ECO102 Lecture 05

Aggregate supply.
- Adds up all marginal cost curves in the economy
- What shifts it
  - Anything that marginal cost, will shift aggregate supply.
  - We have price on the y-axis
  - We put real GDP on the x-axis
    - Why? Because you can't add physical quantities of different goods together.
    - You need to add the dollar value of goods and services produced.
- What determines the slope
- Increasing slope of AS
  - Very elastic, then becomes inelastic.
  - This is potential GDP.
  - The level of output when all resources are fully employed.
    - Factories running at full capacity.
    - Everyone who wants a job has one.
    - $u = u^{*} = 100 %$ employment.
  - Increasing supply will then increase prices significantly.
  - But at the lower end. Factories have idle capacity. Unemployed workers.
  - So increasing output doesn't increase prices much.
  - So the slope of AS is determined by how close we are to potential GDP.
Aggregate demand.
- The total demand for goods and services in the economy. This is just Aggregate Expenditure.
  - Downward sloping.
- What shifts it
  - Anything that changes consumption, investment, government spending, or net exports.
  - Anything that changes C, I, G, or NX will shift AD.
  - Autonomous consumption changes
  - Consumer confidence
  - Wealth
  - Taxes
  - Interest Rates
  - Exchange rates
- What determines the slope of AD
  - Parameters of AE
  - Wealth effect
    - When price level falls, the real value of money increases.
    - So people feel wealthier, and spend more.
    - So quantity demanded increases.
  - Interest rate effect
    - When price level falls, people need less money for transactions.
    - So they save more, which increases the supply of loanable funds.
    - This lowers interest rates, which increases investment and consumption.
    - So quantity demanded increases.
  - Exchange rate effect
    - When price level falls, domestic interest rates fall.
    - This causes capital outflow, which depreciates the domestic currency.
    - A weaker currency makes exports cheaper and imports more expensive.
    - So net exports increase, increasing quantity demanded.?
Illustrate $\frac{A E}{45}$ with $\frac{A S}{A D}$
- $A S = 5 P$
- $C = 14 + 0.9 (Y - 10 - 0.1 Y)$
- $I = 10$
- $G = 4$
- $N X = 11 - 0.01 Y - 0.5 P$
- $x (e, Y^{F}, P^{F}, P)$
  - As price goes up, exports go down.
  - Inverse relationship between CPI and net exports.
- $A E = C + I + G + N X$
- $C = 5 + 0.81 Y$
- $A E = (5 + 0.81 Y) + 10 + 4 + (11 - 0.01 Y - 0.5 P)$
- $A E = - 0.5 P + 0.8 Y + 30$
  - This is technically our AE function.
  - We need to take the price we solve for later, and plug it back in to get AE.
- Set $A E = Y$
  - $Y = - 0.5 P + 0.8 Y + 30$
  - $Y = 150.0 - 2.5 P$
  - This is our AD curve.
  - $A D = 150 - 2.5 P$
- Find equilibrium
  - Set $A S = A D$
  - $5 P = 150 - 2.5 P$
  - $P = 20.0$
- $A E = (- 0.5) (20) + 0.8 Y + 30$
- $A E = 0.8 Y + 20.0$
- Find $Y$
  - $Y = 5 (20) = 100$
  - Equilibrium is at (100, 20)
- AD = AS
```
		left=-5; right=70;
		top=160; bottom=-5;
		---
		y=150-2.5x
		y=5x
		(20,100)
```
- AE / 45
```
		left=-5; right=105;
		top=160; bottom=-5;
		---
		y=0.8x+20
		y=x
		(100,100)
```
Expansionary fiscal policy in AS/AD model
- Government increases spending
  - Shifts AD to the right.
- Government decreases taxes
  - Increases consumption
  - Shifts AD to the right.
- Results
  - In the short run, increases output and price level.
  - In the long run, only increases price level.
    - Because output returns to potential GDP.
- $A E = 30 + 0.8 Y - 0.5 P$
- $A D = 150 - 2.5 P$
- $G_{0} = 4$
- $G_{1} = 16$
- An expansionary fiscal policy includes changes in: $G, T, t, r$ , or anything to make $C, I, N X$ go up.
- Say G goes from 4 to 16.
- New AE
  - $A E = 30 + 12 + 0.8 Y - 0.5 P$
  - $A E = 42 + 0.8 Y - 0.5 P$
- New AD
  - $A D = 162 - 2.5 P$
```
		left=-5; right=180;
		top=180; bottom=-5;
		---
		y=0.8x+20
		y=0.8x+32
		y=x
		(100,100)
		(160,160)
```
```
		left=-5; right=70;
		top=160; bottom=-5;
		---
		y=150-2.5x
		y=162-2.5x
		y=5x
		(20,100)
		y=100|dashed
```
  - Simple Multiplier
  - $\frac{1}{1 - (1 - t) b + m} = 5$
  - When G increases by 12, Real GDP increases by 60.
  - The net export curve isn't shifted.
```
		left=-5; right=180;
