Chapter 0

MACROECONOMICS REVIEW

For Money & Banking
Dr. Amar Anwar
Slides Source: Mankiw et al. 2013

Change & Shift in Demand

Shift in the Demand Curve

Causes of Demand Curve Shifts

• A shift in the demand curve can be caused by various factors that affect the demand relationship:

  • The Prices of Related Goods

  • Consumer Incomes

  • Tastes and Networks

  • Price Expectations

  • Number of Buyers

Shift in the Demand Curve

Example of Demand Curve Shift

• Graphical representation shows shifts in demand curves, such as D₁, D₂, and D₃, reflecting increases and decreases in demand for ice-cream cones as price varies.

Prices of Related Goods

Complementary Goods

• Goods that are consumed together.

  • Example: If the price of electronic readers increases, the demand for electronic books decreases.

Substitute Goods

• Goods that are consumed in lieu of each other.

  • Example: If the price of electronic books increases, demand for paper books increases; similarly, the price increase for iPhones may increase the demand for Android phones.

Effects of Consumer Incomes

Luxury Goods

• As consumer incomes rise, demand for luxurious goods increases.

  • Example: Luxury vehicles like BMW and Mercedes.

Normal Goods

• As incomes rise, demand for normal goods increases.

  • Most goods fall into this category:

  • Examples: Restaurants, concerts, clothing.

Inferior Goods

• As incomes rise, demand for inferior goods decreases.

• Inferior goods are not necessarily of low quality:

  • Examples: Laundromats and public transit.

Tastes and Fashions

• Demand expands when goods or services become more popular.

  • Examples include trends in technology or fashion.

Price Expectations

• If people expect prices to rise in the future, current demand will expand.

  • Example: Anticipating a rise in gold prices may lead consumers to buy gold today.

Number of Buyers

• An increase in the number of buyers leads to an increase in demand.

  • Example: If 10,000 new immigrants arrive in a region, the demand for tea/coffee would increase temporarily.

Shifts Vs. Change in Demand

• A shift in the demand curve occurs due to changes in:

  • Prices of related goods

  • Consumer incomes

  • Consumer preferences

  • Price expectations

  • Number of buyers

• A change in price results in a movement along the demand curve.

  • Note: External factors such as weather or pandemics can also affect demand.

Change & Shift in Supply

Shift in the Supply Curve

Factors Influencing Supply Shifts

• Effect of Technology

  • Technological improvements expand supply.

• Effect of Input Costs

  • An increase in input costs contracts supply; a decrease expands supply.

• Effect of Number of Suppliers

  • Greater numbers of firms lead to greater supply.

• Effect of Future Price Expectations

  • Higher expected future prices can result in lower current supply.

Supply Curve Movement

Graphical Representation

• Similar to demand, supply curves shift based on input prices, technology, and seller numbers.

Understanding Aggregate Demand (AD) and Aggregate Supply (AS)

Aggregate Demand (AD)

Why the Aggregate-Demand Curve Slopes Downward

• The downward slope is influenced by three primary factors:

  • The Wealth Effect

  • The Interest Rate Effect

  • The Real Exchange Rate Effect

Equation for Aggregate Demand

• The aggregate demand (AD) equation: $Y = C + I + G + NX$

  • Where:

  • Y = Output

  • C = Consumption

  • I = Investment

  • G = Government Spending

  • NX = Net Exports

The Wealth Effect

• If the price level (P) rises:

  • The dollar value people hold buys fewer goods and services (g&s).

  • Result: Real wealth decreases, causing consumption (C) to fall.

The Interest-Rate Effect

• If the price level (P) rises:

  • More dollars are needed to purchase goods and services.

  • People sell bonds/assets to obtain sufficient dollars, leading to increased interest rates. - Result: Investment (I) falls, as it is negatively correlated with interest rates.

The Real Exchange Rate Effect

• Understanding appreciation and depreciation is essential:

  • When the price level rises, Canadian interest rates may rise, prompting foreign investors to demand more Canadian bonds.

  • Higher demand for Canadian currency leads to appreciation of the exchange rate.

  • Result: Exports become more expensive for foreign buyers, while imports become cheaper for Canadians.

Defining Currency Appreciation and Depreciation

• Appreciation: A currency rises in value relative to another.

• Depreciation: A currency falls in value relative to another.

• Effect of appreciation:

  • Exports become more expensive; hence, their demand may decrease.

  • Imports become less expensive; hence, demand may increase.

Slope and Shift of the Aggregate Demand Curve

Shifts in AD

• Shifts in the AD curve can occur due to:

  • Changes in consumption, investment, government purchases, and net exports.

