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CHP 14: AGGREGATE DEMAND AND AGGREGATE SUPPLY Context

To this point, our study of macroeconomic theory has concentrated on the behavior of the economy in the long run i.e. factors that determine real GDP growth, productivity, unemployment and inflation over long time periods. In other words, we have concentrated on long term trends. Chapters 14 and 15 adopt an alternative focus i.e. what determines macroeconomic performance in the short run. Specifically, what causes short-term fluctuations in real GDP, unemployment, and inflation around their long-term trends? While we know that most economies grow in the long run, why is it that some economies experience recessions [i.e. a temporary decline in real GDP] in the short run? While we know that the long run trend level of unemployment is measured by the natural rate, why does actual unemployment sometimes sit above this level in the short run? What are the consequences of recessions and high unemployment, and what can government policy makers do about them? The purpose of Chapter 14 is to develop a model economists use to characterize e ec -run fluctuations the model of aggregate demand and aggregate supply [ e AD/AS de ]. The AD/AS model represents an aggregation of all domestic markets where final goods and services are traded e.g. markets for newly produced consumer goods [e.g. retail outlets across the country], markets for newly produced consumer services, markets for newly produced machinery, markets for construction services, etc. You will learn about some of the sources for shifts in the aggregate-demand curve and the aggregate-supply curves and how these shifts can cause recessionary and inflationary gaps. This chapter also examines the economic forces that naturally respond to GDP gaps, eventually restoring the economy to its long run level of real GDP.

Main Message

All market-based societies experience short-run macroeconomic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. The result is recessionary or inflationary gaps in real GDP - real GDP, income, spending, and employment all diverge from their long-run levels. Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, output of final goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. Divergence from long-run trend performance can be initiated by a shift in aggregate demand. For example, when the aggregate-demand curve shifts to the left, output falls below its long run level. However, this new -run a is transitory. Over time, a change in the expected price level occurs, causing perceptions, and in turn, wages and prices, to adjust. In the end, the short-run aggregate-supply curve shifts to the right, and the economy returns to its natural rate of output at a new, lower price level. A shift in short-run aggregate supply is a second possible cause of divergence from long run trend performance. When the short-run aggregate-supply curve shifts to the left, the initial effects are falling output and rising prices a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level falls back to its original level, and output recovers to its long-run level.

Important Advice

Much like Chapter 13, working with a complicated demand/supply diagram can be hard work it is easy to get lost or intimidated. Try the following strategy: [a] read the chapter start-to-finish, [b] read the supplementary notes, trying to match the discussion in the notes with the discussion in the textbook, [c] work through each of the TYU questions and answers.

Key Concepts The business cycle: fluctuations ea GDP a d e ec a a e e ea GDP.

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n-ro-n.se-_- 短期的 波动如何影响

⻓期

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-

在短期 发⽣的 影响或事件会 影响 到⻓期

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Natural real GDP: the level of real GDP where unemployment equals the natural rate (all unemployment is either real wage or search unemployment). Recessionary gap: when actual real GDP is below natural real GDP. Inflationary gap: when actual real GDP exceeds natural real GDP. Aggregate demand (AD) curve: a curve that shows the quantity of domestically produced final goods and services that households, firms, domestic governments, and foreigners want at any price level The nominal wage rate: the dollar amount per period paid to the average worker The real wage rate: the purchasing power of the nominal wage.

The real wage is determined by the interaction of the nominal wage and the price level. For example, if the nominal wage is the same but the price level increases, the real wage declines. To highlight the inverse relationship between the price level and the real wage, the real wage is often expressed as the nominal wage [w] divided by the price level [P], i.e.: Real wage = w/P

Short-run aggregate supply (SRAS) curve: a curve that shows the quantity of final goods and services that firms choose to produce and sell at any given price level, holding price level expectations and nominal wages constant. Aggregate production in the short run will differ from natural real GDP if price level expectations are inaccurate or nominal wage levels imply the real wage deviates from its long run level.. Long-run aggregate supply (LRAS) curve: a curve that shows the quantity of final goods and services that firms choose to produce and sell at any given price level, assuming price level expectations are consistent with (i.e. have adjusted to) the actual price level, and nominal wages are such that the real wages are consistent with their long run level.. Aggregate production in the long run always equals natural real GDP. The AD/AS model: a de c a ac e e e d a d d c ce a de e e a ec ea GDP and price e e , b e a d . T e AD/AS de e e e a a e a e ec a e where final goods and services are traded. Short-run macroeconomic equilibrium: the level of real GDP where the AD curve crosses the SRAS curve. In short- run equilibrium, price level expectations can be inaccurate and the real wage may deviate from its long-run level; therefore, real GDP can differ from natural real GDP. Long-run macroeconomic equilibrium: the level of real GDP where the AD curve crosses the LRAS curve. In long- run equilibrium, price level expectations are accurate and the real wage is equal to its long-run level; therefore, real GDP must equal natural real GDP. Stagflation: a period of falling output and rising prices. Supply-side adjustment mechanism (SSAM): the adjustment of the SRAS curve arising from changes in price level expectations and nominal wages that naturally accompany recessionary or inflationary gap situations.

