Unit 3: Macroeconomics

1. Unit 3: Macroeconomics Chapter 9: An Introduction to Macroeconomics Chapter 10: The Business Cycle and Fiscal Policy Chapter 11: Money and Banking

2. Chapter 10: The Business Cycle and Fiscal Policy • Overview • The macroeconomy and aggregate demand and supply analysis • The fluctuations of the economy as explained by the business cycle • How the Great Depression led to the development of the Keynesian view of government in economic intervention • The use of fiscal policy to influence the business cycle • The limitations and drawbacks of using fiscal policy to mange the economy

3. Introduction to Fiscal Policy • Chapter 9 introduced critical macroeconomic indicators such as: • Unemployment rate • Inflation rate (measured as an annual percentage change in the CPI) • Economic growth (measured as an annual percentage change in the GDP) • In Chapter 1, we examined: • How the production possibilities curve helps to describe the choices that an economy faces • The potential that exists if all its resources are used to maximum efficiency

4. Introduction to Fiscal Policy • In other chapters we also explored how equilibrium is determined in the product, labour, and capital markets • These concepts for the foundation necessary to understand how the macroeconomy works and to examine a long-standing economic debate: • What is the best way to ensure the economic well-being of our society?

5. Aggregate Demand and Supply • In previous chapters, we looked at supply and demand as a way to explain how equilibrium is established in individual markets • Our explanation of equilibrium at the macro level begins with a similar analysis

6. Aggregate Demand and Supply • In theory, if we could add up all consumer demand, at all various price levels, for all markets, we could determin the total demand schedule for an economy • Similarly, if we could add up all of what producers are willing to supply, at all various price levels, for all markets, we could determine the total supply schedule for an economy • When we combine all markets for individual goods and services in society, we are looking at the aggregate, or total, for the entire economy

7. Aggregate Demand • Aggregate demand (AD) is the total demand for all goods and services produced in a society • Table 10.1 shows the total amount of goods and services purchased at each price level, as measured by the chain Fisher volume index, in a particular economy • Figure 10.2 is a graph of its aggregate demand curve • Looks very similar to the market demand curve studied in Unit 2 • As price rises, the total real output (or aggregate quantity demanded) falls

8. Table 10.1: Example of total amount of goods and services purchased at each Particular price level in an economy (aggregate demand)

9. Aggregate Demand

10. Aggregate Demand • It should be pointed out that the aggregate demand at each of the price levels is really equivalent to the GDP that would occur at that price level • i.e. The sum of all consumption, investment, government spending, and net exports in the economy • In the last chapter, we defined this by the formula: GDP = C + I + G + (X – M)

11. Aggregate Demand • For real economic growth to occur, the real GDP must grow • In other words, the aggregate quantity demanded must increase at each of the price levels • This means one or more of the variable in the GDP formula must increase in value

12. Aggregate Supply • Aggregate supply (AS) is the total supply of all goods and services produced in a society • The aggregate supply curve shows the total amount of goods and services that would be supplied at each price level, as measured by the chain Fisher volume index, in an economy • Table 10.3 is an aggregate supply schedule for a particular economy • Figure 10.4 is a graph of the aggregate supply curve

13. Table 10.3: Example of total amount of goods and services supplied at each Particular price level in an economy (aggregate supply)

14. Aggregate Supply

15. Aggregate Supply • While similar in shape to the supply curve from microeconomic supply analysis, the aggregate supply curve does feature important differences • The first is the very elastic portion that occurs at low output levels (first part of graph) • At very low outputs, most of a society’s resources are sitting idle • Ex: When there are many unemployed workers, there is too little competition for workers among producers to force the price of wage labour higher (surpluses force prices down)

16. Aggregate Supply • Therefore, there is little increase in the average costs of production when new workers are hired and output is increased • Price levels would consequently stay fairly low even as output increases • As more output is produced, more competition occurs among producers for limited amounts of land, labour, and capital inputs • As these resources become scarcer, their prices go up and put upward pressure on the prices of all goods and services

17. Aggregate Supply • At higher output levels, prices tend to rise much more rapidly • At some point, the economy would run out of resources altogether • Any attempted increase in output would simply result in producers “bidding up” input prices to higher levels without actually producing any more output

