Aggregate Demand and Aggregate Supply Notes

The AD-AS Framework

• Chapter 21 focuses on the Aggregate Demand (AD) and Aggregate Supply (AS) framework.
• The topics covered include:
  • The AD-AS Framework.
  • Aggregate Demand.
  • Aggregate Supply.
  • Macroeconomic Shocks and Countercyclical Policy.
  • Aggregate Supply in the Short Run and the Long Run.

Aggregate Demand and Aggregate Supply

• The AD-AS framework helps to understand how aggregate demand and aggregate supply determine macroeconomic equilibrium.
• It differentiates between macroeconomic and microeconomic forces.

Macroeconomic Outcomes

• The AD-AS framework focuses on two macroeconomic outcomes:
  • Quantity of output produced across the whole economy, measured by real GDP.
  • The price of that output, measured by the GDP deflator.
    • The GDP deflator represents the price of a basket containing the many goods and services produced.
• This framework is used for forecasting output and the average price level.

Aggregate Demand Curve

• Definition: The aggregate demand curve shows the relationship between the price level and the total quantity of output that buyers plan to purchase.
  • It considers the purchasing plans of all buyers throughout the entire economy, including consumers, businesses, the government, and overseas customers.
• A lower average price level leads buyers to demand a larger quantity of output.
  • This makes the aggregate demand curve downward-sloping.

Aggregate Supply Curve

• Definition: The aggregate supply curve shows the relationship between the price level and the total quantity of output that suppliers collectively produce.
  • It considers the production plans of all suppliers throughout the entire economy.
• A higher average price level leads suppliers to produce a larger quantity of output.
  • This makes the aggregate supply curve upward-sloping.

