Commonwealth of Learning Executive MBA/MPA

C5 The Economic Environment of Business

Block 7
Aggregate Demand, Aggregate Supply
and Economic Fluctuation

C5, Economic Environment of Business,Block 7 page 1 of 45

Course author Farrokh Zandi, PhD
Professor, Schulich School of Business
York University
Toronto, Canada

Course designer Catherine Kerr, BEd

Principal, Bookthought Content Company
Vancouver, Canada

Copyright  Commonwealth of Learning, 2002

All rights reserved. No part of this course may be reproduced in any form by any means
without prior permission in writing from:

The Commonwealth of Learning

1285 West Broadway
Suite 600
Vancouver, BC V6H 3X8
CANADA
e-mail: [email protected]

C5, Economic Environment of Business,Block 7 page 2 of 45

 Contents
1 A Tour of Block Seven: Objectives and Introduction ........................................... 5
1.1 Introduction......................................................................................................... 5
2 Aggregate Demand and Its Components ................................................................ 7
2.1 The Aggregate Demand Curve ........................................................................... 7
2.2 Changes in Aggregate Demand .......................................................................... 9
3 Consumption and Its Determinants ........................................................................ 9
3.1 Practice.............................................................................................................. 11
3.2 Disposable Income............................................................................................ 12
3.3 Wealth ............................................................................................................... 12
3.4 Consumer Expectations .................................................................................... 12
3.5 Interest Rates..................................................................................................... 13
4 Investment and Its Determinants .......................................................................... 13
4.1 Nonresidential Fixed Investment ...................................................................... 14
4.2 Residential Construction................................................................................... 14
4.3 Change in Business Inventories ........................................................................ 15
4.3.3 Investment demand curve................................................................................ 17
5 Government Purchases........................................................................................... 18
6 Net Exports .............................................................................................................. 18
6.1 Foreign Income ................................................................................................. 18
6.2 Exchange Rates................................................................................................. 19
6.3 Trade Policies.................................................................................................... 19
7 Money and Aggregate Demand ............................................................................. 20
7.1 Money, Interest Rates, and the Price Level ...................................................... 20
7.2 The Money Market ........................................................................................... 21
7.2.1 The Demand for Money .................................................................................. 21
7.2.2 The Supply of Money....................................................................................... 22
7.3 Practice.............................................................................................................. 25
8 Output, Aggregate Supply and Its Components .................................................. 25
8.1 The Aggregate Supply Curve............................................................................ 25
8.2 Determination of Natural Level of Output........................................................ 27
9 Short-run vs. Long-run Aggregate Supply Curve ............................................... 28
9.1 Changes in Aggregate Supply........................................................................... 29
9.1.1 Input Prices..................................................................................................... 29
9.1.2 Resources Supplies.......................................................................................... 29
9.1.3 Technological Knowledge............................................................................... 30
9.1.4 Government Policies....................................................................................... 30
9.1.5 Factors Causing the Short-Run Aggregate Supply Curve to Slope Upward .. 31
9.1.6 Factors Causing a Shift in the Short-run Aggregate Supply Curve............... 32
9.2 General Equilibrium.......................................................................................... 32
9.3 Short-Run and Business Cycles ........................................................................ 33

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 9.4 Adjustments to the Long Run ........................................................................... 34
10 Causes of Economic Fluctuations ...................................................................... 35
10.2 Shifts in Aggregate Demand............................................................................. 35
10.3 Shifts in Aggregate Supply ............................................................................... 37
11 Summary and Review......................................................................................... 39
12 Self-Test Questions.............................................................................................. 40
13 Review Problems................................................................................................. 41
14 Answer Key to Review Problems....................................................................... 43

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1 A Tour of Block Seven: Objectives and
Introduction
On working through Block Seven of this course, you should be able to;
1. Describe some predictable interactions among demand, aggregate production and
income.
2. State the characteristics and determinants of the components of aggregate
demand.
3. State the conditions in which demand equilibrium is likely in goods and financial
markets.
4. List the determinants of aggregate supply.
5. Describe in what way the labour market differs from the product market.
6. State what is meant by general equilibrium.
7. Explain some aspects of output determination in the short run that differ from
those which prevail in the long run.
8. Define recessionary and inflationary gaps
9. Comment on the effects that government policy tends to have in the short-run
versus its long-term effects.
10. In general terms, state how shifts in aggregate demand or supply can cause booms
and recessions.

