ECON 102 - Chapter 5

Explain the concepts of potential GDP and the business cycle, and review the source of economic growth.
Explain the concepts of aggregate supply, aggregate demand, and macroeconomic equilibrium.
Describe the factors that can affect aggregate demand and aggregate supply.
List the causes of recessions and inflationary booms.
Explain the main points of disagreement between neoclassical and Keynesian economics.
Explain the modern view of aggregate demand and aggregate supply.

Definition: The total amount that an economy is capable of producing when all of its resources are fully utilized.
Characteristics:
- Not dependent on the price level.

Factors:
- Quantity and quality of labour resources (level of human capital).
- Amount of physical capital available.
- Rate of technological change.
- Amount and quality of natural resources.
Improvements in these factors will increase both Aggregate Supply (AS) and LAS.
On average, Canada’s potential GDP has grown by about 3% per year since the 1990s.

Definition: The aggregate quantity of goods and services produced by all sellers at various price levels.
The relationship between price level and output:
- A higher price level (with wages remaining constant) will increase profit for the average firm, leading to a higher level of output.
- A lower price level implies lower profit and a corresponding lower level of output.
- Characteristic: Higher prices result in a greater quantity of aggregate supply.

Real Wage: The amount of goods and services that an employee can buy for a given amount of nominal wage.
Definition: $ext{Real Wage} = rac{ ext{Nominal Wage}}{ ext{Price Level}}$

Definition: The total quantity of final goods and services that consumers, businesses, government, and those living outside the country would buy at various price levels.
Behavior of the AD curve:
- It is downward sloping due to:
1. Real Balances Effect: Higher price levels reduce real wealth (income), decreasing consumption.
2. Interest Rate Effect: Higher prices lead to higher interest rates, reducing investment.
3. Foreign-trade Effect: Higher prices make exports less attractive, causing net exports to fall.

Definition: A situation in which aggregate demand equals aggregate supply.
Market Dynamics:
- 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.
If equilibrium occurs at the level of long-run aggregate supply (LAS), the economy is at full employment.
Recessionary Gap: If equilibrium occurs below LAS, it indicates a recession. If this situation persists for two consecutive quarters, it is termed a recession.
Inflationary Gap: If equilibrium occurs above LAS, indicating a potential overproduction on an unsustainable basis.

Equilibrium Level of Prices and Real GDP:
- Example data provided for equilibrium analysis.
- At price $100, GDP is $1100.
- Shortage of $125 noted at price $95.

Factors affecting AD:
- Changes in Consumption:
- Individual consumer wealth.
- Age of consumer durables.
- Consumer expectations.
- Changes in Investment:
- Interest rates.
- Costs related to capital goods.
- Business expectations.
- Government regulations.
- Net Exports:
- Exchange rate.
- Income levels abroad.
- Competitive pricing of foreign goods.
- Foreign consumer preferences.
- Government Spending and Tax Rates.
- Money Supply.

Factors affecting AS:
- Changes in human capital.
- Changes in physical capital and technological advancements.
- Changes in amount and quality of natural resources.
- Changes in factor prices (first four affect both short-run and long-run AS; factor prices only affect short-run AS).
Improvements in these factors shift both AS and LAS to the right.
A drop in the price of a factor will shift only AS to the right with no impact on potential GDP (LAS).

Definition: When spending independently changes, the total income changes more significantly as a portion of that income is spent again.

A change in the price of a production factor can shift the aggregate supply curve.
A shift in LAS will also impact AS.

The market is competitive and efficient; prices and wages adjust quickly to surplus or shortage.
AS equates to potential GDP; the economy typically operates at full employment.

The market faces competitive disadvantages owing to market power of corporations and unions.
Prices and wages show stickiness, adjusting slowly to changes.
AS is horizontal at the price level, indicating the necessity for government intervention to maintain full employment.

Economic performance is contingent on economic conditions:
- In deep recessions, there is significant GDP effect.
- Near potential GDP, effects are more likely to be inflationary.
- Changes in factor prices help close recessionary gaps (with AS shifting right) and inflationary gaps (with AS shifting left).

In a recessionary gap, wages decline, shifting AS right until natural full employment is achieved.
In an inflationary gap, wages increase, causing AS to shift left until full employment is restored.

Potential GDP
Sources of economic growth
Aggregate demand and aggregate supply fundamentals and macroeconomic equilibrium
Determinants of aggregate demand and aggregate supply, including the Multiplier Effect
Causes of recessions and inflationary booms
Key differences between Keynesian, Neoclassical, and Modern economic perspectives.