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Chapter 26

Economics 1022 Chapter 26 notes

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Economics 1022A/B
Jeannie Gillmore

Chapter 26 Aggregate supply  Quantity of real GDP supplied: Total quantity of goods and services, valued at constant base year dollars, that firms plan to produce during a given time period o Depends on the quantity of labour employed, quantity of physical and human capital, and state of technology o Quantity of capital and the state of technology are fixed, because they depend on past decisions. o Population is fixed, but the quantity is labour is not, because it depends on household and firms’ choices. o Labour market can be in:  Full employment (quantity of GDP supplied = potential GDP)  Below full employment  Above full employment  Aggregate supply: Relationship between the quantity of real GDP supplied and the price level.  Long-run aggregate supply: Relationship between the quantity of real GDP supplied and the price level when the money wage rate changes in step with the price level to maintain full employment. o Quantity of real GDP supplied at full employment = potential GDP o As price level (price of goods and services) changes, so does the money wage rate (prices of factors of production) by the same percentage change. o This causes real wage rate to be unchanged at full employment equilibrium level. o For this reason, the long run aggregate supply curve is vertical.  Short-run aggregate supply: Relationship between the quantity of real GDP supplied and the price level when the money wage rate, price of other resources, and potential GDP remain constant. o Each point on the short-run aggregate supply curve corresponds to that of short run aggregate supply schedule. o A rise in the price level brings an increase in the quantity of real GDP supplied, and causes the short run aggregate supply curve to shift upwards. o At a certain given real wage rate and price level, quantity of real GDP supplied equals potential GDP, and the SAS curve intersects the LAS curve.  Change in aggregate supply: o Change in price level changes the quantity of real GDP supplied, which causes a movement along the short run aggregate supply curve, but does not affect aggregate supply. o Change in potential GDP  Increase in potential GDP increase long-run and short-run aggregate supply.  Potential GDP can increase due to:  Increase in the full-employment quantity of labour  Increase in the quantity of capital  Advance in technology o Change in money wage rate  When the money wage rate (or the money price of other factors of productions) changes, short-run aggregate supply changes but long-run aggregate supply does not.  A rise in the money wage rate decreases short-run aggregate supply and shifts its curve leftward.  With increased costs, quantity that firms are willing to supply at each price decrease.  Long run aggregate supply does not change because the change in money wage rate is accompanied by an equal percentage change in the price level. With no relative price change, firms have no incentive to change production, and real GDP stays constant at potential GDP.  Money wage rate can change due to:  Departures from full employment (unemployment above the natural rate puts downward pressure on the money wage rate)  Expectations about inflation Aggregate Demand  Quantity of real GDP demanded (Y = C + I + G + NX): o Sum of real consumption expenditure, investment, government expenditure, and exports – imports o Total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy. Such buying plans depend on  Price level  Expectations  Fiscal and monetary policy  World economy  Aggregate demand: Relationship between the quantity of real GDP demanded and the price level o Other things remaining the same, higher the price level, smaller the quantity of real GDP  Aggregate demand curve (AD): o Each point on the AD curve corresponds to a row of schedules o Slops downward due to:  Wealth effect:  Real wealth: Amount of money in the banks, bonds, stocks, and other assets people own, measured in terms of goods and services that it will buy  When price level rises but other things remain the same, real wealth decreases.  People save wealth for educational, renovation, retirement expenses. When price level rises, people try to restore their wealth by increasing savings and decreasing current consumption.  Substitution effect:  When price level rises and other things remain the same, interest rate rises because it decreases the real value of money in peoples’ pockets and bank accounts.  Because smaller amounts of money are around, interest rate rises.  Saving increases to increase future consumption (intertemporal substitution effect)  International relative prices change to encourage people to spend less on Canadian goods and more on foreign items.  When the price level rises and other things remain the same, the quantity of real GDP demanded decrease, causing a movement up along the AD curve (vice versa).  Changes in aggregate demand: o Expectations  Increase in expected future income increases the amount of consumption goods that people plan to buy today, a
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