Unit 3 - CH 10 - Adjusted

Understanding Economics
6th edition
by Mark Lovewell
Copyright 2012 by McGraw-Hill Ryerson

Limited. All rights reserved.
Understanding
Economics
6th edition
by Mark Lovewell
Chapter 10
Economic Fluctuations
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.
Learning Objectives
After this chapter you will be able to:
1. identify aggregate demand and the
2.
3.
4.
5.
factors that affect it

distinguish aggregate supply and the
factors that influence it
understand the economys equilibrium
and how it differs from its potential
define economic growth, its sources and
its impact
summarize Canadas historical record of
economic growth
Aggregate Demand (a)
Aggregate demand (AD):

is the relationship between the general price
level and real expenditures (i.e. total spending)
in an economy
is shown as a schedule or curve

Aggregate Demand (b)

Figure 10.1, Page 261
Aggregate Demand
Schedule
Price Real GDP Point on
Level
Graph
(2002,
$ billions)
200
160
120
650
700
750
a
b
c
Price Level (GDP deflator,

2002 = 100)
Aggregate Demand Curve

200
160
120
80
AD
40
650
700
750
Real GDP (2002 $ billions)

800
The Aggregate Demand

Curve
Two factors cause the aggregate demand

curve to be downward sloping:
The wealth effect means that higher prices
decrease the real value of financial assets and

decrease consumption, since households feel
poorer (and vice versa for lower prices).
The foreign trade effect means that higher
prices decrease exports and increase imports
(and vice versa for lower prices).

Changes in Aggregate Demand (a)
Aggregate demand changes are shown by

shifts in the AD curve.
An increase in spending causes a rightward
shift in the AD curve.

A decrease in spending causes a leftward shift
in the AD curve.

Changes in Aggregate Demand (b)

Aggregate Demand
Schedule
Price
Level
200
160
120
Real GDP
AD0
AD1
(2002 $ billions)
650
700
750
700
750
800

2002 = 100)
Aggregate Demand Curve

200
160
120
AD0
80
AD1
40
650
700
750

800
Aggregate Demand
Factors (a)
AD changes are caused by aggregate demand

factors related to each of the four main
spending components:
consumption (C)
disposable income
wealth (other than wealth changes caused by a
varying price level)
consumer expectations
interest rates

Aggregate Demand
Factors (b)
investment (I)
interest rates
business expectations
government purchases (G)
net exports (X-M)
foreign incomes
exchange rates

Investment Demand (a)

Investment demand is the relationship
between the interest rate and investment and
depends on the real rate of return and the real
interest rate.
Businesses pursue projects whose real rate of
return at least equals the real interest rate,
which means the investment demand curve is
downward-sloping, since more projects are
profitable at lower interest rates.

Investment Demand (b)

Investment Demand Schedule

Real
Total
Point on Projects
Interest Investment Graph Undertaken
Rate
(%) (2002 $ billions)
12
8
4
0
30
60
a
b
c
-A, B
A, B, C, D
Real Rate of Return and

Real Interest Rate (%)
Investment Demand Curve

12
4
A
0
C
30
D1
D
60
Investment (2002 $ billions)

Shifts in the Aggregate Demand Curve

Aggregate demand increases and

the AD curve shifts to the right,
with the following:
Aggregate demand decreases

and the AD curve shifts to the
left, with the following:
(1) An increase in consumption due to

(a) a rise in disposable income
(b) a rise in wealth unrelated to a
change in price level
(c) an expected rise in prices or
incomes
(d) a fall in interest rates
(2) An increase in investment due to
(e) a fall in interest rates
(f) an expected rise in profits
(3) An increase in government
purchases
(4) An increase in net exports due to
(g) a rise in foreign income
(h) a fall in value of the Canadian
dollar
(1) A decrease in consumption due to

(a) a fall in disposable income
(b) a fall in wealth unrelated to a
change in price level
(c) an expected fall in prices or
incomes
(d) a rise in interest rates
(2) A decrease in investment due to
(e) a rise in interest rates
(f) an expected fall in profits
(3) A decrease in government
purchases
(4) A decrease in net exports due to
(g) a fall in foreign income
(h) a rise in value of the Canadian
dollar

Aggregate Supply (a)
Aggregate supply (AS) is:

the relationship between the general price level
and real output in an economy

shown as a schedule or curve

Aggregate Supply (b)

Aggregate Supply
Schedule
Price Real GDP Point on
Level
Graph
(2002,
$ billions)
120
160
200
240
650
700
725
730
a
b
c
d

2002 = 100)
Aggregate Supply Curve

240
AS
d
200
160
120
80
b
a
Potential
Output
40
0
650
675
700
725 730

The Aggregate Supply

Curve
The AS curve is upward-sloping because

higher prices encourage businesses to
produce more, while at lower prices
businesses are forced to reduce output.
The AS curve becomes steep above potential
output because a relatively large increase in
the price level is required if businesses are to
increase output in this range.