Rules of Thumb

Generally speaking, changes in aggregate demand affect the price level and real GDP in the short run, but only the price level in the long run. Changes in long run aggregate supply have permanent effects on real GDP and the price level.

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在 只改变 LRAS 的时候会有 永久性的在 mieled ㄟ (物价 )

和 ulGDP

改变 .

3

Web Links

As noted in the text, the Great Depression that struck Canada beginning in 1930 was the most severe economic c ac e e e e e ced Ca ada. T e ede a e e Ca ad a Ec eb e de a on the economic and social impacts of the Great Depression. Go to http://www65.statcan.gc.ca/acyb01/acyb01_0005- eng.htm.

Learning Objectives

After studying this chapter and the supplementary notes, you should be able to

1. Define the key concepts. 2. Answer e ive e (who, point, movement along, shape, shift) for the AD, SRAS, and LRAS curves. 3. Explain the difference between short-run and long run macroeconomic equilibrium. 4. Explain how adjustments in price level expectations eliminate inflationary and recessionary gaps. 5. Use the AD/AS model to illustrate economic fluctuation around natural real GDP. 6. Use the AD/AS model to illustrate economic growth. 7. Use the AD/AS model to identify the short-run and long-run impact of an exogenous event (e.g. a reduction in

interest rates, an increase in the value of the Canadian dollar, etc). Supplementary Notes 1. The Aggregate Demand/Aggregate Supply Model: The Curves and Their Shifters

1.1 The AD Curve The AD curve represents aggregate spending in our economy. The curve captures the domestic spending decisions of households, firms, government, and foreigners. A point on the AD curve represents the amount of spending households, firms, governments and foreigner desire at the associated price level. The AD curve is downward sloping because economists believe that aggregate spending rises as the price level falls. A variety of explanations have been offered for this relationship between spending and the price level recall the wealth effect, the interest rate effect, and the real exchange rate effect [pp.319-320]. The AD curve shifts when either consumer spending [C], investment spending [I], government spending [G], export spending [X] and/or import spending [M] change for reasons other than a change in the price level. For example, if interest rates increase, C and I decline, causing the AD curve to shift to the left. The key determinants of each type of spending are listed below [see also Table 14-1, p.324]: 1.1.1 AD Shifters Consumption Spending Consumption spending increases, and therefore AD shifts right, if:

¾ interest rates decline (consumers save less, spend more) ¾ consumer confidence increases (consumers save less, spend more) ¾ personal income tax rates decline (consumers spend some of their tax savings) The AD curve shifts left if these variables change in the opposite direction (i.e. if interest rates increase, or consumer confidence declines, etc.)

Investment Spending Investment spending increases, and therefore AD shifts right, if:

¾ interest rates decline (firms find it less costly to use loanable funds for investment purposes) ¾ business confidence increases (firms anticipate a higher future return from investment spending)

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ADshiftsyn.ci/ADT/NXT,ADT/nT,ADl-niIADshifters 的 ⼏个 因素

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¾ corporate tax rates decline (firms capture a higher net return from investment spending) Government Spending

Government spending increases, and therefore AD shifts right, if:

¾ government policy decisions lead to an increase in government spending (e.g. increased infrastructure spending, military spending, etc.)

Export Spending

Export spending increases, and therefore AD shifts right, if:

¾ the foreign exchange value of the Canadian dollar declines (Canadian goods become less expensive to foreigners) ¾ foreign tariffs and non-tariff barriers on Canadian products are reduced (Canadian goods become less expensive and/or more available to foreigners) ¾ foreign GDP levels increase (foreigners have greater incomes to spend and choose to purchase more Canadian goods) ¾ foreign price levels increase (Canadian goods become relatively cheaper to foreigners)

Import Spending

Import spending increases, and therefore AD shifts left, if:

¾ the foreign exchange value of the Canadian dollar increases (foreign goods become less expensive to Canadians) ¾ Canadian tariffs and non-tariff barriers are reduced (foreign goods become less expensive and/or more available to Canadians) ¾ foreign price levels decline (foreign goods become relatively cheaper to Canadians)

