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Macro Chapter 25-27.pdf

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Department
Economics
Course
Economics 1022A/B
Professor
Dr.Mike
Semester
Spring

Description
Chapter 25 Currencies and Exchange Rates  Whenever people buy things from another country they are using the currency of that country to make the transaction  Foreign money is just like Canadian money – consists of notes and coins used by a central bank and mint and deposits in banks and other depository institutions  When we describe Canadian money we distinguish between currency (notes and coins) and deposits  When we talk about foreign money – refer to as foreign currency  Foreign currency – the money of other countries regardless of whether the money is in the form of notes, coins, of bank deposits The Foreign Exchange Market  Foreign exchange market – market in which the currency of one country is exchanged for the currency of another  Made up of thousands of people – importers, exporters, banks, international travelers, and specialist traders called foreign exchange brokers Exchange Rates  Exchange rate – the price at which one currency exchanges for another currency in the foreign exchange market  Exchange rate fluctuates  Rise in exchange rate – appreciation of a dollar  Fall in exchange rate – depreciation of a dollar  Quantity of foreign money that we can buy with out dollar changes when the dollar appreciates or depreciates  Change in the value of the dollar might not change what we really pay for our imports and earn from our exports  Reason is that prices of goods and service might change to offset the change in the value of the dollar and leave the terms on which we trade with other countries unchanged Nominal and Real Exchange Rates  Nominal exchange rate – the value of the Canadian dollar expressed in units of foreign currency per Canadian dollar  measures how much of one money exchanges for a unit of another money  Real exchange rate – the relative price of Canadian produces goods and services to foreign produces goods and services  measure of the quantity of real GDP of other countries that a unit of Canadian real GDP buys  To understand the real exchange rate we use an example  Suppose china produces only snow blowers and Canada produces only airplanes.  Price of snow blower is 8000 Yuan and price of airplane is $8 million  Suppose the exchange rate (nominal) is 10 Yuan per dollar  We can calculate the real exchange rate which is the number of snow blowers that one airplane buys  With price of 8000 Yuan and exchange rate of 10 Yuan per dollar the price of a snow blower is $800 per snow blower  At price of $8 million per airplane and $800 per snow bower one airplane buys 10000 snow blowers  Real exchange rate is 10000 snow blowers per airplane  Airplanes represent Canadian real GPD and snow blowers represent Chinese real GDP  Price of a snow blower in China and price of an airplane in Canada represents price levels in the two countries  P – Canadian price level  P* - Chinese price level  E – nominal exchange rate  RER – real exchange rate RER = E x (P/P*)  Real exchange rate equals the nominal exchange rate multiplied by the ration of the Canadian price level to the foreign price level  Real exchange rate changes if the nominal exchange rate changes and the prices remain constant  But if the dollar appreciates (E rises) and foreign price rises (P* rises) by the same percentage, the real exchange rate does NOT change Canadian Dollar Effective Exchange Rate Index  Canadian dollar effective exchange rate index (CERI) – an average of the exchange rates of the Canadian dollar against the US dollar the European Union euro, the Japanese Yen, the UK pound, the Chinese Yuan, and the Mexico peso  In CERI each currency gets a weight that represents the importance of the currency in Canada’s international trade  Blue line shoes the nominal CERI since 1997  We defines value of this index to be 100 in 1997 so the index tells us the value of the Canadian dollar against the other size currencies as a percentage of its value in 1997  Index shows that dollar depreciated on average through 2002 and then appreciated through 2007 before depreciating again  Red line shows real CERI  The nominal and real exchange rates moved in the same direction, but the nominal exchange rate appreciate by less and depreciated by more than real exchange rate  Absence of a gap between real exchange rate and nominal exchange rate results form the fact that the inflation rates in Canada and the other countries were similar The Foreign Exchange Market  Exchange rate is a price – price of one currency in terms of another  Like all prices, exchange rate is determined in a market – foreign exchange market  Canadian dollar trades in foreign exchange market and is supplied ad demanded by many traders every hour of every business day  Because foreign exchange market has many traders and no restrictions on who may trade, it is a competitive market  so demand and supply determine the price  To understand forces that determine exchange rate we need to study factors that influence demand and supply in foreign exchange market  There is a feature of foreign exchange market that makes it special The Demand for One Money is the Supply of Another Money  When people want to exchange foreign currency for Canadian dollars they demand Canadian dollars and supply the other currency  When people want