Chapter 4
Skating to Where the
Puck is Going
Aggregate Supply and
Aggregate Demand
LEARNING OBJECTIVES
 Aggregate Supply and supply shocks
 Aggregate Demand and a list demand shock
 Use matches and mismatches between aggregate
supply and aggregate demand
to explain the “Yes” and “No” answers to
the fundamental macroeconomic question
 “Yes” and “No” answers about origins, expectations,
and market responses to business cycles
continued…
IF YOU PLAN AND BUILD IT . . .
AGGREGATE SUPPLY
Supply plans for existing inputs determine
aggregate quantity supplied.
Supply plans to increase quantity and quality of inputs,
together with supply shocks, change aggregate supply.
Fig. 4.1: Enlarged GDP Circular Flow of Income
and Spending ($)
AGGREGATE SUPPLY (AS)
Macroeconomic players
consumers, businesses, government make two
kinds of plans for supplying Canadian real GDP
a) supply plans for existing inputs
b) supply plans to increase inputs
a) Supply plans for existing inputs similar to
microeconomic choices about quantity supplied
 Aggregate quantity supplied
quantity of real GDP players plan to supply
at different average price levels
 Law of aggregate supply
as average level of prices rises, aggregate
quantity supplied increases
(up to maximum of potential GDP)
b) Supply plans to increase quantity or quality of inputs
cause increase in aggregate supply — increase in
economy’s capacity to produce real GDP
With existing inputs
Increasing input
(quality & quantity)
new
factories/equipment,
resources, technology.
Business
supply
choices
what to produce, quantities
to produce, quantities of
inputs to hire.
Consumer
supply
choices
participate in labour force,
hours to work, inputs to
supply.
Government
supply
choices
resources to supply.
Determines aggregate
quantity supplied
infrastructure, rules of
the game, policies
Outcome
Determines aggregate
quantity supplied.
Changes AS and
increases potential GDP.
having children,
education and
training.
Negative supply shocks
directly increase costs or reduce inputs,
decreasing aggregate supply
Positive supply shocks
directly decrease costs or improve productivity,
increasing aggregate supply
Fig. 4.2: Law of Aggregate Supply and Changes in AS
The Law of Aggregate Supply
The aggregate quantity supplied of Real GDP
Decreases if:
• average level of prices falls
Increases if:
• average level of prices rises
Changes in Aggregate Supply
The aggregate supply of Real GDP
Decreases if:
• negative supply shock raises
price for resource inputs
• negative supply shock destroys
inputs
Increases if:
• businesses plan to increase
quantity or quality inputs
• positive supply shock lowers
price for resource inputs
• positive supply shock improves
technologies
. . . WILL THEY COME AND BUY IT?
AGGREGATE DEMAND
Demand plans determine aggregate quantity demanded.
Demand shocks — from changes in expectations,
interest rates, government policy, GDP in R.O.W.,
exchange rates — change aggregate demand.
AGGREGATE DEMAND (AD)
All macroeconomic players —
consumers, businesses, government, R.O.W.
make demand plans for spending, like
microeconomic choices about quantity demanded
Aggregate quantity demanded
quantity of real GDP players plan to demand
at different average price levels
Law of aggregate demand
as average level of prices rises,
aggregate quantity demanded decreases
a. Consumers plans to spend (C) a fraction of disposable
income
b. Businesses plan investment spending (I)
for new factories and equipment. I plans are volatile.
c. Government spending plans (G) for products/services
set by budget
d. R.O.W. spending plans (X) for Canadian exports
 subtract imports (IM) from all other planned
spending to get net exports (X — IM) =
difference between what Canada exports and
imports
Planned spending on aggregate demand =
planned C + planned I + planned G + planned (X − IM)
Demand shocks
factors, other than average prices, changing
aggregate demand
Aggregate demand changes with expectations, interest
rates, government policy, GDP in R.O.W., exchange
rates
Negative demand shocks decrease aggregate demand
a) more pessimistic expectations
b) higher interest rates
c) lower government spending and/or higher taxes
d) decreased GDP in R.O.W.
e) higher value Canadian dollar
Positive demand shocks increase aggregate demand
a) more optimistic expectations
b) lower interest rates
c) higher government spending and/or lower taxes
d) increased GDP in R.O.W.
e) lower value Canadian dollar
MATCH OR MISMATCH?
AGGREGATE SUPPLY & AGGREGATE DEMAND
“Yes”
“No”
Matches between aggregate supply and aggregate demand
give equilibrium, Say’s Law, and “Yes” answer;
mismatches give Keynes’s business cycles,
demand and supply shocks, and “No” answer.