Note that domestic real GDP and the domestic price level are not identified as 'shifters' in the above list. To be a shifter, a variable must be determined (measured) "outside" the model domestic real GDP and the domestic price level are found on the axes in the AD/AS model (they are determined "within" the model). Another way of putting it is that changes in the price level and real GDP are the consequence of curve shifts, not the cause of curve shifts. 1.2 The SRAS Curve The short-run aggregate supply (SRAS) curve represents the short-run aggregate production decisions of firms. The short run is the time horizon over which the price level can deviate from the price level that people expect. Economists believe that the actual price level may differ from the level people expected for a variety of reasons - recall the sticky wage, sticky price, and misperceptions theories [pp.329-332]. These reasons imply that a positive relationship exists between the price level and aggregate production - in other words, that the SRAS curve has a positive slope. A point on the SRAS curve indicates the aggregate amount firms are willing to produce at the associated price level, assuming price level expectations have not changed. The SRAS curve shifts when firms decide to alter their production levels at the existing price level. For example, if wage rates rise across the economy firms will experience higher costs, causing them to reduce production at the existing price level. This will shift the SRAS curve to the left. Key shifters of the SRAS curve are listed below [see also Table 14-2, p.333]: 1.2.1 SRAS Shifters

¾ Input Prices (e.g. wage rates, natural resource prices, equipment prices, etc)

Anything that causes input prices to increase shifts the SRAS curve left; anything that causes input prices to decline shifts the SRAS curve right. For example, an increase in raw material prices brought on changing world market conditions (e.g. OPEC raising world oil prices) would shift the SRAS curve left.

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上 的 。

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短_期时 的 产量

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¾ Resource Availability

Anything that causes more resources to be available to the economy shifts the SRAS curve right; anything that decreases resource availability shifts the SRAS curve left. Note that resource availability is linked to input prices - greater resource availability leads to lower input prices, lesser availability increases input prices. Factors influencing resource availability include immigration policy, natural resource depletion rates, resource discoveries (e.g. discovery of new oil or gas fields), etc.

¾ Price Level Expectations

Changes in people's expectations of the price level lead to adjustments that shift the SRAS curve. For example, if workers come to expect an increase in the price level they will demand a higher nominal wage to protect their real wages. Similarly, if firms come to expect an increase in the price level they will eventually raise their output prices without expanding output (firms only increase production when they experience a relative price increase). Such adjustments by workers and firms will cause the SRAS curve to left. In general: An increase in the expected price level decreases the quantity of goods and services supplied and shifts the short- run aggregate-supply curve to the left. Conversely, a lower expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right. [p.333]

¾ Technology

Technological advance increases the productivity of an economy's resources. This shifts the SRAS curve right.

¾ Government Regulations

Government regulations (e.g. environmental regulations, tax remittance procedures, etc.) add to business costs. More regulation shifts the SRAS curve left; less regulation shifts the SRAS curve right.

1.3 The LRAS Curve The long-run aggregate supply (LRAS) curve represents the aggregate production decisions of firms in the long run. The long run is time horizon over which expectations, wages and prices have sufficient time to adjust to prevailing economic conditions. For example, if an increase in aggregate demand (a rightward shift of the AD curve) causes the price level to exceed expectations, it will take time for workers and firms to identify the price level change. Before expectations are adjusted, the economy is operating in the short run. Once enough time has elapsed for adjustment of expectations, the economy is in the long run. O ce e ec a , a e a d ce a e ad ed e a c d , e ec d a d services solely depends on its supplies of capital, labor and natural resources and the available production technology. A a e , e LRAS c e e ca a e ec -run productive capacity (i.e. at potential real GDP). The curve is vertical because the price level does not influence productive capacity. Potential real GDP is consistent with the natural rate of unemployment any unemployment that remains in the economy is due to frictional, structural or seasonal influences.

1.3.1 LRAS Shifters

T e LRAS c e e e ec -run productive capacity changes. LRAS shifts are caused by changes in:

¾ Resource Availability I e e ce (e. . ca a , ab , a a e ce ) bec e a a ab e, e ec d c e ca ac increased and the LRAS curve shifts to the right. Increased net investment, population growth, natural resource discovery, etc could cause this. ¾ Technology

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可⽤于 ⽣产的 资源 上 ⼝ SRASL 资源的的少

,

公司 对于物价 的 期望 。

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6

Tec ca ad a ce c ea e e ec d c e ca ac a d e LRAS c e e . Technological advance can occur for exogenous or endogenous reasons. An example of the latter would be changes in government policy that improve incentives for research and development (e.g. improved enforcement of intellectual property rights, tax exemptions for research and development expenditures, etc.). Note that the shifters of the LRAS curve are also shifters of the SRAS curve. Therefore, if the LRAS curve shifts, the SRAS curve must also shift, and in the same direction as the LRAS curve.

2. The Aggregate Demand/Aggregate Supply Model: Moving from Short to Long-Run

Equilibrium Long-Run Equilibrium The economy is in long-run equilibrium when real wages are at long run levels and price level expectations are accurate. In other words, the economy is operating with the AD, SRAS, and LRAS curves all intersecting at the natural level of real GDP. See Figure 1 below.

