Unit 3 - Chapter Notes (AD & AS)

Unit 3 – Aggregate Demand & Supply

Potential GDP

• Represents the amount of GDP achievable at the natural rate of employment.

• Indicates economic capacity without unsustainable growth.

• Fundamental for understanding economic growth dynamics between unsustained and sustained growth patterns.

Potential GDP Characteristics

• Potential GDP is depicted as a vertical line, highlighting its independence from price levels.

• Changes in nominal GDP can occur if the price level (measured by the GDP deflator) fluctuates; however, potential real GDP remains consistent.

• Categories of goods:

  • Capital Goods: long-term assets used in production.

  • Consumer Goods: goods intended for consumption.

Shifts in Potential GDP

• Potential GDP can shift right or left depending on various factors:

  • Right Shift: Indicates positive changes in economic factors such as an increase in the quality of the labor force or higher productivity.

  • Left Shift: Signals negative economic changes, which may include a reduction in labor quality.

• Labor productivity is defined as the output per unit of time worked, affecting overall economic growth.

Sources of Economic Growth

• Various elements contribute to economic growth, represented by the Production Possibilities Curve (PPC):

  1. Quality of Labor Force/Human Capital: Skill level and education.

  2. Amount of Capital: Tools, machinery, and facilities used for production.

  3. Technology: Innovations that improve production processes.

  4. Natural Resources: Availability and accessibility of raw materials.

• Business cycles reflect the continuous fluctuation of real GDP growth rates over time.

Aggregate Supply

Overview of Aggregate Supply

• Aggregate supply defines the total quantity of goods and services produced in the economy.

• The graph depicts an upward-sloping AS curve.

• Axes:

  • Price Level (measured by the GDP Deflator)

  • Real GDP: Total output of goods and services at current prices.

Economic Conditions

• At price levels below 100 and GDP of $950, the economy faces a recession.

• The AS curve becomes steeper as it approaches potential GDP, indicating increased productivity per worker as the economy strengthens.

• The AS curve transitions to become vertical once it reaches potential GDP, indicating full capacity output.

Aggregate Demand

Characteristics of Aggregate Demand

• Aggregate demand reflects the total quantity of goods and services that consumers are willing to purchase.

• The AD curve is downward-sloping, showing an inverse relationship between the price level and quantity demanded.

Effects of Price Level Changes

• Real-Balances Effect: When the price level rises:

  • The real value of savings decreases due to inflation.

  • Lower real wealth leads to reduced spending and consumption, negatively impacting real GDP.

• Interest-Rate Effect: An increase in price levels results in:

  • Higher inflation rates, causing borrowing costs to rise.

  • A decrease in business investments leading to lower real GDP.

• Foreign-Trade Effect: If Canadian goods become more expensive due to rising price levels:

  • Exports decline as they become less attractive globally.

  • Imports may increase as foreign goods become relatively cheaper, negatively affecting net exports and real GDP.

Macroeconomic Equilibrium

Concepts of Surplus and Shortage

• Surplus: Occurs when the total production of goods and services exceeds the quantity demanded (AS > AD).

• Shortage: Happens when demand for goods and services surpasses total production (AD > AS).

Equilibrium Dynamics

• The economy moves towards equilibrium when:

  • Surpluses lead to price reductions, increasing consumption until equilibrium is reached.

  • Shortages result in rising prices, restoring balance between supply and demand.

Economic Gaps

Recessionary and Inflationary Gaps

• Recessionary Gap: Occurs when real GDP is below potential GDP, indicating higher unemployment levels.

• Inflationary Gap: Happens when real GDP exceeds potential GDP, reflecting lower unemployment and potential price inflation.

• The economy trends back towards full-employment equilibrium over time.

Factors Influencing AD Changes

Consumption Factors

• Influences on consumption include:

  • National wealth fluctuations (e.g., stock market changes).

  • The age and condition of consumer durables (e.g., necessity of replacing old appliances).

  • Consumer expectations regarding future economic conditions.

Investment Factors

• Key factors influencing investments are:

  • Interest rates affecting borrowing costs.

  • Capital goods associated with installation and maintenance costs.

  • The age, condition, and capacity of existing capital goods.

  • Business expectations regarding future economic performance.

• Government regulations can impact investment decisions, highlighting the role of bureaucratic processes and compliance costs.

Net Exports and Government Influence

Net Exports Influences

• Factors affecting net exports include:

  • The exchange rate of the Canadian dollar.

  • Income levels abroad, affecting demand for Canadian exports.

  • Prices of competitive foreign goods, influencing import dynamics.

Government Spending and Taxation

• Direct impacts on aggregate demand include changes in:

  • Government spending allocations (e.g., health care budgets).

  • Taxation rates, impacting disposable income of consumers and businesses.

Money Supply and Economic Effects

Money Supply Dynamics

• Changes in the money supply (e.g., printing more currency) directly influence interest rates and overall economic activity.

Aggregate Supply Changes

Factors of Production Impacting AS

• Aggregate supply can shift based on:

  1. Human Capital: Quality and training of the workforce.

  2. Amount of Capital: Availability of machinery and tools.

  3. Technology: The level of innovation in production methods.

  4. Natural Resources: Availability and management of environmental assets.

AS Equilibrium

• Changes in quality or quantity of input factors can shift both AS and potential GDP, leading to full-employment scenarios.

• Changes in price or costs will influence AS without impacting potential GDP, potentially creating recessionary or inflationary gaps.

Economic Multipliers

• An increase in consumption, investment, or government spending leads to a more significant increase in overall income, demonstrating the multiplier effect.

Neoclassical vs. Keynesian Perspectives

Neoclassical View

• Asserts that the money supply is the primary factor influencing aggregate demand, claiming it affects the price level without altering real GDP.

Keynesian View

• Argues that aggregate demand matters significantly, especially in recessionary conditions. At full employment, AD adjustments will influence price levels.

Graph Examples for Aggregate Demand & Supply

1. Aggregate Supply (AS) Curve

   • Axes:

     • Y-Axis: Price Level (Measured by GDP Deflator)

     • X-Axis: Real GDP

   • Shape: Upward-sloping AS curve, indicating total quantity of goods and services produced.

   • Key Characteristics:

     • Steeper as it approaches potential GDP.

     • Becomes vertical at potential GDP (full capacity output).

2. Aggregate Demand (AD) Curve

   • Axes:

     • Y-Axis: Price Level

     • X-Axis: Quantity of Goods and Services Demanded

   • Shape: Downward-sloping AD curve, showing an inverse relationship between price level and quantity demanded.

   • Key Characteristics:

     • Real-Balances Effect: Higher price levels lead to decreased consumption.

     • Interest-Rate Effect: Higher price levels result in increased borrowing costs and reduced investments.

     • Foreign-Trade Effect: Higher Canadian prices lead to lower exports and higher imports.

3. Macroeconomic Equilibrium

   • Axes:

     • Y-Axis: Price Level

     • X-Axis: Real GDP

   • Graph Features:

     • Intersection of AD and AS curves determines equilibrium price level and real GDP.

     • Surpluses and shortages illustrated by shifts in AD and AS.

4. Economic Gaps

   • Graphs showing Recessionary and Inflationary Gaps:

     • Recessionary Gap: Equilibrium below potential GDP, indicating higher unemployment.

     • Inflationary Gap: Equilibrium above potential GDP, indicating lower unemployment and potential inflation.