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).
  • Average price level.

Key Take-Aways of the AD-AS Framework

• Aggregate Demand:
  • Shows the quantity of output that buyers collectively plan to purchase falls as the average price level rises.
• Aggregate Supply:
  • Shows the quantity of output that sellers collectively produce rises as the average price level rises.
• Macroeconomic Equilibrium:
  • Occurs where the aggregate demand and aggregate supply curves intersect.
  • Indicates where the economy is headed.

Aggregate Expenditure

• The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level.
  • Aggregate expenditure: The total amount of goods and services that people want to buy across the whole economy.
  • AE = C + I + G + NX
    • AE = Aggregate expenditure
    • C = Consumption
    • I = Planned Investment
    • G = Government Purchases
    • NX = Net Exports

Aggregate Demand and the Central Bank

• Inflation is the rate of change of the price level.
  • The higher the price level this year compared to last year's prices, the higher the inflation rate.
• The Bank of Canada (BoC) responds to higher inflation by raising the real interest rate.
  • Higher real interest rates raise the opportunity cost of spending, reducing aggregate expenditure.
• The aggregate demand curve summarizes the link from the average price level to the quantity of output that buyers demand.

Downward-Sloping Aggregate Demand

• A higher price level ultimately leads buyers to demand a lower quantity of output.
  • This is sometimes called the central bank channel.
• Other economic forces contributing to the downward-sloping nature include:
  • International trade effect (small effect).
  • Wealth effect (small effect), partially offset by the debt effect.

Shifts vs. Movements Along the Aggregate Demand Curve

• Changes in the price level cause a movement along the aggregate demand curve.
• Other changes in spending cause the aggregate demand curve to shift.
  • Any factor other than a change in the price level that causes consumers, investors, the government, or foreigners to change their spending plans.

Movements Along the Aggregate Demand Curve (detailed)

• Higher price levels:
  • Lead the Bank of Canada to raise the real interest rate.
  • Reducing the quantity of output demanded.
• Lower price levels:
  • Lead the Bank of Canada to cut the real interest rate.
  • Raising the quantity of output demanded.

Increases in Aggregate Demand

• An increase in aggregate expenditure at any price level causes the aggregate demand curve to shift to the right.
• This leads the economy to move to a new equilibrium with:
  • A rise in prices (inflation).
  • A rise in output (economic expansion).

Decreases in Aggregate Demand

• A decrease in aggregate expenditure at any price level causes the aggregate demand curve to shift to the left.
• This leads the economy to move to a new equilibrium with:
  • A fall in prices (deflation, or lower inflation).
  • A fall in output (recession).

Aggregate Demand Shifters

• Consumption:
  • Rises if people feel more prosperous.
  • Factors include: ↑ Wealth, ↑ Consumer confidence, ↑Government assistance, ↓ Taxes, ↓ Inequality
• Investment:
  • Rises if it’s profitable to expand production.
  • Factors include: ↑ GDP growth, ↑ Business confidence, ↑ Investment tax credits, ↓ Corporate taxes, ↑ Easier lending standards and more cash reserves, ↓ Uncertainty
• Government Purchases:
  • Rise in response to expansionary fiscal policy.
  • Factors include: Spending bills, Automatic stabilizers, but not transfer payments (at least not directly).
• Net Exports:
  • Rise in response to global factors.
  • Factors include: ↑ Global GDP growth, ↓ Canadian dollar, ↓ Trade barriers in foreign markets, ↑ Trade barriers to Canadian market

Interest Rate Changes and Aggregate Demand

• Changes in the real interest rate can lead to changes in aggregate expenditure, but only some interest rate changes shift the aggregate demand curve.
  • Some interest rate changes lead to a movement along the curve, while others lead to a shift of the curve.
• The aggregate demand curve already reflects the changes in aggregate expenditure due to the Bank of Canada adjusting interest rates in response to inflation.

Key Take-Aways: Aggregate Demand (Recap)

• The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level.
  • Aggregate expenditure = C + I + G + NX
• Shifting aggregate demand:
  • Increased spending shifts AD right.
  • Decreased spending shifts AD left.