1.1 Introduction
Describing the regular patterns that economies experience as they fluctuate over time is
easy. Explaining what causes these fluctuations is more difficult. Indeed, compared with
the topics you have studied up to now, the theory of economic fluctuations remains
controversial. This and the next two blocks develop a model that most economists use to
explain short-run fluctuations in economic activity.
Most business decisions are short-run determinations and most are made under conditions
of uncertainty. These uncertainties typically reflect short-term fluctuations in economic
demand in response to the impact of the business cycle. These fluctuations, in turn,
represent the reaction of the most basic economic decision makers—households and
businesses—to the economic conditions that prevail at a particular time.
This unit describes changes in economic forces that result in fluctuations in economic and
business activities, in both the short and long run. You realize already that it is not
possible for managers to anticipate the exact behaviour of the economy all the time, nor
do most managers need to track fluctuations scientifically. Specialists can do this.
However, a competent manager should not only be aware of the effects of the short-term

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economic fluctuations on her business but also be sensitive to current economic
conditions.
For example, suppose a manager, say of a chain of upscale department stores, is to order
its line of summer designer several months ahead of time. Since the demand for the
dresses will be affected by the economic conditions prevalent at that future time, it is
necessary for the manager to foresee those economic conditions. Naturally, the manager
should combine the forecasted future conditions with the present economic conditions.
Two points emerge. (1) The manager needs to be proactive. (2) The future is uncertain
and forecasts are not always accurate. Should the manager expect a buoyant economy and
instead it weakens, the stores will be stuck with expensive dresses they cannot sell. On
the contrary, if she looks for a lacklustre economy and, in fact, it grows strongly, the
stores will miss out on sales that could have been made. Thus, misjudging the economy's
strength can prove to be a costly error. However, while managers are not to be blamed for
economic misforecasts—which are normally done by a third party, to avoid unpredictable
consequences—they should take measures to avoid all-or-nothing strategies.
From a policy point of view, economic forces that affect the demand and supply of goods
and services as well as labour also affect the demand and supply of credit. Such changes
in turn will set influence the central bank’s monetary policy as central bankers respond to
those situations. Again, while firms and households cannot prevent certain policy
measures from being taken by authorities, they should be prepared to revise their
decisions accordingly.

Learning Tip
Firms and households make their decisions based on certain criteria that
we discussed in earlier chapters. The determinants of the outcome of these
decisions are referred to as variables or factors. Broadly speaking, these
variables can be categorized into two groups:
o strategic variables or factors that can be manipulated by the decision-
making unit to enhance the benefits and increase the gains;
o uncontrollable variables or factors.
Government policy and industrial strategies are among the key variables
that are beyond the control of the decision-making unit. (Such variables
are usually termed ‘exogenous.’) Needless to say, government policies are
not always based on normative criteria. Such criteria represent the
expectation that government actions be concerned with efficiency and
market failure, macroeconomic stabilization, and fairness and equity.
Instead, government strategies may be influenced by factors such as
special interest groups (lobbying) and direct self-interest.

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2 Aggregate Demand and Its Components
What does determine the connections among price, GDP, and levels of spending and real
output in an economy? As in the case of individual markets, the explanation can be given
in terms of demand and supply. First, we will look at how the concept of demand can be
applied to the economy as a whole to see the relationship between the general price level
and total spending in the economy, which is known as aggregate demand (AD).
Recall that total spending on an economy's goods and services is the sum of four
components: consumption, investment, government purchases, and net exports. The
primary groups responsible for this spending are households, businesses, governments
and foreigners. Total spending in an economy, adjusted for changes in the general price
level, is referred to as real expenditures and is calculated with the use of the GDP price
deflator.

2.1 The Aggregate Demand Curve

Aggregate demand can be expressed in a table known as the aggregate demand schedule
or on a graph known as the aggregate demand curve (AD). Figure 7-1 and Table 7-1
show an aggregate demand schedule and an aggregate demand curve.
Table 7-1
Real GDP Demanded Price Level
(Billions of dollars)

520 100
440 110
360 120
280 130
200 140
120 150
40 160

As indicated in Table 7-1, output demanded and the price level are inversely related.
Recall that price and quantity demanded of a single product almost always have an
inverse relationship: as price rises, quantity demanded decreases, and vice versa. The
same can be said for the general price level and real aggregate expenditures, although for
different reasons. Whereas quantity demanded of a certain product can be explained by
the price of that product, the story is different for the aggregate output. As the general
level of prices increases, less real output is bought for three reasons:
1. The real value of financial assets, such as bank accounts and bonds,
decreases—the wealth effect. As a result, households feel less wealthy so they
reduce their consumption spending.
2. Net export spending decreases as foreigners spend less on domestic exports —
real exchange rate effect.

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 3. To these reasons, one can add the less intuitively obvious channel of interest
rates. A rise in the price level tends to lower the rate of interest that in turn
tends to encourage investment spending —interest rate effect.

Just as with a demand curve for a single product, the price variable is placed on the
vertical axis of the graph, and the output variable is placed on the horizontal axis.
Figure 7-1

Price
(GDP
Deflator)

AD

Y(GDP)

As discussed in Unit 1, this relationship can be represented by a key equation as follows:

Y (GDP) = C + I + G + (X - M)— (1)

This relationship represents aggregate demand: the sum of personal consumption

expenditures, C, residential investment plus businesses (nonresidential) investment, I,
government expenditures, G, and net foreign expenditures or net exports, (X –M), which
is exports minus imports, on the goods and services produced in the economy.

