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Chapter 26

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ECON 1010
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Aggregate Supply and Aggregate Demand Aggregate Supply • AS-AD model explain how real GDP and the price level are determined and how they interact • Model of an imaginary market for the total of all final goods and services that make up real GDP • The quantity of this “market” is real GDP and the price is the price level measured by the GDP deflator • AS-AD model and competitive market model both distinguish between supply and quantity supplied Quantity Supplied and Supply • Quantity of real GDP supplied: total quantity of goods and services, valued in constant base year (2002) dollars, that firms plan to produce during a given period • Quantity depends on; quantity of labour employed, quantity of physical and human capital, and the state of technology • Quantity of capital and state of technology are fixed- they depend on decisions made in the past • Population is also fixed • Quantity of labour is NOT fixed- depends on decisions made by households and firms about supply of and demand for labour • Labour market in any one of three states: full employment, above full employment, or below full employment • At full employment: quantity of real GDP supplied is potential GDP- depends on full employment quantity of labour • Over business cycle, employment fluctuates around full employment and the quantity of real GDP supplied fluctuates around potential GDP • Aggregate supply: the relationship between the quantity of real GDP supplied and the price level • Two time frames of aggregate supply: Long-run aggregate supply Short-run aggregate supply Long-RunAggregate Supply • 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 achieve full employment • Quantity of real GDP supplied at full employment is potential GDP and this quantity is the same regardless of the price level • The long run aggregate supply curve is always vertical and located at potential GDP • Along the long run aggregate supply curve, as the price level changes, the money wage rate also changes so the real wage rate is constant and real GDP remains at potential GDP • LRASC (long run aggregate supply curve) is vertical because potential GDP is independent of the price level • Independent because two sets in prices changes along the curve: the price of goods and services-the price level- and the prices of the factors of production (notably the money wage rate) • Because price level and money wage rate have a direct relationship (change by the same percentage) the real wage rate remains constant at its full employment equilibrium level • Price level changes, real wage rate remains constant, employment remains constant, and real GDP remains constant at potential GDP Short-Run Aggregate Supply • Short run aggregate supply: 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 • In the short run, a rise in the price level brings an increase in the quantity of real GDP supplied-the short run aggregate supply curve slopes upward • With a given money wage rate, there is one price level at which the real wage rate is at its full employment equilibrium • At this price level the quantity of real GDP supplied= potential GDP and the SAS curve intersects the LAS curve • When all prices rise, the price level rises • If price level rises and money wage rate and other factor prices remain constant, all firms increase production and the quantity of real GDP supplied increases • Afall in the price level has the opposite effect and decreases the quantity of real GDP supplied Changes inAggregate Supply • Aggregate supply changes when an influence on production plans other than the price level changes • Other influences include: change in potential GDP and money wage rate, and other factor prices Changes in Potential GDP • When potential GDP changes, aggregate supply changes • Increase in potential GDP also increases both short run aggregate supply and long run aggregate supply • The two supply curves shift by the same amount only if the full employment price level remains constant • Potential GDP can increase for any of three reasons: An increase in the full employment quantity of labour -The larger the quantity of labour employed the greater real GDP -Over time, potential GDP increases because the labour force increases. But, with constant capital and technology, potential GDP increases only if the full employment quantity of labour increases -fluctuations in employment over the business cycle bring fluctuations in real GDP (which are fluctuations around potential GDP). They are NOT changes in potential GDP and LAS. An increase in the quantity of capital - For the economy, the larger the quantity of capital, the more productive is the labour force and the greater is its potential GDP - Capital includes human capital - The larger the quantity of human capital- the skills that people have acquired in school and through on the job training-the greater potential GDP An advance in technology - Technological change enables firms to produce more from any given amount of factors of production. - Even with fixed quantities of labour and capital, imporvements in technology increase potential GDP Changes in the Money Wage Rate and Other Factor Prices • When the money wage rate (or the