Understanding Economics 3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 11 Economic Fluctuations Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives In this chapter you will: learn about aggregate demand and the factors that affect it analyze aggregate supply and the factors that influence it study the economy’s equilibrium and how it differs from its potential

Aggregate Demand (a) Aggregate demand (AD) is the relationship between the general price level and real expenditures (i.e. total spending) in an economy is shown using a schedule or curve

Aggregate Demand (b) Figure 11.1, Page 247 650 700 750 800 40 80 120 160 200 Aggregate Demand Curve Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) Aggregate Demand Schedule Price Level Real GDP (1997, $ billions) Point on Graph a b c AD 200 160 120 650 700 750 a b c

The Aggregate Demand Curve Two factors cause the aggregate demand curve to be downward sloping the wealth effect means that higher prices decrease the real value of financial assets and decrease consumption, since households feel poorer (and vice versa for lower prices) the foreign trade effect means that higher prices decrease exports and increase imports (and vice versa for lower prices)

Changes in Aggregate Demand (a) AD changes are shown by shifts in the AD curve an increase in spending causes a rightward shift in the AD curve a decrease in spending causes a leftward shift in the AD curve

Changes in Aggregate Demand (b) Figure 11.2, Page 249 650 700 750 800 40 80 120 160 200 Aggregate Demand Curve Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) Aggregate Demand Schedule Price Level Real GDP (1997 $ billions) AD0 AD1 AD0 AD1 200 160 120 650 700 750 700 750 800

Aggregate Demand Factors (a) AD changes are caused by aggregate demand factors related to each of the four main spending components consumption (C) disposable income wealth (other than wealth changes caused by a varying price level) consumer expectations interest rates

Aggregate Demand Factors (b) investment (I) interest rates business expectations government purchases (G) net exports (X-M) foreign incomes exchange rates

Investment Demand (a) Investment demand is the relationship between the interest rate and investment and depends on the real rate of return and the real interest rate Businesses pursue projects whose real rate of return at least equals the real interest rate, which means the investment demand curve is downward-sloping (since more projects are profitable at lower interest rates)

Investment Demand (b) Figure 11.3, Page 251 Investment Demand Curve Investment (1997 $ billions) Real Rate of Return and Real Interest Rate (%) 30 60 4 8 12 a Investment Demand Schedule Real Interest Rate (%) Total Investment (1997 $ billions) Point on Graph Projects Undertaken b 12 8 4 30 60 a b c -- A, B A, B, C, D c D1 A B C D

Shifts in the Aggregate Demand Curve Figure 11.4, Page 253 Aggregate demand increases and the AD curve shifts to the right, with the following: Aggregate demand decreases and the AD curve shifts to the left, with the following: (1) An increase in consumption due to a rise in disposable income a rise in wealth unrelated to a change in price level an expected rise in prices or incomes a fall in interest rates (2) An increase in investment due to an expected rise in profits (3) An increase in government purchases (4) An increase in net exports due to a rise in foreign income a fall in value of the Canadian dollar (1) A decrease in consumption due to a fall in disposable income a fall in wealth unrelated to a change in price level an expected fall in prices or incomes a rise in interest rates (2) A decrease in investment due to an expected fall in profits (3) A decrease in government purchases (4) A decrease in net exports due to a fall in foreign income a rise in value of the Canadian dollar

Aggregate Supply (a) Aggregate supply (AS) is the relationship between the general price level and real output in an economy is shown using a schedule or curve

Aggregate Supply (b) Figure 11.5, Page 254 650 675 700 800 40 80 120 160 240 Aggregate Supply Curve Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 750 725 AS d Aggregate Supply Schedule Price Level Real GDP (1997, $ billions) Point on Graph c b Potential Output a 120 160 200 240 650 700 725 730 a b c d

The Aggregate Supply Curve The AS curve is upward-sloping because higher prices encourage businesses to produce more, while at lower prices businesses are forced to reduce output The AS curve becomes steep above potential output because a relatively large increase in the price level is required if businesses are to increase output in this range

Short-Run Changes in Aggregate Supply Short-run AS changes are shown by shifts in the AS curve and a constant potential output for the economy a short-run increase in AS occurs when the AS curve shifts rightward while potential output stays constant a short-run decrease in AS occurs when the AS curve shifts leftward while potential output stays constant