Figure 1: Long-Run Equilibrium

P LRAS0 SRAS0 (Pe=P0) P0 A AD0 0 YN Y Short-Run Equilibrium The economy is in short-run equilibrium when the economy is sitting in an inflationary or recessionary gap [i.e. when Y is not equal to YN]. In short-run equilibrium, real wages are not at their long run levels, and price level expectations are inaccurate. Short-run equilibrium occurs when the AD curve is intersecting the SRAS curve to the right or left of the LRAS curve F e 2 a e e ca e a a a a , e F e 3 e e e a ece a a . I e ca e Figure 2, price level expectations [Pe] are less than the actual price level [P1]. Since the nominal wage is unchanged between point A in Figure 1, yet the price level is higher in Figure 2, real wages are below their long run levels at point B in Figure 2. The opposite is true in Figure 3 price level expectations exceed the actual price level, and real wages are above their long-run level.

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会 产⽣ 个 两个 aup.int/utionaryGupi 膨胀 区间

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7

Figure 2: An Inflationary Gap

P LRAS0 SRAS0 (Pe< P1) P1 B AD1 0 YN Y1 Y

Figure 3: A Recessionary Gap

P LRAS0 SRAS0 (Pe>P1) P1 B AD1 0 Y1 YN Y What might cause the economy to be in a short but not long-run equilibrium? The answer is an unanticipated shift in the AD or SRAS curve. For example, if the economy initially rests in long-run equilibrium but exports unexpectedly rise, the AD curve shifts to the right, pushing real GDP above its natural level and increasing the price level in the short run. T e dde c a e e d b e -run equilibrium, throwing the economy into a temporary short- run equilibrium characterized as an inflationary gap. In light of the sticky wage, sticky price, and misperceptions

e e , e e e ec a e ce e e , for a time, be less than the new, prevailing price level. Sticky wages mean that the nominal wage does not change as the AD curve shifts, implying the real wage is below its long run level. Alternatively, if the economy starts in long-run equilibrium but energy prices rise, the SRAS curve shifts to the left, pushing real GDP below its natural level and raising the price level in the short run. The sudden change in

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energy prices again disturbs the long-run equilibrium, putting the economy into a temporary short-run equilibrium characterized as a recessionary gap. A a , e e e ec ations of the price level will, for a time, be less than the new, prevailing price level. In the stagflation case, real wages are below their long run levels because although the nominal wage has not changed, the higher price level has decreased the real wage. Moving from Short-Run back to Long-Run Equilibrium Pe e ce e e e ec a ca be acc a e e e , nor can real wages ultimately deviate from their long run levels. If the economy is temporarily sitting in an inflationary or recessionary gap, people will eventually discover that the price level differs from their expectations. When they adjust their expectations to the actual price level, the SRAS curve shifts to the point where long run equilibrium is restored in the economy. Similarly, labor market conditions in an inflationary or recessionary gap will eventually cause nominal wage adjustment that restores real wages to long run levels. In bo h cases, he econom makes a s ppl -side adj s men . The adj s men process is sometimes called he s ppl -side adj s men mechanism, or SSAM for shor . Consider the case of a short-run inflationary gap. When workers and firms realize the current price level exceeds their expectations, they adjust their price expectation upwards, causing the SRAS curve to shift left [or up] to the point where it crosses the AD and LRAS curves at the natural level of real GDP [see Figure 4 below]. Similarly, inflationary gaps are characterized by low unemployment and heavy demand for labor services. When labor contracts expire and are renegotiated, workers can expect to receive nominal wage increases. Such increases also shift the SRAS curve to the left, eventually restoring long run equilibrium at the natural level of real GDP. Alternatively, if the economy is in a recessionary gap, workers and firms eventually adjust their price expectations downwards, causing the SRAS curve to shift to the right [or down] to the point where the natural level of real GDP is restored [see Figure 5 below]. Similarly, recessionary gaps are characterized by high unemployment and low demand for labor services. When labor contracts expire and are renegotiated, firms can expect to receive a wage cut. Such cuts also shift the SRAS curve to the right, eventually restoring long run equilibrium at the natural level of real GDP. In summary, the economy always operates on the LRAS curve in the long run, with real GDP set at its natural level. In the short run, sudden shifts in AD or SRAS create short-run equilibria characterized by inflationary or recessionary gaps. However, price level expectations and nominal wages eventually adjust to these short-run equilibria - SSAM restores the economy to its long run natural level of real GDP.

Figure 4: Adjusting out of an Inflationary Gap P LRAS0 SRAS1 (Pe=P2) P2 C SRAS0 (Pe< P1) P1 B AD1 0 YN Y1 Y

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Figure 5: Adjusting out of a Recessionary Gap

P LRAS0 SRAS0 (Pe>P1) SRAS1 (Pe=P2) P1 B P2 C AD1 0 Y1 YN Y 3. A Child s G ide o sing he AD/AS Model The AD/AS model is useful for analyzing how the economy responds to changing circumstances in the short and long run. You will be asked in assignments and in the final exam to use the model to trace the short and long run impacts of various events. The following provides a step-by-step guide for dealing with AD/AS model questions. Question: What is the short and long run impact of an increase in consumer confidence on the price level and real GDP? Step 1: Unless otherwise indicated by the context of the question, assume the economy starts in a position of

long-run equilibrium.

