CHAPTER 10

What are negative/positive supply shocks?

A negative supply shock will directly increase the costs of inputs, or reduce inputs → resulting in a decrease in SAS (shifts L). A positive supply shock will directly decrease costs, increase inputs (or improve productivity), increasing SAS (shifts R).

What is the basic concept of macroeconomic trends and fluctuations

Agg demand and Agg supply shocks move the economy away from long-run equilibrium targets.

Explain the hands-off approach to the AS/AD model

Best case scenario... SAS plans match AD plans and the economy will hit its target of LAS. This is the Say's law story... the economy works out on its own. Supply creates its own demand. Even if households save, interest rates adjust to have supply still create its own demand.

Explain the effect of a change in input prices

Change in input prices (also was held constant) can also change short run supply, but not long run supply. Rising input prices shift SAS L, and falling input prices shift SAS R. Note that PRICE LEVEL and INPUT PRICES are two completely different things.

Explain the importance of comparative statistics in this chapter

Changes in real GDP, unemp, and inflation are the RESULT (not cause) of economic events. Start with one equilibrium situation (static) → intersection of agg supply and agg demand, ceteris paribus. Next we change one other variable and compare the resulting equilibrium situation in terms of real GDP unemployment, and inflation to how it was before.

Who are the macroeconomic players for supplying real GDP?

Consumers, businesses, and the government They all make 2 kinds of plans for supplying real GDP... supply plans for existing inputs, and supply plans to increase inputs. Focus on business supply plans as most important. Production takes time so business supply plans are based on expectation of what demand will be when products come to market... EX) Hockey... go where the puck is going not where it is!

Explain demand plans and its relationship to AD

Consumers, businesses, the government, and the ROW make demand plans for spending (these are similar to microeconomic choices about quantity demanded. Remember that all AD plans are in the short run. AD is the quantity of real GDP that macroeconomic players plan to demand at varying PLs. Law of AD states that as PL rises, the aggregate quantity demanded of real GDP decreases (movement along curve, not a shift).

What have central banks done in response to coronavirus? Why?

Corona → interest rates put down 0.5%... trying to counter the negative supply shock from corona. Lower int rate is a pos agg demand shock to offset the neg supply shock. Neg supply shock makes lower real GDP (bad) and agg demand pos shock can bring it back up.

Explain the concept of Aggregate Demand (AD)

Demand plans by macroeconomic players determine aggregate quantity demanded. Demand shocks change aggregate demand. Demand shocks arise from changes in expectations, interest rates, government policies, GDP in ROW, and exchanges rates. Note that for AD, there is no long run short run distinction.

What are demand shocks?

Demand shocks are changes in factors other than the PL that change AD and shift AD curve. Expectations, interest rates, govt spending, GDP in ROW, and exchange rates can all create demand shocks. Negative demand shocks will decrease AD, shifting the AD curve L Positive demand shocks will increase AD, shifting the AD curve R

Explain the disconnect between input and output markets

In the short run, prices are fixed in input markets, but flexible in output markets. In the long run prices are flexible in both. Note that long run and short run are not defined in calendar time, but are defined if all prices have adjusted to equilibrium or not.

Compare/contrast the effects of increases in inputs and increases in input prices

Increase in inputs → Shifts the LAS and SAS curves to the R. Potential GDP rises! Increase in input prices → Shifts the SAS curve L, and does NOT affect the LAS curve as potential GDP only depends on quality and quantity of inputs, not the price of inputs.

Explain the AD curve

It has a negative slope and is linear... at high PLs people buy less (will buy more substitutes) and at lower price people buy more (buy less substitutes).

Compare/contrast SAS and AD with CORONAVIRUS

It is a negative supply shock, but not only that... It is also a negative demand shock because people are buying less and people are getting laid off, meaning we are ending up where there is lower real GDP, higher unemployment. Banks lower interest rates to reverse the decrease in demand.

Why is the LAS curve vertical??

It is just stuff... no matter what the price level at potential GDP, it is still just stuff and PL doesn't matter, does not change the quantity of stuff. Anything to the left of the vertical line is because of unemployment.

What is long-run aggregate supply?

LAS models the macroeconomic target of potential GDP and full employment, given the existing inputs; it is the quantity of real GDP supplied when all inputs are fully employed. The LAS curve is a vertical line at potential GDP as pot GDP does not change when price level changes.

Compare/contrast SAS and LAS curves

Like Fig 10.1... The SAS curve is linear and has a positive slope. This means as PL increases, real GDP will increase as well. So why when PL increases, do businesses increase the amount they supply?? → they will make more money! Higher price means more profit per unit so they make more to sell more. As PL increases, WITH INPUTS FIXED, businesses plan to increase the amount of products and services they are going to supply. In contrast to LAS... inputs not fixed, inputs rise with PL so real GDP stays constant.

Explain the graphical relationship of input prices and aggregate supply

Like fig 10.3. SAS curve shifts but not the LAS curve → Why?? → the max amount of products, in real terms, does not change. Input prices will not affect technology etc; they will not affect potential GDP as it only depends on the quantity and quality of inputs. Note that rise in input prices causes a decrease in SAS. The shocks can go both ways.

What are the time periods for macroeconomic analysis?

Long run: long enough for all prices and wages to adjust to equilibrium; eco at pot GDP, full emp outcome of coordinated smart choices Short run: when some input prices do not change; not all have adjusted to clear all markets. The diff is based on real world observations that prices adjust more slowly in input (labour) markets than in output markets.

What is the relationship of the fallacy of composition to AD?

Makes macroeconomic law of AD different from microeconomic law of demand

Like Fig 10.2 - Explain the graph result of an increase in inputs

More inputs means more outputs (economic growth, PPF shifts out). Level of pot GDP increases as well... target has now moved, meaning LAS and SAS both shift R. For any PL the quantity supplied will be larger.