AGGREGATE SUPPLY & AGGREGATE DEMAND
“Yes” answer
macroeconomic equilibrium with existing inputs when
aggregate demand matches aggregate supply
– AS choices based on expectations of what price level
and aggregate demand will be when products/services
get to market
– price level and AD what suppliers expected
– Real GDP = potential GDP; inputs fully employed
– Say’s Law — supply creates its own demand
continued…
“Yes” answer
equilibrium over time with increasing inputs when
aggregate demand matches aggregate supply
– add savings and investment to explain
growth in living standards over time
(real GDP per person)
– savings threaten Say’s Law, since all income in
input markets not spent demanding
products/services in output markets
continued…
Market for loanable funds
banks coordinate supply of loanable funds (savings)
with demand for loanable funds (borrowing)
– interest rate is price of loanable funds
– if banks loan savings to businesses that use
it for investment spending, offsets consumer
savings, restoring equality between aggregate
income and aggregate spending
Investment spending increases inputs, so potential
GDP and real GDP per person increase over time
– aggregate supply and aggregate demand
both increase, full employment continues,
average prices stay stable
“No” answer
mismatch between aggregate demand and
aggregate supply
– aggregate supply choices based on expectations
of what price level and aggregate demand will
be when products/services get to market
– expectations disappointed,
outcomes do not work out as planned
– adjustments — expansions and contractions —
necessary to get back to smart choices
– Keynes’s business cycles
Mismatch scenarios from demand shocks
– negative demand shock causes recessionary gap —
falling average prices, decreased real GDP,
increased unemployment
– positive demand shock causes inflationary gap —
rising average prices increased real GDP,
decreased unemployment
– demand shocks cause unemployment and
inflation to move in opposite directions,
like Philips Curve
Mismatch scenarios from supply shocks
– negative supply shock causes stagflation —
rising average prices, decreased real GDP,
increased unemployment
– positive supply shock causes falling
average prices, increased real GDP,
decreased unemployment
– supply shocks cause unemployment and
inflation to move in same direction
“Yes” and “No” camps
– agree on descriptions of equilibrium and
impact of demand and supply shocks
– disagree on origins of shocks and how quickly
markets adjust
SHOCKING STARTS AND FINISHES:
ORIGINS AND RESPONSES TO BUSINESS CYCLES
“Yes” and “No” camps disagree about external/internal
origins of shocks, about rational/volatile expectations,
and about how quickly price adjustments
restore match between aggregate supply and demand.
ORIGINS AND RESPONSES TO BUSINESS CYCLES
“Yes” camp
markets quickly self-adjust, so hands-off
– origins of shocks external to economy —
nature, science, mistaken government policies
– government part of problem, not solution
– rational expectations and logical choices
• For “Yes” camp, when shocks occur, price
adjustments in all markets quickly restore match
between aggregate supply and aggregate demand —
example of negative demand shock
– in labour market,
unemployment causes wages to fall,
increasing hiring back to full employment
– in output markets,
prices fall due to surpluses and falling wage
costs, increasing sales back to potential GDP
– in international trade market,
falling Canadian prices increase net exports,
increasing Canadian real GDP and decreasing
unemployment
– in loanable funds market, savings cause interest
rates to fall, increasing investment spending (I),
increasing Canadian real GDP and
decreasing unemployment
“No” camp
markets fail to quickly self-adjust, so hands-on
– origins of shocks internal to economy — changing
expectations, role of money, connections with
R.O.W.
– volatile expectations based on fundamental
uncertainty about future
– facing uncertainty, saving decisions are
internal negative demand shock
– business cycles in other economies affect
Canada through exports and imports
For “No” camp, when shocks occur, difficult
adjustments in all markets — example of negative
demand shock
– in labour market, wages sticky even with
unemployment —layoffs instead of lower wages
– in output markets, prices fall due to surpluses,
but falling incomes from unemployment in input
markets decrease consumption demand (C)
– in international trade market, falling Canadian
prices increase net exports, but destabilizing
effects of cycles in R.O.W.
– in loanable funds market, even if interest rates
fall, pessimistic expectations may cause
investment spending (I) to decrease
– with weak/slow price adjustments, role for
government to bring aggregate supply and
aggregate demand back into balance
Disagreement between “Yes” and “No” camps on
– connections between input
markets and output markets
for both demand and supply sides
– connections between Canada
and R.O.W.
– connections between
money/banks/expectations
and input and output markets
Fig. 4.8
Origins of Shocks and Business Cycles