to exchange Canadian dollars for foreign currency they supply Canadian dollars and demand other currency  Factors that influence demand for Canadian dollars also influence supply of other currencies  And factors that influence demand for other counties’ currencies also influence supply of Canadian dollars Demand in the Foreign Exchange Market  People buy Canadian dollars in the foreign exchange market so that they can buy Canadian produced goods and services (Canadian exports)  Also buy Canadian dollars so that they can buy Canadian assets like bonds, stocks, businesses, and real estate or so that they can keep part of their money in a Canadian dollar bank account  Quantity of Canadian dollars demanded in foreign market is the amount that traders plan to buy during a given time period at a given exchange rate  Quantity depends on o The exchange rate o World demand for Canadian exports o Interest rates in Canada and other countries o The expected future exchange rate  Law of demand in foreign exchange market – relationship between the quantity of Canadian dollars demanded in foreign exchange market The Law of Demand for Foreign Exchange  Law of demand applies to Canadian dollars just as it does to anything that people want  The higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign market  Exchange rate influences the quantity of Canadian dollars demanded for two reasons o Exports effect o Expected profit effect Export Effect  The larger the value of Canadian exports, the larger is the quantity of Canadian dollars demanded in the foreign exchange market  Value of Canadian exports depends on the prices of Canadian produced goods and services expressed in the currency of the foreign buyer  these prices depend on exchange rate  The lower the exchange rate, the lower are the prices of Canadian produced good and services to foreigners and the greater is the volume of Canadian exports  If the exchange rate falls, the quantity of Canadian dollars demanded in foreign exchange market increases Expected Profit Effect  The larger the expected profit from holding Canadian dollars, the greater is the quantity of Canadian dollars demanded in the foreign exchange market  But expected profit depends on exchange rate  For given expected future exchange rate, the lower the exchange rate today, the larger is the expected profit form buying Canadian dollars today and holding them, so the greater is the quantity of Canadian dollars demanded in the foreign markets today  The lower the exchange rate today, the greater is the expected profit from holding Canadian dollars and the greater is the quantity of Canadian dollars demanded in the foreign exchange market today Demand Curve for Canadian Dollars  Diagram shows the demand curve for Canadian dollars in foreign exchange market  Change in the exchange rate brings a change in the quantity of Canadian dollars demanded and a movement along the demand curve Supply in the Foreign Exchange Market  People sell Canadian dollars and buy other currencies so that they can buy foreign produced goods and services – Canadian imports  People also sell Canadian dollars and buy foreign currencies so that they can buy foreign assets such as bonds, stocks, businesses, and real estate or so that they can hold part of their money in bank deposits denominated in foreign currency  Quantity of Canadian dollars supplied in foreign exchange market is amount that traders plan to sell during a given time period at a given exchange rate  Quantity depends on o The exchange rate o Canadian demand for imports o Interest rates in Canada and other countries o The exciter future exchange rate The Law of Supply of Foreign Exchange  The higher the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign exchange market  Exchange rate influence the quantity of dollars supplies for two reasons o Imports effect o Expected profit effect Imports Effect  The larger the value of Canadian imports, the larger is the quantity of Canadian dollars supplied in the foreign exchange market  But the value of Canadian imports depends on the prices of foreign produced goods and service expressed in Canadian dollars  Prices depend on exchange rate  The higher the exchange rate. The lower are the prices of foreign produced goods and services to Canadians and the greater are Canadian imports  If the exchange rate rises, the quantity of Canadian dollars supplied in the foreign exchange market increases Expected Profit Effect  Effect works just like demand for the Canadian dollar but in opposite direction  The higher the exchange rate today, the larger the is the expected profit form selling Canadian dollars today and holding foreign currencies, sot he greater is the quantity of Canadian dollars supplied Supply Curve for Canadian Dollars  Diagram shows the supply curve of Canadian dollars in foreign exchange market  Change in exchange rate, brings a change in the quantity of Canadian dollars supplied and a movement along the supply curve Market Equilibrium  Equilibrium in the foreign exchange market depends on how the Bank of Canada and other central banks operate  Here we study market when central banks keep out of the market  Diagram shows the demand curve for Canadian dollars and the supply curve for Canadian dollars and the equilibrium exchange rate  Exchange rat acts as a regulator of the quantities demanded and supplied  If exchange rate is too high, there is a surplus  If exchange rate is too low, threw