Consumption consists of purchases of non-durable goods such as food and fuel; consumer
durable goods, such as cars; and services, such as travel and banking.
Investment consists of additions to capital stock or real capital formation—not to be
confused with financial investment. There are three elements contained in investment: (a)
machinery and equipment investment, (b) residential and office investment, and (c)
additions to inventories.
Government spending consists of current spending (on goods and services) such as health
and education. Note that part of government spending belongs to consumption and part to
the investment category. For example, government spending on infrastructure such as
roads belongs in the investment category, whereas spending on services, such as civil
servants’ salaries, belongs in the consumption category. However, spending on education
and research and development, which are to be regarded as investment, are curiously
treated as current (consumption) spending.

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Exports comprise spending by foreigners on domestically produced goods and services
and are therefore added to aggregate demand (included in GDP). Imports are, of course,
opposite: domestic spending on foreign-produced goods and services. They are therefore
subtracted (excluded) from aggregate demand.

2.2 Changes in Aggregate Demand

There are other factors besides the price level that can influence total spending. However,
these factors—called aggregate demand factors—change total spending at all price
levels. In other words, they shift the aggregate demand curve. Recall that spending has
four components: consumption, investment, government purchases, and net exports.
When factors other than price level affect any of these components, they, in turn, affect
the entire real expenditures (demand) schedule and hence cause the aggregate demand
curve to shift.
Suppose, for example, that due to an increase in government purchases, the aggregate
demand curve shifts to the right , as shown in Figure 7-2, from AD1 to AD2. This change
is known as an increase in aggregate demand. Similarly, a decrease in another component
of real expenditures, such as exports, causes a decrease in total expenditures. This
decrease in aggregate demand is represented by a shift in the aggregate demand curve to
the left, AD3. Aggregate demand factors can be categorized by the spending component
they immediately affect. As we consider each in turn, we must assume that all other
aggregate demand factors and the price level remain constant.
Figure 7-2

Price
(GDP
deflator)

AD2
D3 AD1

Y (GDP)

3 Consumption and Its Determinants

Personal consumption expenditures, or simply consumption, is the component of
aggregate demand that represents spending by households on goods and services.
Consumption spending constitutes the largest component of economic activity,
accounting for a bit more than two-thirds of GDP.

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A key notion in all of macroeconomics views consumption as the core of aggregate
demand. The other components, in one sense or another, facilitate consumption. Business
investment spending ultimately provides the capacity to produce consumer goods.
Exports are produced to exchange for imported consumer goods. (Although this may not
be the intention of the exporters, it is still true in the end). It can even be argued that
government spending ensures an environment within which “the pursuit of happiness"
can take place.
One of the most basic relationships in economics is that between income and consumer
spending. In The General Theory of Employment, Interest, and Money, the basis for
modern macroeconomics, John Maynard Keynes noted:

1. Consumer spending tends to increase as income increases.

2. The increases in spending are less than the full increase in income (some of
the increased income is saved).
These two aspects of the aggregate income-spending relationship are presented in
Equation (2) and Figures 7-3. Figure 7-3 contrasts real personal consumption
expenditures (C) with real disposable income (income after taxes). Real disposable
income (YD) equals real GDP (Y) minus taxes (T).

C = a + b (Y-T) (2)

Since figures for 1960 became available, data inspection confirms the following
relationship for a country such as Canada:

C = 0.54 + 0.85 YD (3)

Figure 7-3
C

Consumption
Spending b = slope =0.85

a = 0.54

Disposable income (Y-T)

This result indicates that for every $1 increase in after-tax income, individuals spend 85
cents (saving the remaining 15 cents). One can confidently state that equation (2) is a
quite accurate description of the real world’s consumption-income relationship. A

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comparison between the generic equation (2) and the estimated equation (3) suggests that
a = .54, the vertical intercept, and b, the slope of the function, equals 0.85.
Personal consumption and saving are two uses of disposable income. Thus, consumer
spending is decided when households determine how much to spend or save. The
constant term, 0.54, is unimportant. It does, however, highlight the fact that changes in
factors other than disposable income, discussed below, affect the position of the curve,
whereas changes arising from GDP (Y) and hence YD disposable income cause
movement along the curve. Conventionally, b is referred to as marginal propensity to
consume (MPC), which is defined as the change in C brought about by a given change in
YD. In our example, one dollar increase in disposable income results in $0.85 increase in
C and, therefore, MPC = 0.85.

Learning Tip
This is a useful fact for managers to know. The precise relationship is less
important than the general fact that as GDP and after-tax income increase,
consumer spending will increase as well. Since knowledge that the
economy is growing is a basis for expecting increases in consumer
spending, managers must have a sense of the pace and direction of overall
economic activity to determine the prospects for designer dresses. It is not
difficult for managers to estimate these kinds of relationships with
spreadsheet packages through which they can estimate a direct
relationship between sales of their products and GDP. For our designer
dress supplier above, as an example, the implications of this relationship,
equation (3), can be summed up in terms of two fundamental points:
A. Since dresses are non-durable goods—they have a useful life of less
than 3 years—the demand for dresses is closely linked to the rate of
growth in overall GDP
B. As discussed in Block 5, because these are relatively high-priced
items, they are likely to be more responsive to the rate of GDP growth
than purely necessary goods.

