Chapter 5: aggregate supply and demand Potential GDP: the total ...
Chapter 5: aggregate supply and demand Potential GDP: the total amount that an economy is capable of producing when all of it's resources are being fully utilized Labour Productivity: a measure of the amount of output produced per unit (per unit of time) human capital: the accumulated knowledge and skills of human beings business cycle: the expansionary and contradictory phases in the growth of real GDP -this is measured via growth rates (remember that grwoth rates are calculated year by year, not off of a base rate) -usually represented on a line chart-expansionary phase (upward trending) contractionary phase (downward trending), peaks and troughs LABOUR PRODUCTIVITY: OUTPUT PER PERIOD/UNITS OF LABOUR 4 Sources of Economic Growth the quantity and quality of it's labour resources -amount of physical capital available (higher capital-labour ratio) the rate of technological change -the amount and quality of it's natural resources ECONOMIC GROWTH=a right shift in the potential GDP curve Aggregate supply: the aggregate quantity of goods and services produced by all sellers at various price levels -an aggregate supply curve is not a straight line because as production increases productivity decreases real wage: the amount of goods and services that an employee can buy for a given amount of nominal wage Nominal wage: the present day value of a current wage REAL WAGE= NOMINAL WAGE/PRICE LEVEL Aggregate Demand: the total quantity of final goods and services that consumers, businessmen, government and those living outside of the country (CIGX) would buy at various price levels Real Balances Effect: the effect that a change in the vale of real balances has on consumption spending (IE, less REAL weath, less consumption spending. Inflation drives a reduction in consumption spending) Interest Rate Effect: the effect that a change in prices has on interest rates, leads to the effect that interest rates have upon investment MACROECONOMIC EQUILIBRIUMl:AGGREGATE DEMANX EQUALS SHORT RUN AGGREGATE SUPPLY Foreign trade effect: the effect that a change in prices has upon exports and imports The aggregate demand curve is downward sloping because of -the interest rate effect -the foreign trade effect -the real trade effect POTENTIAL GDP:the potential economic output of an economy at FULL EMPLOYMENT AN INCREASE IN POTENTIAL GDP MEANS AN INCREASE IN THE PRODUCTION POSSIBLITIES CURVE MACROECONOMIC EQUILIBRIUM: a situation in which the quantity of real GDP demanded is equal to the qauntity of real GDP supplied RECESSION: a period of time when the economy is producing below it's potential and has had two Chapter 5
consecutive quarters of negative growth RECESSIONARY GAP: the difference between actual real GSP and POTENTIAL Real GDP, the the economy is producing below potential Recessionary to the left INTFLATIONARY GAP: the difference between actual real GDP and potential real GDP when the economy is temporarily producing an output above full employment Inflationary to the right *MACROECONOMIC EQUILIBRIUM MAY OCCUR AT FULL EMPLOYMENT, OR RESULT IN A RECESSIONARY GAP, OR RESULT IN AN INFLATIONARY GAP THE BIG LIST OF DETERMINANTS OF AGGREGATE DEMAND
Chapter 5
1. wealth 2, age of consumer durables 3.consumer expectations 4. interest rates 5.purchase prices, installation and maintainance costs of capital goods 6.age of capital goods and amount of spare capacity 7. business expectations 8. government regulations 9.value of exchange rate 10. income levels abroad 11. price of competitive (foreign) goods 12. tastes of foreigners 13.GOVERNMENT SPENDING 14. TAX RATES 15. MONEY SUPPLY DETERMINANTS OF AGGREGATE SUPPLY -improvement in human capital -an increase in the amount of capital -technological improvement -an increase in natural resources -change in wages rates or the price of factor services (note: change in wages/factors services is the only determinant of aggregate supply which does not ALSO effect potential GDP) NOTE-TRICK QUESTION-THE CHANGE IN THE PRICES OF THE NATURAL RESOURCES DOESN”T SHIFT POT GDP-the change in the EXISTANCE of them does ESSAY QUESTION: Rightward shift means more COMMENT ON ALL 14 OF THE DETERMINANTS OF AGGREGATE DEMAND, AND ALL 4 OF THE DETERMINANTS OF AGGREGATE SUPPLY Who spends? Consumers account for the consumption spending, firms count for investment spending, foreign markets for net exports, the government