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AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM

AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM. 10-800-11 Elements of Economic Analysis in a Canadian Context . content. Aggregate Demand Factors affecting the Aggregate Demand Aggregate Demand curve Aggregate supply Factors affecting the Aggregate Supply

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AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM

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  1. AGGREGATE DEMAND, AGGREGATE SUPPLY AND MACROECONOMIC EQUILIBRIUM 10-800-11 Elements of Economic Analysis in a Canadian Context

  2. content • AggregateDemand • Factorsaffecting the AggregateDemand • AggregateDemandcurve • Aggregatesupply • Factorsaffecting the AggregateSupply • AggregateSupplycurve • Macroeconomicequilibrium

  3. AgregateDemand • Consumption, investment, government purchases of goods and services and net exports are the four components of the aggregate demand (in real terms): AD= C + I + G + (EX - IM) • In addition, it is useful to know that aggregate demand is composed of domestic demand or interior demand (DINT = C + I + G) and of the net exteriordemandDEXT = EX – IM = NX (net export).

  4. Factorsaffecting the AggregateDemand Consumption: C = f c (PDI, r, WEALTH, CONF) + - + + PDI: personaldisposableincome in real terms (alsonotedYd) isdefined as householdpersonnalincome PI minus taxes (T). PDI = Yd= DI - T In french RPD :revenu personnel disponible réel défini comme le revenu des ménages (RP) après impôts (T); r : real interest rate (cost of financing durable goods); WEALTH: financial and non-financialwealth of households in real terms (assets minus debts); CONF: psychological factors such as confidence and expectations by consumers' economic conditions

  5. C o n s o m m a t i o n r é e l l e e t c o n f i a n c e - Real consumption and confidence 1980-2009 for Canada 8 120 2 0 6 110 0 2 e d s I é n 4 100 n d î i a c h e c n ( e 1 2 90 s 9 r 8 a l l 7 o = d 1 0 80 e 0 d 0 s ) d r a i l l -2 70 i M -4 60 1980 1985 1990 1995 2000 2005 C o n s o m m a t i o n r é e l l e C o n f i a n c e

  6. Investment: I = f I(RBEN, r, BCC) + - + RBEN: Real benefits or earnings of corporations (bénéfices réels anticipés des sociétés in french) r: Real interest rate as an indicator of the cost of capital BCC:Business cycle climatebased on the expectations of managers (recession?, durable recovery?, ...). (climat des affaires basé sur l’évaluation et les anticipations des gestionnaires in french )

  7. I n v e s t i s s e m e n t r é e l e t b é n é f i c e s r é e l s a v a n t i m p ô t s - C a n a d a ( 1 9 8 0 - 2 0 0 9 ) 80 20 60 ) % T ( a 40 10 e u c x n d a e s 20 s c i r o o r i 0 c s 0 s e a d n x c u e -20 a ( T % -10 ) -40 -60 1980 1985 1990 1995 2000 2005 I n v e s t i s s e m e n t r é e l B é n é f i c e s r e e l s a v a n t i m p o t

  8. Purchases of goods and services by the goverment: G = G In this model, public expenditures are exogeneous; they are not a direct function of other variables in the model. G is a discretionary variable because it is determinedaccording to the will of the government in thecontext of fiscal policy.

  9. Net exports of goods and services: (EX - IM) = f(EX-IM)(ЄP*/P, DINT*/DINT) + + ЄP*/P : Relative price of foreigngoods over that of local goods: ratio of foreignprices (P*) over local ones (P), converted in local currencyusing the nominal exchage rate (ex. Є= #$CA/$US); DINT*/DINT: Ratio of real interiordemand of foreign countries (DINT*) over local real interiordemand (DINT).

  10. E: Nominal Exchange Rate: interpretation • Given the weight of our trade with the United States, the nominal exchange rate (Є) Canadian is defined as the price of the U.S. dollar in Canadian currency, the value of a U.S. dollar in Canadian dollars. It will be noted as follows: Є= # $CA / $US. • Thus, an increase of Єis interpreted as an increase in the value of the U.S. dollar against the Canadian dollar, then it refers to an appreciation of the U.S. dollar or a depreciation of the Canadian dollar. In the case of a decrease of Є, we have a depreciation of the U.S. dollar or an appreciation of the Canadian dollar.

  11. Small e: Nominal Exchange Rate • WARNING!!!! • In canadian news papers we usually observe the small e e = # $US / $CA. e = 1 / Є A high value of e meansthat the Can $ isstrong A low value of Єmeansthat the Can $ isstrong A low value of e meansthat the Can $ isweak A high value of Єmeansthat the Can $ isweak

  12. Agreggatedemandcurve The aggregate demand (AD) curve represents a relationship between real GDP and the price level. This equilibrium relationship is only valid when firms adjust their output perfectly to any fluctuation in the demand.

