February 03, Chapter 10 AD_AS_Business Cycle.notebook. Chapter 10: Economic Fluctuations Pages ,

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1 Chapter 10: Economic Fluctuations Pages , Aggregate Demand (AD) the relationship between general price level and total spending in the economy. Four components that make up total spending: consumption investment government purchases net exports real expenditures total spending that has been adjusted for changes in the price level. the most important influence is price level. Therefore, price level both affects real expenditures and it is used to calculate real expenditures. The AD Curve: Page 261 Two reasons for inverse relationship between price level and real output (different from a single product): 1. Wealth Effect: Real value of financial assets decrease causing households to feel less wealthy and reduce spending. 2. Foreign Trade Effect: Net exports decrease as Canadian goods become more expensive relative to foreign goods. 1

2 Aggregate Demand Factors factors other than price level that will move the entire AD curve. When consumption, government spending, investment, and net exports are affected by factors other than price level, the curve will shift. Increases > shift to the right Decreases > shift to the left Consumption: Disposable Income (DI): results from changes in items such as population and taxes; an increase in disposable income causes AD to shift to the right. Wealth: Consists of financial and real assets. If the value of these increase, consumers will spend more of their disposable income causing AD to increase. If consumer debt increases, the opposite results. Consumer Expectations: If consumers expect price level to rise, they will spend more and save less and vice versa. Interest Rates If interest rates fall, consumers will borrow more money, spend more money, and cause AD to rise. Investment: Businesses will invest in projects if the benefit they receive from the project is more than the cost which depends on the interest rate. The relationship between interest rates and investment is called investment demand. A rise in investment causes AD to shift to the right and vice versa. Interest rates: If interest rates rise, AD decreases and vice versa. Business Expectations: If businesses think profits will rise, investment demand rises and so does AD and vice versa. Government Purchases: An increase in government purchases increases AD. 2

3 Net Exports: Foreign Incomes: If foreign incomes rise, purchases of exports rise causing AD to increase. Exchange Rates: If the Canadian dollar rises in value, Canadian goods become more expensive causing a decrease in exports and a decrease in AD. Aggregate Supply (AS) the relationship between general price level and real output produced in the economy. As price levels rise in an economy, businesses are encouraged to produce more resulting in a direct relationship between price level and real output. The AS Curve: Important Features of the AS Curve: point a: real output is lower than potential resources are not used to fullest potential real output can rise with fairly small increases in price level to cover the per unit costs of the businesses. point c: Potential output point d: real output is greater than potential resources are maximized increases in output are only possible by large increases in price level to cover the per unit costs of the businesses resulting in a very steep section of the AS curve. 3

4 Aggregate Supply Factors factors other than price level that will move the entire AS curve. When consumption, government spending, investment, and net exports are affected by factors other than price level, the curve will shift. Increases > shift to the right Decreases > shift to the left Input Prices: Increases in input prices (Ex: wages) increases production costs causing real output to fall resulting in a decrease, leftward shift, of the AS curve. short run decrease/increase in AS an increase in total output at all price levels, with no change in potential output. Resource Supplies: Over the long run, resources change in the economy. Changes in production don't occur as quickly as changes in spending so changes in AS tend to occur more slowly than AD. In the long run, changes in AS can have quite an impact on the economy. long run increase/decrease in AS changes in total and potential output at all price levels. 4

5 Page 270 Productivity: real output produced per unit of input over a period of time. Due largely to advances in technology. Government Policies: Certain policies put into affect by government can affect AS. Examples: Increases in taxes may encourage businesses and household to reduce resources provided. Introducing regulations for issues such as the environment increase costs resulting in a decrease in AS. Summary: Page 271 5

6 AD and AS: The equilibrium real output and price levels of an economy is determined by the intersection of the AD and AS curves. Can be explained using two approaches: 1. Inventory approach 2. Injections Withdrawals Inventory Approach Price level > equilibrium: Real Output > Real Expenditures Inventories rise, causing a surplus in inventories. positive unplanned investment an unintended increase in inventories; a surplus. To alleviate the surplus, price level falls causes an increase in spending Price level < equilibrium: Real Output < Real Expenditures Inventories fall, causing a shortage in inventories. negative unplanned investment an unintended decrease in inventories; a shortage. To alleviate the shortage, price level rises causes an decrease in spending 6

7 Injections Withdrawals Approach injection additions to the economy's income spending stream. Three injections: Investment (I) Government (G) Exports (X) Total Injections = I + G + X withdrawal deductions from the economy's income spending stream. Three withdrawals: Savings (S) Taxes (T) Imports (M) Total Withdrawals = S + T + M Total Injections > Total Withdrawals: Real output and spending rise. Total Injections < Total Withdrawals: Real output and spending fall. Total Injections = Total Withdrawals: - Equilibrium Equilibrium vs Potential Output: If equilibrium does not correspond to the potential level of output in an economy, two situations can result: 1. Recessionary Gap the amount by which equilibrium output falls below potential output. 2. Inflationary Gap the amount by which equilibrium output exceeds potential output. unemployment levels fall below the natural level of unemployment and inflation will be an issue. 7

8 Economic Growth: occurs when there is an outward shift in an economy's p p curve or there is movement towards the curve. For Economic Growth 1. Increases standard of living due to increases in incomes and outputs. 2. Improvements in health, education, and equitable distribution of income due to increases in government spending. 3. Creates a mood of optimism and sense of expanding opportunities. Against Economic Growth 1. The promote growth, a country focuses investment on capital goods (can be used to produce more goods) rather than consumption (goods are just consumed) which can have a negative effect on poorer countries. 2. Environmental damage resulting from greater use of limited natural resources and increased pollution. 3. Consumers/businesses may not be able to pay/adapt to results of growth which often comes from technological advances and some may be forced to give up traditional life styles. Economic Growth and Business Cycles: Canada has experienced high rates of economic growth. In 2010, had the fourteenth highest per capita GDP. In 2013, had the 13th highest. Page 287 8

9 Business Cycles (Pages ): Usually, growth in real output happens along with recessionary and expansionary gaps. These gaps occur on the basis of a pattern. Periods of expansion (recovery) (a sustained rise in real output) are usually followed by periods of contraction (an extended period of falling real output). Page 288 Business Cycle rises and falls in real output due to periods of expansion and contraction. inflationary gap => real GDP (output) > potential GDP(output) (difference between a and b) recessionary gap => real GDP (output) < potential GDP(output) (difference between c and d) Contraction occurs when the economy has hit its peak which occurs when unemployment is at its lowest and real output has reached its maximum. Expectations of households and businesses influence greatly the effects of contraction. If the economy is experiencing reductions, households and businesses, thinking income and spending will drop even more so, will decrease spending even more which will affect consumption, investment and net exports. 9

10 Recession occurs when the economy is experiencing longer periods of declining output. Depression occurs when the reduction in output is particularly long and harsh. Expansion occurs when the economy has reached a trough which occurs when unemployment is really high and real output has reached its lowest point in the business cycle. Expectations of households and businesses influence greatly the effects of expansion. If the economy is experiencing increasing real output, households and businesses become optimistic, thinking income and spending will continue to grow. As a result, spending increases even more which will affect consumption, investment and net exports. 10