3.1 Practice
Assuming that taxes (T) are 25% of national income, (T = 0.25Y), and MPC is 0.85,
calculate the increase in T, C and S (saving) if Y increases by one dollar.
Answer: For every $1 increase in Y (GDP), there is an increase of 75 cents in real
disposable income—25 cents taken away as taxes. Of 75 cents, 85% goes
to consumption (MPC = 0.85), which is about 63.7 cents (0.85 x 75 cents)
and the remaining, 25%, goes to personal saving, which is 21.3 cents (.25
x 75).

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3.2 Disposable Income
The most significant determinant of consumer spending is the level of disposable income
(YD). The economy’s total disposable income may change as a result of changes in
population or changes in disposable income per household. Higher income taxes, for
example, decrease household disposable income and hence consumer spending. As a
result, aggregate expenditures drop, shifting the aggregate demand curve to the left.

Learning Tip

Note that the consumption function has a counterpart, known as the saving
function, which also depends on disposable income. In fact, as indicated
before, disposable income comprises consumption spending and saving.
To put this differently, what consumers do not consume out of their
disposable income they save. A rise (fall) in disposable income causes
both consumption spending and saving to rise (fall). The extent to which
they change, however, depends on the marginal propensity to consume
and its counterpart, marginal propensity to save (MPS), which can be
defined in exactly the same fashion as MPC. For example, if MPC is 0.75,
then MPS must be 0.25.

3.3 Wealth
Wealth and income are quite different. Whereas income consists of earnings received
over time, wealth is made of financial and real assets. Real assets (such as houses and
appliances) and financial assets (such as stocks and bonds) are measured at a particular
moment in time. We have already considered the wealth effect—the effect of the price
level on the real value of wealth, which then influences consumer spending. Factors other
than price level can also affect wealth and, in turn, consumer spending. For example, if
stock prices jump, households owning stocks enjoy increased wealth. As a result, these
households will probably spend more of their disposable income. Aggregate demand will
increase, and the aggregate demand curve will shift to the right. Conversely, an increase
in consumer debt means that households lose wealth. Households reduce the spending as
a result—aggregate demand decreases.

3.4 Consumer Expectations

Consumer expectations influence the demand for a single product. Similarly, these
expectations can affect aggregate demand by changing general consumption patterns.
If consumers expect prices to rise—for example, because of a natural disaster, or a war—
they will spend more now and save less. As a result of this higher consumer spending,
aggregate demand increases, and the aggregate demand curve shifts to the right. In the
same way, if consumers expect their incomes to rise soon, they again spend more and
save less. Aggregate demand increases.

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3.5 Interest Rates
Because households often borrow to purchase durable goods such as cars and furniture,
changes in real interest rates can affect their purchasing decisions. If the real interest rate
falls, consumers are more likely to borrow in order to buy big-ticket items. Consumer
spending rises, and the aggregate demand curve shifts to the right. Conversely, a jump in
the real interest rate has the opposite effect: because consumer spending falls, aggregate
demand decreases, and the aggregate demand curve shifts to the left.
In summary, changes in wealth (not triggered by price changes), in expectations, and in
interest rates cause a shift in the AD curve whereas changes in price cause a movement
along the curve.

Learning Tip

Whereas changes in disposable income and wealth affect consumption and

saving in the same direction—i.e., S and C rise together and fall together
with changes in disposable income and wealth—changes in the rate of
interest and expectations affect them in opposite directions. For example,
an increase in the rate of interest lowers consumption spending while it
raises saving. Furthermore, changes in expectations that may be
encouraging for consumption will be discouraging for saving.

4 Investment and Its Determinants

As discussed earlier, investment within GDP comprises three major components:
residential construction, nonresidential fixed investment, and change in business
inventories. These are widely varied in terms of the decision makers, the types of
spending, and the influences that affect the decision-making process. Moreover, evidence
suggests that these spending components are highly cyclical: i.e., vary with business
cycles. In fact, they represent the most cyclically sensitive components of aggregate
demand.
Nonresidential fixed investment is the most conventional form of investment spending. It
is about business managers making decisions to spend to increase a firm's capacity for
producing other goods, or to cut back spending in order to contract capacity. Although
residential construction is consumer spending, a house is different from other types of
consumer spending in that it is such a major expenditure and such a long-lived asset that
it is considered investment in capital rather than merely a purchase to be consumed in the
near term. The change in business inventories is a necessary expenditure to carry on
business. Business managers increase or decrease their holdings of inventories in
anticipation of an economic expansion or contraction, respectively.

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4.1 Nonresidential Fixed Investment
Investment represents spending on projects where earning a profit is anticipated. The
investment component of aggregate demand is limited to planned investment, which
excludes unintended changes in inventories.
As already suggested, nonresidential fixed investment conforms to the commonly held
notion of investment. It consists of spending for structures (plants, office buildings, and
commercial buildings) and for equipment: industrial machinery, office machinery (from
computers to desks to pencil sharpeners), transportation equipment (cars, trucks, ships,
and aircraft), and tools. These items represent the capital goods used to produce goods.
Capital goods are factors of production that are purchased with a large outlay up front but
that yield a stream of income over an extended period.
The usual textbook discussion of investment refers to an inverse relationship between
investment and interest rates. The typical argument holds that interest rates represent the
opportunity cost (foregone rate of return) of tying down money in a specific investment
project. The higher interest rates are, the higher the foregone alternative (opportunity
costs) and the lower the desire to invest in that project.
Alternatively, the impact of interest rates on investments is viewed from the perspective
of costs of borrowing. Clearly, rising borrowing costs tend to discourage investment
activity. However, the relationship between investment and interest rates is far more
complex. It is not the level of interest rates alone that determines investment but rather
the level of interest rates relative to the rate of expected return on investment, with the
interest rate being viewed as a benchmark. This gives substance to an important
behavioral characteristic: businesses invest in increased plant and equipment only if they
can envision increased profits as a result. Investments are not made simply because
interest rates are low.

