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26. Aggregate.docx

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Wilfrid Laurier University
Rizwan Tahir

Chapter 26: Aggregate Supply & Aggregate Demand  Quantity is real GDP, price = price level measured by GDP deflator  Potential output Y*: where AD = LRAS, at full employment equilibrium  Actual Y is determined by intersection of AD and AS Money wage vs. real wage  Money wage: number of dollars in the pay envelope  Real wage: what that money wage can buy in terms of goods  If money wage rises 10% and there’s no change in price level, real wage rises 10%  If money wage and price level both rise 10%, there’s no change in real wage  If money wage rises 10% and price level rises 15%, real wage decreases Aggregate Supply  Aggregate supply: relationship between QS of real GDP & price level. Depends on: 1. Quantity of labour (L) 2. Quantity of capital (K) 3. State of technology (T) - This relationship is different in the long run and the short run  The aggregate production function shows how quantity of real GDP supplied depends on L, K, T - Written as Y = F(L, K, T)  the greater the L, K, or T, the greater the Y - There is no price variable in this  neither prices of individual outputs nor average price level  At any given time, K and T are fixed, but L can vary - L depends on decisions made by households and firms about S and D for labour - The higher the real wage rate, the smaller the L demanded, and greater L supplied - Equilibrium real wage rate: QL demanded = QL supplied  full employment Short-run aggregate supply  Macroeconomic SR is when real GDP has fallen below or risen above potential GDP - Meanwhile, unemployment rate has risen above or fallen below natural unemployment rate  SRAS: relationship between the QS of real GDP and the price level in SR when the money wage rate, resource costs, and potential GDP is constant  upward sloping: rise in price level with no change in costs induces firms to bear a higher marginal cost and increase production  If firms supply whatever level demanded at current prices, SRAS is horizontal at the pre-determined price level  extreme SR assumption: fixed P with variable output  with a given money wage rate, there is one price level at which real wage rate is at full-employment equilibrium level  QS real GDP = potential GDP, and SRAS = LRAS  Increasing slope  When output is low, firms have excess capacity  Keynesian model assumption  output can be expanded without large increase in unit costs  small increase in price needed  When output gets closer to capacity, unit costs increase  larger price increases needed Long run aggregate supply  The macroeconomic LR is long enough for all adjustments to be made so that real GDP = potential GDP (Y = Y*), and there is full employment  LRAS: relationship between the QS of real GDP and price level, when real GDP(Y) = potential GDP(Y*) - Vertical because potential GDP is independent of the price level (classical) - prices and money wage rates vary by the same % so relative prices and the real wage rate remain constant  real wage rate remains constant - Only changes in level of Y* can change level of real GDP  Extreme LR = fixed output with variable price level Movements along SRAS vs. LRAS  potential GDP: value of real GDP when FoP are fully employed  used at normal level of intensity SRAS: At the given wage money wage rate… (constant input prices and technology)  as price level falls, there’s a leftward movement along the SRAS  QS of real GDP < potential GDP  as price level rises, there’s a rightward movement along the SRAS  QS of real GDP > potential GDP  if everyone is working more than “normal hours”, then real GDP > potential GDP LRAS: A change in price level = % change in money wage  When the price of output rises, there’s no change in input cost or technology of production, so goods become more profitable and QS increases  upwards movement along the curve  When the price of output falls, QS decreases  downwards movement along the curve Shifts in SRAS and LRAS  Caused by changes in production plans other than price level Change in potential GDP (Y*)  when potential GDP increases, both LRAS and SRAS shift right  potential GDP changes for 3 reasons 1. change in full-employment quantity of labour L - fluctuations in employment over business cycle bring fluctuations in real GDP around potential GDP, but not changes in actual potential GDP and LRAS 2. Change in the quantity of capital (physical or human) K 3. Advance in technology T Change in money wage rate + other factor prices  Since there is no change in L, K, or T, the LRAS does not change  remains at potential GDP - In LR, change in money wage rate = % change in price level, so no change in relative prices  Rise in money wage rate = left shift of SRAS because of increased firm costs. 