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EC140 3.docx

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Justin Smith

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EC140 February 12 and 14 2013th Question 9: error on My Econ Lab (the test will be marked out of 9.5) - Aggregate demand and supply show the relationship between price and GDP - When prices rise and costs do not change, a firm will increase production and profit will increase - When prices rise by the same amount as costs, then nothing changes - Wages will adjust over the long run to return to the level it was at before (which is potential GDP); wages will shift to match price level changes Aggregate Demand - Quantity of real GDP demanded (Y): the total amount of final goods and services produced in a country that people, businesses, governments, and foreigners plan to buy. - The sum of consumption expenditure, C, investment, I, government expenditure, G, and net exports, X – M. Y = C + I + G + X – M - Demand is driven by people’s buying plans (people plan and desire to spend a certain amount of money - Buying plans depend on many factors and some of the main ones are - The price level - Expectations - Fiscal policy and monetary policy (ex. Gov’t spends more during recession) - The world economy (ex. Recession in US means they will demand less goods from us) - Aggregate demand Curve (AD): the relationship between the quantity of real GDP demanded and the price level. o The AD curve plots the quantity of real GDP demanded against the price level. 1 EC140 February 12 and 14 2013 - The AD curve slopes downward (when price goes up, quantity demanded falls) o Wealth Effects (your assets at any given point in time; if you earn little money but have a lot of cash in the bank you’re wealthy)  Wealth and income affect people’s spending differently o Substitution Effects - The only thing that causes a movement along the demand curve is a change in price level; everything else causes the demand curve to shift - Wealth Effect o The more wealth you have, the more you’ll spend o Your wealth doesn’t matter, what matters is how much you can buy with that wealth (Ex. If the price level is extremely high, $1 million doesn’t get you very much) o If prices increase, other things equal, real wealth falls (value of money, stocks, etc.) o You would consume less, and aggregate spending and GDP would fall o To restore real wealth, people increase saving and decrease spending o The quantity of real GDP demanded decreases o If prices decrease, the opposite happens Substitution Effects - Intertemporal substitution effect • If prices are higher today, it makes things seem cheaper tomorrow • The amount of money people are willing to lend, depends on the price level • When prices go up, the amount of wealth falls, interest rates rise because there is less money to be loaned • A rise in the price level, other things equal, decreases the value of money and raises interest rates. – When the interest rate rises, people spend less since it is more costly not to save money – Business investment will fall (equipment would be more expensive and probably less profitable) – Spending decreases now, in favour of future Spending • A fall in the price level increases the real value of money and lowers the interest rate – People will spend more, GDP will increase International substitution effect • A rise in the price level, other things equal, increases the price of domestic goods relative to foreign goods. – Shift consumption from domestic to foreign (when domestic price levels rise) – Price of imports decreases, and price of exports increases – Reduces domestic Consumption and increase Imports • Imports increase and exports decrease, which decreases the quantity of real GDP demanded. • The reverse happens for a fall in the price level • The AD curve is directly connected to the short-run Keynesian model we discussed • AD curve is the set of equilibrium points from the short-run Keynesian model at various price levels 2 EC140 February 12 and 14 2013th • The equilibrium GDP from the Keynesian model corresponds to a point on the AD curve • Recall, in the Keynesian model, prices were fixed • Now, we consider what happens when prices change in the Keynesian model o Recall that there are wealth and substitution effects - At a price level of 110, the Q of demand is 1200 units of real GDP - Equilibrium is determined where there is no excess production or excess spending - Planned spending = production - Suppose the price level rises from 110 to 130 - Wealth and substitution effects kick in; spending drops - AE curve shifts from AE do0nward to AE 1 - Equilibrium expenditure and GDP decreases from $1,200 to $1,100 billion. - This draws out the AD curve from B to A - Lower wealth lowers autonomous consumption (people who are less wealthy will consume less at each level of income) - Firms will revise their production so total production = planned expenditure (new equilibrium) - Connects price changes to the equilibrium change in GDP - When prices rise, production falls - Suppose now