is a shortage  At equilibrium exchange rate there is neither a surplus nor a shortage  Foreign exchange market is constantly pulled to its equilibrium by the forces of supply and demand  Foreign exchange traders are constantly looking for best price they can get  If they are selling, they want highest price available  If they are buying, they want lowers price available  Information flows from trader to trader though the worldwide computer network and price adjusts minute by minute to keep buying plans and selling plans in balance  Price adjusts minute by minute to keep exchange rate at its equilibrium  Exchange rates are tied together so that no profit can be made by buying one currency, selling it for a second one, and then buying back the first one  If such profit were available, traders would spit it, demand and supply would changed, and exchange rates would snap into alignment Change in Demand and Supply: Exchange Rate Fluctuations  When demand for Canadian dollars or supply of Canadian dollars changes, exchange rate changes A Change in Demand for Canadian Dollars  Demand for Canadian dollars in foreign exchange market changes when there is a change in o World demand for Canadian exports o Canadian and foreign interest rates o The expected future exchange rate World Demand for Canadian Exports  Increase in world demand for Canadian exports increases the demand for Canadian dollars Canadian and Foreign Interest Rates  People buy financial assets to make a return  The higher the interest rate that people can earn on Canadian assets compared with foreign assets, the more Canadian assets they buy  What matters is not the level of Canadian interest rate, but Canadian interest rate minus the foreign interest rate – gap called Canadian interest rate differential  If Canadian inertest rate rises and foreign interest rate remains constant, Canadian interest rate differential increases  The larger the Canadian interest rate differential, the greater is the demand for both Canadian assets and Canadian dollars The Expected Future Exchange Rate  For a given current exchange rate, a rise in expected future exchange rate increases the profit that people expect to make by holding Canadian dollars and the demand for Canadian dollars increases today  Diagram summarizes influence on demand for Canadian dollars  Increase in demand for Canadian exports, rise in Canadian inters rate differential, or rise in expected future exchange rate increase demand for Canadian dollars and shifts demand curve right  Decrease in demand for Canadian exports, fall in Canadian interest rate differential, or fall in expected future exchange rate decreases demand for Canadian dollars and shifts demand curve leftward Changes in the Supply of Canadian Dollars  Supply of Canadian dollars in foreign exchange market changes when there is a change in o Canadian demand for imports o Canadian and foreign interest rates o Expected future exchange rate Canadian Demand for Imports  Increase in Canadian demand for imports increase the supply of Canadian dollars in the foreign exchange market Canadian and Foreign Exchange Rates  Effect of the Canadian interest rate differential on the supply of Canadian dollars it he opposite of its effect on the demand for Canadian dollars  The larger the Canadian interest rate differential, the smaller is the supply of Canadian dollars in the foreign exchange market  The supply of Canadian dollars is smaller because the demand for foreign assets is smaller  If people send less on foreign assets, the quantity of Canadian dollars they supply in the foreign exchange market decreases  So a rise in the Canadian interest rate increases the Canadian interest rate differential and decreases the supply of Canadian dollars in the foreign exchange market The Expected Future Exchange Rate  For a given current exchange rate, a fall in the expected future exchange rate decreases the profit that can be made by holding Canadian dollars and decreases the quantity of Canadian dollars that people want to hold  To reduce their holdings of Canadian assets people must sell Canadian dollars  When this happens supply of Canadian dollars in foreign exchange market increases  Diagrams summarizes the influence on the supply of Canadian dollars  If the supply of Canadian solar decreases, the supply curve shifts leftward and if the supply increases, the supply curve shifts rightward Changes in the Exchange Rate  If demand for Canadian dollar increases and the supply does not change, the exchange rate rises  If demand for Canadian decreases and supply does not change the exchange rate falls  If supply of Canadian dollar decreases and demand does not change, exchange rate rises  If supply of Canadian dollars increases and demand does not change, the exchange rate falls Exchange Rate Expectations  Changes in exchange rate occurred in part because the exchange rate was expected to change  What makes expectation change? Answer is new information about deeper forces that influence the value of one money relative to the value of another money o Interest rate parity o Purchasing power parity Interest Rate Parity  One definition of what money is worth is what it can earn  Two kinds of money might earn different amounts  Say: interest rate on Yen bank deposit in Tokyo is 1% a year and on a Canadian dollar bank deposit in Toronto is 3% a year  Why does anyone deposit money in Tokyo? Why doesn’t all money go to Toronto? Answer