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ECON 209
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WINTER 2017
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~ TABLE OF CONTENTS ~
CHAPTERS 19-20 ............................................................................................................ 1
CHAPTERS 21-22 .......................................................................................................... 18
CHAPTERS 23-24 .......................................................................................................... 36
CHAPTER 25-26 ............................................................................................................ 57
CHAPTER 27 ................................................................................................................. 71
CHAPTER 28 ................................................................................................................. 80
CHAPTER 29 ................................................................................................................. 95
CHAPTER 30 ............................................................................................................... 101
CHAPTER 31 ............................................................................................................... 115
CHAPTER 32 ............................................................................................................... 126
CHAPTER 35 ............................................................................................................... 135
Section 3: The AD/AS Model
Chapters 23-24
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What did we mean by Demand Determined Economy?
In the previous section we assumed firms are willing to produce whatever consumers want
(Demand), at the current price level
In other words, we assumed a constant price level that does not fluctuate with the level of output
Firms will produce however much people want to spend (Demand) without requiring an increase in
the price of their products.
In this model, the price level is exogenous
Let’s look at what happens in the AE Model when the price level changes:
An increase in the price level:
• real wealth falls ! autonomous consumption falls
• relative prices increase ! net exports fall
• both of these cause a downward shift of the AE ! decrease in Equilibrium Y
A decrease in the price level:
• real wealth rises ! autonomous consumption rises
• relative prices fall ! next exports rise
• both of these cause an upward shift of the AE ! increase in Equilibrium Y
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We have a negative (inverse) relationship between the Price Level and Equilibrium GDP from the
“Demand-Side” of the Economy.
If we graph out this relationship, we now have our Aggregate Demand Curve, with high prices
levels associated with low levels of Equilibrium GDP from the Demand Side, and low prices
associated with high levels of Equilibrium GDP from the Demand Side.
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Shifts of the AD Curve?
• The rule is that anything that causes a movement of the AE Function will ALSO cause a movement
in the AD function except for the price level.
• A change in the price level causes a shift in the AE but only a movement along the AD.
• Anything (other than price) that causes an upward shift of the AE (lower interest rate, increased
wealth, increased G, etc.) will also cause a rightward shift of the AD.
• Anything (other than price) that causes a downward shift of the AE (higher interest rate, decreased
wealth, decreased G), etc. will also cause a leftward shift of the AD.
Simple Multiplier with the AD Curve
• In the AE Model, the simple multiplier is Measured by the Change in Equilibrium Y divided by the
change in Autonomous Spending that brought it about
Multiplier = A/B
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•
In the AD Model, the simple multiplier is measured by the horizontal shift (A) in the AD divided
by the change in autonomous spending that brought it about.
In the above scenario, if an increase in government spending of 50 caused the shift from AD1 to AD2, then
the multiplier = (500-300)/50 = 200/50 = 4
Aggregate Supply (AS) Curve
The AS Curve shows us the relationship between the Price Level and the level of output that firms
are willing to produce and sell (holding technology and factors prices constant).
• We make the assumption that as more units are produced, the cost per unit rises.
• Thus, as firms expand output they require a higher price to compensate for this rise in unit costs.
• In other words, firms are only willing to produce more if they can charge a higher price.
Similarly, if they were to produce less, unit costs would decrease, and they would be willing to
charge a lower price.
• We therefore have a positive (direct) relationship between the quantity of output supplied by firms,
and the price level.
•
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Shifts in the AS curve?
• Anything that affects the cost level of production will cause a shift in the AS curve.
• An increase in costs per unit will cause an upward/leftward shift of the AS curve. This is known as
a negative AS shock
• A decrease in costs per unit will cause a downward/rightward shift of the AS curve. This is known
as a positive AS shock.