Aggregate Supply (AS)

Definition of the AS Curve

• The AS curve represents the relationship between output (Y) and the price level (P).

  • Assumes money wage rates and other input prices remain constant.

  • The slope of AS is given by rac{ riangle P}{ riangle Y} > 0 .

  • The AS reflects input prices and other production conditions.

Short-Run vs. Long-Run AS

Differences

• The short-run aggregate supply (SRAS) curve responds quicker to changes than the long-run aggregate supply (LRAS) curve.

• Why is LRAS vertical?

  • Over the long run, technological progress shifts LRAS to the right, leading to growth and inflation.

Factors that Might Shift the Long-Run Aggregate Supply Curve

• Changes in Labor

• Changes in Capital

• Changes in Natural Resources

• Changes in Technological Knowledge

Equilibrium Real GDP and Price

Definition of Equilibrium

• Equilibrium occurs when aggregate demand (AD) equals aggregate supply (AS):

  • At points where planned expenditure on current output equals business sector production.

  • At price (P) level P1, if AD < AS, there is unplanned inventory increase leading to a reduction in output (Y).

Nominal vs. Real Variables

Definitions

• Nominal Variables: Measured in monetary units.

  • Examples: Nominal GDP, nominal interest rate, nominal wage.

• Real Variables: Measured in physical units.

  • Examples: Real GDP, real interest rate, real wage.

Monetary Policy

Purpose of Monetary and Fiscal Policies

• Monetary Policy: Involves altering interest rates, credit availability, and borrowing.

  • Controlled by the central bank.

• Types of monetary policy:

  • Tight monetary policy

  • Easy monetary policy

• Fiscal Policy: Involves government spending and taxation, implemented via provincial and federal levels in Canada.

  • Expansionary fiscal policy: Includes tax cuts, transfer payments, or increased government spending.

  • Contractionary fiscal policy: Involves increasing taxes or reducing government expenditures.

Components of Monetary Policy

Tools

• The Bank of Canada (BOC) uses two primary tools:

  1. Open-market operations (involving bonds and foreign currencies).

  2. Changing the overnight rate (infrequent use of reserve requirements).

Impact of Monetary Policy

Inflation Overview

• Inflation is characterized by an increase in general price levels, often caused by excessive money supply growth.

  • The relationship: more money printed typically leads to higher inflation rates resulting in rising prices.

Short-Run Tradeoff between Inflation and Unemployment

• Economic policies can drive inflation and unemployment in opposite directions for periods of 1 to 2 years.

• The tradeoff exists but may vary based on other factors.

Application of Monetary Policy

Graphical Representation

• The BOC can influence interest rates (r) through adjustments in the money supply:

  • A reduction in money supply leads to increased interest rates, influencing aggregate demand downward.

The Phillips Curve

Definition and Historical Context

• The Phillips curve depicts the short-run tradeoff between inflation and unemployment.

• A. W. Phillips' 1958 article revealed a negative correlation between unemployment and inflation.

• Richard Lipsey confirmed and expanded these observations in subsequent years.

The Phillips Curve Data Representation

• A visual representation showcasing inflation rates relative to unemployment rates.

Long-Run Phillips Curve

Key Concept

• Phillips argued against the existence of a long-run tradeoff between inflation and unemployment, concluding they aren't correlated in the long run.

  • Policymakers thus face a vertical long-run Phillips curve.

Fiscal Policy

Understanding Fiscal Policy

• Fiscal policy's impact involves government actions on spending and taxes, influencing the economy.

The Multiplier Effect

Definition

• The multiplier effect results in additional shifts in aggregate demand due to increased income from expansionary fiscal policy.

Formula for the Spending Multiplier

Marginal Propensity to Consume (MPC)

• Defined as the fraction of extra income that households consume rather than save.

  • Example: An MPC of ¾ indicates that for every extra dollar earned, households spend 75 cents.

Application of MPC

• In a closed economy, the formula for the multiplier is:
  $ext{Multiplier} = rac{1}{1 - ext{MPC}}$

Example Calculation

• If MPC = 0.75, then: $ext{Multiplier} = rac{1}{1 - 0.75} = 4$

  • A $20 billion increase in government spending (G) would lead to an aggregate demand (AD) increase of:

  • $20B imes 4 = 80B$

The Crowding-Out Effect

Definition and Impact

• Fiscal policy may affect AD in the reverse direction; expansion leads to increased interest rates (r), reducing investment and thereby decreasing net overall increase in aggregate demand.

  • This smaller shift in AD from fiscal expansion compared to initial plans is known as the crowding-out effect.