Short-Run Changes in Aggregate

Supply
Short-run AS changes are shown by shifts in

the AS curve and a constant potential output
for the economy.
A short-run increase in AS occurs when the AS
curve shifts rightward while potential output

stays constant.
A short-run decrease in AS occurs when the AS
curve shifts leftward while potential output
stays constant.

A Short-Run Change in Aggregate

Supply
Figure 10.6, page 269
Aggregate Supply
Schedule
Price
Level
120
160
200
240
Real GDP
AS0
AS1
(2002 $ billions)
650
700
725
730
700
725
730
731

2002 = 100)

240
200
160
120
80
AS1
AS0
Potential
Output
40
0
650
675
700
725

750
Long-Run Changes in Aggregate

Supply
Long-run AS changes are shown by shifts in

both the AS curve and in potential output.
A long-run increase in AS occurs when the AS
curve and potential output both shift rightward.

A long-run decrease in AS occurs when the AS
curve and potential output both shift leftward.

A Long-Run Change in Aggregate

Supply
Aggregate Supply
Schedule
Price
Level
120
160
200
240
Real GDP
AS0
AS1
(2002 $ billions)
650
700
725
730
700
750
775
780

2002 = 100)
AS0
AS1
240
200
160
120
40
0
New
Potential
Output
Original
Potential
Output
80
650
725
775

Aggregate Supply
Factors
AS changes are caused by aggregate supply

factors related either to short-run or long-run
trends.
Short-run changes in AS are caused by varying
input prices.
Long-run changes in AS are caused by varying:
resource supplies
productivity
government policies

Shifts in the Aggregate Supply Curve (a)

Aggregate supply increases, with
the AS curve shifting to the right,
and potential output staying the
same with the following:
Aggregate supply decreases with

the AS curve shifting to the left,
and potential output staying the
same with the following:
(1) A decrease in input prices due to

(a) a fall in wages
(b) a fall in raw material prices
(1) An increase in input prices due to

(a) a rise in wages
(b) a rise in raw material prices

Shifts in the Aggregate Supply Curve (b)

Aggregate supply increases, with

the AS curve shifting to the right,
and potential output increasing
with the following:
Aggregate supply decreases, with

the AS curve shifting to the left,
and potential output decreasing
with the following:
(1) An increase in supplies of economic

resources due to
(a) more labour supply
(b) more capital stock
(c) more land
(d) more entrepreneurship
(2) An increase in productivity due to
technological progress
(3) A change in government policies
(e) lower taxes
(f) less government regulation
(1) A decrease in supplies of economic

resources due to
(a) less labour supply
(b) less capital stock
(c) less land
(d) less entrepreneurship
(2) A decrease in productivity due to
technological decline
(3) A change in government policies
(e) higher taxes
(f) more government regulation

Equilibrium in the
Economy (a)
An economys equilibrium occurs at the

intersection of the AD and AS curves.
A price level above equilibrium means an
unintended increase in inventories (or positive

unplanned investment), lowering the price level
towards equilibrium.
A price level below equilibrium leads to an
unintended decrease in inventories (or negative
unplanned investment), raising the price level
towards equilibrium.
An Economy at
Equilibrium
Aggregate Demand and Supply Curves

Aggregate Demand and
Supply Schedules
Price
Level
AS AD
(surplus (+) or
shortage (-))
(2002 $ billions)
200
160
120
(725 650) = +75

(700 700) = 0
(650 750) = -100

2002 = 100)
200
AS
Positive Unplanned
Investment
160
b
120
80
Negative Unplanned
Investment
40
650
700
750

AD
800
Equilibrium in the
Economy (b)
An economys equilibrium occurs at a point

where total injections (I+G+X) equal total
withdrawals (S+T+M).
When total injections exceed total withdrawals
then real output and spending expand until a
new balance is achieved.
When total withdrawals exceed total injections
then real output and spending contract until a
new balance is achieved.

An Economy at Its Potential Output

AS

2002 = 100)
240
200
160
120
80
Potential
Output
40
725

AD
Recessionary and Inflationary Gaps
A recessionary gap:
occurs when equilibrium output falls short of
potential output, and is associated with an

unemployment rate above the natural rate
An inflationary gap:
occurs when equilibrium output exceeds
potential output, and is associated with an

unemployment rate below the natural rate as
well as increased pressure on prices

Economic Growth (a)
Economic growth can be defined in two ways:

The percentage increase in an economys total
output (e.g. real GDP) is most appropriate when

measuring an economys overall productive
capacity.
The percentage increase in per capita output
(e.g. per capita real GDP) is most appropriate
when measuring living standards.