There are two types of events that can influence the cost levels for production:
(1) Change in Input prices: Rise in Input Prices ! Rise in Cost Level, Fall in Input Prices !Fall in Cost
Level
(2) Change in Productivity (Rise in Productivity! Fall in Cost Level, Fall in Productivity ! Rise in
Cost Level)
• Note that an improvement in technology would cause a rise in productivity and therefore a
downward/rightward shift of the AS curve representing a fall in unit costs\
Macroeconomic Equilibrium: Putting AD & AS together
The logic behind why we will always be Po (and therefore Yo), rather than at some disequilibrium price
level (a price other than Po, which would result in either AD>AS or AD<AS), should be clear from having
taken Microeconomics
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Changes in Equilibrium
• A rightward shift in the AD results in a higher P and a higher Y than before.
• A rightward shift in the AS results in a lower P and a higher Y than before.
• Since these each result in an increase in GDP, these are known as positive shocks (positive demand
and supply shocks, respectively).
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A leftward shift in the AD results in a lower P and a lower Y than before.
A leftward shift in the AS results in a higher P and a lower Y than before ! known as Stagflation
Since these each result in a decrease in GDP, these are known as negative shocks (negative demand
and supply shocks, respectively)
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The Real (as opposed to simple) Multiplier.
• The real multiplier measures the change in equilibrium GDP in the AD/AS model divided by the
change in autonomous spending the brought it about.
• The real multiplier will always be smaller than the simple multiplier.
• This is because the AS curve is upward sloping, meaning that any aggregate demand shock leads to
a change in the price level, which partly offsets the change in aggregate demand.
In the above scenario, if an increase in government spending of 50 caused the shift from AD1 to AD2, then
the real multiplier = (400-300)/50 = 100/50 = 2
Shifts in AD on different portions of the AS Curve
• Traditionally when working with the AS Curve we should just draw a straight diagonal line
upwards, for simplicity.
• However, in reality the AS Curve more likely looks like this.
Flat portion: Firms have excess capacity ! unit costs will not rise as output expands. Firms are thus
willing to expand output without increasing the price level.
Intermediate portion: Firms have increasing unit costs and thus an increase an output must be met by an
increase in price.
Steep portion: Firms have reached (or almost reached) their productive capacity and are not capable of
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producing much or (any) more output than they already have.
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An increase in AD over the flat portion causes a large rise in Y with no (or barely any) rise in P
An increase in AD over the intermediate portion causes a moderate increase in both Y and P
An increase in AD over the steep portion causes no (or barely any) rise in Y, and a large rise in P
This last situation occurs because firms are not able to produce any more (all resources have been
exhausted) and so the only way to respond to an increase in Demand is to raise prices.
Discuss when an even causes a shift in both AD and AS – use world oil example from textbook
Output Gaps
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An output gap occurs whenever AD/AS intersect where equilibrium Y is not equal to Y*
Y* is also known at Potential Output: The level of output/GDP when all factors of
production/resources (labor and capital, specifically) are at their Normal Utilization Rates
This is not the maximum level of output that is possible given our resources, as this would involve
overworking employees, overusing machines, keeping factories open overnight, etc.).
Y* is also known as Full Employment Output.
In other words, Y* is determined by our economy’s Productive Capacity (how many workers do
we have !!labor, how many factories/machines do we have ! capital, and how productive are
these workers and machines ! technology).
In the Short Run, Equilibrium Y can either be below Y* (Negative Output Gap or Recessionary
Gap) or Above Y* (Positive Output Gap or Inflationary Gap).
In the short run, Y fluctuates around Y*. Over the Short Run, we assume Y* to be constant.
In other words, over the short run we assume that our productive capacity has not changed
(technology and factor supplies are constant), but the actual level of production can and does
change, as over the short run we can be producing at levels below our normal productive capacity
(recessionary gap) or above it (inflationary gap).
The fluctuation of Y in the short run around a constant Y* is known as the business cycle.
Negative Output Gap
Positive Output Gap
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Definition of the Short Run
The short run is the Period of time during which:
• Technology and factor supplies are constant (therefore Y* is constant)
• Factor prices (wage rage, price of capital) are exogenous!they may change, but the change is not
explained within the model. This will be elaborated upon later.