for, well, the government. CIGX rides again!!! (Also, the money supply-which we'll talk about later) Aggregate demand is broken up into 5 different areas. The first is CONSUMPTION. An increase in individual wealth will increase aggregate demand. The age of consumer durables, such as cars and appliance is calculated-the higher it is, the higher aggregate demand will be. The last is customer expectations. If a customer expects future prices will be higher, they will spend now, lower, they will spend later (recall the negative effects of deflation from last section). The second is Investment, the most important factor of which is the Interest rate. If the rate of interest is high, then investors will borrow less money, and buy less capital goods. If the rate is low they will borrow more. High interest, therefore means less demand. Low interest means more. Also, consider that the money that firms have set aside in banks they will be more liekly to leave in banks, or make investments of thier own, if the interest rate is high and offers a better return. The second is the price of new capital assets (inclusive of installation and maintainance), if there is a change and this price drops, then firms will be more likely to spend on new equipment. Thirdly, the age and excess capacity of present equipment (analogous to consumer durables previously) if a company has new, underused equipemnt, it Chapter 5
will be unlikely to invest in new capital goods. Fourthly, business expectations, self explanatory and analogous to customer expectations. Finally, government policies and regulations-if these regualtions are strict, they are likely to discourage new investment. The third sector is NET EXPORTS. The most important here is the value of the exchange rate. A high dollar means that we buy more imports, a low dollar means that they buy more exports from us, either can significantly affect the balance of trade. Then, the level of foreign incomes-if they go up, export rises, if they drop, export drops (and import rises). Thirdly, the price level of competitive foreign goods-if Russian Mail order brides go up in price, Canadians will bang more local, ugly girls. This may not be the best example... Finally, the tastes of foreigners (do they want softwood lumber? Beaver pelts? Blackberries? Cold, Aloof women? Then come to CANADA!) DETERMINANTS OF SUPPLY: This is the easy one. This makes it go up: -better human capital -an increase in the amount of capital -technological improvement -an increase in natural resources All of these contribute to a new aggregate supply curve, as they increase productivity. Productivity means profit, the more productive a supplier is, the more they are willing and able to produce at a lower price level (rightward shift). Productivity is key. Here, the production possibilities curve rides again, sort of. Also, recall that this curve is crooked because as production increase, productivity decreases (lower quality of human capital, capital, and natural resources)
Chapter 5
Chapter 5
Keynes vs. The neoclassicists: Compare and contrast the two schools of economics Neoclassic: NC believed that the market was competitive and efficient and would adjust rapidly to a general surplus or shortage. The mechanism of adjustment was to be the prices and the wages of the workers. This rapid adjustment would ensure full employment. The NC Aggregate supply curve was vertical, straight up and down. Because the supply was always equal to the full employment supply, the Potential GDP curve became the de facto aggregate supply curve. Prices were determined solely by changes in aggregate demand. Due to the fixed position of the AS/Potential GDP curve, economic growth could only result from an increase in production possibilities due to the afforementioned determinants of supply. NEOCLASSIC ASSUME THE ECONOMY IS ALWAYS AT FULL EMPLOYMENT In the event of a drop in demand: NC's change thier prices, change their wages, but keep the supply the same KEYNES: Prices and wages are inflexxible. They are 'sticky' and tend to resist movement, and changes in demand tend not to have large effects on price levels. The aggregate supply curve, for Keynes, isn't set along a single point on the Real GDP, as for NC's, but rather it was perfectly inflexible, and was a horizontal line set one a certain point at the price level. If there was a recessionary gap, Keynesians believe that wage levels would not change and that prices