Aggregate Supply

• Focuses on evaluating the total quantity of goods and services that businesses want to supply.
• Topics include:
  • Why aggregate supply is upward-sloping.
  • Analyzing aggregate supply.
  • Aggregate supply shifters.

Upward-Sloping Aggregate Supply

• A business’ pricing decision depends on the state of the economy:
  • Times of excess demand: Higher output leads to higher prices.
  • Times of insufficient demand: Lower output leads to lower prices.
• The aggregate supply curve is upward-sloping because higher output leads to a higher price level.

Shifts vs. Movements Along the Aggregate Supply Curve

• Changes in the price level cause a movement along the aggregate supply curve.
• Changes in production costs cause the aggregate supply curve to shift.
  • Changes in production costs can be caused by shifts in:
    1. Input prices.
    2. Productivity.
    3. The exchange rate.

Increases in Aggregate Supply

• A fall in production costs causes the aggregate supply curve to shift down to the right.
• This leads the economy to move to a new equilibrium with:
  • A rise in output (economic expansion).
  • A fall in prices (deflation, or lower inflation).

Decreases in Aggregate Supply

• A rise in production costs causes the aggregate supply curve to shift up to the left.
• This leads the economy to move to a new equilibrium with:
  • A fall in output (recession).
  • A rise in prices (inflation).
• Stagflation: The combination of declining GDP (economic stagnation) and rising prices (inflation).

Aggregate Supply Shifter: Input Prices

• If the prices of your inputs rise:
  • Your marginal costs rise.
  • You’ll raise your prices.
  • Aggregate supply shifts up to the left.
• The same forces operate in reverse if your input prices fall.
• Key input prices: labour and oil prices.

Aggregate Supply Shifter: Productivity

• Lower productivity means having to buy more inputs to produce the same output.
  • Higher production costs.
  • Aggregate supply shifts up to the left.
  • Example: Productivity growth slowed dramatically in the mid-1970s.
• The same forces operate in reverse if productivity is higher, as this allows you to do more with less.

Aggregate Supply Shifter: Exchange Rate

• The exchange rate is the price of a Canadian dollar in another currency.
  • Depreciation of the Canadian dollar leads suppliers to set higher prices, shifting aggregate supply up to the left.
  • Appreciation of the Canadian dollar leads suppliers to set lower prices, shifting aggregate supply down to the right.
• Impacts of depreciating Canadian dollar:
  • Foreign goods are more expensive for people in Canada.
  • More expensive foreign goods lead to higher prices on domestic goods.

Key Take-Aways: Aggregate Supply (Recap)

• The aggregate supply curve describes the production and pricing decisions that suppliers make and how they respond as macroeconomic conditions change.
• Shifting aggregate supply:
  • A rise in production costs shifts AS up to the left.
  • A fall in production costs shifts AS down to the right.
• Shifters: input prices, import prices, productivity, exchange rates.

Macroeconomic Shocks and Countercyclical Policy

• Focuses on forecasting how the economy will respond to changing conditions.
• Topics include:
  • Monetary policy.
  • Fiscal policy and the multiplier.
  • Forecasting macroeconomic outcomes.
  • Diagnosing the causes of macroeconomic shifts.

Monetary Policy

• Definition: The process of setting interest rates in an effort to influence economic conditions.
  • The Bank of Canada cuts interest rates in response to both low inflation and weak output.
    • Inflation-induced response: The Bank cuts the interest rate if they’re worried inflation is too low.
    • Output-induced response: The Bank cuts the interest rate to combat declines in GDP.
• Inflation-induced changes in the interest rate do NOT shift the aggregate demand curve.
• Output-induced changes in the interest rate do shift the aggregate demand curve.