Definition of the Long Run
The long run is the period of time during which:
• Factor prices have now adjusted to any output gap (to be elaborated upon soon)
• Technology and factor supplies are changing
The most important point to take away from, not only this chapter, but this entire course is:
IN THE SHORT RUN, Y FLUCTUATES AROUND Y*, BUT IN THE LONG RUN, Y = Y*
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Therefore, the transition from the short run to the long run involves Y leaving its original position
(either below or above Y*) and returning to Y*.
We will now explore why and how this happens.
Positive Output Gaps
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When Y>Y*, we are above normal utilization rates (and in the short run)
This means an excess demand for factors (specifically labor)
This causes an increase in factors prices (specifically the wage rate)
The rise in factor prices causes the AS curve to shift upward/left
This leftward shift continues until Y=Y*, at which point there is no more excess demand and no
more pressure for factor prices to change (and now in the long run).
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Negative Output Gaps
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When Y < Y*, we are below normal utilization rates (and in the short run)
This means an excess supply of factors (specifically labor)
This causes a decrease in factor prices (specifically the wage rate)
The fall in factor prices causes the AS curve to shift downward/right
This rightward shift continues until Y=Y*, at which point there is no more excess supply and no
more pressure for factor prices to change (and now in the long run).
To summarize, in the long run Y ALWAYS RETURNS TO Y*
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The mechanism for this is changing factor prices/wage rates, which respond and adjust to output
gaps, and thus cause the AS curve to move back towards Y*
We can therefore think of Y* as an anchor, constantly pulling Y back towards Y*, via changing
factor prices
Downward Wage Stickiness
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This describes the phenomenon whereby negative output gaps close more slowly than positive
output gaps.
This occurs because it takes more time for factor prices to fall (because of unions, etc.) than to rise.
Therefore, in response to a recessionary gap, factor prices/wage rate will decrease at a slower rate,
causing the AS curve to shift downward/right at a slower pace, and a longer period of time before Y
returns to Y*
The mechanism by which factor prices/wages adjust to output gaps, leading to a shift in the AS curve and a
return of Y to y* is know as the Automatic Adjustment Mechanism or the Automatic Adjustment Process.
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The Phillips Curve
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The Phillips curve shows the relationship between Y (horizontal axis) and the rate of change of
wages (vertical axis)
We see that when Y>Y*, the rate of change of wages is positive (increasing wages) and when
Y<Y* the rate of change of wages is negative (decreasing wages)
We also see that wages can increase fairly rapidly (a large, positive rate of change of wages during
an inflationary tap) but can fall only very slowly (a small, negative rate of change of wages during a
recessionary gap)
By looking at both Phillips Curves – the first using Y on the horizontal axis and the second using U
on the horizontal - we can notice the simple and direct relationship between the level of output (Y)
and the level of unemployment (U), where U* is the level of unemployment that occurs when we
are at potential output (Y*)
To summarize, if Y=Y*, then U = U*. If Y > Y* then U < U*. If Y < Y* then U > U*.
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AD & AS Shocks Without Government Intervention
Expansionary (Positive) AD Shocks
• We start where Y = Y*
• Now an event causes AD1 to shift right/up (rise in business confidence!rise in investment) to AD2
• We find ourselves with an inflationary gap, and at a higher price level.
• Because Y > Y*, excess demand for factors ! rising factors prices ! AS1 shifts left/up to AS2
until we are back at Y*, and at an even higher price level.
Contractionary (Negative) AD Shocks
• We start where Y = Y*
• Now an event causes AD1 to shift left/down (fall in demand for Canadian exports ! net exports
fall) to AD2
• We find ourselves with a recessionary gap, and at a lower price level
• Because Y < Y*, excess supply of factors ! falling factor prices ! AS1 shifts right/down to AS2
until we are back at Y*, and at an even lower price level.
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This process may be very slow due to sticky wages, however, leading to a prolonged recession.
If wages were very flexible, the recession would be brief, as wages would quickly adjust
downwards.