Learning Tip

Note that investment movements themselves are driven by two sets of

factors. On the one hand, they are inversely related to interest rates—for a
given level of expected profit. A rise in real interest rates, all else being
constant, causes a decrease in aggregate demand, and a fall in real interest
rates causes an increase in aggregate demand. On the other hand, for given
interest rates, movements of investment are positively related to expected
profits (business expectations).

4.2 Residential Construction

Many factors influence investment in residential construction. Intuitively, you would put
interest rates high on the list and you would be right. Other important influences are
income prospects and employment conditions. Clearly, favourable to the housing markets

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are market conditions that are characterized by low and falling interest rates as well as a
business cycle that is in an upswing. The higher the interest rate is, the greater the cost of
carrying a mortgage. A $100,000 mortgage costs $8,000 per year if the interest rate is 8
per cent but $10,000 per year if the interest rate is 10 per cent. As the interest rate rises,
the cost of owning a home rises and the demand for new homes falls. An improvement in
the general health status of the economy causes the demand for housing to rise.

Learning Tip

Evidence shows that residential construction is the most cyclically

sensitive of the investment components. Moreover, residential
construction often reaches a peak before the peak for the overall economy
and reaches a trough before the overall business cycle hits bottom. As
such, trends in residential construction provide useful signals to business
managers even though the activity may seem remote from their day-to-day
businesses. Signs that residential construction has reached a peak can be
regarded as an indicator of an approaching peak in overall economic
activity—a leading indicator. (Residential construction can also be a
useful indicator of an approaching upturn in recession, because it begins to
recover before the overall economy.)

4.3 Change in Business Inventories

Business investment is not restricted to spending on fixed capital-structures and
equipment but also includes stocks of raw materials, goods still in production, and
finished goods ready for sale. These inventories are held by manufacturers, wholesalers,
retailers, and farmers and represent the wherewithal businesses they need to carry out
their business every bit as much as bricks, mortar, and tools.
Inventory management is a vital concern to business managers who determine the inflow
to inventories. Because the inventories have to be paid for and financed until they can be
sold, their buying has a profound effect on the company’s costs.
Part of these costs is the carrying cost of inventories that is influenced by the level of
interest rates. If interest rates are high and expected to rise, the cost of carrying
inventories—given the level of sales—tends to rise and the firm will want to reduce its
inventory level. Managers must also pay attention to current sales trends in coordinating
their buying (ordering) of products for future sale. Investment in inventories is related to
the retailers' sales expectation, which in turn are related to present sales trends. If sales
have been strong, then sales in the near future probably will continue strong, so
inventories will be increased. If sales have been faltering, a firm will probably wish to
curtail future orders, relying on existing inventories to meet future sales.
Therefore, the behaviour of investment in inventories can be summarized as follows: it
rises as the expected sales increase but falls as interest rates increase.

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Learning Tip

The change in business inventories is a crucial indicator for many business

managers across a wide range of business types. The crucial role of past
sales to the decision of how much to invest in inventories is a key reason
for the volatile pattern observed by empirical evidence. Businesses can be
caught off-guard by sudden changes in demand. Consequently, inventories
may continue to rise even after sales have turned down, and vice versa,
because of insufficient information about the state of sales on the part of
business decision makers.
Recent developments in management technology have given rise to a more a more
cautious inventory policy called just in time. This approach aims at minimizing the stocks
of raw materials and finished goods that businesses maintain. If sales pick up, the
business increases its orders, transferring the burden to suppliers, who must fill the
orders. The result is that the primary business shares its sensitivity to near-term demand
with its suppliers.

Learning Tip

Note that interest rates should (and do) serve as a benchmark for
comparing the rate of return on the investment. If the expected returns
from an investment (in increased capacity), as a percentage of its cost,
exceeds the interest rate that could be earned on the same money if
invested in interest-bearing securities, then the firm will choose
investment in productive capital. Furthermore, the rate of return will most
probably rise when profits are on an upward trend, and this is as likely in a
period of rising as falling interest rates. The reason is that business cycle
upswings are often periods of strong credit demands and rising interest
rates. Thus, it is entirely consistent that nonresidential fixed investment
shows a direct relationship to interest rates.

This discussion can be summarized with an equation relating investment I, sum of all of
its components, to the real interest rate r:

I = 1(r). (4)
Figure 7-4 shows this investment function. It slopes downward, because as the interest
rate rises, the quantity of investment demanded falls.

