Economic Fluctuations

Economic Fluctuations

It’s a recession when your neighbor loses his job, it’s a depression when you lose yours.

Harry Truman

Learning Objectives:

Learn about aggregate demand and the factors that will affect it

Analyze aggregate supply and the factors that influence it

Study the economy’s equilibrium and how it differs from its potential

Examine Canada’s historical record of economic growth.

What determines the

connections among

inflation, unemployment,

and levels of spending and

real output in the Canadian

economy?

Answer:

In the economy as a whole, we see the relationship between the general price level and total spending in the economy, which is known as :

Aggregate Demand

Aggregate Demand Curve

Relationship between the general price level and total spending in the economy expressed on a graph.

0 650 700 750 800

40

80

120

160

200

Aggregate Demand Curve

Real GDP (1997 $ billions)

Pric

e Le

vel (

GD

P de

flato

r,19

97 =

100

)

Aggregate DemandSchedule

PriceLevel

Real GDP(1997,

$ billions)

Point onGraph

200160120

650700750

abc

a

b

cAD

Curve Continued….Two factors cause the aggregate demand

curve to be downward sloping:

The wealth effect that higher prices decrease the real value of financial assets and decrease consumption, since households feel poorer than normal.

The foreign trade effect means that higher prices decrease exports and increase imports.

What causes changes to the aggregate demand??

Remember spending has 4 components:

CONSUMPTION INVESTMENTGOVERNMENT PURCHASESNET EXPORTS

An increase in spending causes a rightward shift in the curve

A decrease in spending causes a leftward shift in the curve

CONSUMPTION

Disposable Income:Consumer spending is the most significant determinant of disposable income in the entire economy. The economy’s DI changes as a result of population changes, as well as DI/household. Therefore, when DI rises, then there is a rise on consumer spending, adding to total expenditures, and shifting the aggregate demand curve to the right. Wealth:Consists of real (houses and appliances )and financial assets (stocks and bonds). Eg: if the stock prices increase, a person owning some stocks is going to experience a real gain in wealth, resulting in a greater likelihood of spending more of their disposable income. Aggregate demand will increase, and the curve will shift to the right. Consumer Expectations:Consumer expectations influence the demand for products. If there is higher consumer spending then the aggregate demand increases, and aggregate demand curve shifts to the right.Interest Rates:People often buy durable goods, such as cars and furniture, if the real interest rate falls, consumers are more likely to borrow to pay for big items. Consumer spending rises and the Aggregate demand curve shifts to the right.

INVESTMENT

In the investment demand curve, it’s the relationship between the interest rate and investment and depends on the real rate of return and the real interest rate

Business Expectations: If businesses anticipate that profits will increase, the investment demand curve shifts to the right, thereby causing an increase in the aggregate demand.

0

Investment Demand Curve

Investment (1997 $ billions)

Rea

l Rat

e of

Ret

urn

and

Rea

l Int

eres

t Rat

e (%

)

30 60

4

8

12

A B C D

a

b

cD1

Investment Demand ScheduleReal

InterestRate(%)

TotalInvestment

(1997 $ billions)

Point onGraph

ProjectsUndertaken

1284

03060

abc

--A, B

A, B, C, D

Government purchases

Net Exports

If a rise occurs in Government purchases

Eg: Highway Construction

Aggregate Demand increases

Foreign IncomesIf incomes increase in foreign countries, then its likely that the citizens of that country will purchase more products as a result – their own and those from other countries. Canadian exports increase, thereby increasing Canada’s aggregate demand.

Exchange Rates It’s the value of one nation’s currency in terms of another currency. The impact of exchange rates on prices, are if the Canadian dollar increases in value, then the net exports fall causing aggregate demand to decrease.While the reverse occurs, when the Canadian dollar drops in value then the net exports rise increasing aggregate demand.

Brief Summary

Aggregate demand is the relationship between the price level and the total spending

Changes in the Aggregate Demand are caused by:

ConsumptionInvestment

Government PurchasesNet Exports.

Economic Fluctuation

Part 2Aggregate Supply

Review

-Wealth effect:when the price decrease,household feel richer,then they may buy more,the consumption will increase

-Foreign trade effect: lower prices-->increase exports-->decrease imports -Aggregate Demand : the relationship between

general price level and total spending in the economy -Aggregate demand factors:C+I+G+Nx = GDPConsumption:Disposable income,Wealth,Consumer

expectation,Interest RentInvestment:interest rate,business expectationsGovernment PurchaseNet Exports:foreign incomes,exchange rate

Aggregate Supply

Aggregate Supply: the relationship between price level and real output in the economy

Aggregate Supply Curve :The slope of the total supply curve is upward sloping

Factors that can change in Aggregate Supply Curve

In Short run(potential output stays constant) :

-Input price

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40

80

120

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240

Aggregate Supply Curve

Real GDP (2007 $ billions)

Pric

e Le

vel (

GD

P d

efla

tor,

1997

= 1

00)

200

850825

a

b

c

dAS

PotentialOutput

Factors that can change in Aggregate Supply Curve

In Long run(potential output is variable):-Resources supplies-Productivity-Government policies

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40

80

120

160

240

Aggregate Supply Curve

Real GDP (1993 $ billions)

Pric

e Le

vel (

GD

P d

efla

tor,

1997

= 1

00)

200

750725

NewPotentialOutput

OriginalPotentialOutput

AS0 AS1

Shifting to Rightward

In short run:- a fall in wages- a fall in raw material prices

In Long run:- more labour supply,capital

stock,land,entrepreneurship- an increase in productivity- lower taxes- less government regulation

Shifting to leftward

In Short run:-a rise in wages-a rise in raw material prices

In Long run:- less labour supply,capital

stock,land,entrepreneurship- a decrease in productivity- higher taxes- more government regulation

Part 3 Aggregate Demand and Supply

Aggregate Demand and Supply

- Inventory Changes- Results of an inventory increase- Results of an inventory decrease- The role of unplanned investment

Injections and withdrawals

- Investment and Saving- Government purchases and taxes- Exports and Imports- Total injections and withdrawals

Recessionary Gaps Inflationary Gaps

Equilibrium versus Potential Output

Labour productivity

Business cycles

Definitions

Expansion: A sustained rise in the real output of an economy

Contraction: A sustained fall in the real output of an economy

Business cycle: The cycle of expansions and contractions in the economy

Peak: The point in the business cycle at which real output is at its highest

Effects of a contractionRecessions and Depressions

Recessions: A decline in real output that lasts for six months or more

Depression: A particularly long and harsh period of reduced real output

Trough: The point in the business cycle at which real output is at its lowest

The highest output occurs at a peak in the business cycle. From this point, the economy contracts, so aggregate demand decreases. Consumer and business expectations magnify the downward trend.

The lowest output occurs in a trough in a business cycle. From this point, the economy expands, so aggregate demand increases. Expectations magnify the upward trend.

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