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LESSON 9 Economic Fluctuations: Balancing Aggregate Demand and Supply Assigned Reading 1. Mankiw, N.G., et al. 2014. Principles of Macroeconomics (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 14: Aggregate Demand and Aggregate Supply Recommended Reading 1. Mankiw, N.G., et al. 2014. Study Guide for use with the Principles of Macroeconomics, (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 14: Aggregate Demand and Aggregate Supply Learning Objectives After studying this lesson, students should be able to: 1. explain that short-run economic fluctuations are irregular and unpredictable, that most macroeconomic variables fluctuate together, and that there is an inverse relationship between output and unemployment; 2. explain how economic performance in the short run differs from long run economic behavior; 3. explain why the aggregate demand curve slopes downward; 4. describe the factors that cause the aggregate demand curve to shift; 5. explain why the aggregate supply curve is vertical in the long run; 6. explain what causes the long-run aggregate supply curve to shift; 7. explain why the aggregate supply curve slopes upward in the short run; 8. explain what causes the short-run aggregate supply curve to shift; 9. use the model of aggregate demand and aggregate supply to explain economic fluctuations; and 10. use the model of aggregate demand and aggregate supply to show booms and recessions. Instructor's Comments This lesson is a traditional treatment of aggregate demand/aggregate supply analysis. It is a simple but powerful model of the short-run and long-run operation of a nation or region's economy. It focuses on two important macroeconomic variables: the price level in the economy and the level of real output. The latter is directly linked to household incomes and the level of employment, and thus the unemployment rate, in the 9.1
Lesson 9 economy. Although the aggregate demand and supply curves look like those in microeconomics, they are not the same. In the market for any good, substitution with other goods places an important role in determining the quantity demanded. This is not possible for aggregate demand. The purpose of this lesson is to develop the model economists use to analyze the economy's short-run fluctuations B the model of aggregate demand and aggregate supply. The reasons for the downward sloping aggregate demand curve and the upward sloping aggregate supply curve are discussed in detail. We learn about the sources for shifts in the aggregate demand curve and the aggregate supply curve and how these shifts can cause recessions. This lesson also introduces actions that policymakers might undertake to offset recessions. An important distinction is between short-run and long-run aggregate supply. In the long run, the level of aggregate supply depends on real values supplied by resources, such as human, physical, and natural, at an economy's disposal with a level of technology to support it. Nominal values such as the price level or the quantity of money do not affect aggregate supply. However, in the short run, these can matter. In the short run, aggregate supply will rise with the price level in the economy because of inaccurate expectations of the price level or adjustment costs, such as for the prices of a firm's goods or the wages paid to labour. The importance of real estate in this context follows directly from Chapter 6. In Chapter 6, data was presented to show that about 27.5% of all 2012 personal consumption expenditures were for shelter and shelter-related goods and services. Because this proportion is so large, changes in the demand for these goods are important in determining aggregate demand. Many federal programs can be viewed as serving to increase aggregate demand and employment through their attempts to stimulate demand in real estate markets. Some examples include the Home Buyer's Plan (which allows holders of registered retirement savings plans B RRSPs B to withdraw up to $20,000 tax-free towards the purchase of a home) and the 5% down payment program (which allows purchasers to finance 95% of the purchase price of a home, if the loan is insured). The federal government also affects aggregate demand directly through its own real estate expenditures, which as government expenditures would shift the aggregate demand curve, for items such as public housing and urban renewal, post offices, and office buildings. Although small in size relative to all government expenditures, these expenditures are important to the real estate sector. Review and Discussion Questions 1. When economists look at the data for Canada and other economies, they notice that, when the money supply increases, GDP tends to increase also. Is this consistent with the classical dichotomy? 2. Why is the model of aggregate supply and demand different from the microeconomic theory of supply and demand? 3. Suppose a manager of a firm sees that the firm's output is selling at a price 5% higher than she expected. Explain why she might decide to increase the firm's production in this case. Suppose that what actually happened is that there was inflation, so the overall price level is 5% higher than this manager expected. Was the decision to increase production correct? Explain how such behaviour can result in an upward-sloping aggregate supply curve. 4. Name the three key facts about economic fluctuations. 5. What happens to the natural level of output when the natural rate of unemployment falls? 6. If the economy is in a recession, why might policymakers choose to adjust aggregate demand to eliminate the recession rather then let the economy adjust, or self-correct, on its own? 9.2
Economic Fluctuations: Balancing Aggregate Demand and Supply 7. For the following four cases, trace the impact of each shock in the aggregate-supply aggregatedemand model by answering the following three questions for each: C C C What happens to prices and output in the short run? What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own? If policymakers had intervened to move output back to the natural level instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand? (a) (b) (c) (d) aggregate demand shifts left aggregate demand shifts right short-run aggregate supply shifts left short-run aggregate supply shifts right 8. You are watching the evening news on television with a friend. The news anchor reports that union wage demands are much higher this year because the workers anticipate an increase in the rate of inflation. Your friend says, "Inflation is a self-fulfilling prophecy. If workers think there are going to be higher prices, they demand higher wages. This increases the cost of production and firms raise their prices. Expecting higher prices simply causes higher prices. (a) (b) (c) Is this true in the short run? Explain. If policymakers do nothing and allow the economy to adjust to the natural level of output on its own, does expecting higher prices cause higher prices in the long run? Explain. If policymakers accommodate the adverse supply shock, does the expectation of higher prices cause higher prices in the long run? Explain. 