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Expansionary (Positive) AS Shocks
• We start where Y = Y*
• Now an event causes AS1 to shift right/down (input prices fall) to AS2
• We find ourselves with an inflationary gap, and at a lower price level
• Because Y > Y*, excess demand for factors ! rising factors prices ! AS2 shifts left/up back to
AS1 until we are back at Y*, and the price level has risen back up
Contractionary (Negative) AS Shocks
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We start where Y= Y*
Now an event causes AS1 to shift left/up (input prices rise) to AS2
We find ourselves with a recessionary gap, and at a higher price level
Because Y > Y*, excess supply of factors ! falling factor prices ! AS shifts down/right to AS2
until we are back at Y*, and the price level has fallen back to its original level.
Once again, this adjustment process could either be slow (downwardly sticky wages) or fast
(flexible wages).
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Long Run Equilibrium
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In the long run, we are always at Y*
Since Y* is determined by our productive capacity, Y* is determined only by the supply side of
the economy
Therefore another term for Y* is Long Run Aggregate Supply (LRAS) – also known as Classical
Aggregate Supply Curve
This shows us that in the long run, Y* is compatible with any price level
In fact, in the long run, AD shocks have no influence over GDP. They only influence the price
level.
A rise in AD causes a rise in P* but no change in GDP
A fall in AD causes a fall in P* but no change in GDP
Potential Output (our productive capacity at normal utilization rates) determines the long-run
equilibrium value of GDP. Demand has no say in the matter. This bears repeating.
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Fiscal Stabilization Policy
Fiscal Policy: The government’s attempt to change Equilibrium Y, generally to bring it closer to Y*, either
by changing government expenditure (G) or taxation (T).
Fine Tuning: Attempting to constantly keep Y at or near Y* (with fiscal or monetary policy) by offsetting
virtually all fluctuations in Y from Y* ! this is very difficult to achieve
Gross Tuning: Only using fiscal/monetary policy to remove large and persistent output gaps ! more
realistic and common
Looking at Fiscal Policy in the AE Model:
• Imagine a recessionary gap in which Y < Y*
• In this situation the government would like to increase Y until Y = Y*
• Let’s say we have an output gap of -100
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Since the multiplier = 1/(1-Z) = 1/(1-0.6) = 2.5, this tells us that an increase in autonomous
spending (in this case Government Expenditure) of 40 will lead to an increase in Equilibrium Y of
2.5 * 40 = 100 and close the output gap
Another option is for the government to reduce the tax rate, thereby increasing the slope of the AE
(causing a pivot of the AE function) and closing the output gap as well:
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Looking at Fiscal Policy in the AD/AS Model
Closing A Recessionary Gap
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Either by increase G or reducing t, the government can shift the AD right/upward until Y = Y*
Advantage: Because of downward stickiness of wages, if the government does not intervene and
allows the automatic adjustment process to take place, we may experience a prolonged recession
Disadvantage: If the automatic adjustment process has been activated during the recession (AS
starts shifting right/down) OR if private-sector expenditures start rising due to natural causes (AD
shifts right/up) fiscal policy may overshoot its target, landing us now in an inflationary gap.
