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Chapter 14

ECO1102 Chapter 14: Aggregate Demand and Aggregate Supply

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University of Ottawa
David Gray

ECO 1102 ― Chapter 14: Aggregate Demand and Aggregate Supply Three Key Facts About Economic Fluctuations Fact 1: Economic Fluctuations are Irregular and Unpredictable ● Business Cycle → Fluctuations in the economy ○ Economic fluctuations correspond to changes in business conditions ■ When GDP grows rapidly, business is goods, vice-versa Fact 2: Most Macroeconomic Quantities Fluctuate Together ● For monitoring short-run fluctuations, it doesn’t matter which measure of economic activity you choose because their fluctuations will be very similar ○ Ex) When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on ● Macroeconomic variables fluctuate together, but by different amounts Fact 3: As Output Falls, Unemployment Rises ● When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed ● Unemployment rate never reaches zero, it fluctuates around the natural rate Explaining Short-Run Economic Fluctuations ✓ Describing the patterns that economies experience as they fluctuate over time is easy ✓ Explaining what causes these fluctuations is more difficult The Assumption of Classical Economists ● Classical Dichotomy → Separation of variables into real variables and nominal variables ○ Changes in the money supply affect nominal variables, not real variables ● Monetary Neutrality→ Examines determinants of real variables without introducing nominal variables ECO 1102 ― Chapter 14: Aggregate Demand and Aggregate Supply ○ Real Variables: Real GDP, Real Interest Rate, and Unemployment ○ Nominal Variables: Money Supply and Price Level ● Money does not matter in a classical economic world, in a sense ○ Ex) We don’t care if prices double because that’s a nominal change. As long as our real variables like employment and our ability to afford things are the same, we’re fine ○ “Money is a veil” → We gotta look under the veil to see what’s actually happening The Reality of Short-Run Fluctuations ● Most economists believe that classical theory describes the world in the long run, but not in the short run ● We need a new model that abandons the classical dichotomy and the neutrality of money ● Our new model focuses on how real and nominal variables interact The Model of Aggregate Demand and Aggregate Supply ● Our model of short-run economic fluctuations focuses on the behaviour of two variables ○ The first variable is the economy’s output of goods and services, as measured by real GDP ○ The second variable is the overall price level, as measured by the CPI or the GDP deflator ■ The first is a real variable, while the second is a nominal variable ■ By focusing on the relationship between these two variables, we are departing from the classical assumption that real and nominal variables can be studied separately ● We analyze fluctuations in the economy as a whole with the model of aggregate demand and aggregate supply: ● Y, overall price level in the economy ● X, overall quantity of G&S ● The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level ● The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level The Aggregate-Demand Curve Why the Aggregate-Demand Curve Slopes Downwards ● Recall: The GDP Equation → Y=C+I+G+NX ECO 1102 ― Chapter 14: Aggregate Demand and Aggregate Supply ● Each of these four components contributes to the aggregate demand for goods and services. For now, we assume that government spending is fixed by policy. The other three components of spending—consumption, investment, and net exports—depend on economic conditions and, in particular, on the price level ● To understand the downward slope of the aggregate-demand curve, therefore, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exp The Price-Level and Consumption: The Wealth Effect ● Nominal Value of a dollar is fixed, the real value is not ● When price levels fall, a dollar rises in value ● A decrease in price levels makes a consumer wealthier and encourages them to spend ● A decrease in the price level makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded, vice-versa ○ Explains why slope is negative The Price-Level and Investment: The Interest Rate Effect ● When the price level falls, therefore, households try to reduce their holdings of money by lending some of it out ● Interest rates are driven down because households are purchasing assets ○ A lower interest rate makes borrowing less expensive ■ Encourages firms to borrow more to invest in new plants and equipment ■ Encourages households to borrow more to invest in new housing ● A lower interest rate increases the quantity of goods and services demanded ● A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded, vice-versa ○ Explains why slope is negative The Price-Level and Net Exports: The Real-Exchange Rate Effect ● The real exchange rate measures the rate at which a person can trade Canadian-produced goods and services for the goods and services of other countries ● For a given nominal exchange
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