skating to where the puck is going aggregate supply and aggregate demand chapter 4
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LEARNING OBJECTIVES
Aggregate Supply and supply shocks
Aggregate Demand and a list demand shock
Use matches and mismatches between
aggregate supply and aggregate demand
to explain the “Yes” and “No” answers to
the fundamental macroeconomic question
“Yes” and “No” answers about origins,
expectations, and market responses to
business cycles
continued…
IF YOU PLAN AND BUILD IT . . . AGGREGATE SUPPLY
Supply plans for existing inputs determine aggregate quantity supplied.
Supply plans to increase quantity and quality of inputs,
together with supply shocks, change aggregate supply.
AGGREGATE SUPPLY (AS)
Macroeconomic players
consumers, businesses, government make
two kinds of plans for supplying Canadian
real GDP
a) supply plans for existing inputs
b) supply plans to increase inputs
a) Supply plans for existing inputs similar to microeconomic choices about quantity supplied
Aggregate quantity suppliedquantity of real GDP players plan to supply at different average price levels
Law of aggregate supplyas average level of prices rises, aggregate quantity supplied increases (up to maximum of potential GDP)
b) Supply plans to increase quantity or quality
of inputs cause increase in aggregate
supply — increase in economy’s capacity to
produce real GDP
With existing inputs Increasing input (quality & quantity)
Business supply choices
what to produce, quantities to produce, quantities of inputs to
hire.
new factories/equipment,
resources, technology.
Consumer supply choices
participate in labour force, hours to work,
inputs to supply.
having children, education and
training.
Government supply choices
resources to supply.Determines aggregate
quantity supplied
infrastructure, rules of the game, policies
Outcome Determines aggregate quantity supplied.
Changes AS and increases potential GDP.
Negative supply shocks directly increase costs or reduce inputs,
decreasing aggregate supply
Positive supply shocks directly decrease costs or improve
productivity, increasing aggregate supply
The Law of Aggregate Supply
The aggregate quantity supplied of Real GDP
Decreases if:• average level of prices falls
Increases if:• average level of prices rises
Changes in Aggregate Supply
The aggregate supply of Real GDP
Decreases if:• negative supply shock raises
price for resource inputs• negative supply shock
destroys inputs
Increases if:• businesses plan to increase
quantity or quality inputs• positive supply shock lowers
price for resource inputs• positive supply shock
improves technologies
Fig. 4.2: Law of Aggregate Supply and Changes in AS
. . . WILL THEY COME AND BUY IT? AGGREGATE DEMAND
Demand plans determine aggregate quantity demanded.
Demand shocks — from changes in expectations, interest rates, government policy, GDP in R.O.W.,
exchange rates — change aggregate demand.
AGGREGATE DEMAND (AD)
All macroeconomic players —
consumers, businesses, government, R.O.W.
make demand plans for spending, like
microeconomic choices about quantity
demanded
Aggregate quantity demandedquantity of real GDP players plan to demand at different average price levels
Law of aggregate demandas average level of prices rises, aggregate quantity demanded decreases
a. Consumers plans to spend (C) a fraction of
disposable income
b.Businesses plan investment spending (I)
for new factories and equipment. I plans are
volatile.
c. Government spending plans (G) for
products/services set by budget
d.R.O.W. spending plans (X) for Canadian exports
subtract imports (IM) from all other planned spending to get net exports (X — IM) = difference between what Canada exports and imports
Planned spending on aggregate demand =
planned C + planned I + planned G +
planned (X − IM)
Demand shocks
factors, other than average prices, changing
aggregate demand
Aggregate demand changes with expectations,
interest rates, government policy, GDP in
R.O.W., exchange rates
Negative demand shocks decrease
aggregate demand
a) more pessimistic expectations
b) higher interest rates
c) lower government spending and/or higher
taxes
d) decreased GDP in R.O.W.
e) higher value Canadian dollar
Positive demand shocks increase aggregate
demand
f) more optimistic expectations
g) lower interest rates
h) higher government spending and/or lower
taxes
i) increased GDP in R.O.W.
j) lower value Canadian dollar
MATCH OR MISMATCH? AGGREGATE SUPPLY & AGGREGATE
DEMAND
Matches between aggregate supply and aggregate demand
give equilibrium, Say’s Law, and “Yes” answer; mismatches give Keynes’s business cycles,
demand and supply shocks, and “No” answer.