18. Aggregate Supply • In theory, an economy producing that level of output is producing at a point on its production possibilities curve • It can’t physically produce more output without improvements in technology or the discovery of new physical inputs

19. Equilibrium Output and Price Level • The point at which the AD curve intersects the AS curve is the equilibrium level of price and output for the economy

21. Equilibrium Output and Price Level • When the economy is at full-employment equilibrium the two curves intersect at a point on the AS curve where prices start to rise more rapidly, but the curve is not yet vertical • As the economy approached full employment, competition for scarce resources starts to push price levels up • The economy still has room for further increases in real GDP because of frictional unemployment and the possibility of increasing output beyond the full-employment level (ex: having employees work overtime)

22. Equilibrium Output and Price Level • At some point, the curve would become vertical as an absolute capacity is reached • Full-employment equilibrium is the point at which price levels start to rise more quickly, but below the absolute capacity of the economy

23. Equilibrium Output and Price Level • Two other possibilities exist for an economy • Below full employment equilibrium occurs when the AD curve intersects AS to the left of full-employment equilibrium • At this point, real GDP is lower and price levels are rising very lowly • The low level of output leads to higher unemployment levels and what is known as a recessionary gap • This situation is characterized by high unemployment, low inflation, and low GDP growth

24. Equilibrium Output and Price Level • Above full employment, equilibrium occurs when the AD curve intersects AS to the right of full-employment equilibrium • At this point, real GDP and employment levels are both very high • Price levels, however, are rising very rapidly • This is known as an inflationary gap • High inflation, high employment levels, and high levels of GDP growth are characteristics of inflationary periods

25. Changes in Aggregate Demand • Just as the demand curve might shift in microeconomic analysis, the aggregate demand curve will shift as changes in economic activity are considered • Shifts in the aggregate demand curve can be attributed directly to changes in the variables that make up GDP • Consumption (C) • Investment (I) • Government spending (G) • The balance of foreign trade (X – M)

26. Changes in Aggregate Demand Changes in consumption • Consumer income can be divided into four possible uses • Consumption • Go to government through taxes • Be saved for future use • Be spent on imports • In terms of impact on aggregate demand (AG) we are most concerned with consumption • Makes up 60% of GDP

27. Changes in Aggregate Demand • The amount available for consumption is whatever is left over after the other three components are considered • As a result, an increase in AD will occur when consumption increases • May be the result of either: • An increase in the level of income • A decrease in one or more of savings, taxes, and import spending • An increase in consumption results in a right shift in the AD curve • The result is an increase in the equilibirum level of prices, real GDP, and employment • A decrease in consumption results in a left shift in the AD curve • Decrease in equilibirum level of prices, real GDP, and employment

28. Changes in Aggregate Demand Changes in investment • The overall level of investment spending is related to the expectation of future profits • If business profits are expected to increase and the economic climate looks strong, investment will increase and the AD curve will shift to the right • If businesses foresee a downturn in economic profits, investment will decrease and the AD curve will shift to the left

29. Changes in Aggregate Demand • These movements are also closely tied to interest rate • Any investment is likely to necessitate the borrowing of funds • If the interest rate goes up, the costs associated with the investment also go up • This would reduce the potential for profit • Increases in interest rates also tend to reduce investment spending, shifting the AD curve to the left • Decreases in interest rates have the opposite effect

30. Changes in Aggregate Demand Changes in government spending • If a government increases its spending or transfer payments, the AD curve will shift right • If a government reduces spending, the AD curve will shift left • These changes are at the heart of fiscal policy and will be discussed later in the chapter

31. Changes in Aggregate Demand Changes in export demand (foreign trade) • There are three major factors influencing demand for Canadian-produced exports: • The domestic rate of inflation • The relative levels of income in other countries • The value of the Canadian dollar

32. Changes in Aggregate Demand • Inflation (or a general increase in the level of prices) affects only domestic and not foreign goods and services • A general increase in the price of Canadian goods and services makes them more expensive than foreign-made goods and services • A rapid rise in inflation will reduce export demand • Foreign consumers will buy fewer Canadian products • A decline in the rate of inflation will make Canadian goods less expensive and increase export demand