Macroeconomic Equilibrium

• Macroeconomic equilibrium occurs where the aggregate demand and aggregate supply curves intersect.
  • This is the only point where the quantity of output demanded equals the quantity supplied.
• The equilibrium determines:
  • Equilibrium GDP (e.g., $20 trillion).</li> <li>Average price level.</li></ul></li> </ul> <h3 id="keytakeawaysoftheadasframework">Key Take-Aways of the AD-AS Framework</h3> <ul> <li><strong>Aggregate Demand:</strong><ul> <li>Shows the quantity of output that buyers collectively plan to purchase falls as the average price level rises.</li></ul></li> <li><strong>Aggregate Supply:</strong><ul> <li>Shows the quantity of output that sellers collectively produce rises as the average price level rises.</li></ul></li> <li><strong>Macroeconomic Equilibrium:</strong><ul> <li>Occurs where the aggregate demand and aggregate supply curves intersect.</li> <li>Indicates where the economy is headed.</li></ul></li> </ul> <h3 id="aggregateexpenditure">Aggregate Expenditure</h3> <ul> <li>The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level.<ul> <li><strong>Aggregate expenditure:</strong> The total amount of goods and services that people want to buy across the whole economy.</li> <li>$AE = C + I + G + NX$<ul> <li>AE = Aggregate expenditure</li> <li>C = Consumption</li> <li>I = Planned Investment</li> <li>G = Government Purchases</li> <li>NX = Net Exports</li></ul></li></ul></li> </ul> <h3 id="aggregatedemandandthecentralbank">Aggregate Demand and the Central Bank</h3> <ul> <li>Inflation is the rate of change of the price level.<ul> <li>The higher the price level this year compared to last year's prices, the higher the inflation rate.</li></ul></li> <li>The Bank of Canada (BoC) responds to higher inflation by raising the real interest rate.<ul> <li>Higher real interest rates raise the opportunity cost of spending, reducing aggregate expenditure.</li></ul></li> <li>The aggregate demand curve summarizes the link from the average price level to the quantity of output that buyers demand.</li> </ul> <h3 id="downwardslopingaggregatedemand">Downward-Sloping Aggregate Demand</h3> <ul> <li>A higher price level ultimately leads buyers to demand a lower quantity of output.<ul> <li>This is sometimes called the central bank channel.</li></ul></li> <li>Other economic forces contributing to the downward-sloping nature include:<ul> <li>International trade effect (small effect).</li> <li>Wealth effect (small effect), partially offset by the debt effect.</li></ul></li> </ul> <h3 id="shiftsvsmovementsalongtheaggregatedemandcurve">Shifts vs. Movements Along the Aggregate Demand Curve</h3> <ul> <li>Changes in the price level cause a movement along the aggregate demand curve.</li> <li>Other changes in spending cause the aggregate demand curve to shift.<ul> <li>Any factor other than a change in the price level that causes consumers, investors, the government, or foreigners to change their spending plans.</li></ul></li> </ul> <h3 id="movementsalongtheaggregatedemandcurvedetailed">Movements Along the Aggregate Demand Curve (detailed)</h3> <ul> <li>Higher price levels:<ul> <li>Lead the Bank of Canada to raise the real interest rate.</li> <li>Reducing the quantity of output demanded.</li></ul></li> <li>Lower price levels:<ul> <li>Lead the Bank of Canada to cut the real interest rate.</li> <li>Raising the quantity of output demanded.</li></ul></li> </ul> <h3 id="increasesinaggregatedemand">Increases in Aggregate Demand</h3> <ul> <li>An increase in aggregate expenditure at any price level causes the aggregate demand curve to shift to the right.</li> <li>This leads the economy to move to a new equilibrium with:<ul> <li>A rise in prices (inflation).</li> <li>A rise in output (economic expansion).</li></ul></li> </ul> <h3 id="decreasesinaggregatedemand">Decreases in Aggregate Demand</h3> <ul> <li>A decrease in aggregate expenditure at any price level causes the aggregate demand curve to shift to the left.</li> <li>This leads the economy to move to a new equilibrium with:<ul> <li>A fall in prices (deflation, or lower inflation).</li> <li>A fall in output (recession).</li></ul></li> </ul> <h3 id="aggregatedemandshifters">Aggregate Demand Shifters</h3> <ul> <li><strong>Consumption:</strong><ul> <li>Rises if people feel more prosperous.</li> <li>Factors include: ↑ Wealth, ↑ Consumer confidence, ↑Government assistance, ↓ Taxes, ↓ Inequality</li></ul></li> <li><strong>Investment:</strong><ul> <li>Rises if it’s profitable to expand production.</li> <li>Factors include: ↑ GDP growth, ↑ Business confidence, ↑ Investment tax credits, ↓ Corporate taxes, ↑ Easier lending standards and more cash reserves, ↓ Uncertainty</li></ul></li> <li><strong>Government Purchases:</strong><ul> <li>Rise in response to expansionary fiscal policy.</li> <li>Factors include: Spending bills, Automatic stabilizers, but not transfer payments (at least not directly).</li></ul></li> <li><strong>Net Exports:</strong><ul> <li>Rise in response to global factors.</li> <li>Factors include: ↑ Global GDP growth, ↓ Canadian dollar, ↓ Trade barriers in foreign markets, ↑ Trade barriers to Canadian market</li></ul></li> </ul> <h3 id="interestratechangesandaggregatedemand">Interest Rate Changes and Aggregate Demand</h3> <ul> <li>Changes in the real interest rate can lead to changes in aggregate expenditure, but only some interest rate changes shift the aggregate demand curve.<ul> <li>Some interest rate changes lead to a movement along the curve, while others lead to a shift of the curve.</li></ul></li> <li>The aggregate demand curve already reflects the changes in aggregate expenditure due to the Bank of Canada adjusting interest rates in response to inflation.</li> </ul> <h3 id="keytakeawaysaggregatedemandrecap">Key Take-Aways: Aggregate Demand (Recap)</h3> <ul> <li>The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level.<ul> <li>Aggregate expenditure = C + I + G + NX</li></ul></li> <li>Shifting aggregate demand:<ul> <li>Increased spending shifts AD right.</li> <li>Decreased spending shifts AD left.</li></ul></li> </ul> <h3 id="aggregatesupply">Aggregate Supply</h3> <ul> <li>Focuses on evaluating the total quantity of goods and services that businesses want to supply.</li> <li>Topics include:<ul> <li>Why aggregate supply is upward-sloping.