  13. AggregateDemandcurve P AD Y (Real GDP)

  14. Slope of AD • Real money balances effect Effet d’encaisses réelles in french:  P   (M/P)   wealth   C   Y • Interest rate effect (r):  P  householdsneed more money  householdswillsellfinancialassets   r   I et  C   Y • Effet de substitution internationale :  P   (ЄP*/P) Our products are more expensiverelatively to foreigngoods EX et  IM  Y

  15. Shift of the AD Movements of the AD: • While changes in the general price level (P) create a movement along the aggregate demand curve, • changes in factors other than the general price level, which affect one or more of the four components of aggregate demand, cause a shift of the entire curve.

  16. EXAMPLE:Suppose the government decides to cut taxes for individuals: 1. Consumption is positively connected to personal disposable income (PDI = PI - T). A decrease taxes (T) increases the personal disposable income of households; 2.Private consumption is stimulated; 3.The aggregate demand is stimulated (rightward shift of the curve).

  17. + AD = C(PI-T,…) + I + G +(EX-IM) P AD1(PI-T1,…) AD0(PI-T0,…) Y Lower income taxes (T0 to T1 ) increases the disposable income of households, this helps boost consumption and thus the aggregate demand. Therefore the curve moves to the right.

  18. EXAMPLE:Suppose an increase in the real interest rates in the economy • 1. Two components of aggregate demand depend negatively on real interest rates: consumption and investment; • 2. This increase in interest rates increases the cost of financing purchases of durable goods and therefore discourage consumption; • 3. This increase also discourages investment projects of companies because it increases their cost of financing.

  19. P - - AD = C (r,…) + I (r,…) + G +(EX-IM) DA0 (r0,…) DA1(r1,…) Y Rising real interest rate (from r0 to r1) discourages the purchase of durable goods (consumption) and investment by companies. Aggregate demand decreases and aggregate demand curve shifts to the left.

  20. EXAMPLE:The government adopted a program of infrastructure spending • 1. This transaction represent a purchase of goods and services by the government(increasing the component G). • 2. The transaction therefore boosts the aggregate demand. • 3. The aggregate demand curve shifts to the right.

  21. P AD = C + I + G +(EX-IM) AD1 (G1) AD0(G0) Y When the government increases its purchases of goods and services (G0 to G1), aggregate demand is stimulated and the aggregate demand curve shifts to the right.

  22. EXAMPLE:The United States is experiencing a strong growth of its domestic demand, while the Canadian domestic demand stagnates. • 1.This time, it is the component (NX= EX - IM) which changes. • 2. U.S. growth translates into an increase in the ratio DINT * / DINT. This ratio is positively related to local net exports NX, the ratio will increase because Americans will then consume more domestic goods and imported goods. The increased demand for imported goods in the United States is thus reflected by an increase in exports. • 3. Because net exports increase, aggregate demand is stimulated and therefore the curve moves to the right.

  23. P AD = C + I + G + (EX-IM) AD1 (DINT*1 /DINT,...) AD0(DINT*0 /DINT,...) Y If U.S. domestic demand grows, Americans import  more Canadian goods and services, which translates intoan increase in exports and a rightward shift of the aggregate demand curve.

  24. Aggregatesupply • Relationship between the quantity supplied real GDP and the level of P, ceteris paribus • Twocurves • Long RunAggregatesupply (LRAS) Offre agrégée à long terme (OALT) • Short RunAggregatesupply (SRAS) Offre agrégée à court terme (OACT)

  25. LRAS • Relationship between the quantity supplied real GDP and the level of P when: • firms are at their optimal (not maximum) production capacity • resources are used in a sustainable manner • GDP = potential GDP or long run GDP or trend GDP • Unemployment rate = natural rate of unemployment • Is vertical: real GDP does not depend on prices in the long run (money neutrality)

  26. LRAS curve P LRAS YP Real GDP

  27. Shift of the LRAS Productivity • Anything that changes the capacity (potential output) of the economy shifts the LRAS • Labor force • Human Capital • Capital • Technology

  28. Technological changes LRAS1 YP1 P LRAS0 YP0 Real GDP

  29. Short RunAggregateSupply • Relationship between the supplied quantity of real GDP and the level of P, where Pf (prices of factors of production) are constant • Positive slope: P  production (hiring) • Potentialexplanation : • Theory of wagerigidity

  30. La théorie des salaires rigides • Nominal wages adjust slowly (are rigid) in the short run • Causes: long-term contracts, notions of fairness, justice, collective agreement • P   (W/P)   unit cost (of production)  profits   labor and production

  31. LRAS and SRAS curves P LRAS SRAS YP Real GDP

  32. Shift of the LRAS and SRAS • If the LRAS moves  the SRAS moves • The two curves move if the production capacity of the economy changes • Amount of labor • Productivity

  33. EXAMPLE:The introduction of computers in the manufacturing process allows workers to perform certain tasks more efficiently • This example illustrates the effect of increased productivity on the unit cost of labor for companies; • In fact, the unit production costs decrease (as wages do not increase); • Production capacity increases and the two aggregate supply curves shift to the right.