Explain how Pos demand shocks Inc AD, shift curve R

More optimistic expectations → Inc investments Lower interest rates → Inc investment and/or consumer spending Higher govt spending or lower taxes → Increases either G or C, consumer spending Increased GDP in ROW → Increase canadian exports Lower value of C$ → Increase canadian exports and/or decreased imports

Explain how Neg demand shocks dec agg demand (AD shifts L)

More pessimistic expectations → Decrease "I" (postpone investment decisions). Dec AD. Higher interest rates → Decrease 'I' or 'C' (less consumer expenditure and investment). Dec AD Lower govt spending / higher taxes → dec G or dec C and therefore dec AD Decreased GDP in ROW → Decreases X and therefore dec AD Higher value of C$ → decrease X or inc IM ... dec AD again.

Explain the effects of negative demand shocks

Neg demand shocks cause a recessionary gap. Average prices will fall, real GDP decreases, and unemployment increases. The AD shifts to the left (as consumers are buying less). Comparing the new equilibrium to the old... real GDP has fallen!! (recessionary gap). PL has also fallen! Makes sense lol, downward pressure. Note that labour wages are down as well most likely.

Explain the effects of negative supply shocks

Neg supply shocks cause stagflation. Average prices rise, real GDP decreases, and unemployment increases. The SAS shifts L and LAS curve does not change (as it is a target). There is an increase in both unemployment and inflation (different from demand shocks).

What happens if the PL of all products increases??

People will substitute products with foreign products to try and save money. This makes Canadian real GDP go down of course. The only subs are imports from ROW!! Canadians buy more imports and ROW buys fewer Can imports. Less important are the wealth effects and intertemporal substitution effects. Planned spending on agg demand = planned C + planned I + planned G + planned (X - IM). Note that we are looking at almost all paths in the circular flow of income and spending.

Explain the effects of positive demand shocks

Pos demand shocks create an inflationary gap. Average prices rise, real GDP increases, and unemployment goes down. The AD shifts R (consumers buy more). There is a shortage which puts upward pressure on the PL. Real GDP increases and is above pot GDP. This is an inflationary gap. Excess demand for labour (demand for workers) → unemployment rate will be lower than the natural rate of unemployment.

Explain the effects of positive supply shocks

Positive supply shock will increase potential GDP. Average prices fall, real GDP rises, and full unemployment continues. LAS and SAS both shift right. The target has increased. Note PL goes down and pot and real GDP both increase. More people working but technically just constant employment... still in state of full employment when LAS shifts R. .

What is full employment?

Potential GDP (full-emp output) is modeled as points on the PPF (from micro), but also as at the LAS supply curve. Existing inputs are unused or unemployed at points inside the PPF, and any quantity of real GDP less than pot GDP (to the left of the LAS curve).

How can we use the AS/AD model?

Remember LAS is diff from SAS and AD... LAS just a target!! SAS and AD are plans. Always start the story in long-run equilibrium (all 3 intersect). We model a 'macroeconomic event' as 1 of the 4 possible shocks. Then examine the results of the shock on GDP, unemployment, and inflation. We can then analyze the return to long-run equilibrium after the shock. Keep in mind the hands-on and hands-off camps will disagree about how markets adjust after shocks → there are no simple stories!

Explain the AS/AD Model put together

SAS is the short-run supply plans of all macro players with fixed input prices. AD is the short-run demand plans of all macro players. LAS is a performance target, where we want the economy to end up.

What is short-run aggregate supply?

Supply plans for existing inputs determine agg quantity supplied. Supply plans increase the quantity and quality of inputs, and together we supply shocks, change agg supply.

Explain how supply plans can affect real GDP and the SAS/LAS curves

Supply plans to increase quantity or quality of inputs (including technological change) cause inc in agg supply... leading to an increase in the economy's capacity to produce real GDP. Note that a change in quantity or quality of inputs will shift both the LAS and SAS curves in the same direction. Both shift R for an increase in inputs, and both shift L for a decrease in inputs.

Explain the hands-on approach to the AS/AD model

There are four mismatches between AD and SAS plans. These mismatches move the economy away from LAS target. The mismatches are between households and output markets (both ways), and between businesses and input markets (both ways).

Where/what is the Short and Long run Macroeconomic Equilibrium?

There will be a point on the PL vs real GDP graph where all 3 curves (LAS, SAS, and AD) will intersect. Here there are no economic problems, we are at potential GDP, full employment... everything is ideal. The short-run macro equilibrium is just the intersection between SAS and AD. Long-run macro equilibrium is the intersection of SAS, AD, and LAS. Here aggregate quantity supplied = aggregate quantity demanded and real GDP = potential GDP.

Price level vs Real GDP (graph)

These are the axes for the outcomes of agg supply and agg demand model. Real GDP and unemployment are inversely related... remember!

Explain business supply plans for existing inputs with fixed input prices (SAS)

They are like microeconomic choices about quantity supplied... SAS quantity of real GDP macroeconomic players plan to supply at different PLs. The law of SAS states as PL rises, agg quantity supplied of real GDP also increases. Changes in PL cause movement along an unchanged SAS curve. **SAS → FIXED INPUT PRICES

What is the Aggregate Supply and Demand Model?

This model explains: When the economy hits target potential GDP, full employment, and stable prices. When the economy misses targets... creating business cycles, unemployment, inflation Shifts of agg supply and demand are aka supply shocks and demand shocks. Diffs btw hands-off and hands-on camps on origins of shocks, and how eco responds after a shock.

What is common to both types of demand shock?

Y and P move in the same direction. Unemployment and inflation move in opposite directions (like Philips curve). Note: does not uphold for supply shocks.