Macroeconomics Review

MACROECONOMICS REVIEW

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

Change & Shift in Demand

Shift in the Demand Curve

A shift in the demand curve occurs due to factors that change the demand relationship, rather than just the price of the good itself. The following factors may lead to a shift in the demand curve:

• Prices of Related Goods

• Consumer Incomes

• Tastes and Networks

• Price Expectations

• Number of Buyers

Factors Affecting the Demand Curve

1. Prices of Related Goods

• Complementary Goods: These are goods that are consumed together. If the price of one complements increases, the demand for the other decreases.
  Example: Electronic readers and electronic books.

• Substitute Goods: These are goods that can replace each other. If the price of one substitute increases, the demand for the other increases.
  Examples: Electronic books and paper books; iPhones and Android phones.

2. Effects of Consumer Incomes

• Luxurious Goods: Demand increases as consumer incomes rise.
  Examples: BMW, Mercedes, Cruz.

• Normal Goods: Most goods fall into this category, where demand rises with income.
  Examples: Restaurants; concerts; clothing.

• Inferior Goods: Demand for these goods falls with income. Inferior goods aren’t necessarily of lower quality.
  Examples: Laundromats; public transit.

3. Effects of Tastes and Fashions

• When goods or services see an increase in popularity, the demand for them expands.
  Examples: iPhones and certain clothing styles.

4. Effects of Price Expectations

• If consumers expect prices to rise in the future, they may choose to buy more now in anticipation.
  Example: If gold prices are expected to rise, consumers buy gold today rather than waiting.

5. Effect of Number of Buyers

• An increase in the number of buyers will lead to an increase in demand.
  Example: An influx of 10,000 new immigrants in Toronto may increase the demand for Tea/Coffee.

Distinguishing Shifts from Changes in Demand

• A shift in the demand curve occurs due to changes in factors like the prices of related goods, consumer incomes, consumer preferences, expectations, or number of buyers. However, a change in the price of the good itself results in a movement along the same demand curve.
  EXTREMELY IMPORTANT NOTE: The factors mentioned above are only examples. Other factors such as weather changes or pandemics can also influence demand.

Summary of Variables Influencing Demand Shift

Change & Shift in Supply

Shift in the Supply Curve

Key Factors Leading to Supply Curve Shifts

1. Effect of Technology: Improvements in technology can lead to an expansion in supply.

2. Effect of Input Costs: An increase in input costs can contract supply, while a decrease may expand supply.

3. Effect of the Number of Suppliers: An increase in the number of firms in an industry increases supply.

4. Effect of Future Prices: If future prices are expected to rise, current supply may be lower as producers hold back products for future sale at higher prices.

Example Illustration of Shift in Supply Curve

The supply curve showing different supply states of Ice-Cream Cones can be understood visually with curves shifting to reflect increases or decreases in supply depending on the factors mentioned earlier.

Distinguishing Shifts from Changes in Supply

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

Aggregate Demand (AD)

Understanding why the aggregate demand curve slopes downward involves three major effects:

• The Wealth Effect: A rise in price level diminishes the purchasing power of money, leading to reduced consumption (C).

• The Interest Rate Effect: A rise in price requires more dollars for transactions, leading people to sell assets to obtain the required amount. This drives interest rates up, resulting in lower investment (I).

• The Exchange Rate Effect: A rise in domestic price levels can lead to appreciation of the currency, making exports more expensive and imports cheaper, thereby causing net exports (NX) to fall.

The aggregate demand in an economy can be represented in the following equation:
$Y = C + I + G + NX$
Where Y stands for total output, C for consumption, I for investment, G for government spending, and NX for net exports.

Wealth Effect Example

Suppose the price level (P) rises, leading to the following results:

• The dollars held by individuals can now buy fewer goods and services (g&s).

• This results in a decrease in real wealth and makes people feel poorer, causing consumption (C) to fall.

Interest Rate Effect Example

Similarly, if price level (P) rises:

• More dollars are needed for buying goods and services.

• To acquire necessary funds, individuals may sell bonds or other assets, thereby driving up interest rates. Consequently, the result is a fall in investment (I).

Exchange Rate Effect Explanation

Before discussing the exchange rate effect, one needs to understand appreciation and depreciation:

1. Appreciation: A currency rises in value compared to another currency.

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

When prices rise:

• Canadian interest rates rise due to the interest-rate effect, which attracts foreign investment in Canadian bonds.

• The higher demand leads to the appreciation of the Canadian dollar.

• This makes Canadian exports more expensive for foreign buyers and reduces net exports (NX).

Example of Currency Impact

January 2020:

• Price of Wine: 1000 €

• Exchange Rate: $1.32/1€

• Total Cost: $1320

March 2020:

• Price of Wine: 1000 €

• Exchange Rate: $1.5/1€

• Total Cost: $1500

• Indicating a depreciation of the dollar relative to the euro.

Aggregate Demand Curve Shifts

Reasons for the aggregate-demand curve to shift include:

• Changes in consumption.

• Changes in investment.

• Changes in government purchases.

• Changes in net exports.

Aggregate Supply (AS)

Understanding Aggregate Supply

The aggregate supply (AS) curve represents the relationship between output and the price level. Key characteristics include:

• Assumption: Money wage rates and other input prices are constant.

• The slope of AS is defined by the equation rac{ riangle P}{ riangle Y} > 0

• The AS curve location is influenced by input prices and other production conditions.

• The short-run aggregate supply (SRAS) curve differs from the long-run aggregate supply (LRAS) curve primarily due to wage and price flexibility over time.

Aggregate Supply Curve Details

The AS curve represents the prices businesses require to produce given outputs (Y). An increase in output (Y) leads to a rise in unit costs, resulting in increased prices (P). Additionally, the expression has the ability: rac{ riangle P}{ riangle Y} > 0 to illustrate this positive correlation.