  34. Increase in productivity SRAS1 LRAS1 YP1 SRAS0 P LRAS0 YP0 Real GDP

  35. Independent shift of the OACT • Variation of PfVariation of unit cost  Variation of the SRAS • Wages: W • Price of otherfactors of production: Pf • Changes in price expectations Changes in wages  Changes of the SRAS • These variations do not change the long runpotential output: So the LRAS doesn’t move

  36. SRAS1 Increase in oilprices P SRAS0 LRAS YP Real GDP

  37. Macroeconomicequilibrium • Short runequilibrium: crossing point of AD and SRAS • At a price level that does not equate these two curves, stocks vary • Firms change their production and the economy reached the equilibrium

  38. Macroeconomicequilibrium P SRAS E PE AD Y YE

  39. YE = YPE The economy is at full employment or potential employment Macroeconomicequilibrium and potential output The macroeconomic equilibrium is characterized by one of the following three cases: • YE < YPE The economy is in recessionary gap • YE > YPE The economy is inflationary gap

  40. full employment equilibrium P Full employment is characterizedby the values ​​of P and Ythat will remain in the absenceexogenous shocks. This is theposition around whichthe economy is stabilizing in the long run. This balance istherefore compatible with the stability of prices and the long-term maintenance of the natural rate of unemployment. LRAS SRAS E PE AD Y YE =YPE

  41. recessionary gap scenario The economy is characterized by a recessionary gap when the equilibrium real GDP (YE) is below its full employment level (YPE), the observed unemployment rate is now higher than the natural rate of unemployment. The recessionary gap represents the difference between YPE and YE. We see that the values ​​of P and Y associated with this underemployment equilibrium cannot be maintained in the long run, even in the absence of exogenous shocks. P SRAS LRAS E PE AD YE < YPE Y

  42. inflationary gap scenario The economy is characterized by an inflationary gap when the equilibrium real GDP (YE) is higher than its full employment level (YPE), the observed unemployment rate is now lower than the natural rate of unemployment. The inflationary gap represents the difference between YPE and YE. We also see in this case that the values ​​of P and Y associated with this over-employment scenario cannot be maintained in the long run, even in the absence of exogenous shocks. P LRAS SRAS E PE AD YPE < YE Y

  43. macroeconomic equilibrium and the potential of the economy • We saw that there may be a macroeconomic equilibrium to the left or right of full employment ni the short run. • Is there a mechanism that will bring the economy back to its potential, in the absence of exogenous shocks, including the intervention of the state? • This is a fundamental question in macroeconomics. The answer is yes but it depends on the cyclical position of the economy and the flexibility of agents, particularly of the wages in the labor market. This determines the speed with which the economy will return to its potential output.

  44. Analysis of macroeconomic shocks • The economy is regularly subject to shocks that affect the aggregate demand and / or the aggregate supply. So these shocks affect the macroeconomic equilibrium. • If the shock is moving one of the curves, we can make the following observation: • Shocks (positive or negative) on aggregate demand lead to changes in real GDP and the price level in the same direction. • Shocks (positive or negative) of the SRAS lead to changes in real GDP and the price level in opposite directions.

  45. Negativeshock to the SRAS • A negative supply shock caused by an increase in the prices of the factors of production (wages or Pf), shifts the SRAS curve to the left. • Real GDP decreases and the price level rises. In the short run, there is a recessionary gap.

  46. Negativeshock to the SRAS SRAS1 P1 Y1 P LRAS SRAS0 E1 E0 P0 AD YPE Real GDP

  47. The economy in a recession • The unemployment rate is higher than the natural rate • In the labor market, there is a downward pressure on wages, which reduces the unit costs of production and stimulates the SRAS; while lowering inflation expectations the wages decrease. • The short run aggregate supply curve moves back gradually moves to the right; • Gradual return to the potential

  48. The return to the long run equilibriumBaby I’mcoming home! The economy is in an equilibrium stateof underemployment in E1 , therecessionary gap observed isequals to Y1 - YPE. The high unemployment exerts downward pressure on wages (W1) and hence on the unit cost of production.The Short Run Aggregate Supply curve moves to the right while the prices go down until the economy stabilizes at full employment (E0) P SRAS1(w1,..) SRAS0 E1 P1 P0 AD E0 Y1 YPE Y

  49. A positive shock to the aggregate demand • A positive demand shock caused by a decline in real interest rates and a strong U.S. growth will shift the AD curve to the right. • Real GDP and the price level increase. In the short run there is a inflationary gap

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