the price level falls from 110 to 90 - Wealth and substitution effects kick in - People’s wealth increases; spending increases - Autonomous consumption rises - AE curve shifts up from AE to0AE 2 - Equilibrium expenditure and GDP increases from $1,200 to $1,300 billion - Draws out AD curve from point B to C - Firms will increase production to match spending - Firms will stop increasing production at the point where planned expenditure = GDP - A drop in the price level increased production 3 EC140 February 12 and 14 2013 - Points A, B, and C on the AD curve correspond to the equilibrium expenditure points A, B, and C at the intersection of the AE curve and the 45° line. - Changes in price change autonomous consumption (movement along the demand curve) Changes in Aggregate Demand - A change in any influence on buying plans other than the price level changes aggregate demand. - When the price level remains constant, these things can affect consumption today - The main influences on aggregate demand are o Expectations (if you think your income will increase in the future, you will spend more today; if you expect that prices will double tomorrow, you will buy more today) o Fiscal policy and monetary policy o The world economy Expectations • Expectations about future income, future inflation, and future profits change aggregate demand. – Increases in expected future income increase people’s consumption today and increases aggregate demand. – A rise in the expected inflation rate makes buying goods cheaper today and increases aggregate demand. – An increase in expected future profits boosts firms’ investment, which increases aggregate demand. – As people expect inflation to increase, they will buy as soon as possible because prices will rapidly increase and de-value their money and wealth Fiscal Policy and Monetary Policy • Fiscal policy: the government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services. • Increase in government spending, decreases in tax, and increases in transfer payments (the opposite of a tax) increase spending – A tax cut or an increase in transfer payments increases households’ disposable income – An increase in disposable income increases consumption expenditure and increases aggregate demand • Bank of Canada works independent of the government and makes sure that the inflation rate remains at around 2% (they will influence the economy by producing more money or taking away money) – monetary policy • Higher interest rates make borrowing more expensive; spending will decrease • Lower interest rates make it cheaper to borrow money; induce spending • Government expenditure on goods and services is one component of aggregate demand • An increase in government expenditure increases aggregate demand. • Monetary policy: changes in interest rates and the quantity of money in the economy • An increase in the quantity of money increases buying power and increases aggregate demand • A cut in interest rates increases expenditure and increases aggregate demand. 4 EC140 February 12 and 14 2013h The World Economy • The world economy influences aggregate demand in two ways: – A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services • Increases exports, decreases imports, and increases aggregate demand. – An increase in foreign income increases the demand for Canadian exports and increases aggregate demand. – An increase in the price of goods in Britain will make Canadian goods seem cheaper and they will import more Canadian goods – When the Canadian exchange rate falls, foreign countries will import more Canadian goods (the Canadian dollar will be worth less) – If other countries become richer, they demand more of our goods – If our goods seem cheaper to them, they will demand more • An increase in AD shifts the curve right • A decrease shifts the curve left • Price doesn’t shift the demand curve, it only moves along the curve • We can again relate this to the short-run Keynesian model • Suppose there is an autonomous increase in investment. • Caused by one of the factors mentioned in the previous 6 slides • The AE curve shifts upward • Causes the AD curve to shift rightward • Shift is equal to the change in autonomous spending times the multiplier • Price levels do not change • At every fixed price level, demand is higher (when the demand curve shifts to the right) • The shift in demand from one curve to another, the rightward movement = the change in autonomous expenditure x the multiplier Explaining Macroeconomic Fluctuations - Short-run macroeconomic equilibrium: occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SRAS curve 5 EC140 February 12 and 14 2013th - If the price level were higher than 110, there would be excess supply (people don’t want to buy that much) – firms will start cutting the price - Firms will move down the supply curve, and as prices fall people will increase demand - They will meet at point C, the equilibrium - If the price is at 100, there will be excess demand (a shortage of goods) - Price levels will rise be
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