This means you should start with an AD/AS diagram illustrated in Figure 6 below. Identify the initial long-run e b e e e A .

经济不好

TT

Reaing Gup 达不到 最⼤ 产量

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Figure 6: Initial Long-Run Equilibrium

P LRAS0 SRAS0 (Pe=P0) P0 A AD0 0 YN Y

Step 2: Identify the changing circumstance(s) indicated by the question, and shift the relevant curve [or in some

cases, curves] in the appropriate direction. This step requires that you know all the relevant shifters of the AD, SRAS, and LRAS curves you should memorize these and be able to call them up like a file in your mind when you address the question. The question at hand indicates consumer confidence has increased. This is an AD shifter, causing the AD curve to shift to right. In the case of this question, the economy ends up in a short-run equilibrium characterized by an inflationary gap see Figure 7 be . Ide e e e b e e e B .

Figure 7: An Inflationary Gap Emerges in the Short Run

P LRAS0 SRAS0 (Pe=P0< P1) P1 B P0 A AD1 AD0 0 YN Y1 Y

citnADTY7Tinfktinaygupf.tgsRAii.in-_- ⇒eaessgdemandoflubour-wagetu.lu ⇒ACT-7SRASl-Y-YN.lt_ǔ y.PT

11

Step 3: If the changing circumstance(s) imply a short-run equilibrium characterized by an inflationary or recessionary gap, show the long-run adjustment of the SRAS curve that restores the economy to its natural level of real GDP. In this step you are illustrating the long-run outcome arising when price level expectations and nominal wages adjust to the changing circumstance(s). For the question at hand, the fact the economy is in an inflationary gap means price level expectations and nominal wages eventually increase - SSAM shifts the SRAS curve leftward [or up] until the point where real GDP is once again at its natural level [i.e. the point where the AD, SRAS, and LRAS curves once again intersect] see Figure 8 below. Identify the new long-run equilib e e e C .

Figure 8: Long Run Equilibrium Restored

P LRAS0 SRAS1 (Pe=P2) P2 C SRAS0 (Pe=P0< P1) P1 B P0 A AD1 0 YN Y1 Y

Using this step-by-step approach, the answer to the stated question is as follows: In he shor -run, an increase in consumer confidence increases real GDP beyond its natural level and causes the price level to increase. In the long run, real GDP drifts back to its natural level as price level expectations and nominal wages adjust upwards. In he end, onl he price le el increases.

There are many alternative scenarios that you may asked to illustrate with the AD/AS model. Try illustrating the short and long run consequences of each of the following: 1. A sudden decrease in AD [see TYU question 1, Question for Review #6, and TYU question 2, Problems and Applications #12 [a] and [d] below] . 2. A sudden increase in SRAS [but not in LRAS]. 3. A sudden decrease in SRAS [but not in LRAS] [see TYU question 1, Question for Review #7, and TYU question 2, Problems and Applications #9, below]. 4. A sudden increase in SRAS and LRAS [see TYU question 2, Problems and Applications #12 [c] below]. 5. A sudden decrease in SRAS and LRAS.

12

TYU Questions

1. Complete Questions for Review 1 7 on p.347 of the text. 2. Complete Quick Check Multiple Choice 1 6 on pp.347-348. 3. Complete Problems and Applications 2 6, 8 13 on p.348-350.

TYU Answers

1. 1. Two macroeconomic variables that decline when the economy goes into a recession are real GDP and investment spending (many other answers are possible). A macroeconomic variable that rises during a recession is the unemployment rate. 2. Figure 9 shows aggregate demand, short-run aggregate supply, and long-run aggregate supply.

Figure 9

3. The aggregate-demand curve is downward sloping because: (1) a decrease in the price level increases the a e e d e a ea , which in turn encourages them to spend more, so there is a larger quantity of goods and services demanded; (2) a lower price level reduces the real interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services demanded; (3) a fall in the Canadian price level causes the real exchange rate to depreciate, stimulating Canadian net exports, so there is a larger quantity of goods and services demanded. 4. The long-run aggregate supply curve is vertical because in the long run, an economy's supply of goods and services depends on its supplies of capital, labour, and natural resources and on the available production technology used to turn these resources into goods and services. The price level does not affect these long-run determinants of real GDP. 5. Three theories explain why the short-run aggregate-supply curve is upward sloping: (1) the sticky-wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services

supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce; and (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

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6. The aggregate-demand curve might shift to the left when something (other than a rise in the price level) causes a reduction in consumption spending (such as a desire for increased saving), a reduction in investment spending (such as increased taxes on the returns to investment), decreased government spending (such as a cutback in defense spending), or reduced net exports (such as when foreign economies go into recession, so our exports fall.