levels would remain the same, In the event of a drop in demand: Keynesians keep thier price, keep thier wage level, but lower the level of production (ie, lay off workers, but less of the other factors) KEYNESIAN ASSUMES THE ECONOMY IS ALWAYS BELOW FULL EMPLOYMENT IN LIGHT OF THE PREVIOS DISCUSSION, EXPLAIN THE MODERN VIEW OF ECONOMICS the modern view is a combination of these two schools of thought. In the lower section of the supply curve, where the economy is distant form full employment, the keynsian view holds. The price level is low, the prices are sticky, and producers are more likely to adjust thier supply then thier prices. As the curve move towards full employment, we enter the neoclassical range-small changes in supply, but large changes in prices. For what three reasons is the aggregate demand curve downward sloping? Firstly, the real balance effect, which is the effect that a change in the value of real balances has on consumption spending (the less real wealth an individual possesses, the less they will spend). Second, the interest rate effect. Higher price level pushes up interest rates, which lowers investment spending. Thirdly, foreign trade effect, the simplest of the three. High price levels will shift the balance of trade, more imports, less exports (CIX, no G-government is independant of market)
Chapter 5
consecutive quarters of negative growth RECESSIONARY GAP: the difference between actual real GSP and POTENTIAL Real GDP, the the economy is producing below potential Recessionary to the left INTFLATIONARY GAP: the difference between actual real GDP and potential real GDP when the economy is temporarily producing an output above full employment Inflationary to the right *MACROECONOMIC EQUILIBRIUM MAY OCCUR AT FULL EMPLOYMENT, OR RESULT IN A RECESSIONARY GAP, OR RESULT IN AN INFLATIONARY GAP THE BIG LIST OF DETERMINANTS OF AGGREGATE DEMAND
Chapter 5
1. wealth 2, age of consumer durables 3.consumer expectations 4. interest rates 5.purchase prices, installation and maintainance costs of capital goods 6.age of capital goods and amount of spare capacity 7. business expectations 8. government regulations 9.value of exchange rate 10. income levels abroad 11. price of competitive (foreign) goods 12. tastes of foreigners 13.GOVERNMENT SPENDING 14. TAX RATES 15. MONEY SUPPLY DETERMINANTS OF AGGREGATE SUPPLY -improvement in human capital -an increase in the amount of capital -technological improvement -an increase in natural resources -change in wages rates or the price of factor services (note: change in wages/factors services is the only determinant of aggregate supply which does not ALSO effect potential GDP) NOTE-TRICK QUESTION-THE CHANGE IN THE PRICES OF THE NATURAL RESOURCES DOESN”T SHIFT POT GDP-the change in the EXISTANCE of them does ESSAY QUESTION: Rightward shift means more COMMENT ON ALL 14 OF THE DETERMINANTS OF AGGREGATE DEMAND, AND ALL 4 OF THE DETERMINANTS OF AGGREGATE SUPPLY Who spends? Consumers account for the consumption spending, firms count for investment spending, foreign markets for net exports, the government for, well, the government. CIGX rides again!!! (Also, the money supply-which we'll talk about later) Aggregate demand is broken up into 5 different areas. The first is CONSUMPTION. An increase in individual wealth will increase aggregate demand. The age of consumer durables, such as cars and appliance is calculated-the higher it is, the higher aggregate demand will be. The last is customer expectations. If a customer expects future prices will be higher, they will spend now, lower, they will spend later (recall the negative effects of deflation from last section). The second is Investment, the most important factor of which is the Interest rate. If the rate of interest is high, then investors will borrow less money, and buy less capital goods. If the rate is low they will borrow more. High interest, therefore means less demand. Low interest means more. Also, consider that the money that firms have set aside in banks they will be more liekly to leave in banks, or make investments of thier own, if the interest rate is high and offers a better return. The second is the price of new capital assets (inclusive of installation and maintainance), if there is a change and this price drops, then firms will be more likely to spend on new equipment. Thirdly, the age and excess capacity of present equipment (analogous to consumer durables previously) if a company has new, underused equipemnt, it Chapter 5
