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Chapter 4. Skating to Where the Puck is Going Aggregate Supply and Aggregate Demand. LEARNING OBJECTIVES. Aggregate Supply and supply shocks Aggregate Demand and a list demand shock

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skating to where the puck is going aggregate supply and aggregate demand

Chapter 4

Skating to Where the Puck is Going

Aggregate Supply and Aggregate Demand

learning objectives
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

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
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

slide6
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

slide8
Negative supply shocks directly increase costs or reduce inputs, decreasing aggregate supply

Positive supply shocks directly decrease costs or improve productivity, increasing aggregate supply

will they come and buy it aggregate demand

. . . 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
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

slide12
Consumers plans to spend (C) a fraction of disposable income

Businesses plan investment spending (I)for new factories and equipment. Iplans are volatile.

Government spending plans (G) for products/services set by budget

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

slide13
Planned spending on aggregate demand = planned C + planned I + planned G + planned (X −IM)

Demand shocksfactors, other than average prices, changing aggregate demand

Aggregate demand changes with expectations, interest rates, government policy, GDP in R.O.W., exchange rates

slide14
Negative demand shocks decrease aggregate demand

more pessimistic expectations

higher interest rates

lower government spending and/or higher taxes

decreased GDP in R.O.W.

higher value Canadian dollar

Positive demand shocks increase aggregate demand

more optimistic expectations

lower interest rates

higher government spending and/or lower taxes

increased GDP in R.O.W.

lower value Canadian dollar

match or mismatch aggregate supply aggregate demand

MATCH OR MISMATCH? AGGREGATE SUPPLY & AGGREGATE DEMAND

“Yes”

“No”

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.

aggregate supply aggregate demand
AGGREGATE SUPPLY & AGGREGATE DEMAND

“Yes” answermacroeconomic equilibrium with existing inputs when aggregate demand matchesaggregate 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…

slide17
“Yes” answerequilibrium over time with increasing inputs when aggregate demand matchesaggregate 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…

slide18
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

slide19
“No” answermismatchbetween 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

slide20
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

slide21
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

slide22
“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

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 adjustmentsrestore match between aggregate supply and demand.

slide24
“Yes” campmarkets 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

slide25
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

slide26
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

slide27
“No” campmarkets 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

slide28
For “No” camp, when shocks occur, difficult adjustments in all markets — example of negative demand shock

in labourmarket, 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.

slide29
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

slide30
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