Chapter 10: Economic Fluctuations
Group: Vivian He, Aaron Huang, Alex Karanis, and Arun Jeyabavan
Section 10.1: Aggregate Demand
Aggregate Demand (AD) the relationship between the general price level and total spending
in the economy
Real Expenditures  total spending in an economy adjusted for changes in the general price
level and is calculated using the GDP price deflator
Real value of financial assets = nominal value of financial assets/ price level
Wealth effect  the real value of households’ financial assets fluctuates due to the changes in
price levels causing households’ to adjust their spending
Foreign trade effect  with changes in the price level, expenditures on imports change in the
same direction, while expenditures on exports change in the opposite direction
Changes in Aggregate Demand
The four components of spending are:
1. Consumption (C)
2. Investment (I)
3. Government Purchases (G)
4. Net Exports (X-M)
Consumption  households determine how much to spend or save, four factors affecting
consumer spending are:
 Disposable Income (DI)

DI and consumer spending have a direct relationship

Example: higher income taxes decrease households’ DI

 DI,  Consumer spending,  Total expenditures, AD curve shifts 
 Wealth

Made up of financial (e.g. stocks) and real (e.g. houses) assets

Example: if stock prices jump, households that own stocks enjoy increased wealth

 Wealth,  Consumer spending,  Total expenditures, AD curve shifts 
 Consumer Expectations

Example: an expectation that prices will rise in the future, consumers will spend
more now and save less

 Consumer spending,  Total expenditure, AD curve shifts 
 Interest Rates

Example: if real interest rate falls, consumers are more likely to borrow money

 Real interest rates,  Consumer spending, AD curve shifts 
Investment  spending on projects where earning a profit is anticipated
 Interest Rates

Real interest rates and investment have an inverse relationship

 Real interest rates,  Investments,  AD, AD curve shifts 
 Business expectations

Example: if businesses anticipate that profits will increase, investment increases

 Investment,  AD, AD curve shifts 
Government Purchases

Example: a rise in government purchase for highway construction


 Government purchases,  AD, AD curve shifts 
Excluding government transfer payments (e.g. seniors’ benefit payments)
Net Exports  factor that cause a change in aggregate demand:

Foreign incomes

Example: incomes rise in France allowing French citizens to buy more products,
both domestic and foreign


 Foreign incomes,  Net exports,  AD, AD curve shifts 
Exchange rates

Example: if the value of the CAD goes up, exports from Canada become more
expensive for foreign countries

 Net Exports,  AD, AD curve shifts 
Investment Demand
 The relationship between interest rates and investment
 Businesses borrow money to finance their investment projects

They pursue projects whose real rate of return exceeds or at least equals the real
interest rate they will be charged
 Real rate of return  the constant-dollar extra profit provided by the project (the
business has invested in) each year, stated as a percentage of the project’s initial cost

Example: Pure ‘n’ Simple T-Shirts, a T-shirt making company, invests their money
to buy a $100 sewing machine which is expected to last one year. The machine is
expected to add $112 to the net revenue. Therefore, the extra profit gained from
purchasing the machine is $12 (=$112-$100). As a percentage, the real rate of
return of its $100 price is 12% (= [($12/$100) x 100%]).
Section 10.2: Aggregate Supply
 _____________ ____________is the relationship between the general price level and real
output produced in an economy.
 Below is an “_________ __________ _________”
Price Level
Real GDP
Point on Graph
120
650
A
160
700
B
200
725
C
240
730
D
 Below is an “_________ __________ __________”
 What causes a movement along the aggregate supply curve?
 What would cause the economy to reach its potential output?
 If unemployment rate falls below natural unemployment rate, what will happen to real
output?
 ___________________ __________ reduces real output
 Production above a business’s normal output (producing greater than the potential
output) is only possible in the ________ ________ if the business
1.
Employs overtime labour
2.
Temporarily rent new machinery
 These measures mean that any expansion in ___________ _________ requires a higher
increase in _________ ____________ to cover additional ______-________ costs.
 A business’s production capacity is _______________ at price levels below the potential
output price.
 Factors that affect aggregate supply are called “aggregate supply factors”
1.
Real output are affected at all price levels
2.
The whole aggregate supply curve will shift either to the right or left
3.
Short-run change in AS does not affect potential output
4.
Long-run change in AS affects potential output
 ____________ _____________ will cause a short-run decrease in aggregate supply or shortrun increase in aggregate supply.
 What are the three factors that affect AS in the long run?
1.
2.
3.
Section 10.3: Equilibrium
An economy’s equilibrium occurs at a point where total __________(I+G+X) equal total
___________ (S+T+M).
When total injections exceed total withdrawals than _______ _______and spending expand
until a new balance is achieved.
When total withdrawals exceed total injections then real output and spending _________until
a new balance is achieved.
Equilibrium vs. Potential Output
Recessionary gap  occurs when equilibrium output falls short of ________ output, and is
associated with an unemployment rate above the natural rate
Inflationary gap occurs when equilibrium output ________ potential output, and is
associated with an unemployment rate below the natural rate as well as increased pressure
on prices
Section 10.4: Economic Growth
Economic Growth  an increase in the total output of goods and services from a certain
country, there are two ways to define it:
 Real GDP measures the economy’s overall productive capacity
 Real GDP per capita measures the living standards
Economic growth can also be portrayed using the production possibilities curve in two ways:
 An outward shift in the production possibilities curve due to technological change or an
increase in economic resources
 A movement towards the curve because not all resources have been employed or used
to their fullest capacity
Production Options
Country A:
 Focuses more of their resources on producing capital goods (lasers)
 Encourages greater growth as capital goods are an investment for further production
 More of both consumer and capital goods will be produced in the future
Country B:
 Focuses more of their resources on producing consumer goods (hamburgers)
 The opportunity cost of having more consumer goods is fewer capital goods
 Their economy grows considerably less than Country A’s
Rule of 72  a formula that takes into consideration exponential growth, growth that occurs
annually in each new calculation for the next year.
Rule of 72: # of years for variable to double = 72/ annual % growth rate
 Example: An economy grows at 4% per year. How many years does it take for the
variable (4) to double?

