Chapter 19 Aggregate Demand and Aggregate Supply Three key facts about economic fluctuations Explaining Short-Run Economic Fluctuations The Aggregate-Demand Curve The Aggregate-Supply Curve Two causes of economic fluctuations

Economic activity fluctuates from year to year Economic activity fluctuates from year to year. In some years, the production of goods and services rises. In other years normal growth does not occur, leading to recession. A recession is a situation of declining real GDP, falling incomes and rising unemployment for two consecutive quarters. Depression: a severe recession Three Key Facts About Economic Fluctuations Economic Fluctuations are Irregular and Unpredictable. Recessions occur with unpredictable frequency and duration. See Figure 19-1 Recessions defined here as two or more consecutive quarters of negative real GDP growth, are shown as the shaded areas.

Most Macroeconomic Variables Fluctuate Together. Most macroeconomic variables are closely related and move together. As Output Falls, Unemployment Rises. Changes in real GDP and the unemployment rate are inversely related. Explaining short-run economic fluctuations Model of Aggregate Demand and Aggregate Supply: the model hat most economists use to explain short-run fluctuations in economic activity around its long-run trend. The Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices.

The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices. Two variables are used in developing AD-AS model to analyze the short-run fluctuations: 1. The economy’s output of goods and services, measured by real GDP 2. The overall price level, measured by the CPI or GDP Deflator See figure 19-2

The Aggregate Demand Curve The aggregate demand for goods and services may be referred to as:Y = C + I + G + NX See figure 19-3 AD curve Why is the aggregate demand curve downward sloping? 1. Pigou’s Wealth Effect 2. Keynes’ Interest Rate Effect Real Exchange Rate Effect Pigou’s Wealth Effect: “Consumers feel wealthier, which stimulates the demand for consumption goods.” A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded.

Keynes’ Interest-Rate Effect: “The lower the price level, the less money households need to hold to buy the goods and services they want.” A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Real Exchange-Rate Effect: “When prices of Canadian goods go down, foreigners buy more of our goods and we purchase less of their goods.” When a fall in the Canadian price level causes the real exchange rate to depreciate, this stimulates Canadian net exports, thereby increasing the quantity of goods and services demanded.

Why the AD curve might shift The downward slope of the AD curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at a give price level. When one of these other factors changes, the AD curve shift. Shifts in the aggregate demand curve may arise because of: 1. Changes in spending plans by consumers or firms. 2. Changes in fiscal or monetary policy. “Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand schedule to shift.” See Table 19-1

The Aggregate Supply Curve Why the AS curve is vertical in the long run The Long-Run Aggregate Supply Curve is vertical at full-employment GDP with respect to the price level. In the long-run the quantity of output supplied depends on the economy’s resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run. See Figure 19-4 Why the long-run AS curve might shift Over time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift. Because output in the classical model depends on labour, capital, natural resources and technological knowledge, we can categorize shifts in the long-run AS as changes from these sources.

An event that reduces potential output shifts the schedule to the left. Any change that increases the economy’s potential output will shift the curve to the right. A new way to depict long-run growth and inflation See Figure 19-5 Long Run growth and inflation in the model of AD-AS The LRAS may shift to the right because of technological progress. At the same time, as the Bank of Canada increases the money supply, the AD curve also shifts to the right. So price level rises and output grows. Thus, AD-AS model provide a new way to depict long-run growth and inflation.

Why the aggregate-supply curve slopes upward in the short-run See Figure 19-6 In the short-run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied. There are three alternative explanations for the upward slope of the short-run aggregate supply curve. New Classical Misperceptions Theory The Keynesian Sticky-Wage Theory The New Keynesian Sticky-Price Theory

The New Classical Misperceptions Theory: “A higher price level signals to each firm a greater demand for their product inducing them to produce more.” Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their output. The Keynesian Sticky-Wage Theory: “The higher product prices cause a temporary decrease in real wages stimulating employment and output.” Nominal wages are slow to adjust, or are “sticky” in the short-run, thus a lower price level makes employment and production less profitable, which induces firms to reduce production.

The New Keynesian Sticky-Price Theory: “Prices that do not increase immediately are temporarily low thereby stimulating spending and output on those goods.” Prices of some goods and services adjust sluggishly in response to changing economic conditions. Remember Menu Costs. Why the short-run AS curve might shift Three factors may lead to a shift in the short-run aggregate supply curve. Changes in Factor (input) Prices Changes in Productivity Legal-Institutional Environment

Changes in factor (input) prices: Changes in the prices of domestic or imported resources will change the cost of producing final goods. An increase in input prices will shift the supply curve to the left. A decrease in input prices will shift the supply curve to the right. Changes in productivity: If changes in the resource markets increase factor productivity, more goods can be made available at a lower cost. New technologies can increase the output per unit of labour or capital and hence make available more final goods. Legal-institutional environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing. See Table 19-2

Two Causes of Economic Fluctuations The long-run equilibrium: See Figure 19-7 Equilibrium output and price level are determined by the intersection of the aggregate demand curve and the long-run aggregate supply curve. Output is at its natural rate and the short-run aggregate supply curve passes through the point of intersection. Two sources from which a recession in the economy may occur: A decrease in aggregate demand A decrease in aggregate supply Shifts in the aggregate demand or the aggregate supply curves result in fluctuations in the economy’s output of goods and services.

Source of Recession: A Decrease in Aggregate Demand A decrease in one or more components of the total spending function will cause the aggregate demand schedule to shift leftward. Output will fall below the full employment output Unemployment will rise See Figure 19-8 Point A and Point B Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in AD is to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment. Increase in G or an increase of money supply would increase the quantity of goods and services demanded at any price and therefore, would shift the AD curve back to the right.

Even without action by policymakers, the recession will remedy itself over a period of time. Because of the reduction in AD, the price level falls. Eventually, expectations catch up with this new reality, and the expected price level falls as well. Because the fall in the expected price level alters perceptions, wages, and prices, it shifts the SRAS to the right from AS1 to AS2. This adjustment of expectations allows the economy over time to approach point C in figure 19-8. In the new long run equilibrium, point C, output is back to its natural level. Thus, the long-run effect of a shift in AD is a nominal change ( the price level is lower) but not a real change (output is the same). See Figure 19-9 Big shifts in AD in Canada

Source of Recession: A Decrease in Aggregate Supply A decrease in short-run aggregate supply will result in a new equilibrium along the aggregate demand curve below full employment. A fall in total output below full output An increase in unemployment See Figure 19-10 Point A to Point B When the economy falls due to a decrease in the aggregate supply, the price level rises and output decreases. This is called Stagflation. Alternatively, policymakers who control monetary and fiscal policy might attempt to offset some of the effects of the shift in the SRAS curve by shifting the AD curve. See Figure 19-11. In this case, policymakers are said to accommodate the shift in AS because they allow the increase in costs to affect the level of prices permanently.

Actions by Policy-makers During Periods of Recession Policy-makers, when faced by decreasing aggregate demand or supply could: Do nothing, assuming that perceptions will adjust prices and wages. Example: Figure 19-8 Take action to increase aggregate demand (implement monetary and fiscal policy). Example: Figure 19-11