is because of exchange rate expectations  People expect yen to appreciate 2% a year – Canadian investors expect that if they buy and hold yen for a year they will earn 1% interest and 2% from the yen to give a total of 3%  Interest rate in terms of Canadian dollars is the same in Tokyo and Toronto  this situation is one of interest rate parity which means equal rate of returns  Adjusted for risk, interest rate parity always prevails  Funds move to get highest return available Purchasing Power Parity  Another definition of what money is worth is what it will buy  But two kinds of money might buy different amounts of goods and services  Say memory stick is 5000 yen in Tokyo and $50 in Vancouver  If exchange rate is 100 yen per dollar tow monies have same value  You can buy a memory stick in both places for the same price  price is the same in the two currencies  Situation is called purchasing power parity – equal value of money  If purchasing power parity does not prevail some powerful forces go to work  If all prices have increase in Canada and not Japan then people will generally expect value of Canadian dollar in foreign exchange market must fall  Demand for Canadian dollar decreases and supply for Canadian dollar increases  Exchange rate falls as expected  If prices increase in Japan and other countries but remain constant in Canada, then people will generally expect value of Canadian dollar in foreign exchange market is too low and that it is going to rise  The exchange rate is expected to rise  Demand for Canadian dollars decreases  Exchange rate rises, as expected Instant Exchange Rate Response  Exchange rate responds instantly to news about changes in the variable that influence demand and supply in foreign exchange market The Nominal and Real Exchange Rates in the Short Run and in the Long Run  The equation that links nominal and real exchange rate is RER = E x (P/P*)  Where P is Canadian price level and P* is the japans price level  RER is real exchange rate  In short run this equation determines the real exchange rate  Price levels in Canada and Japan do not change every time the nominal exchange rate changes  So a change in E brings an equivalent change in RER  In long run, demand and supply in markets for goods and services determine the real exchange rate  If Japan and Canada produce identical goods purchasing power parity would make the real exchange rate equal 1  Although there is an overlap in what each country produces, Canadian real GDP is different bindle of goods and services from Japan real GDP  So relative price of Japanese and Canadian real GDP is not 1 and it fluctuates  Forces of demand and supply in markets for millions of goods and services that make up GDP determine relative prices of japans and Canada’s real GDP  In long run, with real exchange rate determine by real forces of demand and supply in markets for goods and services the equation must be turned round to determine nominal exchange rate  Nominal exchange rate is E = RER x (P/P*)  This equation tells us that in long run the nominal exchange rate is determined by equilibrium real exchange rate and prices levels in the two countries  Rise in Japanese price level brings a ruse in E and dollar appreciation and rise in Canadian price level brings a fall in E and dollar depreciation  Quantity of money in Japan determines the price level in Japan and the quantity of money in Canada determines the price level in Canada  Nominal exchange rate in the long run is monetary phenomenon  determined by quantities of money in both countries Financing International Trade Balance of Payments Accounts  Country’s balance of payments accounts records its international trading, borrowing and lending in three accounts o Current account o Capital account o Official settlements account  Current account – records receipts form exports of goods and services sold abroad, payments for imports of goods and services from abroad, net interest income pad abroad and net transfers abroad  Current account balance equals the sum of exports minus imports, net interest income and net transfers  Capital account – records foreign investment in Canada minus Canadian investment abroad  Official settlements accounts – records the change in official reserves which are the governments holdings of foreign currency  If official reserves increase, official settlements account balance is negative  Reason is that holding foreign money is like investing abroad  Canadian investment abroad is a minus item in the capital account and in the official settlement account  Items in current account and capital account that provide foreign currency to Canada have a plus sign  Items that cost Canada foreign currency have a minus sign  We had a surplus as exports were bigger than imports and we use the surplus by lending to the rest of the world  Capital account tells us how much we lend  There is almost always a statistical discrepancy between our capital account and current transactions  Our capital account plus our current account balance equals the change in Canadian official reserves  The sum of the current account balance, the capital account balance and the official settlement balance equals zero An Individual’s Balance of Payments Accounts  An individual’s current account records the individual’s income from supplying the services of factors of production and expenditure on goods and services Borrowers and Lenders  Country that is borrowing more