Chapter 10: Aggregate Demand and Supply

Canada’s economy has been growing since the…

Industrial revolution

What average rate has Canada been growing for 100 yrs?

2%

What does long term economic growth measure?

Real GDP over time

Economic changes can be split into 2:

1. Long term GROWTH

2. Short term FLUCTUATIONS

What are economic fluctuations?

Recurring expansions and contractions in real GDP in the long term.

Fluctuations occur due to…

Changes in business conditions

Fluctuations are also known as…

Business cycles

What are the phases of the business cycle?

1. Recession

2. Trough

3. Expansion/recovery

4. Peak

How to measure business cycles?

• Peak to peak

• Trough to trough

Peak and trough are…

Turning points

Characteristics of business cycles

• Unpredictable/irregular

• Macroeconomic variables move together w/ real GDP

What do we want to focus on regarding change?

1. Direction of the change

2. Timing of the change

DIRECTIONS of change:

1. Procyclical

2. Countercyclical

3. Acyclical

Procyclical variable

High in recovery

Countercyclical variable

High in recession

Acyclical variable

Doesn’t change with business cycles

TIMING of change:

1. Leading

2. Lagging

3. Coincidence

Leading variable

Peak and trough happen before real GDP

Lagging variable

Peak and trough happen after real GDP

Coincidence variable

Neither!

What are the business cycle models?

• Aggregate demand

• Aggregate supply

What are the variables in the aggregate supply model?

• Qs (quantity supplied of real GDP)

• P (price level: CPI or GDP deflator)

What are the 2 kinds of aggregate supply?

1. LRAS (long run aggregate supply)

2. SRAS (short run aggregate supply)

LRAS is…

• Always vertical

• Real GDP = potential GDP

SRAS is…

• Positive relationship between Q and P

• When everything else is constant (only P changes)

Equilibrium when…

• LRAS = SRAS

• Potential GDP = Actual GDP

What causes a movement ALONG the supply curve?

Change in Qs (change in P)

What causes a SHIFT of the supply curve?

Change in supply factors

What are the supply factors?

• Potential GDP (LRAS, SRAS)

• Wage rate (SRAS)

Aggregate DEMAND is…

Negative relationship between Quantity of real GDP demanded (Qd) and Price (P)

As price goes up, demand goes…

down

As price goes up, supply goes…

up

2 ways to represent agg. demand

1. Schedule

2. Curve

Demand components

1. Consumption (C)

2. Investment (I)

3. Government expenditure (G)

4. Net exports (NX) = X - M

Aggregate demand formula?

Y = C + I + G + NX

2 reasons why AD is a negative relationship

1. Wealth effect

2. Substitution effects

What’s the wealth effect?

When P goes up, W goes down, so consumption (C) goes down —> Qd decreases

2 kinds of substitution effect:

1. Intertemporal

2. International

What’s the intertemporal substitution effect?

• Change over TIME.

• As P goes up, interest rates go up, Investment (I) goes down —> Qd decreases

What’s the international substitution effect?

• P goes up, real exchange rate goes up

• X goes down, M goes up, (NX) goes down —> Qd decreases

Price level going up or down causes a ____ the curve

Movement along

Factors that shift aggregate demand

• Expectations (future income, profit, price level)

• Fiscal policy

• World economy

How does fiscal policy shift aggregate demand?

1. Expansionary policy

• G goes up or T goes down

• AD goes UP

1. Contractionary policy

• G goes down or T goes up

• AD goes DOWN

How does the world economy shift aggregate demand?

1. Nominal exchange rate

• E goes up, NX goes down —> AD goes DOWN

2. Foreign income

• Y goes up, AD goes UP

• Y goes down, AD goes DOWN

Equilibrium occurs when…

AD = AS!

Short run equilibrium

SRAS = AD

Long run equilibrium

• LRAS = AD = AS

• Real GDP = potential GDP

LRAS is ____ on a graph

vertical

2 output gaps occur during business cycles:

1. Recessionary

2. Inflationary

Recessionary gap happens when…

Y < potential GDP

Inflationary gap happens when…

Y > potential GDP

Economic growth happens when _____ increases

LRAS

What is the adjustment process?

• When AD increases, SRAS moves back

• When AD decreases, SRAS moves forward

(To maintain equilibrium with LRAS)

In the long run, should we let the economy run its course (adjust natural)?

No way! We need government intervention to keep things in control