PART 3: MACROECONOMIC MODELS AND FISCAL POLICY Prepared by Dr. Amy Peng Ryerson University ©2013 McGraw-Hill Ryerson Ltd.

1. Define aggregate demand (AD) and explain the factors that cause it to change. 2. Define aggregate supply (AS) and explain the factors that cause it to change. 3. Discuss how AD and AS determine an economy’s equilibrium price level and level of real GDP. ©2013 McGraw-Hill Ryerson Ltd.2Chapter 10

 Aggregate demand is a schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level ©2013 McGraw-Hill Ryerson Ltd.3Chapter 10.1

Real domestic output, GDP Price level AD 0 ©2013 McGraw-Hill Ryerson Ltd.4Chapter 10.1

 Slopes downward because of the following effects of a change in price level: 1. Real-balances Effect 2. Interest-rate Effect 3. Foreign Trade Effect 5©2013 McGraw-Hill Ryerson Ltd.Chapter 10.1

Real domestic output, GDP Price level AD 1 AD 3 AD 2 LO ©2013 McGraw-Hill Ryerson Ltd.6Chapter 10.1

 Changes in Consumer Spending  Consumer wealth  Consumer expectations  Household borrowing  Personal taxes 7©2013 McGraw-Hill Ryerson Ltd.Chapter 10.1

 Changes in Investment Spending  Interest Rates  Expected Returns ▪ Expectations about future business conditions ▪ Technology ▪ Degree of excess capacity ▪ Business taxes 8©2013 McGraw-Hill Ryerson Ltd.Chapter 10.1

 Changes in Government Spending  Government spending increases, aggregate demand increases (as long as interest rates and tax rates do not change) ▪ More computers for government agencies  Government spending decreases, aggregate demand decreases ▪ Less transportation projects 9©2013 McGraw-Hill Ryerson Ltd.Chapter 10.1

 Changes in Net Export Spending  National income abroad  Exchange rates ▪ Dollar depreciation ▪ Dollar appreciation 10©2013 McGraw-Hill Ryerson Ltd.Chapter 10.1

 Aggregate supply is a schedule or curve showing the relationship between the price level of output and the amount of real domestic output that firms in the economy produce  This relationship varies depending on three time horizons: The immediate short run The short run The long run 11©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

 In the immediate short run, both input prices and output prices are fixed  In the immediate short run, the aggregate supply curve is horizontal at an economy’s current price level  With output prices fixed, firms collectively supply the level of output that is demanded at those prices 12

Real domestic output, GDP Price level AS ISR GDP f Immediate-short-run aggregate supply P1P1 0 13©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

 The short run begins after the immediate short run ends.  The short run is a period of time during which output prices are flexible but input prices are either totally fixed or highly inflexible. 14©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

 The upward-sloping aggregate supply curve AS indicates a direct (or positive) relationship between the price level and the amount of real output that firms will offer for sale  The AS curve is relatively flat below the full- employment output  It is relatively steep beyond the full- employment output 15©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

Real domestic output, GDP Price level 0 GDP f AS Aggregate supply (short run) 16©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

 For the economy as a whole, it is the time horizon over which all output and input prices are fully flexible  It begins after the short run ends  Price-level changes do not affect firms’ profits and thus they create no incentive for firms to alter their output. 17©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

Real domestic output, GDP Price level AS LR GDP f 0 Long-run aggregate supply 18©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

1. Change in input prices a. Domestic resource price b. Price of imported resources 2. Change in productivity 3. Change in legal-institutional environment a. Business taxes and subsidies b. Government regulation 19©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

Real domestic output, GDP Price level AS 1 AS 3 AS ©2013 McGraw-Hill Ryerson Ltd.Chapter 10.2

 Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied 21 Real Output Demanded (billions) Price Level (index number) Real Output Supplied (billions) $ ©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

Real domestic output, GDP (billions of dollars) Price level (index numbers) a b AD AS Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $506108$ ©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

 For any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level  Demand-pull inflation 23©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 GDP 2 GDP 1 GDP f AD ©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

 Deflation, a decline in the price level, is a rarity in the Canadian economy  Real output takes the full brunt of the decline in AD because product prices are “sticky” in the short run  fear of price wars  menu costs  wage contracts  morale, effort, & productivity  minimum wage  menu costs  fear of price wars 25©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

Real domestic output, GDP Price level AD 1 AS P1P1 P2P2 GDP 1 GDP 2 GDP f AD 2 c a b 0 26©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

 Effects of a leftward shift in AS are doubly bad  output decreases  price level increases 27©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

Real domestic output, GDP Price level AD AS 1 P1P1 P2P2 GDP 1 GDP f AS 2 a b 0 28©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

 Increases in AD should normally lead to inflation  In the late 1990s, productivity growth has shifted the long-run AS curve to the right  Economy slowed down in 2001 due to a substantial fall in investment spending  During economy rebounded but followed by the recession of ©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

Real domestic output, GDP Price level AD 1 AS 2 P1P1 P2P2 GDP 2 GDP 1 AS 1 b AD 2 c P3P3 GDP 3 a 0 30©2013 McGraw-Hill Ryerson Ltd.Chapter 10.3

 Aggregate supply shocks  Cost push inflation  Oil prices affected core inflation prior to 1980  Core inflation unaffected post 1980  Energy efficiency  Composition of GDP  Bank of Canada vigilance ©2013 McGraw-Hill Ryerson Ltd.Chapter 1031

 10.1 Aggregate Demand  10.2 Aggregate Supply  10.3 Equilibrium and Changes in Equilibrium ©2013 McGraw-Hill Ryerson Ltd.Chapter 1032