from the rest of the world than it is lending to the rest of the world is called a net borrower  Net lender – country that is lending more to the rest of the world than it is borrowing from the rest of the world Debtors and Creditors  Net borrower might be decreasing its net assets held in the rest of the world or it might be going deeper in debt  Nations total stock of foreign investment determines whether it is a debtor or creditors  Debtor nation – country that during its entire history has borrowed more form the rest of the world than it has lent to other countries  It has stock of outstanding debt to the rest of the world that exceeds the stock of its own claims on the rest of the world  Creditor nation – country that during its entire history has invested more in the rest of the world than other countries have invested in it  Canada is a debtor nation  Capital hungry counties are among the largest debtor nations  Should we be nervous if a country is a big net borrower and debtor? Answer depends in what net borrower is doing with borrowed money  If borrowing is financing investment that in turn generates economic growth and higher income, borrowing is not a problem  earns a return that more than pays interest  But if borrowed money is used to finance consumption to pay interest and repay loan, consumption will eventually have to be reduces Current Account Balance  We can define current account balance as (CAB) CAB = NX + Net interest income + Net transfers Net Exports  Net exports are determined by the government budget and private saving and investment  Net exports – exports of goods and services minus imports of goods and services  Government sector balance = equal to net taxes minus government expenditure on goods and services  If number is positive a government sector surplus is lent to other sector  If number is negative government deficit must be financed by borrowing from other sectors  Government sector deficit is sum of the deficits of the federal, provincial and local governments  Private sector balance – saving minus investment  If saving exceeds investment, a private sector surplus is lent to the sector  If investment exceeds saving, private sector deficit is financed by borrowing from other sectors  From national income accounts we know that real GDP is the sum of C + I + G + (X-M)  Real GDP also equals the sum of consumption expenditure saving and net taxes  Rearranging the equation tells us that net exports equals sum of government sector balance and private sector balance (X –M) = (T – G) + (S – I) Where is the Exchange Rate?  In short run, a gall in nominal exchange rate lowers the real exchange rate which makes our imports more costly and our exports more competitive  Higher price of imported consumption goods and services might induce a decrease in consumption expenditure and in increase in saving  Higher prices of imported capital goods might induce a decrease in investment  An increase in saving or a decrease in investment decreases the private sector deficit and decreases the current account deficit  In long run, change in nominal exchange rate leaves the real exchange rate and all other real values unchanged  In long run, nominal exchange rate plays no role in influence current account balance Exchange Rate Policy  Because exchange rate is price of a country’s money in terms of another country’s money, governments and central banks must have a policy towards the exchange rate  Three possible exchange rate policies o Flexible exchange rate o Fixed exchange rate o Crawling peg Flexible Exchange Rate  Flexible exchange rate policy – one that permits exchange rate to be determined by demand and supply with no direct intervention in foreign exchange market by the central bank  Most countries operate a flexible exchange rate  But even flexible exchange rate is influence by central banks actions  If bank of Canada raises Canadian interest rate and other countries keep their interest rates unchanged demand for Canadian dollar increases supply decreases and exchange rate rises  In flexible exchange regime when central bank changes interest rate, its purpose is not to influence the exchange rate but to achieve some other monetary policy objective Fixed Exchange Rate  Fixed exchange rate policy – on that pegs the exchange rate at a value decided by government or central bank and that blocks unregulated forces of demand and supply by direct intervention in foreign exchange market  Fixed exchange rate requires active intervention in foreign exchange market  If bank of Canada wanted to fix Canadian dollar exchange rate against US dollar it would sell Canadian dollars to prevent exchange rate form rising above the target value and buy Canadian dollars to prevent the exchange rate from falling below the target value  There is no limit toe the quantity of Canadian dollars the bank of Canada can sell  Bank of Canada creates Canadian dollars and can create any quantity it chooses  There is a limit to the quantity bank of Canada can buy  That limit is set by Canadian official foreign currency reserves because to buy Canadian dollars the bank of Canada must sell foreign currency  Intervention to buy Canadian dollars stops when Canadian official foreign currency reserves run out  Suppose bank of Canada wants exchange rate to be steady at () US cents per Canadian dollar  If exchange rate falls below this the bank of Canada buys dollar  By these actions the bank of Canada