Economic Growth (b)
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

The Rule of 72
The Rule of 72:

shows the effects of exponential growth
states that the number of years it takes a
variable to double can be estimated by dividing

72 by the variables annual percentage change

Sources of Economic Growth (a)

A main cause of growth in Canadas real
output is the increase in the quantity of
labour.
Growth in per capita output is closely
associated with growth in labour productivity,
which depends on six factors:
the quantity of capital

technological progress
the quality of labour
efficiency in production
Sources of Economic Growth (b)

the quantity of natural resources
social and political factors

The Benefits of Growth
There are three main advantages of economic

growth:
its positive effect on living standards
its possible effect on social improvements
its psychological benefits

The Costs of Growth
There are three main disadvantages of

economic growth:
its opportunity cost in terms of sacrificed
current consumption
its environmental costs
its social costs

Canadas Economic
Growth (a)

Business Cycles (a)
The business cycle is the 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.

The Business Cycle

Real GDP
CONTRACTION
EXPANSION
Long-Run Trend
of Potential Output
Peak
a
c
Recessionary gap
Inflationary gap
b
d
Trough
Time

Contractions
A contraction:
is 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

Expansions
An expansion is 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.

Expansion and
Contraction

2002 = 100)
AS
f
240
160
Inflationary
Gap
AD0
Potential
Output
AD1
0
700
725
730

Recessionary
Gap
Economic Development (OLC)

The Worlds Rich and Poor
The World Bank classifies nations into three

groups based on their per capita GNP (2009
figures):
high-income countries (US$12196 or more)
middle-income countries (US$996 to $12195)
low-income countries (US $995 or less)


The Vicious Cycle of Poverty
Figure C
Low per
capita income
Low productivity
growth
Low investment in capital Rapid population

and human resources
growth
Labour-intensive
production


Strategies for Development (a)
Breaking the vicious cycle of poverty involves

three domestic strategies for development:
ensuring political and economic stability
investing in human capital and capital goods
population control


Strategies for Development (b)
Breaking the vicious cycle of poverty involves

two international strategies for development:
trade liberalization
foreign aid

Understanding
Economics
6th edition
by Mark Lovewell
Chapter 10
The End
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

Unit 3 - CH 10 - Adjusted

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Understanding Economics

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factors that affect it

Aggregate Demand (a)

Aggregate demand (AD):

Copyright 2012 by McGraw-Hill Ryerson

Aggregate Demand (b)

Price Level (GDP deflator,

Aggregate Demand Curve

Real GDP (2002 $ billions)

Copyright 2012 by McGraw-Hill Ryerson

The Aggregate Demand

Two factors cause the aggregate demand

The wealth effect means that higher prices

decrease the real value of financial assets and

Copyright 2012 by McGraw-Hill Ryerson

Changes in Aggregate Demand (a)

Aggregate demand changes are shown by

shift in the AD curve.

Copyright 2012 by McGraw-Hill Ryerson

Changes in Aggregate Demand (b)

Price Level (GDP deflator,

Aggregate Demand Curve

Real GDP (2002 $ billions)

Copyright 2012 by McGraw-Hill Ryerson

AD changes are caused by aggregate demand

Copyright 2012 by McGraw-Hill Ryerson

Copyright 2012 by McGraw-Hill Ryerson

Investment Demand (a)

Copyright 2012 by McGraw-Hill Ryerson

Investment Demand (b)

Investment Demand Schedule

Real Rate of Return and

Investment Demand Curve

Investment (2002 $ billions)

Copyright 2012 by McGraw-Hill Ryerson

Shifts in the Aggregate Demand Curve

Aggregate demand increases and

Aggregate demand decreases

(1) An increase in consumption due to

(1) A decrease in consumption due to

Copyright 2012 by McGraw-Hill Ryerson

Aggregate Supply (a)

Aggregate supply (AS) is:

and real output in an economy

Copyright 2012 by McGraw-Hill Ryerson

Aggregate Supply (b)

Price Level (GDP deflator,

Aggregate Supply Curve

Real GDP (2002 $ billions)

Copyright 2012 by McGraw-Hill Ryerson

The Aggregate Supply

The AS curve is upward-sloping because

Copyright 2012 by McGraw-Hill Ryerson

Short-Run Changes in Aggregate

Short-run AS changes are shown by shifts in

curve shifts rightward while potential output

Copyright 2012 by McGraw-Hill Ryerson

A Short-Run Change in Aggregate

Price Level (GDP deflator,

Aggregate Supply Curve

Real GDP (2002 $ billions)

Copyright 2012 by McGraw-Hill Ryerson