Figure 10 traces through the steps of such a shift in aggregate demand. The economy begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate demand, AD1, at point A. When the aggregate- demand curve shifts to the left to AD2, the economy moves from point A to point B, reducing the price level and the quantity of output. Over time, people adjust their perceptions, wages, and prices, shifting the short- run aggregate-supply curve down to AS2, and moving the economy from point B to point C, which is back on the long-run aggregate supply curve and has a lower price level.

Figure 10

7. The aggregate-supply curve might shift to the left because of a decline in the economy's capital stock, labour supply, or productivity, or an increase in the natural rate of unemployment, all of which shift both the long- run and short-run aggregate supply curves to the left. An increase in the expected price level shifts just the short-run aggregate-supply curve (not the long-run aggregate-supply curve) to the left. Figure 11 traces through the effects of such a shift. The economy starts in equilibrium at point A. The aggregate-supply curve then shifts to the left from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS2. As time goes on, the economy returns to long-run equilibrium at point A, as the short-run aggregate supply curve shifts back to its original position.

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Figure 11

2. 1. [c] 2. [a] 3. [b] 4. [a] 5. [c] 6. [d] 3. 2. a. The current state of the economy is shown in Figure 10 above. The aggregate-demand curve and short- run aggregate-supply curve intersect at a point on the long-run aggregate supply at point A.

b. A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall see point B. Since the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment.

c. If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the short-run aggregate supply curve will shift to the right moving the economy back to the natural rate of output at point C.

3. a. When Canada experiences a wave of immigration, the labour force increases, so long-run aggregate supply increases [shifts to the right] as there are more people who can produce output. b. When provincial governments raise the minimum wage to $10 per hour, the natural rate of unemployment rises [see Chp. 10], so the long-run aggregate-supply curve shifts to the left. c. When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increases [shifts to the right] as more output can be produced with the same inputs. d. When a severe hurricane damages factories along the east coast, the capital stock is smaller, so long- run aggregate supply declines [shifts to the left]. 4. [a] See the figure below. [b] See the figure below. [c] See the figure below. The economy moves from B to C as [i] workers in the long run renegotiate labor contracts with employers, receiving higher nominal wages, and [ii] workers and firms adjust price level expectations upwards as full information regarding the behavior of the price level becomes available. [d] Nominal wages at A and B are the same. Nominal wages at C are greater than at A. [e] Real wages at B are lower than at A [due to the higher price level at B]. Real wages at C are the same as at A [while the nominal wage is higher at C, the price level is also higher]. [f] Yes the increase in the money supply affects real GDP and real wages in the short run, but only the

price level and nominal wages in the long run.

𦒄璺

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5. a. The statement that "the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregate-demand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect. b. The statement that "the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply. c. The statement that "if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short-run aggregate supply curve, then the short-run aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed. d. The statement that "whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a recession if the aggregate-demand curve or the short-run aggregate-supply curve shift to the left. 6. a. According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high, thus labour demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment. According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long-run aggregate-supply curve. According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve. b. The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

8. Figure 12 depicts an economy in a recession. The short-run aggregate supply curve is AS1 and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply curve. If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to AS2. The economy's new equilibrium is at point B.

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Figure 12

9. a. If people believe that inflation will be high over the next year, workers will want higher nominal wages. If the price level does not rise as much as wages do, real wages will increase, so firms will not hire as many workers. b. Figure 11 above shows the economy starting out at point A on short-run aggregate-supply curve AS1. With higher nominal wages, the short-run aggregate-supply curve will shift to the left to AS2. The new equilibrium is at point B, with output less than long-run aggregate supply. In the short run, the price level rises and output falls. In the long-run, the economy will return to point A, as the decline in output eventually leads to a decline in the price level and the short-run aggregate-supply curve returns to AS1. c. In the short-run, expectations of higher inflation were e - a d e e e accurate, as the price level is higher at point B than at point A (however, the price level at point B is not as high as was expected). But inflation expectations were wrong in the long run.

10. a. The AD curve has shifted leftward. b. The capacity to produce diamonds has increased over the years, which has caused the long run and short run aggregate supply curve to shift rightward. c. The long run and short run aggregate supply have shifted rightward. Due to increased investment, the AD curve shifts rightward as well. d. The demand for tourist attractions, flights, restaurants, hotels, etc. is reduced, shifting aggregate demand to the left. 11. a. If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 4. The equilibrium changes from point A to point B, so the price level declines and output declines. In the long run, price level expectations adjust downwards, shifting the SRAS curve to point C, where long run equilibrium is restored. b. If Okanagan peach orchards suffer a prolonged period of below-freezing temperatures, the peach harvest will be reduced. This is represented in Figure 11 above by a shift to the left in the short-run aggregate-supply curve [the long run capacity of the orchards to produce fruit is assumed to be unaffected]. The equilibrium changes from point A to point B, so the price level rises and output declines. c. If increased job opportunities cause people to leave the country, the short-run aggregate-supply and long run aggregate supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 13 shows. Whether the price level rises or declines depends on the relative size of the shifts in the aggregate-demand and aggregate-supply curves.

