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Chapter 26 - Aggregate demand and supply.docx

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Department
Economics
Course Code
ECON 1010
Professor
Steven Edwards

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Chapter Twenty Six – Aggregate supply and demand Intro What determines the uneven pace at which production grows and prices rise—the business cycle—and the uneven pace of economic growth and inflation? This chapter explains the aggregate supply– aggregate demand model or AS-AD model. The model provides a framework for understanding the forces that make our economy expand, that bring inflation, and that cause business cycle fluctuations. The AS-AD model also provides a framework within which we can see the range of views of macroeconomists in different schools of thought. Aggregate supply The purpose of the ASAD model is to explain how real GDP and the price level are determined and how they interact. ASAD model is a model of imaginary market for the total of all the final goods and services that make up real GDP. The quantity in this market is real GDP and the price is the price level measured by GDP deflator. One thing ASAD shares with the competitive market model is that both distinguish between supply and the quantity supplied. What do we mean by quantity of GDP supplied? The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period. Aggregate supply is the relationship between the quantity of real GDP supplied and the price level. We distinguish two time frames associated with different states of the labour market: Long-run aggregate supply and short-run aggregate supply. Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. Potential GDP is independent of the price level. So the long- run aggregate supply curve (LAS) is vertical at potential GDP. 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. A rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied. The short-run aggregate supply curve (SAS) is upward sloping. In the long run, the quantity of real GDP supplied is potential GDP. As the price level rises and the money wage rate change by the same percentage, the quantity of real GDP supplied remains at potential GDP. In the short run, the quantity of real GDP supplied increases if the price level rises. The SAS curve slopes upward. A rise in the price level with no change in the money wage rate induces firms to increase production. With a given money wage rate, the SAS curve cuts the LAS curve at potential GDP. The price level is 110. With the given money wage rate, as the price level falls below 110 the quantity of real GDP supplied decreases along the SAS curve. With the given money wage rate, as the price level rises above 110 the quantity of real GDP supplied increases along the SAS curve. Real GDP exceeds potential GDP. Changes in aggregate supply can occur for several reasons: Aggregate supply changes if an influence on production plans other than the price level changes. These influences include changes in potential GDP and changes in money wage rate (and other factor prices). Changes in potential GDP - When potential GDP increases, both the LAS and SAS curves shift rightward. Potential GDP increases if: The full-employment quantity of labour increases OR the quantity of capital (physical or human) increases OR there is an advance in technology occurs. The LAS curve shifts rightward and the SAS curve shifts along with the LAS curve. Changes in money wage rate – The diagram above shows the effect of a rise in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward. Long-run aggregate supply does not change. Aggregate demand The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy. This quantity is the sum of consumption expenditures, C, investment, I, government expenditure, G, and net exports, X – M. That is, Y = C + I + G + X – M. Buying plans depend on many factors and some of the main ones are: The price level, expectations, fiscal/monetary policy and the world economy. Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price level. The AD curve slopes downward for two reasons: Wealth effect and substitution effect. Wealth effect - A rise in the price level, other things remaining the same, decreases the quantity of real wealth (money, stocks, etc.). To restore their real wealth, people increase saving and decrease spending. This leads to the quantity of real GDP demanded decreasing (because people spend less). Similarly, a fall in the price level, other things remaining the same, increases the quantity of real wealth and increases the quantity of real GDP demanded. Substitution effect - A rise in the price level, other things remaining the same, decreases the real value of money and raises the interest rate. When the interest rate rises, people borrow and spend less (save more), so the quantity of real GDP demanded decreases (because people buy less). Similarly, a fall in the price level increases the real value of money and lowers the interest rate. When the interest rate falls, people borrow and spend more, so the quantity of real GDP demanded increases. International substitution effect - A rise in the price level, other things remaining the same, increases the price of domestic goods relative to foreign goods. So imports increase and exports decrease, which decreases the quantity of real GDP demanded. Similarly, a fall in the price level, other things remaining the same, increases the quantity of real GDP demanded. Changes in aggregate demand can occur for several reasons: A change in any influence on buying plans other than the price level changes aggregate demand. The main influences on aggregate demand are: Expectations, fiscal/monetary policy and 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 inf
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