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Chapter 26 Notes.docx

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Economics 1022A/B
Jeannie Gillmore

Chapter 26 Notes Aggregate Supply  the aggregate supply and demand model is different from the competitive market model o differences arise because the AS-AD model is a model of an imaginary market for the total of all the final goods and services that make up real GDP o the quantity in this market is GDP and the price is the price level measured by the GDP deflator Quantity Supplied and Supply  the quantity of real GDP supplied is the total quantity of goods and services, valued in base-year prices (2002), that firms plan to produce during a given period o depends on the quantity of labour employed, quantity of physical and human capital, and state of technology  at any given time, the quantity of capital and the state of technology are fixed, as they depend on decisions made in the past  the quantity of labour is not fixed, as it depends on decisions made by households and firms about the supply of and demand for labour o the labour market can be in any one of three states:  at full employment  real GDP supplied is potential GDP  above full employment  below full employment  aggregate supply is the relationship between the quantity of real GDP supplied and the price level o different in the long run and the short run Long-Run Aggregate Supply  long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate changes in step with the price level to maintain full employment o the quantity of real GDP supplied at full employment equals potential GDP and this quantity is the same regardless of the price level  along the long run aggregate supply curve: o as the price level changes, the money wage rate also changes so the real wage rate remains at the full-employment equilibrium level and real GDP remains at potential GDP o always vertical and is always located at potential GDP  long-run aggregate supply is vertical because potential GDP is independent of the price level o any % increase in price of goods is matched by the same % increase in the money wage rate  since these change by the same percentage, the real wage rate remains unchanged  with no change in price relative to cost, production does not change Short-Run Aggregate Supply  short-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant o in the short-run, a rise in the price level increases the quantity of real GDP supplied  with a given money wage rate, there is one price level at which the real wage rate is at its full- employment equilibrium level o at this price level, the quantity of real GDP supplied equals potential GDP and the SAS curve intersects the LAS curve  when the prices rise, the price level rises o if the price level rises and the money wage rate and other factor prices remain constant, all firms increase production and the quantity of real GDP supplied increases o opposite if price level falls Changes in Aggregate Supply  aggregate supply changes when an influence on production plans other than the price level changes  changes in potential GDP o if potential GDP increases, LAS increases, as does SAS by the same amount (if the full employment price level remains constant) o potential GDP can increase for three reasons:  increase in the full-employment quantity of labour  an increase in the quantity of capital  an advance in technology  changes in the money wages rate o when the money wage rate (or the money price of any other factor of production such as oil) changes, SAS changes (but not LAS) o a rise in the money wage rate decreases SAS and shifts the SAS curve leftward  occurs because it increases a firms costs, so they produce less o money wage rate can change for two reasons:  departures form full employment  unemployment above natural rate puts downward pressure on the money wage rate, and employment below the natural rate puts pressure on it  expectations about inflation  an expected rise in inflation rate makes the money wage rate rise faster, and an expected fall in the inflation rate slows the rate of at which the money wage rate rises Aggregate Demand  the quantity of real GDP demanded is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy o buying plans depend on the following factors:  the price level  expectations  fiscal and monetary policy  the world economy The Aggregate Demand Curve  ceteris parabas, the higher the price level the smaller the quantity of real GDP demanded o the relationship between the quantity of real GDP demand and the price level is called aggregate demand  the aggregate demand curve slopes downward for two reasons: o wealth effect  when the price level rises but other things remain the same, real wealth decreases  real wealth is the amount of money in the bank, bonds, stocks, and other assets measured in terms of the goods and services that the money, bonds, and stocks will buy  if the price level rises, real wealth decreases and people try to restore it  they increase saving, and thus decrease current consumption  decrease in demand o substitution effects  when the price level rises, the interest rate rises  a rise in the price level decreases the real value of the money in people’s pockets and bank accounts  with a smaller amount of real money, banks and other lenders can get a higher interest rate on loans  faced with a higher interest rate, people and business delay plans to buy new capital and cut back on spending  this substitution effect involves changing the timing of purchases of capital and consumer durable goods and is called an intertemporal substitution effect (substitution across time)  saving increases to increase future consumption  e/x if the Canadian price level rises to the Japanese price level, Japan buys fewer Canadian cars (exports decrease) and Canadians buy more Japanese cars (imports increase), thus Canadian GDP decreases  changes in the quantity of real GDP demanded o when the price level rises, ceteris parabas, the quantity of real GDP demanded decreases Changes in Aggregate Demand  expectations o an increase in expected future income increases the amount of consumption goods (especially big ticket items) that people plan to buy and increases aggregate demand o an increase in the expected future inflation rate increases aggregate demand today because people decide to buy more goods and services at today’s relatively lower prices o an increase in expected future profits increases the investment that firms plan to undertake today and increases aggregate demand  fiscal and monetary policy o the governments attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy  a tax cut or an increase in transfer payments (e/x unemployment benefits) increases aggregate demand  these influence a households disposable income (income minus taxes plus transfer payments)  the greater the disposable income, the greater the quantity of goods that households plan to buy  if government expenditure increases, aggregate demand increases o the Bank of Canada’s attempt to influence the economy by changing interest rates and the quantity of money is called monetary policy  an increase in the quantity of money increases aggregate demand through two main channels:  lowers interest rates, and makes it easier to get a loan  with a lower interest rate, businesses plan a greater investment in new capital  banks lower their standards for making loans and more people are able to get home loans and other consumer loans  a decrease in the quantity of money has the opposite effect  the World economy o an increase in the exchange rate decreases aggregate demand  people will buy more foreign goods (exports decrease, imports increase) o an increase in foreign income increases Canadian exports and increases
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