		top=10; bottom=-5;
		---
		y=1-0.01x
		(100,0)
		(160,-0.6)
```
  - Now we have a deficit.
  - See that $A E = 42 + 0.8 Y - 0.5 P$
  - $Y = A E$
  - $A E = 42 + 0.8 Y - 0.5 P$
  - $Y = 42 + 0.8 Y - 0.5 P$
  - $Y = 210.0 - 2.5 P$
  - New AD curve is $A D = 210 - 2.5 P$
  - Find new Equilibrium
  - Set $A S = A D$
  - $5 P = 210 - 2.5 P$
  - $P = 28.0$
  - With new price level, find new AE
  - $A E = (- 0.5) (28) + 0.8 Y + 42$
  - $A E = 0.8 Y + 28.0$
```
		left=-5; right=180;
		top=180; bottom=-5;
		---
		y=0.8x+20
		y=0.8x+28
		y=0.8x+32
		y=x
		(100,100)
		(160,160)
```
  - $N X = 11 - 0.01 Y - (0.5) (28)$
  - $N X = - 0.01 Y - 3.0$
  - New net export curve
```
left=-5; right=180;
top=10; bottom=-5;
---
y=1-0.01x
y=-3-0.01x
(100,0)
(160,-0.6)
(160,-4.6)
y=-0.6|dashed
y=-4.6|dashed
```
- The spending multiplier is smaller because as prices rise, net exports fall.
- So the total increase in output is smaller.
- The new multiplier is:
  - $\frac{1}{1 - (1 - t) b + m^{'}} = 3.33$
  - $\frac{140 - 100}{16 - 4} = 3.33333333333333$
  - So real GDP increases by 40 instead of 60.
- Impact of the multiplier depends on elasticity of supply.
- If the supply was flatter, the increase in output would be cheaper.
  - Multiplier is more effective.
- If the supply was steeper, the increase in output would be more expensive.
  - Multiplier is less effective.
- If it was completely horizontal, there would be no increase in price level.
  - Same multiplier effect.
- If it was completely vertical, there would be no increase in output.
  - $0$ multiplier effect.
- Normally we need diagrams for:
  - $A E / 45$
    - 3 curves
  - $A S / A D$
    - 3 curves
  - Net Exports
    - 2 curves
  - Budget Balance
    - 2 curves
  - $S$ Savings
    - 1 curve
Negative Foreign Shock with Stabilization
- $A S = 5 P$
- $C = 14 + 0.9 (Y - 10 - 0.1 Y)$
- $I = 10$
- $G = 4$
- $N X_{0} = 11 - 0.01 Y - 0.5 P$
- $N X_{1} = 5 - 0.01 Y - 0.5 P$
- $A E = 30 + 0.8 Y - 0.5 P$
- …
- $A E_{0} = 0.8 Y + 20$
- $A E_{1} = 0.8 Y + 10$
- When net exports fall, AE falls.
- $A S = A D$
- $A S = 210 - 2.5 P$
- $A D$ shifts left
- $6$ dollar decrease in net exports causes $30$ dollar decrease in real GDP.
```
left=-5; right=180;
top=10; bottom=-10;
---
y=1-0.01x
y=-2.5-0.01x
y=-5-0.01x
(100,0)
(50,-5.5)
```
  - Middle part is new net export curve.
  - #tk little confused on all this.
- Increase government spending to offset the negative foreign shock.
- $G ↑$ so that $Y = Y_{0}$
- Or $T ↓$ or $t ↓$ or $r ↓$
- Discuss overshifting.
- $A E = 30 + 0.8 Y - 0.5 P$
- $A D = 150 - 2.5 P$
- To offset the shock, you need to move from point $C$ to $C^{'}$
- Increase G to get to $C^{'}$
- Need to overshift $A E_{2}$ to the same real gdp as where $C^{'}$ is.
  - When you overshift, then when the AD adjusts, we get the original intersection as Equilibrium A.
- When you increase govt spending, $N X$ doesn't shift.
  - $C^{'}$ lies on $N X_{1}$
A Supply Shock With Stabilization
- $A S_{0} = 5 P$
- $C = 14 + 0.9 (Y - 10 - 0.1 Y)$
- $I = 10$
- $G = 4$
- $N X = 11 - 0.01 Y - 0.5 P$
- $A S_{1} = 5 P - 75$
```
		left=-5; right=160;
    top=70; bottom=-5;
    ---
    x=150-2.5y
    x=5y
    x=5y-75
    (100,20)|label:A
    (75,30)|label:C
    x=100|dashed|0<=y<=20
    x=75|dashed|0<=y<=30
    (75,15)
```
- $x = 5 y$
- $75 = 5 y$
- $y = 15$
```
    left=-5; right=160;
top=150; bottom=-5;
---
x=0.8y+20
x=0.8y+5
y=x|dotted
(100,100)|label:A
(75,75)|label:C
x=100|dashed
x=75|dashed
```
- Since $A S$ is the $M C$ of the firm, if wages go up, then $M C$ goes up, so $A S$ shifts left.
  - It shifts left every winter in Canada because.
  - Derailed trains.
  - Bad weather.
  - Heating costs.
- No Equilibrium $B$ , that's an $A E$ with a fixed price level that causes the shift from $A$ to $B$ .
- No changes in price. So no equilibrium B.
- We need to shift the aggregate demand curve to get back to potential GDP.
- $A D = 150 - 2.5 P$
- $A D = x - 2.5 P$
- Since $A E = 30 + 0.8 Y - 0.5 P$
- The $5$ multiplier turned $30 \to 150$
- $A S_{0} = 5 P - 75$
- $100 = 5 P - 75$
- $P = 35$
- $A E = (- 0.5) (35) + 0.8 Y + 30$
- $A E = 0.8 Y + 12.5$
- $100 = x - (2.5) (35)$
- $x = 187.5$
- New AD curve is $A D = 187.5 - 2.5 P$
- New $A E$ curve is $A E = 12.5 + 0.8 Y - 0.5 P$
- $30 - 12.5 = 17.5$ change in govt spending.