keeps the exchange rate close to its target  When demand for Canadian dollars increases demand curve shifts rightward the bank of Canada sells $10 billion  This action prevents the exchange rate from falling  If demand for Canadian dollar fluctuates the bank of Canada can repeatedly intervene  Sometimes it buys and sometimes it sells, but on average it neither buys not sells  Suppose demand for Canadian dollars increases permanently  To maintain exchange rate the bank of Canada must sell dollars and buy foreign currency so Canadian official foreign currency reserves would be increasing  At some point bank would abandon the exchange rate target to stop piling up foreign currency reserves  Suppose demand for Canadian dollars decreases permanently  Bank of Canada cannot maintain exchange rate target indefinitely  It must buy Canadian dollars using official foreign currency reserves  Eventually bank would run out of foreign currency reserve and have to abandon target exchange rate Crawling Peg  Crawling peg exchange rate policy – one that selects a target for the exchange rate that changes periodically with intervention in the foreign exchange market to receive the target  Crawling peg works like fixed exchange rate expect that target value changes  Sometimes target changes once a month and sometimes every day  Bank of Canada has never operated no crawling peg  Some prominent countries do use this system  Ideal crawling peg sets a target for the exchange rate equal to the equilibrium exchange rate on average  Peg seeks only to prevent large swings in the expected future exchange rate that change demand and supply and make the exchange rate fluctuate too wildly  Crawling peg departs from the ideal if the target rate departs form the equilibrium rate for too long  When this happens country ether runs out of reserves or piles up reserves Chapter 26 Aggregate Supply  Purpose of aggregate supply and aggregate demand model is to explain how real GDP and price level are determined and how they interact  AS-AD model is of an imaginary market for total of all final goods and services that make up real GDP  Quantity in this “market” is real GDP and price is GDP deflator Quantity Supplied and Supply  Quantity of real GDP supplied – total quantity of goods and services valued in constant base year dollars, that firms plan to produce during a given period  Quantity depends on quantity of labour employed, quantity of physical capital and human capital and the state of technology  At a given time, quantity of capital and state of technology are fixed – they depends on decisions that were made in the past  Population is also fixed but quantity of labour is not fixed  depends on decisions made by households and firms about supply of and demand for labour  Labour market can bi in any one of 3 states: o At full employment – the quantity of real GDP supplied is potential GDP which depends on the fill employment quantity of labour o Above full employment o Below full employment  Over the business cycle employment fluctuates around gill employment and the quantity of real GDP supplied fluctuates around potential GDP  Aggregate supply – relationship between the quantity of real GDP supplied and the price level  Relationship is different in long run and short run Long Run Aggregate Supply  Long run aggregate supply – relationship between the quantity of real GDP supplied and the price level when money wage rate changes in step with the price level to achieve full employment  Quantity of real GDP supplied at fill employment equals potential GDP and this quantity is the same regardless of the price level  Long run aggregate supply curve is vertical line at potential GDP  Along long run aggregate supply curve as price level changes, money wage rate also changes so real wage rate is constant and real GDP remains at potential GDP  Long run aggregate supply curve is always vertical and always located at potential GDP  Vertical because potential GDP is independent of price level  reason for independence is that a movement along LAS curve is accompanied by a change in two sets of prices: prices of goods and services (price level) and prices of factors of production – money wage  Because price level and money wage rate change by same percentage the real wage rate remains constant at its full employment equilibrium level so when price level changes and real wage rate remains constant, employment remains constant and real GDP remains constant at potential GDP Short Run Aggregate Supply  Short run aggregate supply – relationship between quantity of real GDP supplied and price level when the money wage rate, the prices of other resources, and potential GDP remain constant  Short run aggregate supply curve slopes upward  With given money wage rate, there is one price level at which the real wage rate is at its full employment equilibrium level  At this price level quantity of real GDP supplied equals potential GDP and SAS curve intersects LAS curve Changes in Aggregate Supply  Aggregate supply changes when an influence on production plans other then the price level changes  Other influence include a change in potential GDP ad the money wage rate and other factor prices Changes in Potential GDP  When potential GDP changes, aggregate supply changes  Increase in potential GDP increases both long run aggregate supply and short run aggregate supply  Diagram sows the effects of increase in potential GDP  If potential GPD