Chapter 5 – Aggregate Demand and Supply

Potential GDP/LAS (long-run aggregate supply line) 

The total amount that an economy is capable of producing when all of its resources are fully utilized as represented by a vertical long-run aggregate supply line. Not dependent on price levels.

Sources of Long-Term Economic Growth  

• Quantity and quality of labour resources (level of human capital available) 

• Amount of physical capital available 

• Rate of technological change  

• Amount and quality of natural resources 

Economic Growth and Potential GDP 

• A positive change in any of the determinants of economic growth will result in a rightward shift of the potential GDP curve, referred to as Economic Growth  

• On average Canada has been 2% growth of potential GDP per year 

Aggregate Supply (AS) 

Total quantity of goods and services produced by all sellers at various price levels, assuming the prices of factors of production remain constant. Affected by change in price levels and overall production costs.

Real Wage

Amount of goods and services that an employee can but for a given amount of nominal wage 

Nominal Wage

The present day value of a current wage

Aggregate Supply (AS) and Wages 

As price rise, real wages decline 

• Producers real wages cost of declining, resulting in higher profits 

• Causes an increase in aggregate quantity supplies 

Aggregate Demand (AD) 

The total quantity of final goods and services that consumers, businesses, government, and those living outside the country would buy at various price levels 

The AD curve is downward sloping due to: 

• Real Balances Effect  

  • Higher prices results in lower real wealth, lowering consumption C 

• Interest Rate Effect 

  • Higher prices causes higher interest rates, lowering investments I 

• Foreign-trade Effect 

  • Higher prices make Canadian exports less attractive, lowing net exports Xn 

  • Weak Canadian dollar is attractive to other country's due to the exchange rate making it cheaper for foreign buyers  

Macroeconomic Equilibrium  

AD=AS.

• At a price above equilibrium  

  • A surplus will cause producers to drop prices  

• At a price below equilibrium  

  • A shortage will cause buyers to bid up the price  

Equilibrium in the macroeconomy might occur: 

Full employment

Equilibrium in the macroeconomy might occur below:

below full employment. Output level is below potential GDP. Capable of producing more if this occurs for two consecutive quarters it is a recession.

Equilibrium in the macroeconomy might occur above:

above full employment. Output level is greater than potential GDP. Producing at a greater output that is causing inflation. LAS is max output, to operate above it demand is higher than supply, there is an ability to operate at a higher capacity but not sustainable 

Determinates of AD 

• Changes in Consumption  

  • Individual consumer wealth, age of consumer durable, consumer confidence 

• Changes in Investment 

  • Changes in interest rates, change in purchase price, age of capital goods and amount of spare capacity, business expectations, government regulation  

• Changes in Net Exports  

  • Value of exchange rate, income levels abroad, price of foreign competitive goods, tastes of foreigners  

• Changes in Government Spending, Tax Rates and the money supply 

Shifts in the AD curve

• Change in an determinates of AD means that at any given price level buyers would be willing to buy more or less goods and services then before  

• Any change in C or I or G or Xn will cause AD to shift right or left  

Determinants of Aggregate Supply 

Economic growth is due to: 

• A change in human capital 

• A change in the amount of capital 

• Technological change 

• Natural resource change 

What effect will the following changes have on aggregate supply and on the potential GDP (LAS).

1. An increase in the price of imported crude oil?

2. An increase in immigrants entering Canada?

3. Discovery of oil deposits in Canada?

4. Increase in wage settlements?

5. Increased technology efficiency?

1. Decrease AS

2. Increase AS and LAS

3. Increase AS and LAS

4. Decrease AS

5. Increase AS and LAS

A change in the AD – The Multiplier  

• When spending independently changes, total income changes more, as some of the income is spent again  

• One person's spending becomes another person's income 

• An increase in AD will increase both real GDP and price level 

Increase in AS 

A decrease in the price factor of production will shift the AS curve right resulting in an increase in GDP but a fall in price level  

Increasing AS determinants

• Wages decreasing, no effect of LAS 

• Factor prices decreasing, no effect of LAS 

• Quantity and quality of human capital increasing, increasing LAS 

• Quantity and quality of physical capital increasing, increasing LAS 

• Technology increasing, increasing LAS 

• Natural resources increasing, increasing LAS 

Decreasing AS determinants  

• Wages increasing, no effect of LAS 

• Factor prices increasing, no effect of LAS 

• Quantity and quality of human capital decreasing, decreasing LAS 

• Quantity and quality of physical capital decreasing, decreasing LAS 

• Technology decreasing, decreasing LAS 

• Natural resources decreasing, decreasing LAS  

Causes of Inflation

Inflation can be caused by an increase in AD (demand-pull) or by a decrease in AS (cost-push) 

Cause of Recessions 

A decrease in AD or by a decrease in AS

Neoclassical assumptions: 

• The market is competitive an efficient 

• Prices and wages adjust rapidly to a surplus or shortage 

• Economy always remains at full employment 

• Always operating at full potential, the only change is that prices adjust quickly to changes in demand  

• Output is fixed, moving the price up or down. Very simplistic  

The Modern View

• The impact of an increase in AS depends on the condition of the economy  

• In big recessions, there is a big effect on GDP 

• At close to potential GDP, the effect will be more inflationary  

• In a recession, the economy acts Keynesian  

• Close to potential GDP, the economy acts Neoclassical 

Keynesian assumptions 

• The more is not very competitive due to the market power of big corporations and unions 

• Prices and wages are sticky, adjusting slowly 

• Government intervention is sometimes requited to maintain full employment  

• Economy is underperforming, increased demand does not change price. Increasing demand on a set price level. 

Is the Economy Self-Adjusting? R

Wages fall and AS shifts right until natural full employment is reached. Real GDP is higher, prices are lower 

 

Is the Economy Self-Adjusting? I

Wages rise and AS shifts left until eventually natural full employment is reached. Real GDP is lower, prices are higher 

Increase in investment spending will result in:

increased aggregate demand

Decrease in imports will result in:

increased aggregate demand

Increase in factor prices will result in:

Decreased aggregate supply as production costs rise, leading to reduced output.

Decrease in productivity will result in:

Decreased aggregate supply and potential GDP

Decrease in factor prices will result in:

Increase aggregate supply

Increase in human capital will result in:

Increased aggregate supply and potential GDP

Real GDP increases, and the price level increases. This could have occurred with a(n)

Increase in aggregate demand.

Real GDP decreases, and the price level increases. This could have occurred with a(n)

Decrease in aggregate supply

Real GDP increases, and the price level decreases. This could have occurred with a(n)

Increase in aggregate supply

Real GDP decreases, and the price level decreases. This could have occurred with a(n)

Decrease in aggregate demand

Interest rates impact:

Aggregate demand

Technology imporvemnts’s or decline impacts:

Aggregate supply

Increase or decrease in exchange rates impacts:

Aggregate demand

Increase or decrease in government spending will impact:

Aggregate demand

Increase or decrease money supply

Aggregate demand

Increase and decrease nominal wages

Aggregate supply

An appreciation of the Canadian exchange rate will ______ imports and ______ exports.

increase; decrease

If there is an injection of $5 million dollars what will be the ultimate effect on the economy?

It will increase by more than $5 million because of the multiplier. This multiplier effect occurs as the initial injection leads to increased consumption and investment, further boosting aggregate demand.

According to the modern view, at high levels of real GDP an increase in aggregate demand will have a relatively ______ effect on prices and a relatively ______ effect on real GDP.

large; small