will be unlikely to invest in new capital goods. Fourthly, business expectations, self explanatory and analogous to customer expectations. Finally, government policies and regulations-if these regualtions are strict, they are likely to discourage new investment. The third sector is NET EXPORTS. The most important here is the value of the exchange rate. A high dollar means that we buy more imports, a low dollar means that they buy more exports from us, either can significantly affect the balance of trade. Then, the level of foreign incomes-if they go up, export rises, if they drop, export drops (and import rises). Thirdly, the price level of competitive foreign goods-if Russian Mail order brides go up in price, Canadians will bang more local, ugly girls. This may not be the best example... Finally, the tastes of foreigners (do they want softwood lumber? Beaver pelts? Blackberries? Cold, Aloof women? Then come to CANADA!) DETERMINANTS OF SUPPLY: This is the easy one. This makes it go up: -better human capital -an increase in the amount of capital -technological improvement -an increase in natural resources All of these contribute to a new aggregate supply curve, as they increase productivity. Productivity means profit, the more productive a supplier is, the more they are willing and able to produce at a lower price level (rightward shift). Productivity is key. Here, the production possibilities curve rides again, sort of. Also, recall that this curve is crooked because as production increase, productivity decreases (lower quality of human capital, capital, and natural resources)
Chapter 5
Chapter 5
Keynes vs. The neoclassicists: Compare and contrast the two schools of economics Neoclassic: NC believed that the market was competitive and efficient and would adjust rapidly to a general surplus or shortage. The mechanism of adjustment was to be the prices and the wages of the workers. This rapid adjustment would ensure full employment. The NC Aggregate supply curve was vertical, straight up and down. Because the supply was always equal to the full employment supply, the Potential GDP curve became the de facto aggregate supply curve. Prices were determined solely by changes in aggregate demand. Due to the fixed position of the AS/Potential GDP curve, economic growth could only result from an increase in production possibilities due to the afforementioned determinants of supply. NEOCLASSIC ASSUME THE ECONOMY IS ALWAYS AT FULL EMPLOYMENT In the event of a drop in demand: NC's change thier prices, change their wages, but keep the supply the same KEYNES: Prices and wages are inflexxible. They are 'sticky' and tend to resist movement, and changes in demand tend not to have large effects on price levels. The aggregate supply curve, for Keynes, isn't set along a single point on the Real GDP, as for NC's, but rather it was perfectly inflexible, and was a horizontal line set one a certain point at the price level. If there was a recessionary gap, Keynesians believe that wage levels would not change and that prices levels would remain the same, In the event of a drop in demand: Keynesians keep thier price, keep thier wage level, but lower the level of production (ie, lay off workers, but less of the other factors) KEYNESIAN ASSUMES THE ECONOMY IS ALWAYS BELOW FULL EMPLOYMENT IN LIGHT OF THE PREVIOS DISCUSSION, EXPLAIN THE MODERN VIEW OF ECONOMICS the modern view is a combination of these two schools of thought. In the lower section of the supply curve, where the economy is distant form full employment, the keynsian view holds. The price level is low, the prices are sticky, and producers are more likely to adjust thier supply then thier prices. As the curve move towards full employment, we enter the neoclassical range-small changes in supply, but large changes in prices. For what three reasons is the aggregate demand curve downward sloping? Firstly, the real balance effect, which is the effect that a change in the value of real balances has on consumption spending (the less real wealth an individual possesses, the less they will spend). Second, the interest rate effect. Higher price level pushes up interest rates, which lowers investment spending. Thirdly, foreign trade effect, the simplest of the three. High price levels will shift the balance of trade, more imports, less exports (CIX, no G-government is independant of market)
Chapter 5
