: The Wage- Price Spiral Wages constitute nearly two-thirds of the cost of doing business –Whenever workers receive a significant wage increase, this increase is passed along to consumers in the form of higher prices –Higher prices raise everyone’s cost of living, engendering further wage increases

Cost-Push Inflation: Profit Push –Because just a handful of firms dominate many industries, they have the power to administer prices rather than accept the dictates of the market forces of supply and demand –To the degree that they are able, these firms will respond to any rise in cost by passing them on to their customers

Cost-Push Inflation: Supply- Side Cost Shocks –Finally, we have supply-side shocks, most prominently the oil price shocks of and 1979 OPEC nations raised the price of oil When the price of oil rises, the cost of making many other things rise as well –Cost increases are quickly translated into price increases

Anticipated and Unanticipated Inflation: Who Is Hurt? Debtors (people who take on debt) benefit from unanticipated inflation –They get to repay their loan in dollars that are worth less than the dollars they borrowed –The biggest debtor and gainer from unanticipated inflation has been the U.S. government

Anticipated and Unanticipated Inflation: Who Is Hurt by Inflation and Who Is Helped? Creditors, the people who lend out money, are hurt by unanticipated inflation –The ultimate creditors, or lenders, are the people who put their money in banks, life insurance, or any other financial instrument paying a fixed rate of interest

Who is hurt by Unanticipated Inflation? People who live on fixed incomes, particular retired people who depend on pensions

Anticipated and Unanticipated Inflation: When inflation is fully anticipated there are no winners and losers –Creditors have learned to charge enough interest to take into account, or anticipate, the rate of inflation over the course of the loan This is tacked onto the regular interest rate that the lender would charge had no inflation been expected