money price of any other factor of production such as oil) changes, short run aggregate supply changes but long run aggregate supply does not change • Arise in the money wage rate decreases short run aggregate supply and shifts the short run aggregate supply leftward • Arise in the money wage rate decreases SAS because it increases firms costs. With increased costs, the quantity that firms are willing to supply at each price level decreases (shown by leftward shift) What makes the money wage rate change • Two possibilities: departures from full employment or expectations about inflation • Unemployment above the natural rate puts downward pressure on the money wage rate, and unemployment below the natural rate puts upward pressure on it • An expected rise in inflation rate makes the money wage rate rise faster, and an expected fall in inflation rate slows the rate at which the money wage rate rises Aggregate Demand • Y = C + I + X – M • The quantity of real GDP demanded is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy • Buying plans demand on many factors including: the price level, expectations, fiscal policy and monetary policy, the world economy TheAggregate Demand Curve • With other things remaining the same, the higher the price level, the smaller the quantity of real GDP demanded • Aggregate demand: the relationship between quantity of real GDP demanded and the price level • Aggregate demand is described by anAD schedule andAD curve • TheAD curve slopes downward for two reasons : Wealth Effect - when the price level rises but other things remain the same, real wealth decreases - people save, hold money, bonds, and stocks for many reasons - one reason is to build up funds for education expenses, or medical bills, etc - the biggest reason is to build up retirement income - if the price level rises, real wealth decreases, people then try to restore their wealth. To do so they must increase saving and decrease current consumption - such a decrease in consumption is a decrease inAD Substitution Effects - when the price level rises and other things remain the same, interest rates rise - a rise in the price level decreases the real value of the money in people pockets and bank accounts - with a smaller amount of real money around, banks can get higher interest rates on loans - increase interest rate decreases consumer spending and people delay business plans to buy new capital - the substitution effect involves substituting goods in the future for goods in the present and is called an intertemporal substitution effect- a substitution across time - saving increases to increase future consumption - when the Canadian price level rises, Canadian made goods and services become more expensive relative to foreign goods and services - Encourages people to spend less on Canadian goods and services and more on foreign - Canadian GDP decreases Changes in the Quantity of Real GDP demanded • When the price level rises and other things remain the same, the quantity of real GDP demanded decreases (movement up alongAD curve) • When the price level falls and other things remain the same, the quantity of real GDP demanded increases (movement down along theAD curve) Changes inAggregate Demand • Achange in any factor that influences buying plans other than price level brings a change in aggregate demand • The main factors are Expectations - An increase in expected future income increases the amount of consumption goods (big ticket items, cars etc) that people plan to buy and increases aggregate demand - An increase in the expected future inflation rate increasesAD today because people decide to buy more goods and services at todays relatively lower prices - An increase in expected future profits increases the investment that firms plan to undertake today and increases AD Fiscal policy and monetary policy - Governments attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy - Atax cut or an increase in transfer payments (eg. welfare payments, unemployment benefits etc) increaseAD - Both of these operate by increasing households’disposable income - Disposable income = aggregate income – taxes + transfer payments - Greater disposable income, the greater the quantity of consumption goods and services the household plans to buy and the greaterAD - Government spending on hospitals, schools, highways etc also increases AD since this is also included in government expenditure - Monetary policy consists of changes in the interest rate and in the quantity of money in the economy - The quantity of money is determined by the Bank of Canada and the banks - An increase in the quantity of money in the economy increases AD The world economy • Two influences that the world economy has onAD are: The exchange rate - Exchange rate: the amount of a foreign currency that you can buy with a Canadian dollar - With other things remaining the same, a rise in the exchange rate decreases AD Foreign income - An increase in foreign income increases Canadian exports and increases Canadian AD Shifts of theAggregate Demand Curve • When aggregate demand changes, theAD curve shifts • AD increases and theAD curve shifts rightward when expected future income, inflation, or profit increases; government expenditure on goods and services increases; taxes are cut; transfer payments increase; the q
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