“Yes” “No”
AGGREGATE SUPPLY & AGGREGATE DEMAND
“Yes” answermacroeconomic equilibrium with existing inputs when aggregate demand matches aggregate supply
– AS choices based on expectations of what price level and aggregate demand will be when products/services get to market
– price level and AD what suppliers expected
– Real GDP = potential GDP; inputs fully employed
– Say’s Law — supply creates its own demand
continued…
“Yes” answer
equilibrium over time with increasing inputs
when aggregate demand matches aggregate
supply
– add savings and investment to explain growth in living standards over time (real GDP per person)
– savings threaten Say’s Law, since all income in input markets not spent demanding products/services in output markets
continued…
Market for loanable fundsbanks coordinate supply of loanable funds
(savings) with demand for loanable funds
(borrowing)
– interest rate is price of loanable funds
– if banks loan savings to businesses that use it for investment spending, offsets consumer savings, restoring equality between aggregate income and aggregate spending
Investment spending increases inputs, so
potential GDP and real GDP per person increase
over time
– aggregate supply and aggregate demand both increase, full employment continues, average prices stay stable
“No” answer
mismatch between aggregate demand and
aggregate supply
– aggregate supply choices based on expectations of what price level and aggregate demand will be when products/services get to market
– expectations disappointed,outcomes do not work out as planned
– adjustments — expansions and contractions — necessary to get back to smart choices
– Keynes’s business cycles
Mismatch scenarios from demand shocks
– negative demand shock causes recessionary gap — falling average prices, decreased real GDP, increased unemployment
– positive demand shock causes inflationary gap —rising average prices increased real GDP, decreased unemployment
– demand shocks cause unemployment and inflation to move in opposite directions, like Philips Curve
Mismatch scenarios from supply shocks
– negative supply shock causes stagflation —rising average prices, decreased real GDP, increased unemployment
– positive supply shock causes falling average prices, increased real GDP, decreased unemployment
– supply shocks cause unemployment and inflation to move in same direction
“Yes” and “No” camps
– agree on descriptions of equilibrium and impact of demand and supply shocks
– disagree on origins of shocks and how quickly markets adjust
SHOCKING STARTS AND FINISHES: ORIGINS AND RESPONSES TO BUSINESS
CYCLES
“Yes” and “No” camps disagree about external/internal
origins of shocks, about rational/volatile expectations, and about how quickly price adjustments
restore match between aggregate supply and demand.
“Yes” camp
markets quickly self-adjust, so hands-off
– origins of shocks external to economy — nature, science, mistaken government policies
– government part of problem, not solution
– rational expectations and logical choices
ORIGINS AND RESPONSES TO BUSINESS CYCLES
• For “Yes” camp, when shocks occur, price
adjustments in all markets quickly restore
match between aggregate supply and
aggregate demand — example of negative
demand shock
– in labour market, unemployment causes wages to fall, increasing hiring back to full employment
– in output markets, prices fall due to surpluses and falling wage costs, increasing sales back to potential GDP
– in international trade market,
falling Canadian prices increase net exports,
increasing Canadian real GDP and decreasing
unemployment
– in loanable funds market, savings cause
interest rates to fall, increasing investment
spending (I), increasing Canadian real GDP
and
decreasing unemployment
“No” camp
markets fail to quickly self-adjust, so hands-on
– origins of shocks internal to economy — changing expectations, role of money, connections with R.O.W.
– volatile expectations based on fundamental uncertainty about future
– facing uncertainty, saving decisions are internal negative demand shock
– business cycles in other economies affect Canada through exports and imports
For “No” camp, when shocks occur, difficult
adjustments in all markets — example of
negative demand shock
– in labour market, wages sticky even with unemployment —layoffs instead of lower wages
– in output markets, prices fall due to surpluses,
but falling incomes from unemployment in input markets decrease consumption demand (C)
– in international trade market, falling Canadian prices increase net exports, but destabilizing effects of cycles in R.O.W.
– in loanable funds market, even if interest rates fall, pessimistic expectations may cause investment spending (I) to decrease
– with weak/slow price adjustments, role for government to bring aggregate supply and aggregate demand back into balance
Disagreement between “Yes” and “No”
camps on
– connections between input markets and output markets for both demand and supply sides
– connections between Canada and R.O.W.
– connections between money/banks/expectations and input and output markets
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