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Figure 13

P LRAS1 LRAS0 SRAS1 SRAS0 B A AD1 AD0 0 YN1 YN0 Y 12. a. When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 14. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

Figure 14

b. When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 15. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A.

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Figure 15

c. When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 16. The economy moves from point A to point B, as output rises and the price level declines.

Figure 16

d. When a recession overseas causes foreigners to buy fewer Canadian goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 14 above. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

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13. a. If firms become optimistic about future business conditions and invest a lot, the result is shown in Figure 17. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The equilibrium has price level P1 and output level Y1. Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with price level P2 and output level Y2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

b. Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts up to AS2 and the economy gets to equilibrium at point C, with price level P3 and output level Y1. The quantity of output demanded declines as the price level rises.

c. The investment boom will eventually increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output. The appropriate long run diagram is therefore Figure 18.

Figure 17

Figure 18 P LRAS0 LRAS1 SRAS1 C SRAS0 SRAS2 B A D AD0 AD1 0 YN0 YN1 Y

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Assigned Problems

Note: Before attempting this question set, ask yourself whether you have allocated the time necessary to grasp the AD/SRAS/LRAS model developed in Chapter 14. If not, first review the notes in Section 2 of the Chapter 14 Student Package as ell as Chap er 13 of he co rse e book. If hings aren clear, consider reaching o for help in the Chapter 14 Help Forum on the Moodle course website, or attending my office hours.

1. What macroeconomic market does the AD/AS model represent? What is exchanged in this market?

Hints: See pp.1-2 in the Chapter 14 Student Package. See pp.317-318 in Chapter 14 of the course textbook.

2. The economy is in the short-run macroeconomic equilibrium at point E1 in the diagram below. Based on the diagram, answer the following questions. Hints: See pp. 334-341 in Chapter 14 of the course text book. See Section 2 in the Supplementary Notes found in the Chapter 14 Student Package. P LRAS

SRAS E1 P1

AD Y1 YP Y [a] What kind of macroeconomic "gap" is the economy experiencing? [b] If the government does not intervene, explain how the economy will naturally be restored to its long-run equilibrium? When compared to its short-run level, what would happen to the economy's price level [i.e. P] in the long run [i.e. increase, decrease, no effect, indeterminate]?

When compared to its short-run level, what would happen to the economy's real GDP level [i.e. Y] in the long run [i.e. increase, decrease, no effect, indeterminate]?

3. The economy is in the short-run macroeconomic equilibrium at point E1 in the diagram below. Based on the diagram, answer the following questions. Hints: See pp. 334-341 in Chapter 14 of the course text book. See Section 2 in the Supplementary Notes found in the Chapter 14 Student Package.

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P LRAS

SRAS E1 P1

AD YP Y1 Y [a] What kind of macroeconomic "gap" is the economy experiencing? [b] If the government does not intervene, explain how the economy will naturally be restored to its long-run equilibrium?

When compared to its short-run level, what would happen to the economy's price level [i.e. P] in the long run [i.e. increase, decrease, no effect, indeterminate]? When compared to its short-run level, what would happen to the economy's real GDP level [i.e. Y] in the long run [i.e. increase, decrease, no effect, indeterminate]?

4. Hints: See pp. 318-334 in Chapter 14 of the course text [Table 14.1 [p.324] and Table 14.2 [p.333] may be Particularly helpful]. See Sections 1 and 2 in the Supplementary Notes found in the Chapter 14 Student Package. [a] Indicate how each of the following events would affect the aggregate demand [AD] curve [i.e. shift the curve left, shift the curve right, move along the curve, no effect on the curve]. [i] Higher federal income taxes [ii] An appreciation of the Canadian dollar in foreign exchange markets [iii] A short-run decrease in the price level [iv] An increase in world oil prices [b] Indicate how each of the following events would affect the short run aggregate supply [SRAS] curve [i.e. shift the curve left, shift the curve right, move along the curve, no effect on the curve]. [i] An increase in price level expectations of firms [ii] A short-run increase in the price level [iii] A decrease in the price of an important raw material [iv] An increase in the size of the labor force

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[c] Indicate how each of the following events would affect the long run aggregate supply [LRAS] curve [i.e. shift the curve left, shift the curve right, move along the curve, no effect on the curve]. [i] An advance in production technology [ii] An increase in consumer spending [iii] A long-run decrease in the price level [iv] A decrease in nominal wage rates 5. The Canadian economy suffered two shocks in 2008, leading to the recession in 2008-2009. One shock related to rising oil prices; the other was the slump in both consumer and business confidence. Hint: See Sections 2 and 3 in the Supplementary Notes found in the Chapter 14 Student Package. [a] How would these two events affect the Canadian real GDP [Y] in the short run [increase, decrease, no effect,

or indeterminate]? The Canadian price level [P] [increase, decrease, no effect, or indeterminate]? Hint: To derive your answer, first sketch an AD/SRAS/LRAS diagram, and ask yourself how the two shocks affect the model. What happens to Yin your diagram? P?

