1. Define Aggregate demand and aggregate supply model
Aggregate demand and aggregate supply model
A model that explains short-run fluctuations in real GDP and the price level.
*Holding everything else constant
Aggregate demand (AD) curve
Short-run aggregate supply (SRAS) curve
Aggregate demand (AD) curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.
Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.
1. What is the formula for GDP
2. What is the general (most basic) explanation as to why the aggregate demand (AD) curve is downward sloping?
1. Y = C + I + G + NX
2. The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. (Negative relationship between CPI and GDP).
* However, this is assuming government purchases are not affected
1. What are the 3 reasons why the AD curve is sloping downward in terms of consumption (C)?
2. What is this situation called?
3. What are the 3 aspects of why the AD curve is sloping downward in terms of investment (I)?
4. What is this situation called?
5. What are the 3 aspects of why the AD curve is sloping downward in terms of net exports (NX)?
6. What is this situation called?
1a. Some of a household’s wealth, the difference between the value of its assets and the value of its debts, is held in cash or other nominal assets that lose value as the price level rises and gain value as the price level falls.
b. When the price level falls, the real value of household wealth rises, and so will consumption and the demand for goods and services.
- c. When the price level falls, consumers feel more wealthy and they spend more.
- This is called the wealth effect.
2. The Wealth Effect
3a. With a lower price level
, the less money households need to hold to buy the goods and services they want. So, Households try to reduce their holdings of money by lending some of it out or deposit its excess money in an interest-bearing assets or savings account.
b. Either way, it will drive down interest rates, which encourages greater spending on investment goods.
c. This increase in investment spending means a larger quantity of goods and services demanded.
4. This is called the interest-rate effect
5a. Net exports equal spending by foreign households and firms on goods and services produced in Canada minus spending by Canadian households and firms on goods and services produced in other countries.
b. A higher price level in Canada relative to other countries causes net exports to fall, reducing the quantity of goods and services demanded.
c. A lower price level in Canada relative to other countries causes net exports to rise, increasing the quantity of goods and services demanded
6. the international -trade effect
1. What causes a movement along the aggregate demand curve (AD) as opposed to a shift in the curve?
2. How would a stock market boom affect the AD curve? Visualize
1. If the price level changes but other variables that affect the willingness of households, firms, and the government to spend are unchanged, the economy will move up or down a stationary aggregate demand curve.
If any variable other than the price level changes, the aggregate demand curve will shift. In other words, any event that changes C, I, G, or NX – except a change in P – will shift the AD curve.
2. A stock market boom makes households feel wealthier, and therefore they spend more. C rises, and so the AD curve shifts right.
What changes cause a shift in the AD curve?
1. In terms of C - 3
2. In terms of I - 4
3. In terms of G - 2
4. In terms of NX - 1
- 1. Changes in C
- a. Stock market boom/crash
- b. Preferences re: consumption/saving tradeoff
- c. Tax hikes/cuts
- 2. Changes in Ia. Firms buy new computers, equipment, factories
- b. Expectations, optimism/pessimism
- c. Interest rates, monetary policy
- 4. Investment Tax Credit or other tax incentives
- 3. Changes in Ga. Federal spending, e.g., defense
- b. Provincial & municipal spending, e.g., roads, schools
- Changes in NXa. Booms/recessions in countries that buy our exports
What happens to the AD curve in each of the following scenarios?
1. A ten-year-old investment tax credit expires.
2. The Canadian exchange rate falls, which is depreciation.
3. A fall in prices increases the real value of consumers’ wealth.
4. Provincial governments replace their sales taxes with new taxes on interest, dividends, and capital gains.
1. I falls, AD curve shifts left.
2. NX rises, AD curve shifts right.
3. Move down along AD curve (wealth-effect).
4. C rises, AD shifts right. (Note. there will be decline in investment, but the size will be smaller than consumption increase)
Describe and visualize what happens to the AD curve when there is an increase in the following variables and explain why?
1. Interest rates
2. Government purchase
3. Personal income taxes, or business taxes
4. Household expectations of their future income
5. Firms expectations of the future profitability of investment spending
6. The growth rate of domestic GDP relative to the growth rate of foreign GDP
7. The exchange rate (the value of the Canadian dollar) relative to foreign currencies
1. What do AS curves show?
2. What are their 2 properties?
1. The AS curve shows the total quantity of g&s firms produce and sell at any given price level.
2. AS curves are upward sloping (positive relationship with price level) and are vertical in the long run
1. Define: Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.
2. In the long run, what 3 factors determine AS, and what factor does not?
3. What is the level of real GDP in the long run called? (2 names)
4. When does the LRAS curve shift?
1. Long-run aggregate supply (LRAS) curve
A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.
is NOT affected by changes in the price level (but SRAS is).
is determined by:
- a. the number of workers
- b. the capital stock
- c. the available technology
* In other words, changes
in the price level ABSOLUTELY DO NOT
affect the level of real GDP
in the long run
3.potential GDP or full-employment GDP
4. Each year the long-run aggregate supply curve shifts to the right, as the number of workers in the economy increases, more machinery and equipment are accumulated, and technological change occurs.