33. Changes in Aggregate Demand • A similar effect will occur as the income levels rise for consumers in countries that are trading partners • Their demand for goods will increase and Canadian exports to these countries will rise • The opposite will occur for a decrease in the level of foreign incomes

34. Changes in Aggregate Demand • Increases in the value of the Canadian dollar will increase the cost of Canadian products for foreign consumers • An increase in the value of the Canadian dollar can translate into a decrease in AD because we are selling fewer exports • Decreases in the value of the collar make the relative price of Canadian products cheaper for foreign consumers, thus increasing AD

36. Changes in Aggregate Supply • Just as events in the marketplace can shift the AD curve, the AS curve is subject to shifts as well • There are three reasons why the AS curve might shift: • A change in the price of any of the basic inputs (land labour, and capital) • A change in the amount of basic inputs available • A change in the efficiency of the production process

37. Changes in Aggregate Supply Changes in price of inputs • If the prices for land, labour, or capital increase, firms will produce less at each price level • The AS curve will shift upward and to the left at all points to the left of its perfectly inelastic section • The perfectly inelastic section will not move because, while prices are higher, the same amount of inputs are available • Therefore, the maximum real GDP possible is the same as it was before the price increases • Decreases in the price of inputs will shift the AS curve downward

38. Changes in Aggregate Supply Changes in the amount of inputs available • If new resources are discovered, more capital goods are made available, or the workspace grows, there are more inputs available for use • Just as these changes would shift the production possibilities curve outward, they would increase the maximum capacity of the economy • The availability of more resources also reduced competition for them, pushing down the costs of basic inputs

39. Changes in Aggregate Supply • The effect of the AS curve is: • To shift the relatively elastic, horizontal portion downward, reflecting decreases input prices • To shift the vertical portion to the right, reflecting the increased capacity of the economy

40. Changes in Aggregate Supply Changes in efficiency • Improvements in technology make the workforce more productive • As the workforce becomes more efficient, it can produce more output with the same resources • The resulting effect on the AS curve is the same as increasing the amount of resources available • The curve shits downward, with the vertical portion moving farther to the right

41. Changes in Aggregate Supply

42. The Business Cycle & Aggregate Supply and Demand • A business cycle covers periods of alternating economic growth and recession (or negative economic growth) as measured by changes in the real GDP • In other words, business cycles are the ups and downs of the economy • The duration in time of a business cycle and its size (in loss or gain of real GDP) vary from one cycle to the next

43. The Business Cycle & Aggregate Supply and Demand • A business cycle occurs because of the fluctuations that economies experience over time • Result from changes in economic growth and patterns of consumption • In the previous section, we explained these changes as shifts of the AD and AS curves

44. The Business Cycle & Aggregate Supply and Demand • Business cycles are the heart of macroeconomics • Economists try to determine how well the economy is doing and where it is heading • Forecasting the coming economic climate allows economists to advise political and business leaders on how to deal with possible future economic events • When the economy is heading in an undesirable direction, economists can advise a nation’s leaders to apply fiscal or monetary policy tools to try to change the course of the economy

45. The Dynamics of the Business Cycle • The causes of these fluctuations in economic activity are varied • The cyclical nature of the marketplace is dynamic • It’s not possible to detail all the reasons for cyclical fluctuations in the economy • We will now go through how a simple macroeconomic model works

47. The Dynamics of the Business Cycle • An expansion period begins when consumer spending increases and production increases • Represented by an upward trend in the business cycle • Let’s assume the Canadian economy is on an upswing • Unemployment is declining • Business activity is increasing • Increased production • Increased production leads to new workers being hired • New employment leads to a general rise in consumer incomes • Generates increased levels of consumption

48. The Dynamics of the Business Cycle • Consumer psychology that is influenced by positive economic news can also contribute to increased spending • Increased spending translates into an increase in aggregate demand for goods and services • This leads to an higher levels of output and employment as well as higher prices • This higher demand leads to increased production, more workers being hired, and the cycle starts again • This prosperity cycle is the result of aggregate demand feeding itself

49. The Dynamics of the Business Cycle

50. The Dynamics of the Business Cycle • It looks like, as long as resources are available, this trend of greater and greater economic expansion should continue • However, at some point the economy will peak, and then the trend will begin to reverse