[b] Assuming no government policy intervention, how would these two events affect Canadian Y and P in the long run [increase, decrease, no effect, or indeterminate]? Use the short-run macroeconomic equilibrium position as a comparison basis for your answer. Hint: Refer to your diagram in question [a]. Starting from the short run equilibrium position, and assuming no policy intervention, where will the supply-side adjustment mechanism take the Canadian economy in the long run?

6. Assume the Canadian economy starts in long run macroeconomic equilibrium. For each of the following events, identify [i] the relevant figure [see Figures 1-10 in the Question 5 of the Assigned Questions section, Chapter 14 Student Package], [ii] the short run effect on the price level, [iii] the short run effect on real GDP, [iv] the short run effect on unemployment, [v] the long run effect on the price level, [vi] the long run effect on real GDP, and [vii] the long run effect on unemployment i.e. increase, decrease, no change, or indeterminate. Note: all effects [i.e.

a d ] a e be ea ed a c a ed e a e b [ A e diagram].

Hint: See the Supplementary Notes [pp. 3-9, especially the recommended practice questions on p. 9] found in the Chapter 14 Student Package. Here is an example question to illustrate the approach and format I am asking you to employ when answering this question.

Example: Consumer confidence increases. Answer [i] Figure 1 [Explantation: the increase in consumer confidence increases consumer spending, shifting AD to the right. The resulting short run inflationary gap is eventually corrected by a long-run supply-side adjustment of the SRAS curve. Note: I do not expect you to provide an explanation – this explanation is meant to clarify the reasoning behind the answer.] [ii] increase [compare point A to point B – the price level rises from P0 to P1]

[iii] increase [compare point A to point B – real GDP from YN to Y1]

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[iv] decrease [at point B, Y is above YN; therefore, unemployment has fallen below its natural rate] [v] increase [compare point A to point C – the price level rises from P0 to P2] [vi] no change [compare point A to point C – Y is restored to YN] [vii] no change [at point C, Y equals YN – unemployment has returned to its natural rate]

[a] The federal government decides to permanently raise income tax rates. [i] [ii] [iii] [iv] [v] [vi] [vii] [b] The federal government decides to permanently raise defense spending. [i] [ii] [iii] [iv] [v] [vi] [vii] [c] Canadian and world oil prices permanently increase. [i] [ii] [iii] [iv] [v] [vi] [vii] [d] T e U ed S a e c a a Ca ad a d c ; a e a e e, a d e expectations of the price level decline.

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[i] [ii] [iii] [iv] [v] [vi] [vii] [e] Federal tax cuts for firms employing productive new technologies lead to an immediate increase in investment spending and eventual economic growth. [i] [ii] [iii] [iv] [v] [vi] [vii]

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Figures for Question 5: Figure 1 Figure 2

P P LRAS0 LRAS0 SRAS1 SRAS0 SRAS0 2 P2 C SRAS1 P1 B 1 P0 A P0 A 2 P1 B 1 AD1 P2 C AD1 AD0 AD0 YN Y1 Y Y1 YN Y Figure 3 Figure 4 P P LRAS0 LRAS0 SRAS1 1 SRAS0,2 SRAS0,2 1 2 SRAS1 P1 B P0 A,C P0 A,C 2 P1 B AD0 AD0 Y1 YN Y YN Y1 Y

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Figure 5 Figure 6 P P LRAS0 LRAS0 SRAS2 SRAS1 SRAS0 SRAS0 2 SRAS1 P2 C 1 1 SRAS2 P0 = P1 = ? A B P0 = P1 = ? B A 1 2 AD1 P2 C 1 AD1 AD0 AD0 YN Y1 Y Y1 YN Y Figure 7 Figure 8 P P LRAS0 LRAS0 SRAS1 SRAS0 SRAS0 1 P1 B 1 1 SRAS1 P0 A P0 A 1 AD1 P1 B AD1 AD0 AD0 YN Y YN Y Figure 9 Figure 10 P P LRAS0 LRAS1 LRAS1 LRAS0 2 SRAS0 SRAS1 SRAS0 1 P1 B 2 SRAS1 P1 B 1 P0 = P2 = ? A C P0 A AD1 1 AD0 AD0 YN0 Y1 YN1 Y YN1 YN0 Y