1. What are the effects that causes AD and LRAS to shift to the right in the long run?
2. What is the result?
1. Over the long run, tech. progress shifts LRAS to the right, and growth in the money supply shifts AD to the right (will be discussed later chapter).
2. This results in ongoing inflation (increase in price levels) and growth in output
1, What does the SRAS curve show us?
2. Why is the slope of the SRAS curve important, compared to the LRAS curve?
1. The relationship between the price level (P) and the quantity of goods and services supplied. Short-run can be roughly a period of 1-2 years
2. If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.
If AS slopes up on the other hand, then shifts in AD DO
affect output and employment.
1. What are the two theories of SRAS
2. What two things do they have in common?
3. What is the formula explaining these theories, and what does each component of the formula representÉ
1. The Sticky-Wage Theory
and The Sticky-Price Theory
2. Each one is explained by some type of market imperfection
that results in output deviating from the natural rate when the actual price level deviates from the price level people expected
In other words, Y deviates from YN when P deviates from PE.
3. Y = YN + a(P – PE)
- Y = Output (GDP)
- YN = Natural rate of output (long-run)
- a = a > 0, measures how much Y responds to unexpected changes in P
- P = actual price level
- PE = Expected price level
1. What is the main premise of the sticky-wage theory, and why does it occur?
2. What does PE have to do with the slope of the SRAS curve using the sticky-wage theory?
3. What is the main premise of the sticky-price theory, and why does it occur?
4. What does PE have to do with the slope of the SRAS curve using the sticky-price theory?
1. Market imperfection
: Nominal wages are sticky in the short run, they adjust slowly due to labour contracts, social norms
Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail.
2. If P > PE (meaning if the actual price level turns out to be higher than the price level firms had expected), revenue is higher, but labour cost is not.
- Production becomes more profitable because the price of the goods they produce is higher than they expected, while the wages they pay are comparatively lower, making it cheaper to produce each unit. So firms increase output and employment.
- Hence, higher P causes higher Y, so the SRAS curve slopes upward.
3. Market imperfection
: Many prices are sticky in the short run. due to menu costs
, the costs of adjusting prices.
Examples: cost of printing new menus, the time required to change price tags
Firms set sticky prices in advance based on PE.
- 4. Suppose the Bank of Canada increases the money supply unexpectedly. In the long run, P will rise.
- In the short run, firms without menu costs can raise their prices immediately.
- Firms with menu costs wait to raise prices. Meantime, their prices are relatively low,
- which increases demand for their products, so they increase output and employment.
Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.
1. What happens when P > PE, and what happens when P < PE.
2. Visualize on a graph.
1. When P > PE, there is a increasing movement along the SRAS curve, causing output (Y) to go up.
When P < PE, there is a decreasing movement along the SRAS curve, causing output (Y) to go down.
Describe and visualize what happens to the SRAS curve when there is an increase in the following variables and explain why?
1. The labour force or capial stock
3. The expected future price level
4. Workers and firms adjusting to having previously underestimated the price level
5. The expected price of an important natural resource
1. What do LRAS and SRAS have in common?
2. How do they differ?
3. How are they related?
1. The same factors that shift LRAS also shift SRAS
- 2. But SRAS also shifts because of PE
- If PE rises, workers and firms set higher wages, meaning that production is less profitable causing Y to fall and SRAS to shift to the left.
3. Over time, however, sticky wages and prices become flexible, and misperceptions are corrected. This means that PE = P and Y = YN, causing the AS curve to become vertical.
- Therefore, there is equalibrium and unemployment is at its natural rate.
1. What are the short run and long run effects of a recession (decrease in aggragate demand)?
2. Outline the 3 steps
- 1. In the short run, a decrease in aggregate demand causes a recession. In the long run,
- it causes only a decrease in the price level.
2. Step 1: A decline in investment shfts AD to the left causing a recession
Step 2: As firms and workers adjust to the price level being lower than they expected, costs will fall and cause SRAS to shift to the right.
Step 3: Equalibrium moves from point A on the LRAS curve, to point B on the SRAS curve, and back to the LRAS curve at a lower price, but same output as before.
* In the new short-run macroeconomic equilibrium, real GDP declines below its potential level and the economy moves into a recession.Economists refer to the process of adjustment back to potential GDP as an automatic mechanism because it occurs without any actions by the government
1. What are the short run and long run effects of inflationary expansion (increase in aggragate demand)?
2. Outline the 3 steps
1. In the short run, an increase in aggregate demand causes an increase in real GDP. In the long run, it causes only an increase in the price level.
- Step 1: An increase in investment shifts AD curve to the right, causing an inflationary expansion
As firms and workers adjust to the price level being higher than they had expected, costs will rise and cause SRAS to shift to the left.
Equalibrium moves from point B back to potential GDP at point C, with a higher price level
1. What is stagflation?
2. What causes stagflation?
1. A combination of inflation and recession, usually resulting from a supply shock.
2. When the economy experiences a combination of inflation and recession, usually resulting from a supply shock, a situation known as stagflation occurs. Stagflation shifts the SRAS curve to the left, increasing the price level and decreasing actual GDP.
What are menu costs?
The cost to firms of changing prices
What 3 factors cause the SRAS curve to slope upwards?
- 1. Menu costs,
- 2. Slow adjustments of wages, and prices
- 3. Slow adjustment of input prices