A Short-Run Change in Aggregate Supply Figure 11.6, page 256 650 675 700 40 80 120 160 240 Aggregate Supply Curve Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 750 725 Aggregate Supply Schedule Price Level Real GDP (1997 $ billions) AS0 AS1 Potential Output AS0 AS1 120 160 200 240 650 700 725 730 700 725 730 731

Long-Run Changes in Aggregate Supply Long-run AS changes are shown by shifts in both the AS curve and in potential output a long-run increase in AS occurs when the AS curve and potential output both shift rightward a long-run decrease in AS occurs when the AS curve and potential output both shift leftward

A Long-Run Change in Aggregate Supply Figure 11.7, Page 256 650 675 700 800 40 80 120 160 240 Aggregate Supply Curve Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 750 725 AS0 AS1 Aggregate Supply Schedule Price Level Real GDP (1997 $ billions) AS0 AS1 120 160 200 240 650 700 725 730 700 750 775 780 Original Potential Output New Potential Output

Aggregate Supply Factors AS changes are caused by aggregate supply factors related either to short-run or long-run trends short-run changes in AS are caused by varying input prices long-run changes in AS are caused by varying resource supplies productivity government policies

Shifts in the Aggregate Supply Curve (a) Figure 11.8, Page 257 Aggregate supply increases, with the AS curve shifting to the right, and potential output staying the same with the following: Aggregate supply decreases with the AS curve shifting to the left, and potential output staying the same with the following: (1) A decrease in input prices due to a fall in wages a fall in raw material prices (1) An increase in input prices due to a rise in wages a rise in raw material prices

Shifts in the Aggregate Supply Curve (b) Figure 11.8, Page 257 Aggregate supply increases, with the AS curve shifting to the right, and potential output increasing with the following: Aggregate supply decreases, with the AS curve shifting to the left, and potential output decreasing with the following: (1) An increase in supplies of economic resources due to more labour supply more capital stock more land more entrepreneurship (2) An increase in productivity due to technological progress (3) A change in government policies lower taxes less government regulation (1) A decrease in supplies of economic resources due to less labour supply less capital stock less land less entrepreneurship (2) A decrease in productivity due to technological decline (3) A change in government policies higher taxes more government regulation

Equilibrium in the Economy (a) An economy’s equilibrium occurs at the intersection of the AD and AS curves A price level above equilibrium means an unintended increase in inventories (or positive unplanned investment), lowering the price level towards equilibrium A price level below equilibrium leads to an unintended decrease in inventories (or negative unplanned investment), raising the price level towards equilibrium

An Economy at Equilibrium Figure 11.9, Page 259 650 800 40 80 120 200 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 750 Aggregate Demand and Supply Curves AS a a Aggregate Demand and Supply Schedules Price Level AS – AD (surplus (+) or shortage (-)) (1997 $ billions) Positive Unplanned Investment 160 b c c AD Negative Unplanned Investment 200 160 120 (725 – 650) = +75 (700 – 700) = 0 (650 – 750) = -100 700

Equilibrium in the Economy (b) An economy’s equilibrium occurs at a point where total injections (I+G+X) equal total withdrawals (S+T+M) When total injections exceed total withdrawals then real output and spending expand until a new balance is achieved When total withdrawals exceed total injections then real output and spending contract until a new balance is achieved

An Economy at Its Potential Output Figure 11.10, Page 262 40 80 120 160 240 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 725 AS AD Potential Output

Recessionary and Inflationary Gaps A recessionary gap occurs when equilibrium output falls short of potential output and is associated with an unemployment rate above the natural rate An inflationary gap occurs when equilibrium output exceeds potential output and is associated with an unemployment rate below the natural rate as well as increased pressure on prices

Recessionary and Inflationary Gaps Figure 11.11, Page 263 40 80 120 160 240 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 725 700 Recessionary Gap 40 80 120 160 240 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 200 725 700 Inflationary Gap AS Potential Output AS Inflationary Gap AD Recessionary Gap Potential Output AD

Economic Growth Economic growth can be defined in two ways the percentage increase in an economy’s total output (e.g. real GDP) is most appropriate when measuring an economy’s overall productive capacity the percentage increase in per capita output (e.g. per capita real GDP) is most appropriate when measuring living standards

Canada’s Economic Growth (a) Figure 11.12, Page 265

Economic Growth in Canada Before World War I (1870-1914), Canada’s per-capita output (in 1997 dollars) more than doubled from $2312 to $5283. In the interwar period (1914-1945), the country’s per-capita real output almost doubled from $5283 to $9660. In the postwar period (1945-), per-capita real output more than tripled to $33 389 by 2002.