72/4% = 18 years
Labor Productivity = Real Output/ Total Hours worked
Economic Productivity
 Quantity of Capital

By saving a higher proportion of their disposable incomes, Canadians can
increase net investment, which accelerates the accumulation of capital resources,
which, in turn, pushes out the productions possibilities curve and fuels the
economy.
 Technological Progress

Consists of scientific discoveries and their application, advances in production
methods, and the development of new types of products.
 Research and Development Expenditures

Spending that is meant to accelerate the pace of technological progress
 Quality of Labor

Investment in Human capital through education and training. Ex: Schools, Staff
Training.
 Efficiency in Production

Efficiency in production means that quantity of a certain good or service is varied.
 Quantity of Natural Resources

Natural Resources are essential to make products and goods. The amount of
natural resources varies the amount of goods produced.
 Social, Political and Legal Factors

Growth will be enhanced in a society that promotes competition, innovation and
entrepreneurship, and by social institutions geared toward enterprise and profit
making.
Arguments for Economic Growth
 Living Standards

With Rising incomes and output, more wants can be satisfied, both for individuals
and for society as a whole.
 Social Improvements

Higher government spending allows for greater expenditures in such areas as
health, education, and the promotion of income equity.
 Psychological Benefits

A growing economy helps create a mood of optimism and a sense of expanding
opportunities.
Arguments against Economic Growth
 Opportunity Cost of Growth

To promote growth, a country must devote most of its scarce resources to
investment in capital goods, rather than to current consumption. While this cost
is not an overwhelming one for a rich country, such a s Canada, it is far more
significant for citizens of poor countries as they choose an appropriate growth
strategy.
 Environmental Costs

Another indirect cost of economic growth is the potential to damage the
environment by releasing more pollutants if the country is to produce more
goods for output.
 Social Costs

The social costs come with the risks from technological progress. While
technology progresses, some business owners who are more traditional may be
hurt by the change.
Section 10.5: Economic Growth and Business Cycles
Economic Growth in Canada
 Before World War 1 (1870-1914)

Canada’s per-capita output rose from $2312 to$5283 (measured in 1997 dollars)
 The Interwar Period (1914-1945)

Experienced a negative growth after WW1 when Canada’s per-capita output fell
sharply during the 1920s and early 1930s

The country’s per-capita real output almost doubled from $5283 to $9660
 The Postwar Period (1945-2000s)

Canada achieved a fairly steady growth in living standards about 2% annually

Per-capita real output has increased more than four times to $35 194 in 2010
Business Cycles
Business Cycle  a cycle of expansions and contractions in an economy
 An expansion is a sustained rise in real output
 A contraction is a sustained fall in real output
 A peak is the point in the business cycle at which real output is at its highest
 A trough is the point in the business cycle at which real output is at its lowest
Contraction
 The economy has reached its peak, the point in the business cycle where the real output
is at its highest
 Inflationary gap has reached its maximum width, unemployment is at its lowest possible
level, and real output cannot grow much more in the short run
 Usually caused by a decrease in AD magnified by the reactions of both households and
businesses, who spend less due to pessimism about the future
 May be a recession, which is a decline in real output for six months or more
 May be a depression, which is a particularly long and harsh period of reduced real
output
Expansion
 The economy eventually reaches a trough, where real output is at its lowest possible
value in the business cycle
 Usually caused by an increase in AD magnified by the reactions of both households and
businesses as they spend more due to more optimistic expectations of the future