9. Why do you think that investment is more variable over the business cycle than consumer spending? Which category of consumer spending do you think would be most volatile: durable goods (such as furniture and car purchases), nondurable goods (such as food and clothing), or services (such as haircuts and medical care)? Why? 10. Explain whether each of the following events will increase, decrease, or have no effect on long-run aggregate supply: (a) (b) (c) (d) Canada experiences a wave of immigration. Provincial governments raise the minimum wage to $12.50 per hour. Intel invents a new and more powerful computer chip. A severe ice storm damages factories along the east coast. 11. Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate-demand curve, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy. (a) (b) (c) Households decide to save a larger share of their income. Okanagan peach orchards suffer a prolonged period of below-freezing temperatures. Increased job opportunities overseas cause many people to leave the country. 9.3
Lesson 9 ASSIGNMENT 9 CHAPTER 14: Aggregate Demand and Aggregate Supply Marks: 1 mark per question. 1. When households buy bonds, the price of bonds rises; therefore: (1) interest rates fall. (2) interest rates rise. (3) interest rates do not change. (4) any of the above are possible. 2. Which of the following factors shifts the long-run aggregate supply curve? (1) Monetary policy (2) Aggregate demand (3) Price level (4) Technology 3. In a recession, real GDP falls and consumer spending: (1) is unaffected. (2) rises. (3) falls. (4) may rise or fall. 4. Which of the following is NOT a key fact about economic fluctuations according to the textbook? (1) As output falls, unemployment rises. (2) Economic fluctuations follow the regular business cycle. (3) Most macroeconomic quantities fluctuate together. (4) Economic fluctuations are irregular and unpredictable. 9.4 Assignment 9 continues on the next page
Economic Fluctuations: Balancing Aggregate Demand and Supply THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING DIAGRAM: 5. Starting with AD1 and AS1, if personal income taxes increase, the new long-run equilibrium is at point: (1) a (2) b (3) c (4) d 6. Starting with AD1 and AS1, if personal income taxes increase, the new short-run equilibrium is at point: (1) a (2) b (3) c (4) d 7. The aggregate demand curve would shift if: (1) stock prices rise causing people to feel wealthier. (2) stock prices fall causing people to conserve their spending. (3) the government cuts taxes. (4) All of the above 8. According to the, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. (1) sticky-price theory (2) deceiving theory (3) misperceptions theory (4) sticky-wage theory Assignment 9 continues on the next page 9.5
Lesson 9 9. When the price level falls, households: (1) use their excess money to buy bonds or other assets. (2) use their excess money to sell bonds or other assets. (3) use all of their excess money to buy more goods and services. (4) are forced to pay their excess money to the government through higher taxes. 10. Which of the following is NOT one of the reasons the aggregate-demand curve slopes downward? (1) When price level falls, interest rates fall, which stimulates the demand for investment of goods. (2) When price level falls, the exchange rate depreciates, which stimulates the demand for net exports. (3) When price level falls, consumers are wealthier, which stimulates the demand for consumption of goods. (4) When price level falls, the supply of money increases, which allows for higher consumption of goods. 11. The model of aggregate demand and aggregate supply is the model that most economists use to explain fluctuations in economic activity around its trend. (1) short-run, long-run (2) long-run, short-run (3) aggregate-demand, long-run (4) aggregate-supply, short-run 12. To fully understand year-to-year changes in the economy, we need to: (1) use the assumption of monetary neutrality. (2) avoid including money in the model. (3) use the assumption of monetary non-neutrality. (4) use a combination of monetary neutrality and non-neutrality. 13. The aggregate supply curve shows: (1) an inverse relationship between the quantity of goods and services supplied by firms and the overall price level. (2) an inverse relationship between the quantity of goods and services demanded by firms and the overall price level. (3) a direct relationship between the quantity of goods and services supplied by firms and the overall price level. (4) a direct relationship between the quantity of goods and services demanded by firms and the overall price level. 14. The economy experiences stagflation when: (1) decreases in output are accompanied by higher prices. (2) decreases in output are accompanied by lower prices. (3) increases in output are accompanied by lower prices. (4) increases in output are accompanied by higher prices. 9.6 Assignment 9 continues on the next page
Economic Fluctuations: Balancing Aggregate Demand and Supply 15. Economists are able to examine the determinants of real variables without introducing nominal variables because of: (1) scientific thinking. (2) income neutrality. (3) government policy neutrality. (4) money neutrality. 16. If resources become more productive: (1) neither the short-run aggregate curve nor the long-run supply curve shifts. (2) the short-run aggregate supply curve is not affected but the long-run aggregate curve shifts. (3) the short-run and the long-run aggregate supply curves shift to the right. (4) the short-run and long-run aggregate supply curves shift to the left. 17. If the natural rate of unemployment falls: (1) the long-run aggregate supply curve shifts right. (2) the long-run aggregate supply curve is not affected. (3) the long-run aggregate supply becomes horizontal. (4) the aggregate demand curve shifts. 18. If the money supply increases, there will be: (1) a shift of the aggregate demand curve to the right. (2) a shift of the aggregate demand curve to the left. (3) a shift of the aggregate supply curve. (4) a movement along the aggregate demand curve. 19. When the price level in Canada rises: (1) the dollar appreciates; therefore, net exports rise. (2) the dollar depreciates; therefore, net exports rise. (3) the dollar appreciates; therefore, net exports fall. (4) the dollar depreciates; therefore, net exports fall. 20. Real GDP is the most commonly used variable to monitor short-run changes in the economy because it: (1) measures income levels. (2) measures trade levels. (3) measures consumption levels. (4) is the most comprehensive measure of economic activity. 20 Total Marks End of Assignment 9 9.7