C5, Economic Environment of Business,Block 7 page 16 of 45

Figure 7-4

Real interest
Rate (r)

Investment (I)

When studying the role of interest rates in the economy, economists distinguish between
the nominal interest rate and the real interest rate. This distinction is relevant when the
overall level of prices is changing. The nominal (or market) interest rate is the interest
rate that is usually reported in the financial press: it is the rate of interest the investors pay
to borrow money. The real interest rate is the nominal interest rate corrected for the
effects of inflation. A full discussion of the relationship between the real and nominal
interest rates is postponed until Block 8. At this stage, suffice it to know that investors'
decision to invest or not, and how much, is sensitive to the inflation-adjusted (real rate)
cost of borrowing.

Learning Tip

Be careful when referring to investment. From this point on, investment

will refer to the sum of residential and nonresidential investment, etc.
Investment does not refer to the purchase of sticks or bonds or to the
money placed in a bank account.

4.3.3 Investment demand curve

A drop in interest rates increases investment and hence aggregate demand, giving rise to
a shift in the aggregate demand curve to the right, whereas an increase in interest rates
does the opposite. A change in business expectations, optimistic or pessimistic, can affect
the position of the investment demand curve. If businesses anticipate that profits will
increase, the investment demand curve shifts to the right, thereby causing an increase in
aggregate demand. Conversely, if businesses anticipate that profits will drop, the
investment demand curve shifts to the left, leading to a decrease in aggregate demand.

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5 Government Purchases
Government purchases are the third component of the demand for goods and services.
The government buys helicopters, computers, and the services of government employees.
It buys library books, builds schools and hospitals, and hires teachers and doctors.
These purchases are only one type of government spending. The other type is transfer
payments to households, such as welfare for the poor and the government pension
payments for the elderly. Unlike government purchases, transfer payments are not made
in exchange for some of the economy's output of goods and services. Therefore, they are
not included in the variable G. Transfer payments, however, do affect the demand for
goods and services indirectly. Transfer payments are the opposite of taxes: they increase
households' disposable income, just as taxes reduce disposable income. Thus, an increase
in transfer payments financed by an increase in taxes leaves disposable income
unchanged. We can now revise our definition of T to equal taxes minus transfer
payments. Disposable income, Y - T, includes both the negative impact taxes and the
positive impact of transfer payments.
A rise in such government purchases as highway construction, for example, causes an
increase in aggregate demand while a fall in government purchases causes a decrease in
aggregate demand.

6 Net Exports
As seen earlier, net exports can vary with changes in the price level. For example, a drop
in the Canadian price level increases net exports because Canadian exports are made
cheaper in the rest of the world and imports are made more expensive in Canada. As a
result of this foreign trade effect, a change in the price level influences total spending as a
movement of the aggregate demand curve.
Other factors such as changes in incomes in foreign countries, currency movements (the
rate of exchange), and changes in trade instruments (e.g., tariffs) cause an overall change
in net exports. Then aggregate demand changes at all prices: again there is a shift in the
aggregate demand curve.

6.1 Foreign Income

Consider two countries, Canada and the US. Suppose Canada is home country and the US
the foreign country. Suppose income rises in the US. Americans will be able to buy more
products as a result: not only US-made products but also those made in Canada. As a
result, Canada’s (net) exports to the US will rise, thereby increasing Canada's aggregate
demand. Conversely, a fall in the US income will reduce Canadian net exports, thereby
decreasing Canada’s aggregate demand.

C5, Economic Environment of Business,Block 7 page 18 of 45

6.2 Exchange Rates
An exchange rate is the value of one nation’s currency in terms of another currency. The
value of the Canadian dollar, for example, can be expressed in any other currency but is
usually compared with American dollars. Therefore, the exchange rate can show how
many American cents are needed to buy one Canadian dollar. A rise in the value of the
Canadian dollar—for example, from 65 to 70 cents—means more American currency is
needed to purchase Canadian funds. In this example, Canada's currency becomes more
expensive for Americans to purchase. At the same time, American currency becomes
cheaper for Canadians to purchase, since more of it—70 cents as opposed to 65 cents—is
given in exchange for one Canadian dollar.
If the Canadian dollar goes up in value this way, exports from Canada become more
expensive for Americans. Therefore, a product priced at CAN$1 in Canada costs not 65
cents in American funds but 70 cents. At the same time, American products imported into
Canada fall in price when expressed in Canadian currency. One Canadian dollar now
buys American products with an American price of 70 cents, whereas earlier the same
dollar could buy American products with an American price of only 65 cents.
Because of the impact of exchange rates on prices, net Canadian exports fall when the
Canadian dollar goes up in value, causing aggregate demand to decrease. A drop in the
value of the Canadian dollar has the opposite effect: net exports rise, thereby increasing
aggregate demand.

6.3 Trade Policies

Most industrial nations trade in environments characterized by trade restrictions such as
tariffs and quotas and other administrative restrictions. In this setting, net exports and
therefore aggregate demand will be affected by trade liberalization initiatives, whether on
bilateral bases between two countries, multilateral bases within a regional trade
agreement, or on a broader basis, such as the World Trade Organization (WTO). For
example, a reduction in general level of tariffs causes the aggregate demand curve to shift
to the right, whereas instituting new barriers does the opposite.

