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Chapter 9 (Lecture Notes and Textbook Notes)
Tuesday, March 14, 2023
Birdget O’Shaughnessy
ECON 1BB3 C02
Lecture Notes (Tuesday, March 14, 2023)
Expansion
Low unemployment
Upward pressure on wages
Entice workers into labour force or pull them from other firms
( WP ) ↑
Labour becomes expensive
Recession
High unemployment
Downward pressure on wages
( WP ) ↓
Labour becomes inexpensive
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Textbook Notes (pg 255-290)
9.1 Aggregate Demand
Aggregate demand and aggregate supply model = model that explains short-run fluctuations in
real GDP/price level
Price level = measure of average price of goods/services in economy
Aggregate demand (AD) curve = relationship b/t price level and quantity of real GDP demand by
households, firms, and govt
Short-run aggregate supply (SRAS) curve = shows relationship in short run b/t price level and
quantity of real GDP supplied by firms
Why is the aggregate demand curve downward sloping?
GDP /Y =C+ I +G+ NX
Fall in price level increases quantity of real GDP demanded
Govt purchases determined by policy decisions of lawmakers and not influenced by changes in
price level
Wealth effect: how change in price level affects consumption
Income most important variable determining household consumption
Household’s wealth = difference b/t value of assets and debts
Nominal assets = assets that loose value as price level rises and gain value as price level falls
Real value = higher price levels lead to low consumption spending by households
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Impact of price level on consumption = wealth effect, and is one reason aggregate demand
curve downward sloping
Interest-rate effect: how change in price level affects investment
When price level rises, households and firms increase amount of money hold by withdrawing
funds from banks, borrowing from banks, or selling financial assets
International-trade effect: how change in price level affects net exports
Net exports = spending by foreign households and firms and goods and services produced in
Canada minus spending by Canadian
Price level in Canada ↑, Canadian exports become more expensive, and foreign-made products
less expensive
Impact of price level on net exports = international-trade effect
Shifts in aggregate demand curve vs movements along it
Tells relationship b/t price level and quantity of real GDP demanded, holding everything else
constant
Movement = variable that changed on x-axis/y-axis
Shift = variable that changed isn’t on either axes
Variables that shift
1. Changes in govt policy
Monetary policy = actions BOC takes to mange money supply and interest rates
to peruse macro policy goals/objectives
Fiscal policy = changes in federal taxes and purchases that are intended to
achieve macro policy objectives
2. Changes in expectations of households and firms
More money means higher spending = shift right
3. Changes in foreign variables
Buying more foreign goods = shift left
Changes in exchange rate
Increase in net exports shift right
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9.2 Aggregate Supply
Shows effect of changes in price level on quantity of goods/services that firms willing/able to
provide
Long-run aggregate supply curve
Level of real GDP determined by supply of inputs—labour force and capital stock—and available
tech
Potential GDP = level of real GDP attained when all firms producing at capacity
Firms operate at normal level of capacity, and unemployment will be structural and
frictional
Not influenced by changes in price level
Long-run aggregate supply (LRAS) curve = curve that shows relationship in long run b/t price
level and quantity of real GDP supplied
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Short-run aggregate supply curve
LRAS curve upward sloping
As prices of final goods and services rise, prices of inputs rise more slowly
As price levels change firms slow to adjust prices
Some firms and workers fail to accurately predict changes in price level
Contracts make some wages and prices "sticky"
Prices/wages “sticky” when don't respond quickly to changes in demand/supply
Firms often slow to adjust wages
Menu costs make some prices sticky
Menu costs = costs to firms of changing prices
Shifts of short-run aggregate supply curve vs movements along it
Short-run aggregate supply curve tells short-run relationship b/t price level and quantity of
goods/services firms willing to supply, holding everything constant
If price level changes economy move up/down stationary aggregate supply curve
Any variable other than the price level changes, aggregate supply curve shift
Variables that shift short-run aggregate supply curve
1. Increases in labour force and in capital stock
Labour force and capital stock grow, firms supply more output at every price
Supply curve shift right
2. Tech change
Increase productivity reduces firms' costs of production and allows to produce more at
every price
Supply curve shift right
3. Expected changes in future price level
Adjust wages and prices accordingly
Workers and firms expect price level to increase by certain %, SRAS curve shift by that
amount
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4. Adjustments of workers and firms to errors in past expectations about price level
Shift left = adjusting price level being higher than expected
Shift right = adjusting to the price level being lower than expected
5. Unexpected changes in price of important natural resource
Supply shock = unexpected event that causes short-run aggregate supply curve to shift
Caused by unexpected increases/decreases in prices of natural resources
9.3 Macroeconomic Equilibrium in the Long Run and the Short Run
In long-run macroeconomic equilibrium, AD and SRAS curves intersect at point on LRAS curve
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Recessions, expansions, and supply shocks
Begin with simplified case, using 2 assumptions
1. Economy not been experiencing any inflation
2. Economy not experiencing any long-run growth
Assumptions are simplifications to focus on main idea
Short-run effect of a decline in aggregate demand
Decline in investment that results will shift the aggregate demand curve to the left
Economy moves from A to new short-run macro equilibrium, where curve intersects SRAS curve
at B
Lower level of GDP result in declining profitability for many firms and layoffs for some workers =
recession
Adjustment back to potential GDP in long run
Firms willing to accept lower prices due to lower sales
Unemployment resulting from recession make workers willing to accept lower wages
Decline in aggregate demand causes recession in short run, but long run causes only decline in
price level
Automatic mechanism = process of adjustment back to potential GDP
Occurs without actions by govt
Expansion the short-run effect of an increase in aggregate demand
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Firms operating beyond normal capacity, and some who would be structurally or frictionally
unemployed/who would not be in labour force are employed
Adjustment back to potential GDP in the long run
Workers and firms adjust to price level being higher than they had expected
Workers push for higher wages and firms charge higher prices
Easier for workers to negotiate for higher wages, and increase demand easier for firms
to increase prices
SRAS will shift to left
The short-run effect of a supply shock
Stagflation = combination of inflation and recession, usually resulting form supply shock
Adjustment back to potential GDP in long run
Recession caused by supply shock increases unemployment and reduces output
Workers willing to accept lower wages and firms accept lower prices
9.4 A Dynamic Aggregate Demand and Aggregate Supply Model
Make changes to basic model to be more accurate
1. Potential GDP increases continually, shifting long-run aggregate supply curve right
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2. Aggregate demand curve shifts right
3. Except during periods when workers and firms expect high rates of inflation, short-run
aggregate supply curve shifts right
Increases in labour force and capital stock as well as tech change cause long-run aggregate
supply curve to shift over year
Aggregate demand shift spending by consumers, firms, and govt increases during year
Changes in price level and real GDP in short run determined by shifts in SRAS and AD curves
What is usual cause of inflation?
If AD curve shifts to right > LRAS curve = inflation b/c equilibrium occurs at higher price level
Shift to left of short-run aggregate supply curve also cause increase in price level
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