Economic Growth and Productivity Growth in per capita output is closely associated with growth in labour productivity which depends on factors such as the quantity of capital the quality of labour technological progress

Business Cycles (a) The business cycle is the cycle of expansions and contractions in an economy an expansion is a sustained rise in real output a contraction is a sustained fall in real output a peak is the point in the business cycle at which real output is at its highest a trough is the point in the business cycle at which real output is at its lowest

The Business Cycle Figure 11.13, Page 266 Real GDP Time CONTRACTION EXPANSION Long-Run Trend of Potential Output Peak a c Recessionary gap Inflationary gap b d Trough

Contractions A contraction is usually caused by a decrease in AD magnified by the reactions of both households and businesses, who spend less due to pessimism about the future may be a recession, which is a decline in real output for six months or more may be a depression, which is a particularly long and harsh period of reduced real output

Expansions An expansion is usually caused by an increase in AD magnified by the reactions of both households and businesses as they spend more due to more optimistic expectations of the future

Expansion and Contraction Figure 11.14, Page 268 700 725 160 240 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) 730 AS f Inflationary Gap e AD0 Recessionary Gap Potential Output AD1

The Aggregate Expenditures Model The aggregate demand and aggregate supply approach highlights the impact of price changes on spending and output. In contrast, the aggregate expenditures model focuses on individual spending components while assuming that the price level is constant.

Consumption and Saving (a) Households divide their disposable income (DI) between consumption (C) and saving (S). We assume the only component of C to change with DI is purchases of domestically produced goods. Then the effect of a change in DI on consumption is shown by MPC and the effect on saving is shown by MPS.

Consumption and Saving (b) When defined relative to disposable income, both MPC and MPS must sum to one. For example, if a $200 billion increase in DI raises C by $150 billion, then MPC is 0.75 (or $150 b. divided by $200 b.). Meanwhile, the remaining $50 is saved, which means that MPS is 0.25 (or $50 b. divided by $200 b.).

Consumption and Saving Figure A, page 274 400 1400 1200 1000 800 600 200 Disposable Income ($ billions) Consumptions, Savings ($ billions) -200 Consumption and Saving Lines C Consumption and Saving Schedules DI C ($ billions) S 200 400 600 800 1000 1200 1400 200 350 500 650 800 950 1100 1250 -200 -150 -100 -50 50 100 150 $1250b. $800b. S $200b. $150b. -$200b.

The Spending-Output Approach (a) In a private economy with no government purchases or taxes, DI and GDP are equal. Using the spending-output approach, equilibrium occurs where the aggregate expenditures (AE) line meets the 45-degree line passing through the origin.

The Spending-Output Approach (b) Along the 45-degree line, all output produced is purchased. At GDP levels below the equilibrium level, there is negative unplanned investment, since AE exceeds the 45-degree line. GDP expands until equilibrium is attained. At GDP levels above the equilibrium level, there is positive unplanned investment, since AE is below the 45-degree line. GDP contracts until equilibrium is attained.

Spending-Output Approach Equilibrium with No Government (a) Figure B, page 275 (continued in part (b)) Expenditures ($ billions) 400 200 1400 1200 1000 800 600 GDP ($ billions) -$50 b. positive unplanned investment AE0 = C + I + (X – M) Spending-Output Approach GDP C I X-M AE ($ billions) C -$50 b. negative unplanned investment a 200 400 600 800 1000 1200 1400 200 350 500 650 800 950 1100 1250 25 25 250 400 550 700 820 1000 1150 1300 45°

The Injections-Withdrawals Approach (a) Using the injections-withdrawals approach, equilibrium is found where total injections (I+X) equal total withdrawals (S+M). This approach gives the same equilibrium GDP as does the spending-output approach.

Injections-Withdrawals Approach Equilibrium with No Government (b) Figure B, page 309 (continued from part (a)) 1400 1200 1000 800 600 400 200 Injections, Withdrawals ($ billions) GDP ($ billions) -200 Injections-Withdrawals Approach GDP M S S+M I X I+X ($ billions) S+M b 200 400 600 800 1000 1200 1400 -200 -150 -100 -50 50 100 150 350 150 200 250 300 350 400 450 500 25 375 400 I+X S I

Making an Economy Grow Paul Romer has devised a new growth theory which emphasizes the role of knowledge as an integral factor of production along with labour and capital argues that new ideas should be given a low price to stimulate further discoveries

Understanding Economics 3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 11 The End Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.