Factors Influencing Long-Run Aggregate Supply Curve Shifts

Factors that might lead to shifts in the long-run aggregate supply (LRAS) include:

• Changes in labor.

• Changes in capital.

• Changes in natural resources.

• Changes in technological knowledge.

Equilibrium Real GDP and Price

Equilibrium occurs when aggregate demand (AD) equals aggregate supply (AS). At price level P0 and output level Y0, AD = AS, implying that planned expenditure on current output equals business sector's current production.

• If price level is P1, with Y1 < Y2, it results in unplanned inventory increases, leading to reduced output Y. The graphical representation illustrates two unplanned shifts in inventories leading to adjustments in price and output.

NOMINAL VS REAL VARIABLES

Differentiating Between Variables

• Nominal Variables: Measured in monetary units. Examples include nominal GDP, nominal interest rate (the rate of return expressed in dollars), and nominal wage (dollars per hour worked).

• Real Variables: Measured in physical units. Examples include real GDP, real interest rate (measured in output), and real wage (measured in output).

MONETARY POLICY

Purpose of Monetary and Fiscal Policies

• Monetary Policy: Involves altering interest rates, the availability of credit, and borrowing levels within the economy. This policy is determined by a nation’s central bank. Types of monetary policy include tight monetary policy, which restricts money supply, and easy monetary policy which aims to increase money supply.

• Fiscal Policy: Refers to government spending and taxes. In Canada, fiscal policy is implemented by provincial and federal governments through finance ministers.

  • Expansionary Fiscal Policy involves reducing taxes, increasing government spending, and transfer payments.

  • Contractionary Fiscal Policy entails increasing taxes and reducing expenditures.

Tools of Monetary Policy

The Bank of Canada (BOC) employs two primary tools in its monetary toolbox:

1. Open-Market Operations: Activities involving government bonds and foreign currencies.

2. Changing the Overnight Rate: Primarily used by BOC; changing reserve requirements is rarely utilized to regulate the money supply.

Impact of Monetary Policy

Understanding Inflation

Inflation is defined as an increase in the general level of prices. In the long run, it is typically driven by excessive growth in the money supply, causing the value of money to decline. The more money the government prints, the greater the inflation rate. Inflation occurs when excessive money is produced, driving up prices.

Tradeoff Between Inflation and Unemployment

In the short run (1-2 years), many economic policies can affect inflation and unemployment in opposing directions. Although other factors may condition this tradeoff, it continuously exists, presenting society with a short-run tradeoff between inflation and unemployment.

THE PHILLIPS CURVE

Overview of the Phillips Curve

The Phillips curve illustrates the short-run tradeoff between inflation and unemployment. In 1958, economist A. W. Phillips published findings showing a negative correlation between unemployment rates and inflation rates over a historical span from 1861 to 1957 in the United Kingdom. Two years later, Canadian economist Richard Lipsey validated and extended Phillips’s observations.

Illustration of the Phillips Curve

A graph demonstrating inflation rates (percentage per year) against unemployment rates (percentage) highlights the relationship observed by Phillips.

Aggregate Demand, Aggregate Supply, and the Phillips Curve Integration

The aggregate demand and supply model effectively explains the outcomes illustrated by the Phillips curve. As shifts in the aggregate-demand curve move the economy along the short-run aggregate supply curve, they illustrate the varied combinations of inflation and unemployment observed in the short run.

Long-Run Phillips Curve Implications

• Phillips argued in a subsequent paper against the long-run trade-off between inflation and unemployment. It was concluded that the long-run rate of inflation is not dependent on the rate of unemployment.

• Policymakers thus operate under the premise that the long-run Phillips curve is vertical.

Long-Run Phillips Curve Effects

1. When the Bank of Canada increases the money supply growth rate, inflation rates escalate.

2. However, despite inflation rates rising, unemployment remains stable at its natural rate in the long run.

FISCAL POLICY

Understanding Fiscal Policy

Fiscal policies play a role in economic management through government response in spending and taxation.
The multiplier effect is a significant outcome of expansionary fiscal policy. It emphasizes the additional shifts in aggregate demand resulting from increased income leading to higher consumer spending.

The Multiplier Effect

• The multiplier effect demonstrates how an increase in government spending can lead to further increases in demand as income levels rise, thereby boosting consumer spending in a closed economy.

Spending Multiplier Formula

• The marginal propensity to consume (MPC) is a crucial concept in understanding how much of any additional income is spent as opposed to saved. For example, with an MPC of $\frac{3}{4}$ (0.75), if a household earns an additional dollar, it spends $0.75 and saves $0.25.

• Consequently, if workers earn an extra $5 billion, consumption increases by $0.75 \times $5 billion = $3.75 billion.

Multiplier Calculation

In a closed economy:
$Multiplier = \frac{1}{(1 - MPC)}$
If MPC = 0.75, then
$Multiplier = \frac{1}{(1-0.75)} = 4$
Thus, if government spending increases (G) by $20 billion, aggregate demand will increase by $20 billion x 4 = $80 billion.

Further Note on the Crowding-Out Effect

• This effect occurs when fiscal policy, which may initially increase aggregate demand, inadvertently raises interest rates, reducing investment and thus tempering the overall increase in aggregate demand.

Conclusion: Crowding-Out Impact on Demand

As illustrated, a $20 billion increase in G can initially shift aggregate demand right by $20 billion. However, the rise in income leads to increased demand for money, which subsequently raises interest rates and reduces aggregate demand. The final graphical shift illustrates the interaction and adjustments within the economy - leading to a more complex understanding of fiscal policy impacts.