Closing an Inflationary Gap
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Either by reducing G or increasing t, the government can shift the AD left/downward until Y = Y*
Advantage: Avoids the inflationary increase in prices that would occur if we allowed the automatic
adjustment process to occur ! AS shifts upward/left and P* rises
Disadvantage: If the automatic adjustment process has been activated during the inflationary gap
(AS starts shifting up/left) OR private-sector expenditures start to fall due to natural causes (AD
shifts down/left) then fiscal policy may overshoot its target, landing us now in a recessionary gap49
Paradox of Thrift
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In the short run we may be experiencing a recessionary gap
People are worried about getting fired, business owners are worried about future sales
This may cause people to increase saving ! reduce consumption as a precaution
Unfortunately this would lead to a leftward shift of the AD curve, intensifying and prolonging the
recessionary gap
Therefore, during a recession, the government may try to encourage people to spend more money
than usual, rather than save more money than usual ! It would be advisable for everyone to do the
exact opposite of what their instincts tell them to do
The paradox of thrift only applies in the short run
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Recall that in the long run, Y =Y*, with AD only influencing the price level
In fact a high rate of saving in the long run will result in a high level of investment and an increase
growth rate of Y* ! this will be explored further in future chapters
The increasing level of Potential Output (Y*) over time is known as Economic Growth
Automatic Fiscal Stabilizers
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The tax-and-transfer system acts as an automatic stabilizer for the economy
As we saw in AE Model, adding in taxation (t) leads to a smaller Z and thus a smaller multiplier
A smaller multiplier means a smaller change in Y resulting from changes in autonomous spending
! smaller shocks in response to economic events ! smaller inflationary and recessionary gaps
Positive shock ! GDP rises ! higher tax revenues and fewer transfer payments ! dampens the rise in
national income ! smaller inflationary gap than would otherwise occur
Negative shock ! GDP falls ! lower tax revenues and higher transfer payments ! dampens the loss in
national income ! smaller recessionary gap than would otherwise occur
Limitations of Discretionary Fiscal Policy
Decision Lags: Time between perceiving a problem and deciding what action to take
Execution Lags: Time to implement policies once decision has been made ! possible that by the time the
decision has taken effect, policy is no longer appropriate b/c economic circumstances have changes
Temporary Vs. Permanent Tax Changes: Changes in taxation known to be temporary are less effective
than those expected to be permanent. People are less likely to changes consumption habits if they believe
the reduced taxation is only short-term, for example.
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Increasing G vs. Reducing T in Fiscal Policy
Government Spending
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Start a Y* ! Rise in government spending (G) ! AD shifts right ! inflationary gap ! factor
prices rise ! AS shifts leftward ! Back at Y*
Y is now equal to its original level but G is higher, which means private expenditures [C + I + NX]
must have fallen ! The increase in G has “crowded out” private expenditures
This is especially concerning if Investment Expenditure (private investment in plant and equipment)
has fallen ! slower rate of accumulation of physical capital ! fall in growth rate of Y* "
Taxation
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Start at Y* ! lower tax rate (t) which is believed to be long-term ! consumption and investment
increase ! AD shifts right ! inflationary gap ! factor prices rise ! AS shifts leftward ! Back
at Y*
What are the long run effects of lowering taxes?
Lower corporate income tax rates ! investment is more profitable for firms ! increased
investment ! increased growth rate of Y*
Lower personal income tax rates ! more people motivated to work ! increase in the labor force
! rise in Y*
!
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Section 3: Review Questions
(1) Consider the following news headline: ʺ Governments plan massive hospital construction programs across
the country.ʺ Choose the statement below that best describes the likely macroeconomic effects.
A) The AD curve shifts to the right; the price level rises and real GDP rises
B) The AD and AS curves both shift to the right; the effect on the price level is indeterminate and real GDP rises
C) The AD curve shifts to the left; the price level falls and real GDP falls
D) The AD curve shifts to the left and the AS curve shifts to the right; the price level falls and the effect on
real GDP is indeterminate’
E) The AD curve shifts to the right and the AS curve shifts to the left; the price level rises and the effect on
real GDP is indeterminate
(2) Aggregate supply shocks cause the price level and real GDP to change in
A) opposite directions but by the same amount.
B) the same direction with price changing by more than output.
C) the same direction and by the same amount.
D) opposite directions with price changing by less than output.
E) opposite directions but not necessarily by the same amount.
(3) Which of the following will cause a negative aggregate demand shock?
A) a decrease in the domestic price level
B) an increase in the domestic price level
C) an increase in the price of raw materials
D) an increase in tax rates
E) an increase in government expenditures
(4) If the AS curve is vertical and there is a decrease in aggregate demand, the result is
A) an increase in national income.
B) a decrease in the price level with no change in real GDP.
C) no change in either price level or real GDP.
D) an equal decrease in national income.
E) an increase in the price level.
(5) In building a macro model with an AS curve, it is assumed that producers will
A) decrease their prices without changing output.
B) decrease their prices when they expand output.
C) increase prices without changing their output.
D) produce as much as possible at the existing price level.
E) produce more output only if prices rise.
(6) Consider the basic AD/AS model. If there is a decrease in the cost of non-labour inputs to production, the
result will be to
A) cause a movement to the left along the AS curve.