</li> <li>Analyzing aggregate supply.</li> <li>Aggregate supply shifters.</li></ul></li> </ul> <h3 id="upwardslopingaggregatesupply">Upward-Sloping Aggregate Supply</h3> <ul> <li>A business’ pricing decision depends on the state of the economy:<ul> <li>Times of excess demand: Higher output leads to higher prices.</li> <li>Times of insufficient demand: Lower output leads to lower prices.</li></ul></li> <li>The aggregate supply curve is upward-sloping because higher output leads to a higher price level.</li> </ul> <h3 id="shiftsvsmovementsalongtheaggregatesupplycurve">Shifts vs. Movements Along the Aggregate Supply Curve</h3> <ul> <li>Changes in the price level cause a movement along the aggregate supply curve.</li> <li>Changes in production costs cause the aggregate supply curve to shift.<ul> <li>Changes in production costs can be caused by shifts in:<ol> <li>Input prices.</li> <li>Productivity.</li> <li>The exchange rate.</li></ol></li></ul></li> </ul> <h3 id="increasesinaggregatesupply">Increases in Aggregate Supply</h3> <ul> <li>A fall in production costs causes the aggregate supply curve to shift down to the right.</li> <li>This leads the economy to move to a new equilibrium with:<ul> <li>A rise in output (economic expansion).</li> <li>A fall in prices (deflation, or lower inflation).</li></ul></li> </ul> <h3 id="decreasesinaggregatesupply">Decreases in Aggregate Supply</h3> <ul> <li>A rise in production costs causes the aggregate supply curve to shift up to the left.</li> <li>This leads the economy to move to a new equilibrium with:<ul> <li>A fall in output (recession).</li> <li>A rise in prices (inflation).</li></ul></li> <li><strong>Stagflation:</strong> The combination of declining GDP (economic stagnation) and rising prices (inflation).</li> </ul> <h3 id="aggregatesupplyshifterinputprices">Aggregate Supply Shifter: Input Prices</h3> <ul> <li>If the prices of your inputs rise:<ul> <li>Your marginal costs rise.</li> <li>You’ll raise your prices.</li> <li>Aggregate supply shifts up to the left.</li></ul></li> <li>The same forces operate in reverse if your input prices fall.</li> <li>Key input prices: labour and oil prices.</li> </ul> <h3 id="aggregatesupplyshifterproductivity">Aggregate Supply Shifter: Productivity</h3> <ul> <li>Lower productivity means having to buy more inputs to produce the same output.<ul> <li>Higher production costs.</li> <li>Aggregate supply shifts up to the left.</li> <li>Example: Productivity growth slowed dramatically in the mid-1970s.</li></ul></li> <li>The same forces operate in reverse if productivity is higher, as this allows you to do more with less.</li> </ul> <h3 id="aggregatesupplyshifterexchangerate">Aggregate Supply Shifter: Exchange Rate</h3> <ul> <li>The exchange rate is the price of a Canadian dollar in another currency.<ul> <li>Depreciation of the Canadian dollar leads suppliers to set higher prices, shifting aggregate supply up to the left.</li> <li>Appreciation of the Canadian dollar leads suppliers to set lower prices, shifting aggregate supply down to the right.</li></ul></li> <li>Impacts of depreciating Canadian dollar:<ul> <li>Foreign goods are more expensive for people in Canada.</li> <li>More expensive foreign goods lead to higher prices on domestic goods.</li></ul></li> </ul> <h3 id="keytakeawaysaggregatesupplyrecap">Key Take-Aways: Aggregate Supply (Recap)</h3> <ul> <li>The aggregate supply curve describes the production and pricing decisions that suppliers make and how they respond as macroeconomic conditions change.</li> <li>Shifting aggregate supply:<ul> <li>A rise in production costs shifts AS up to the left.</li> <li>A fall in production costs shifts AS down to the right.</li></ul></li> <li>Shifters: input prices, import prices, productivity, exchange rates.</li> </ul> <h3 id="macroeconomicshocksandcountercyclicalpolicy">Macroeconomic Shocks and Countercyclical Policy</h3> <ul> <li>Focuses on forecasting how the economy will respond to changing conditions.</li> <li>Topics include:<ul> <li>Monetary policy.</li> <li>Fiscal policy and the multiplier.</li> <li>Forecasting macroeconomic outcomes.</li> <li>Diagnosing the causes of macroeconomic shifts.</li></ul></li> </ul> <h3 id="monetarypolicy">Monetary Policy</h3> <ul> <li><strong>Definition:</strong> The process of setting interest rates in an effort to influence economic conditions.<ul> <li>The Bank of Canada cuts interest rates in response to both low inflation and weak output.<ul> <li>Inflation-induced response: The Bank cuts the interest rate if they’re worried inflation is too low.</li> <li>Output-induced response: The Bank cuts the interest rate to combat declines in GDP.</li></ul></li></ul></li> <li>Inflation-induced changes in the interest rate do NOT shift the aggregate demand curve.</li> <li>Output-induced changes in the interest rate do shift the aggregate demand curve.</li> </ul> <h3 id="fiscalpolicyandthemultiplier">Fiscal Policy and the Multiplier</h3> <ul> <li><strong>Fiscal policy:</strong> The government’s use of spending and tax policies to influence economic conditions.<ul> <li>Expansionary fiscal policy examples: direct purchases of buildings, roads, and bridges; tax cuts.<ul> <li>Increased spending shifts aggregate demand to the right.</li></ul></li></ul></li> <li><strong>Fiscal policy and the multiplier:</strong> An initial increase in spending has a multiplied effect on aggregate expenditure.<ul> <li>$∆GDP = ∆Spending × Multiplier$<ul> <li>Multiplier summarizes the direct impact, subsequent ripple effects, and crowding out.</li></ul></li></ul></li> </ul> <h3 id="themultipliereffect">The Multiplier Effect</h3> <ul> <li><strong>Multiplier:</strong> A measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending.<ul> <li>$∆GDP = ∆Spending × Multiplier$</li></ul></li> <li>Example:<ul> <li>Multiplier = 2</li> <li>Initial government spending:$40 b
  • Generates a total of 2 × $40 b =$80 b in additional spending (and hence output).
• Direct effect on construction workers and companies providing materials.
• Ripple effects: These workers spend some of their earnings on daycare. The child care provider then spends some of their extra income at restaurants, and so on.
• Crowding out of some private spending dampens the overall effect on output.