Fiscal Policy and the Multiplier

• Fiscal policy: The government’s use of spending and tax policies to influence economic conditions.
  • Expansionary fiscal policy examples: direct purchases of buildings, roads, and bridges; tax cuts.
    • Increased spending shifts aggregate demand to the right.
• Fiscal policy and the multiplier: An initial increase in spending has a multiplied effect on aggregate expenditure.
  • ∆GDP = ∆Spending × Multiplier
    • Multiplier summarizes the direct impact, subsequent ripple effects, and crowding out.

The Multiplier Effect

• Multiplier: A measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending.
  • ∆GDP = ∆Spending × Multiplier
• Example:
  • Multiplier = 2
  • 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.

Expansionary Monetary and Fiscal Policy

• An output-induced interest rate cut, or a boost to government purchases, will shift the aggregate demand curve to the right.
• This leads the economy to move to a new equilibrium with:
  • A rise in prices.
  • A rise in output.

Forecasting Macroeconomic Outcomes (Steps)

1. Is there a shift in aggregate demand or aggregate supply?
   • AD shifts in response to changes in aggregate expenditure (C + I + G + NX).
   • AS shifts in response to changes in production costs.
2. Is that shift an increase, shifting the curve to the right? Or is it a decrease, shifting the curve to the left?
3. How will the price level and quantity of output change in the new equilibrium?

Forecasting Macroeconomic Outcomes: Examples

• In 2020: The government gave extra GST credit

  1. The extra GST (increased consumption) shifts the AD curve.
  2. Aggregate demand shifts right.
  3. Output and price level rise.

• In September 2008: The world’s financial system froze

  1. Higher real interest rate led to decreased consumption, which shifts the AD curve.
  2. Aggregate demand shifts left.
  3. Output and prices fall.

• Gulf War: Caused oil prices to rise

  1. This increased businesses’ production costs, shifting AS.
  2. Aggregate supply shifts left.
  3. Output falls, and the price level rises.

• Rapid Advances in Technology: Projected to boost productivity growth

  1. This decreases businesses’ production costs, shifting AS.
  2. Aggregate supply shifts right.
  3. Output rises, and the price level falls.

Diagnosing Macroeconomic Shifts

• Aggregate demand shocks lead output and prices to move in the same direction.
• Aggregate supply shocks lead output and prices to move in opposite directions.

Diagnosing the Macroeconomic Shock (Example)

• Scenario:
  • As the pandemic hit, basically everything closed down, and so analysts were unsure whether to think about this as a shock to aggregate demand or aggregate supply. In those first few months, output fell, as did the average price level.
• Diagnosis:
  • Falling prices and falling output occur when aggregate demand decreases, due to a decline in spending.

Diagnosing Macro Shocks (Example)

• Scenario:
  • Analysts were puzzled to observe inflation rising even as the economy slide into a recession.
• Diagnosis:
  • Rising prices and falling output occur when aggregate supply decreases, such as when production costs rise.

Forecasting Macroeconomic Outcomes (Recap)

1. Is there a shift in aggregate demand or aggregate supply?
2. Is that shift an increase, shifting the curve to the right? Or is it a decrease, shifting the curve to the left?
3. How will the price level and quantity of output change in new equilibrium?

• Aggregate Demand shifts in response to changes in aggregate expenditure:
  1. Consumption (C)
  2. Planned investment (I)
  3. Government purchases (G)
  4. Net exports (NX)
• Aggregate Supply shifts in response to changes in production costs:
  1. Input prices
  2. Productivity
  3. The exchange rate

Long-Run Aggregate Supply Curve

• In the long run, the quantity of output supplied is unaffected by the average price level, yielding a vertical long-run aggregate supply curve.
• Changes in aggregate demand have no effect on output.
  • Aggregate demand is irrelevant to long-run output.

Short-Run Aggregate Supply Curve

• Changing prices is costly!
• Sticky prices: Prices that adjust sporadically and sluggishly to changes in market conditions.
• In the very short run, the price level is stuck at its preexisting level.
• But as time passes:
  • If insufficient demand… some sellers will cut prices.
  • If excess demand… some sellers will raise prices.
• Result: upward-sloping short-run aggregate supply curve.