Chapter 12 Economic Fluctuations

Aggregate DemandThis is the connection among: InflationUnemploymentLevel of spending real output in the Canadian

economy

The relationship between:The general price and GDP (expenditure) Real expenditure = Spending – (Spending / GDP Deflator)

Demand Curve

Downward SlopeAs price goes up, demand goes downAs price goes down, demand goes up

Price Qd Qs

$3.00 5 13 17

$2.50 7 11 15

$2.00 9 9 13

$1.50 11 7 11

$1.00 13 5 9

Market Demand and Supply Schedules for

Strawberries

0 1 3 5 7 9 11 13 15

3.00

Price ($)

2.00

1.00

Quantity

(millions of kilogram per year)

S0

D

Market Demand and Supple Curves for Strawberries

Change in Supply on Equilibrium

a

S1

b

Surplus

Price Qd Qs

$3.00 5 9 13

$2.50 7 11 11

$2.00 9 13 9

$1.50 11 15 7

$1.00 13 17 5

Market Demand and Supply Schedules for

Strawberries

0 1 3 5 7 9 11 13 15

3.00

Price ($)

2.00

1.00

Quantity

(millions of kilogram per year)

S

D0

Market Demand and Supple Curves for StrawberriesChange in Demand

on Equilibrium

D1

b

a Shortage

Movement Along the Demand curve is Caused by

WealthAssets such as money in bank accounts or

RSPS have unchanging nominal valuesBut their real value change

Real value for asset = nominal value / price level Therefore, when price levels rise, the real value

of assets decreases, this gives people less wealth and lower spending causing real expenditure to decrease

Foreign TradeAs the Canadian price level rises, so do

the export prices, foreign markets will buy less(decrease in export), but we will import more (because their price level is lower than ours). Hence, net export decrease (X – M) and real expenditure decrease

Factors causing shifts in the demand curve

ConsumptionDisposable Income Is the amount of money that can be spent,

the more spending the more real expenditure(shift to the right).

Consumer expectationsCause consumers to spend more or less

depending on if they predict the price will rise or fall

Interest RatePlay a roll when it comes for people making big

purchases, lower interest rates cause consumers to borrow more and spend more making total expenditures increase, and vice versa

Investment Investment refer to planned investments, not

unintentional changes in inventory

Rate of Return Is the percentage change of the constant extra

profit provided per year generated by the investment

Investment DemandRelies on interest rates, production costs and

technological breakthroughs. As interest rates decrease, companies will be able to borrow more to pursue new investments. Taxes may cause production cost to increase, and fewer investments will be pursued(hence less expenditure and a shift to the left).

Net ExportsWhen foreign incomes and exchange rate

change exports will be affected. If foreign incomes rise, they will import more causing us to export more (net exports increase). When the dollar value increases their price level will be increased and exports will decrease.

Shifts in the Aggregate Demand Curve

Aggregate demand increase, thereby shifting the AD curve to the right / left, with the following:An increase/decrease in consumption due to

A rise/fall in disposable incomeA rise/fall in wealth An expected rise/fall in prices or incomesA fall/rise in interest rate

An increase/decrease in investment due toA fall/rise in interest ratesAn expected rise/fall in profitA fall/rise in production costs

An increase/decrease in government purchases

An increase/decrease in net exports due to A rise/fall in foreign incomesA fall/rise in the value of the Canadian dollar

Aggregate SupplyAggregate SupplyThe relationship between the general price

level and real output produced in the economy

Aggregate Supply CurveThe relationship between the general price

level and real output expressed as a graph

Change in Aggregate Supply

Aggregate supply factorVariables that change total output at all

price levels

Input PricesShort-run increase in aggregate supply

An increase in total output at all price levels, with no change in potential output

Resource SupplyLong-run increase in aggregate supply

An increase in total and potential output at all price levels

Productivity Is the real output produced per unit of input over a

given periodSpecifically labor productivity for example would

be calculated as followsLabour productivity = Real output

Total hours worked• Here we divide the nations real output by the

total number of hours worked by its labour force

Government PoliciesGovernment policies can also influence

aggregate supply through their effects on the business environment in an economy

ExampleSuppose taxes rise for businesses and households.

Because the after taxes on supplying economic resources are reduced, business and households may reduce the resources they supply at every price level. As a result real output falls, causing a long-run decrease in aggregate supply

EquilibriumAggregate Demand and SupplyAn economy’s equilibrium price level and

real output occur at the intersection of the aggregate demand and aggregate supply curves

Inventory ChangesUnintended changes in inventories cause price levels and real outputs to reach equilibrium. There are two possible changes: an inventory increase or decrease Results of a inventory increase cause a surplus

and the prices of individual products decrease, pushing down the general price level. This is known as a positive unplanned investment. The decrease influences both households and businesses to buy and creates equilibrium

Results of an inventory decrease cause a shortage. This leads to a decrease in inventory and therefore the prices rise, this is known as negative unplanned investment. Buyers decrease spending, businesses raise real output and this creates equilibrium

The role of unplanned investment players a central role of stabilizing the economy. It is identical to the discrepancy between aggregate demand and aggregate supply. (Has a monetary value)

Injection and WithdrawalsInjection Are additions to an economy’s income spending

stream. There are three flows Investment (I) Government Spending (G) Exports (X)

Withdrawals Are deductions from an economy’s income-

spending stream. There are three flows: Saving (S) Taxes (T) Imports (M)

To understand we look at related pairs of injections and withdrawals Investment and Savings

Households provide personal savings into the loanable funds market. Most of these funds are borrowed by businesses for investment. However the amount saved and the amount invested in an economy are not equal for three reasons.

Companies keep a portion of their profit to reinvest

Government also borrow Foreign exchange flow must also be considered

Government Purchases and TaxesGovernments purchases usually exceed taxes,

and to make up for the discrepancy governments borrow money from financial markets. In the odd case when taxes exceed government spending they can use the money to pay off debt

Exports and ImportsForeign lending tends to be greater than foreign

borrowing, therefore the surplus in lending makes up for the short fall in net exports

Total injections and withdrawalHave an important connection that applies when

an economy is at equilibrium. Total injections are the sum of I + G + X and total withdrawals are the sum of S + T + M. This determines the state of the economy

Equilibrium vs. Potential Output

If an economy’s equilibrium occurs at its potential output, then unemployment at equilibrium equals the natural unemployment rateRecessionary Gap Occur when the amount by which equilibrium

output falls short of potential output

Inflationary Gap Occur when the amount by which equilibrium

output exceeds potential output