Saturday, January 30, 2010


So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?

Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!

The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment

This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium

Aggregate Demand Shocks and Macroeconomic Equilibrium:

These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!

As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)

You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.

The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.

When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.

When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.

When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.

Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.

We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.

Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.

Okay- that's all you'll need for the test. Good luck!

Aggregate Supply

In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)

The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.

Aggregate Supply is positively sloped!


Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.

What about the slope? Why is it increasing?

Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)

At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.

Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)

Aggregate Demand




We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...

Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.

We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand

OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?

2 Reasons:

1: A Decline in Wealth
An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.

2: A Decline in Net Exports
An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)

The overall effect is that AE and Prices are negatively related...

SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)

When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!

The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.
-The Y-axis is price, and the X-axis is equilibrium national income
-It is downward sloping (As price decreases, equilibrium national income increases)
-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)
-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two

Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.

The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level

That's all for this section

Wednesday, January 20, 2010

Putting it ALL together! Building and fiddling with aggregate expenditures!


Consumption is a function of disposable income (income minus net taxes) and net taxes are taxes minus transfer payments.
So, when you add the government to the economy, you have to substitute (income minus net taxes) into the consumption equation!
As such, consumption is a function of income: C = f(Y) (the disposable part is now implicit with the addition of the government)

Taxes and transfer payments are thus subtly incorporated into the consumption function

DESIRED AGGREGATE EXPENDITURE is a function of actual income! E = f(Y)
AE = C + I + G +NetX

The marginal propensity to spend is the slope of the aggregate expenditure function: This is the portion of each additional added dollar of national income which is spent.

(Don't confuse this with MPS, which is the marginal propensity to save)

MPSpend = z = Marginal Propensity to consume multiplied by (one minus the marginal propensity to tax) minus the marginal propensity to import.
MPSpend = z = MPC(1-MPT) - MPM

C = 10+0.8Yd
I = 25
G = 17
NX = 24-0.1Y

Let's put it together to make our formula for aggregate expenditure as a function of national income

AE = (Autonomous C + I + G + X) + MPSpendY
AE = (10+25+17+24) + (0.8(1-0.1) - 0.1)Y
AE = 76 + 0.62Y


EQUILIBRIUM IN THE GOVERNED (CLOSED) ECONOMY: This involves Households, firms, and governments as economic actors (banks just act as instruments for investments and savings). We assume that the household uses the bank to save money, and that firms loan from banks to fund investments. We also assume that the government taxes and spends.

In the garden hose theory, then, equilibrium happens when National Income is equal to Expenditures (C + I + G). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, equilibrium is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T = I + G)
EQUILIBRIUM IN THE OPEN ECONOMY: This involves Households, firms, the government, and the world as economic actors. This is similar to the open economy, but with the world added, domestic consumers can purchase imports, and foreign consumers can purchase exports.

In the garden hose theory, equilibrium happens when National Income is equal to Expenditures (C + I + G + NetX). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, this is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T + M= I + G + X)

(1/(1 - the MPSpend)) is the simple multiplier!
Taxes and imports reduce the value of the simple multiplier (which makes sense mathematically, because they reduce the value of MPSpend): This is because taxes and imports are directly linked to national income, so as the national income increases, the withdraws or leakages from the economy causes by taxes and imports also increase!
-The simple multiplier causes injections into the economy to lead to an increase in equilibrium expenditure/income which is larger than the injection itself: the value of this equilibrium difference is the sum of the injection multiplied by the simple multiplier
-The simple multiplier in Canada, however, is only 1.2 =(
-Net exports is affected by both foreign, autonomous effects on exports and domestic, induced effects on imports
-The marginal propensity to import is subtracted from MPSpend

Fiscal policy is changes in government purchases or spending administered to affect the national income
Stabilization Policy is policy where the government tries to maintain the national income at a given level (usually potential GDP) , and to reduce the extreme effects of business cycles
Expansionary fiscal policy is where the government increases purchases and reduces taxation in order to increase the national income
Contractionary fiscal policy is where the government decreases purchases and increases taxation in order to decrease the national income

IMPORTANT: Balanced budgets actually are expansionary in nature! Why is this??
Well, simple multiplier for balanced budgets is 1, so when we have a balanced budget, the equilibrium value for national income actually has a net increase equal to government purchases (or taxation, seeing as purchases and taxation are equal)
SO FAR, prices are constant in our model. This will change once we start to fiddle with interest and exchange rates...
Remember** the budget function is the opposite of the government's withdrawal and injections in terms of the circular flow economy

Withdrawals as a function of Y are upward sloping lines

Injections as a function of Y are flat lines

Net Additions to AE as a function of Y are downward sloping lines


All injections are autonomous, while all withdrawals are a function of national income!

-Wealth - Direct Effect
-Expectations - Direct Effect
-Interest Rates - Inverse Effect

-Interest Rates - Inverse Effect
-Change In Sales - Direct Effect
-Business Confidence - Direct Effect

-Elections/Political Agendas - Direct Effect

-Foreign Income (affects exports)
-Relative Canadian Prices (affects exports)
-Canadian National Income (affects imports)
-Relative Canadian Prices (affects imports)