B) shift the AD curve to the right.
C) shift the AD curve to the left.
D) shift the AS curve to the right.
E) shift the AS curve to the left.
(7) Which of the following characteristics define the long run in macroeconomics.
A) Factor prices are exogenous, technology and factor prices are exogenous.
B) Factor prices adjust to output gaps, and technology and factor supplies are constant.
C) Factor prices are exogenous, and technology and factor supplies are changing.
D) Factor prices are exogenous, and technology and factor supplies are constant.
E) Factor prices adjust to output gaps, and technology and factor supplies are changing.
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(8) Which of the following will occur as part of the automatic adjustment process in an economy with an
inflationary gap?
A) rising wages
B) increasing investment
C) falling prices
D) declining government purchases
E) increasing tax rates
(9) Consider the basic AD/AS macro model. An expansionary AD shock has ________ price-level effect in the short
run and _________ price-level effect in the long-run.
A) a positive; a smaller
B) a negative; no
C) a positive; no
D) a negative; a positive
E) a positive; an even larger
(10) The growth rate of potential output might be decreased by an expansionary fiscal policy if
A) public investment has high productivity.
B) the simple multiplier is small.
C) the budget deficits are persistent.
D) the policy crowds out private investment.
E) the composition of output is not altered.
(11) Consider the nature of macroeconomic equilibrium. If, at a particular price level, the total output demanded is greater
than that supplied by producers, then
A) the aggregate supply curve will shift to the right, re- establishing an equilibrium.
B) the price level will decline toward its equilibrium value.
C) the price level will rise toward its equilibrium value.
D) the aggregate demand curve will shift to the left, re- establishing an equilibrium.
E) none of the above.
(12) Consider the figure above. Initially the economy is in equilibrium at point A. An unexpected shock then shifts both the
AD and the AS curves as shown and results in a new equilibrium represented by point B. Which of the following events
could cause such a shock?
A) a decrease in firms' desired investment expenditures
B) a decrease in the world price of oil
C) a decrease in labour productivity
D) an increase in factor prices
E) an increase in the net tax rate
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(13) Suppose the economy is experiencing an inflationary gap in the short run. The advantage of using a contractionary fiscal
policy rather than allowing the country’s natural adjustment process to operate is that
A) it will reduce the inflationary pressure on prices that would otherwise occur
B) it will close the output gap
C) it will shorten what might otherwise be a long recession
D) it will reduce the downward pressure on prices that would otherwise occur
E) if private- sector expenditures increase on their own, the policy will stabilize real GDP
(14) What is sometimes called the "long- run aggregate supply curve" relates the aggregate price level to real GDP
A) when wages are in adjustment but prices are unstable
B) when national income is at less than potential income
C) when technology is allowed to change
D) in the short run
E) after factor prices have fully adjusted to eliminate output gaps
(15) Consider the basic AD/AS model, and suppose there is a negative output gap. If an expansionary fiscal policy is pursued
and the AS curve shifts right unexpectedly, the fiscal policy may be ________, and real GDP may ________ potential
GDP.
A) appropriate; equal
B) too strong; stay below
C) too weak; rise above
D) too strong; rise above
E) too weak; stay below
(16) A common assumption among macroeconomists is that when real GDP is less than potential output, factor prices adjust
and the
A) AS curve shifts to the right only very slowly.
B) AS curve shifts to the left fairly rapidly.
C) AS curve shifts to the right very rapidly.
D) AD curve shifts to the left rapidly.
E) none of the above -- the AS curve remains unchanged.
(17) If wages rise faster than increases in labour productivity, then unit labour costs will
A) rise and the AS curve will shift left.
B) not change because only total labour costs change.
C) fall and the AS curve will shift right.
D) fall and the AS curve will shift left.
E) rise and the AS curve will shift right.
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Section 3: Answers
(1) A
(2) E
(3) D
(4) B
(5) E
(6) D
(7) E
(8) A
(9) E
(10) D
(11) C
(12) B
(13) A
(14) E
(15) D
(16) A
(17) A
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