AGGREGATE DEMAND, AGGREGATE SUPPLY

AND MACROECONOMIC EQUILIBRIUM

10-800-11

Elements of Economic Analysis in a Canadian Context

1. Aggregate Demand

2. Factors affecting the Aggregate Demand

3. Aggregate Demand curve

4. Aggregate supply

5. Factors affecting the Aggregate Supply

6. Aggregate Supply curve

7. Macroeconomic equilibrium

content

1. Agregate Demand

• 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 exterior demand DEXT = EX – IM = NX

(net export).

Factors affecting the Aggregate Demand

Consumption:

C = f c (PDI, r, RICH, CONF) + - + +

PDI: personal disposable income in real terms (also noted Yd ) is defined as household personnal income 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);

RICH : financial and non-financial wealth of households in real terms (assets minus debts);

CONF : psychological factors such as confidence and expectations by consumers' economic conditions

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Consom m ation rée lle Confiance

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Consom mation réelle et confiance - Real consumption and confidence 1980-2009 for Canada

Investment:

I = f I (BENR, r, CLAFF) + - +

BENR: 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

CLAFF : Business cycle climate based on the

expectations of managers (recession?, durable recovery?, ...).

(climat des affaires basé sur l’évaluation et les anticipations des gestionnaires in french )

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Inv e stisse m e nt rée l Bénéfice s re e ls av ant im pot

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e (%)T

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)Inv estissement réel et bénéfices réels av ant impôts -

Canada (1980-2009)

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.

Net exports of goods and services:

(EX - IM) = f(EX-IM) (E P*/P, DINT*/DINT) + +

E P*/P : Relative price of foreign goods over that of local goods: ratio of foreign prices (P*) over local ones (P), converted in local currency using the nominal exchage rate (ex. E = #$CA/$US);

DINT*/DINT: Ratio of real interior demand of foreign countries (DINT*) over local real interior demand (DINT).

E: Nominal Exchange Rate: interpretation

• Given the weight of our trade with the United States, the nominal exchange rate (E) 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:

E = # $CA / $US.

• Thus, an increase of E is 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 E, we have a depreciation of the U.S. dollar or an appreciation of the Canadian dollar.

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Exportations nettes réelles Taux de change ($CA/$US)

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Taux de change ($C

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Exportations nettes réelles de biens et serviceset le taux de change du dollar canadien

1980-2007

Small e: Nominal Exchange Rate

• WARNING!!!!• In canadian news papers we usually observe the

small e

e = # $US / $CA.

e = 1 / E

A high value of e means that the Can $ is strong

A low value of E means that the Can $ is strong

A low value of e means that the Can $ is weak

A high value of E means that the Can $ is weak

3. Agreggate demand curve

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.

Aggregate Demand curve

P

Y (Real GDP)

AD

Slope of AD

• Real money balances effect Effet d’encaisses réelles in french:

P (M/P) wealth C Y• Interest rate effect (r):

P households need more money households will sell financial assets r I et C Y

• Effet de substitution internationale :

P (E P*/P) Our products are more expensive relatively to foreign goods EX et IM Y

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.

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).

Y

P

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.

AD = C(PI-T,…) + I + G +(EX-IM)

AD0(PI-T0,…)

AD1(PI-T1,…)

+

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.

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.

DA0 (r0,…)

Y

P

DA1(r1,…)

AD = C (r,…) + I (r,…) + G +(EX-IM)- -

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.

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.

Y

P

AD0 (G0)

AD1 (G1)

AD = C + I + G +(EX-IM)

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.

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.

Y

P

AD0(DINT*0 /DINT,...)

AD1 (DINT*1 /DINT,...)

AD = C + I + G + (EX-IM)

4. Aggregate supply

• Relationship between the quantity supplied real GDP and the level of P, ceteris paribus

• Two curves

oLong Run Aggregate supply (LRAS) Offre agrégée à long terme (OALT)

oShort Run Aggregate supply (SRAS)

Offre agrégée à court terme (OACT)

LRAS

• Relationship between the quantity supplied real GDP and the level of P when:o firms are at their optimal (not maximum)

production capacityo 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)

LRAS curve

LRAS

P

Real GDPYP

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Shift of the LRAS

• Anything that changes the capacity (potential output) of the economy shifts the OALToLabor forceoHuman CapitaloCapitaloTechnology

Productivity

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Technological changes

LRAS0

P

Real GDPYP0

LRAS1

YP1

Short Run Aggregate Supply

• 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)

• Potential explanation :oTheory of wage rigidity

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

LRAS SRAS

LRAS and SRAS curvesP

Real GDPYP

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

oAmount of labor

o Productivity

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.

Increase in productivity

LRAS0

P

Real GDPYP0

SRAS1

LRAS1

YP1

SRAS0

Independent shift of the OACT

• Variation of Pf Variation of unit cost Variation of the

SRASo Wages: W

o Price of other factors of production: Pf

• Changes in price expectations Changes in wages Changes of the SRAS

• These variations do not change the long run potential output: So the LRAS doesn’t move

LRAS

SRAS0

Increase in oil prices SRAS1

P

Real GDPYP

38

7. Macroeconomic equilibrium

• Short run equilibrium: 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

Macroeconomic equilibrium

Y

P

AD

SRAS

PE

YE

E

Macroeconomic equilibrium and potential output

• YE = YPE The economy is at full employment

or potential employment

The macroeconomic equilibrium is characterized by one of the following three cases:

• YE < YPE

• YE > YPE

The economy is in recessionary gap

The economy is inflationary gap

full employment equilibrium

Y

P

PE

AD

LRAS

=YPE

E

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.

YE

SRAS

recessionary gap scenario

Y

P

PE

AD

SRAS

YE

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.

< YPE

E

LRAS

inflationary gap scenario

P

PE

AD

SRAS

YE

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.

YPE <

E

Y

LRAS

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.

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.

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Negative shock 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.

AD

LRAS

Negative shock to the SRAS

SRAS0

YPE

P0

SRAS1

P1

Y1

P

Real GDP

E0

E1

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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

Y

P

YPE

AD

P1

Y1

SRAS1(w1,..)

P0

SRAS0

E1

E0

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)

The return to the long run equilibrium

Baby I’m coming home!

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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

SRAS

AD0

LRAS

Positive shock to the AD (Short run effect)

AD1

P

PIB réelYPE Y1

P1

P0

E1

E0

The economy inflationary gap• The unemployment rate is lower than the

natural rate; labor is scarce.• in the labor market, there is an upward

pressure on wages, which increases unit costs of production and reduces the SRAS. This increases inflationary expectations.

• The SRAS curve moves gradually upwards and to the left.

Gradual return to full employment

Y

P

YPE

AD1P1

Y1

SRAS0(w0,..)

P0

SRAS1

E1

E0

The economy is in equilibrium ofover-employment E1 , the observed production gapequals to Y1 – YPE > 0. The lowest unemployment rate exerts upward pressure on wages (w0) so that the unit costs of production increase.The SRAS curve moves upward and to the left and will make prices rise until the economy stabilizes at full employment (E0)

Return to the Long run equilibrium

Wage flexibility

The movement of the SRAS that allows the return to full employment depends on wage flexibility.

In real life, we can expect that the natural elimination of a recessionary gap will take longer than for an inflationary gap, as there is a perceived fatality for people went they observe a decrease in their wages.