Change in income tax rate.

$A S = 2.5 P$
$C = 20 + 0.8 (Y - 10 - 0.2 Y)$
$I = 18$
$G = 40$
$X = 50 - 2 P$
$Im = 0.04 Y + 2 P$
What if $t_{1} = 0.1$
$A E_{0} = (20 + (0.8) (Y - 10 - 0.2 Y)) + 18 + 40 + ((50 - 2 P) - (0.04 Y + 2 P))$
$A E_{0} = - 4 P + 0.6 Y + 120.0$
- $A D_{0}$
- $Y = - 4 P + 0.6 Y + 120$
- $A D_{0} = 300.0 - 10.0 P$
- Find Equilibrium
- Set $A S = A D$
- $2.5 P = 300 - 10 P$
- $P = 24.0$
- $A E_{0} = (- 4) (24) + 0.6 Y + 120$
- $A E_{0} = 0.6 Y + 24.0$
- Find $Y$
- $Y = 2.5 (24) = 60.0$
$A E_{1} = (20 + (0.8) (Y - 10 - 0.1 Y)) + 18 + 40 + ((50 - 2 P) - (0.04 Y + 2 P))$
$A E_{1} = - 4 P + 0.68 Y + 120.0$
- $A D_{1}$
- $Y = - 4 P + 0.68 Y + 120$
- $Y = 375.0 - 12.5 P$
- $A S = A D$
- $2.5 P = 375 - 12.5 P$
- $P = 25.0$
- $A E = (- 4) (25) + 0.68 Y + 120$
- $A E = 0.68 Y + 20$
If $t ↓$ then $S$ rotates.

$\frac{A E}{45}$

    left=-5; right=80;
    top=160; bottom=-5;
    ---
    y=0.6x+24
    y=0.68x+20
    y=x
    (60,60)|label:A
    (68.75,68.75)|label:B
    x=60|dashed
    x=68.75|dashed

$A S / A D$ graph

    left=-5; right=70;
    top=160; bottom=-5;
    ---
    y=300-10x
    y=375-12.5x
    y=2.5x
    (24,60)|label:A
    (25,68.75)|label:B
    y=60|dashed
    y=68.75|dashed

NX graph

left=-5; right=80;
top=60; bottom=-5;
---
y=50-0.04x-4x
(60,6.6)|label:A
(68.75,3.25)|label:B

Savings Graph

left=-5; right=80;
top=60; bottom=-5;
---
y=-10+0.2x
(60,2)|label:A
(68.75,3.75)|label:B

Budget Balance graph

left=-5; right=80;
top=40; bottom=-10;
---
y=-40+0.1x
(60,-34)|label:A
(68.75,-33.125)|label:B