Learning Tip

Note that net exports are also influenced not only by domestic foreign
income but also by domestic income. For instance, in the example given
above, if income rises in Canada, Canadians are likely to spend more and
hence buy more of Canadian-made as well US-made products. The latter
will represent an increase in imports and therefore a fall in net exports.
The difference between a change in the two incomes, domestic and
foreign, is that while both cause a change in aggregate demand, the former
results in a movement along the aggregate demand curve whereas the
latter shifts that curve.

C5, Economic Environment of Business,Block 7 page 19 of 45

Though aggregate demand comprises consumption, investment, government spending
and net exports (exports less imports), keeping matters simple at this stage means you
must assume a closed economy: i.e., one that conducts no foreign trade. Despite the
importance of world trade, the closed economy assumption is not unrealistic. It
approximates the position of the larger industrial countries or blocs such as Japan, the US
and the EU, because the larger the economic entity, the lower the ratio of trade to GDP. A
full discussion of the economy in a global context is done in Block 10.

7 Money and Aggregate Demand

We shall now turn our attention to the role of money and how it affects aggregate demand
and the price level. As you recall, aggregate demand traces the relationship between
output demanded and the price. The importance of the role of money in this discussion
arises from (a) the fact that virtually all economic transactions in an industrial economy
involve the use of money and (b) an important link between money and interest rates is
imbedded in the aggregate demand relationship and feeds into the link between interest
rates and investment. A full grasp of this link is a prerequisite to understanding of the
demand side of the economy and therefore how the economy’s general equilibrium is
attained.

7.1 Money, Interest Rates, and the Price Level

Suppose we define money as the stock of notes and coins held by the public, plus
deposits in commercial banks. If people do not have enough money, they cut back
spending in an attempt to add to their money balances. If they feel they have too much
money, they go out and spend it on goods, or equities or bonds, etc., in an effort to reduce
their money stock. This link between desired money balances and aggregate spending is a
major focus of attention in this analysis. Furthermore, when central banks inject more
money into circulation, as defined below, banks can lend more easily since the supply of
credit from which loans are extended has increased. This has an easing impact on lending
rates also: the cost of borrowing falls. Therefore, an increase in supply of money into the
economy by lowering the borrowing rates tends to stimulate spending and hence to
increase aggregate demand. The latter, in normal circumstances, in turn, will increase
production. It also puts pressure on prices.
A full discussion of the role of money and monetary policy and the aggregate demand
curve is delayed until Block 9, where we will examine how the tools of monetary policy
can shift aggregate demand and whether policy makers should use these tools for that
purpose. At this point, however, you should have some idea about why the aggregate
demand curve slopes downward and what kinds of events and policies can shift this
curve. This block will also briefly discuss how financial markets function and how
demand and supply of money (financial assets) interact to bring about equilibrium in that
market.

C5, Economic Environment of Business,Block 7 page 20 of 45

7.2 The Money Market
7.2.1 The Demand for Money
Consider now what determines the amount of money people want to hold. If, for some
reason, people were to feel that they had too much money and if they decided to spend
part of their money stock on other financial assets such as bonds and equities or goods
and services, this would have a dramatic impact on the level of aggregate demand. Note
that money is conventionally and strictly defined as the sum of cash, or more
appropriately currency (bills and coins of the central bank) as well as banks deposits.
Individuals typically hold a combination of various forms of financial assets. We can call
this a portfolio of assets. In their portfolio, they hold certain amount of currency on hand,
a balance on deposit in the bank, and other forms of assets. The decision to hold this
amount of currency (money) is influenced by availability of money substitutes such as
credit cards and automatic bank tellers. The impact of these on the amount of cash people
demand are mostly noticed during the transitional period within which the public is in the
process of utilizing these new facilities and adapting to the new environment. Once the
period of transition has passed, no further noticeable change should be observed.
People hold money because of a variety of reasons that we will discuss in the following
blocks. At this stage, however, a unique and indisputable reason is that, unlike other
assets such as bonds and stocks, money can be used to buy the goods and services on a
shopping list. How much money people choose to hold for this purpose, given the
availability of credit cards and other similar facilities, depends on the level of their
average income, the price of those products, and the interest rate.
1. Income. The richer you are, the more money you are likely to hold in absolute
terms, even though the proportion of your total assets held as money may fall.
Individuals hold currency to finance daily transactions. They use bank
accounts to cover such items as monthly credit card charges,
telecommunications bills, and other bills which fall due for payment on a
regular basis. Companies require money for much the same reasons.
2. The price level. The higher prices are, the more money the typical transaction
requires and the more money people will choose to hold in their wallets and
chequing account. When prices fall, people reduce their demand for money by
embarking on a shopping spree or allocating a bigger share of their portfolio
to financial assets. Note the close link between the price level and aggregate
demand implicit in this explanation.
3. The interest rate. No interest is on paid on currency, and deposits often
receive only a token rate of return. Higher interest rates, therefore, increase
the opportunity cost of holding money and reduce the demand for it.