increases long run aggregate supply increases and long run aggregate supply curve shifts rightwards\  Short run aggregate supply also increases, and the short run aggregate supply curve shifts rightward  The two supply curves shift by the same amount only if the full employment price level remains constant which we will assume to be the case  Potential GDP can increase for any of 3 reasons o An increases in the full employment quantity of labour o An increase in the quantity of capital o An advance in technology An Increase in the Full Employment Quantity of Labour  The larger the quantity of labour employed, the greater is real GDP  Over time, potential GDP increases because the labour force increases  But with constant capital and technology, potential GDP increases only if the fill employment quantity of labour increases  Fluctuations in employment over the business cycle bring fluctuations in real GDP  These changes in real GDP are fluctuations around potential GDP  not changes in potential GDP and long run aggregate supply An Increase in the Quantity of Capital  Capital includes human capital  For economy as a whole, the larger the quantity of human capital – skills that people have acquired in school and through on the job training – the greater is potential GDP An Advance in Technology  Technological advances are by far the most important source of increased production over the past two centuries Changes in the Money Wage Rate and Other Factor Prices  When money wage rate (or money price of any other factor of production such as oil) changes, short run aggregate supply changes but long aggregate supply does not change  Diagram shows the effect of an increase in money wage rate  Rise in money wage rate decreases short run aggregate supply and shifts the short run aggregate supply curve leftward  Rise in money wage rate decreases short run aggregate supply because in increases firms’ costs  With increases costs, quantity that firms are willing to supply at each price level decreases, which is shown by leftward shirt f SAS curve  Change in money wage rate does not change long run aggregate supply because on LAS curve, change in money wage rate is accompanied by equal percentage change in price level  With no change in relative prices, firms have no incentive to change production and real GPD remains constant at potential GDP  With no change in potential GDP, long run aggregate supply curve LAS does NOT shift What Makes the Money Wage Rate Change?  Money wage rate can change for 2 reasons o Departure from full employment and o Expectation about inflation  Unemployment above natural rate pts downward pressure on money wage rate and unemployment below the natural rate puts upward pressure on it  Expected rise in inflation rate makes money wage rate rise faster and expected fall in inflation rate slows the rate at which the money wage rate rises Aggregate Demand  Quantity of real GDP demanded (Y) is sum of real consumption expenditure (C), investment (I), government expenditure (G), and exports (X) minus imports (M) Y = G + I + C + (X – M)  Quantity of real GDP demanded – total amount of final goods and services produced in Canada that people, businesses, government, and foreigners plan to buy  These buying plans depend on many factors  Some main ones are o Price level o Expectations o Fiscal policy and monetary policy o The world economy The Aggregate Demand Curve  The higher the price level, the smaller is the quantity of real GDP demanded  Relationship between the quantity if real GDP demanded and the price level is called aggregate demand  Aggregate demand is descried by aggregate demand schedule and aggregate demand curve  Diagram shows aggregate demand curve each  Aggregate demand curve sloped downward for two reasons o Wealth effect o Substitution effect Wealth Effect  When price level rises but other things remain the same, real wealth decreases  Real wealth – amount of money in the bank, bonds, stocks and other assets that people own, measure not in dollar but in terms of goods and services the money, bonds, and stock will buy  People save and hold money, bonds and stock for many reasons  One is to build funds for education expenses, another is to build enough funds to meet possible medical expenses or other big bills  Biggest reason – to build up enough funds to provide retirement income  If price level rises, real wealth decreases  People then try to restore wealth and to do this they mist increase saving and equivalently decreases current consumption  Such a decrease in consumption is a decrease in aggregate demand Substitution Effect  When price level rises and other things remains the same, and interest rates rise  Reason is related to wealth effect  Rise in price level decreases the real value of the money in people’s pockets and bank accounts  With smaller amount of real money around, banks can get a higher interest rate on loans  But faced with a higher interest rate, people and businesses delay plans to buy new capital and consumer durable goods and cut back on spending  Substitution effect involves substituting goods in the future for goods in the present and is called an intertemporal substitution effect – substitution across time  Saving increase to increase future consumption  Second substitution effect works through international prices  When Canadian price level rises and other things remain the same
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