1. Departure from full employment - Unemployment above natural rate = downward pressure on money wage rate and vice versa 2. Expectations about inflation - Expected rise in inflation = faster rise in money wage rate and vice versa Aggregate Demand  quantity demanded, Y = total amount of final goods and services produced in Canada that people plan to buy = C + I + G + X – M - depends on price level, expectations, fiscal and monetary policy, and world economy  Aggregate expenditure curve: relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same  Aggregate demand curve: relationship between QD of real GDP and the price level, with all other influences on aggregate demand remaining the same  Slopes down for 2 reasons 1. Wealth effect: amount of goods and services money can buy  falls with increasing P 2. Substitution effect (imports vs. exports, and changing interest) - When P rises, interest rates rise so people save instead of spend - Intertemporal effect: substituting goods in the future for goods in the present - International effect: when Canadian P rises, imports increase (imports are cheaper) Movements along AD (and shifts in AE = consumption)  When price level changes, wealth and substitution effects change planned AE and QD of real GDP.  If prices fell, AE shifts right, and a movement right along the AD curve  The intersection of AE and the 45 degree line = the points on the AD curve  Wealth effect: increase in average price level decreases real value of wealth  AE shifts downward - If prices and wages both increase 10%, current consumption from current income should not change. But bonds and other wealth is worth less in terms of real goods. - If people have wealth targets, current wealth has fallen below target. To maintain wealth, people save more and spend less (tighten their belts)  Intertemporal substitution effect: assume there is a finite amount of money supply in the system - If prices rise, people demand more money  rise in transactions demand = rise in money demand overall  excess demand due to fixed money supply  rise in interest rates  fall in amount of real spending (mainly effect on desired investment expenditure I)  International substitution effect: - Higher prices of domestic goods means more imports which reduces AE on domestic goods and smaller export revenue  reductions in planned spending and left shift of AE Shifts in AD  Change in any influence on buying plans other than the price level changes AD  Expectations: about future income, inflation, and profits. Increases in inflation expectations increase AD now because buying power = more now.  Fiscal policy: government’s attempt to influence economy by setting and changes taxes, making transfer payments and purchasing goods - A tax cut increases households’ disposable income (Aggregate income minus taxes + transfers) - Increase in disposable income = increase AE and AD  Monetary policy: changes in interest rates and quantity of money in economy - Increase in quantity of money or cut in interest rates increases buying power and AD  World economy: influence AD in 2 ways 1. Fall in foreign exchange rate lowers price of domestic goods  increase exports and decrease imports  increases AD 2. Increase in foreign income increases demand for Canadian exports  increases AD Equilibrium in SR and LR  Short run: change in AS or AD can cause macroeconomic fluctuations  Long run: flow rate of GDP determined by potential output (depends on factor supply & technology) 3 times frames Characteristics of short run 1. Factor prices are assumed to be constant 2. Technology and factor supplies (L, K, T) are constant Characteristics of Adjustment of FoP 1. Factor prices are flexible 2. Technology and factor supplies (L, K, T) constant Characteristics of long run 1. Factor prices have completely adjusted 2. Technology and factor supplies (L, K, T) are changing Short run equilibrium  QD real GDP = QS real GDP  point of intersection of AD & SRAS  If real GDP < equilibrium GDP, firms increase production& raise prices move along to equilibrium - GDP produced < GDP demanded  If real GDP > equilibrium GDP, decrease production& lower prices  move along to equilibrium  In SR equilibrium, real GDP can be > or < potential GDP  When there’s an AD shock, Y changes in proportion to AD shift, and P is unchanged Long run equilibrium  AD = LRAS when real GDP = potential GDP  when economy is on LRAS curve  Factor prices are well adjusted to output gaps  full employment of factors prevails  Money wage has adjusted to put SRAS curve through LR equilibrium point  When there is an AD shock, Y does not change, but P changes in proportion to the shift in AD Adjustments to increases in price level  Start at some price level, and assume operations on the LRAS (at potential GDP)  If prices rise while money wage rates constant, there’s a movement right along SRAS  real wages fall  Workers demand pay rises  firms pay more  increase in money wage  shift SRAS left  Eventually, output flow returns to that associated with LRAS (potential GDP)  higher P equilibrium  Conclusion: increase in output driven on
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