C5, Economic Environment of Business,Block 7 page 21 of 45

Learning Tip
For a given money stock (or money supply), the higher the price level is,
the lower the volume of spending and the lower the level of aggregate
demand. And, the lower the price level is, the higher the volume of
spending and the higher the level of aggregate demand. The AD curve is
downward sloping.

7.2.2 The Supply of Money

Money supply is defined as the sum of currency in circulation plus public deposits with
financial institutions. This definition, however, changes depending on the type of deposits
included in it. Therefore, there are several types of money supply that central banks
monitor. Some serve specific purpose and include only a limited number of deposits
while other definitions of money consist of a wider spectrum of deposits, including
saving deposits, term deposits, money market mutual funds, and foreign-currency-
denominated deposits A full discussion of this subject appears in Block 9.

Learning Tip
Definitions differ between countries, but you needn’t grapple with these
fine distinctions. Suffice it to say that the boundary line between money
and non-money assets (less liquid assets) is arbitrary.

Figure 7-5 shows the elements of the money market. The nominal interest rate (i) is
measured on the vertical axis and the quantity of money on the horizontal axis. The
demand for money is represented by a downward sloping curve, Md. The logic behind
this is that higher interest rates increase the opportunity cost of holding money and
therefore decrease the quantity of money demanded. This curve is also referred to as the
liquidity preference curve.
Supply of money, as discussed above, is assumed to be determined by the central bank.
Regarded as an exogenous variable—a factor whose value is determined outside the
systemmoney supply (stock) is represented by a vertical line in this space, Ms. The
logic behind this is that the quantity of money in circulation is independent of the rate of
interest. Equilibrium in the money market is achieved when Md = Ms, point E1.

C5, Economic Environment of Business,Block 7 page 22 of 45

Figure 7-5

Interest
Rate (i)

i2 A B

i1
E1

M1
Quantity of money
Other variables, such as inflationary expectations and credit card technology, also affect
the demand for money, but we will ignore them for now in order to avoid unnecessary
complications.
According to this mechanism, the interest rate adjusts to the level that at which the
demand for money is equal to the supply. To understand better how this mechanism
works, assume that initially the interest rate is at a different level—say, i2. This figure
shows that at i2, the demand for money is equal to i2 A. The money supply is equal to i2 B.
Therefore, money supply is greater than money demandexcess supply of money. This
is the case because at this higher interest rate, the opportunity cost of holding money is so
high that the central bank makes more money available than the amount individuals wish
to keep in circulation, Ms. Therefore, the interest rate must fall to balance demand and
supply. Conversely, if the interest rate is below the equilibrium level, people will want to
hold more money than the quantity available, and the interest rate must rise to balance
demand and supply.

Learning Tip

Note that the interest rate relevant to the money and other financial
markets is the nominal rate, not the real. The measure of the opportunity
cost of holding cash is the nominal rate that incorporates not only the real
rate of interest rate but also the inflation factor. This opportunity cost
calculation contrasts with that of the goods market in which the real, not
the nominal interest rate, is the basis for investment decisions.

C5, Economic Environment of Business,Block 7 page 23 of 45

The following tables, 7-2 and 7-3, summarize the points made on this topic so far.

Table 7-2 Factors Causing the Aggregate Demand Curve to Slope Downward:
1 The Wealth Effect: A lower price level increases real wealth, which
encourages spending on consumption.
2 The Interest Rate Effect: A lower price level reduces the interest rate by
increasing the real value (purchasing power) of money
in the hands of the public that, in turn, encourages
spending on investment.
3 The Real Exchange-Rate A lower price level causes the real exchange rate to
Effect: depreciate, which encourages spending on net exports.

Table 7-3 Factor Causing A Shift In The Aggregate Demand Curve:

Shift to the right  Shift to the left Á
1 Shifts A change in consumption due to an An event that makes
Arising from increase in wealth unrelated to a consumers spend less, e.g.:
Consumption change in the price level, e.g.: Á a tax hike
 a stock market boom Á a stock market decline.
 a tax cut
2 Shifts Events that make firms invest more Events that make firms invest
Arising from at a given price level, e.g.: less at a given price
Investment Âa fall in interest rates due to rising
levelsuch as:
money supply Á a rise in interest rates due
Âan increase in optimism about to a decrease in money supply
future expected profits Áan increase in pessimism
about future expected profits
3 Shifts An increase in government purchases A decrease in government
Arising from of goods and services, such as: purchases on goods and
Government Âgreater spending on health and services, for example
Purchases education Á a cutback in the allocated
 highway construction. budget
4 Shifts An increase in net exports due to: Á An event that reduces
Arising from Âa boom experienced by a major spending on net exports at a
Net Exports trading partner given price level.
 an exchange-rate depreciation,
 a change in trade policy
characterized by, for instance,
reduced tariff barriers.

C5, Economic Environment of Business,Block 7 page 24 of 45

7.3 Practice
1. Which of the following events would shift the aggregate demand curve to the left?

C. A decrease in tax rates

D. An increase in government spending
E. An exchange rate appreciation
F. A fall in the price level.
Answer: C. A and B cause a rightward shift, whereas D causes a movement along
the curve. An exchange rate appreciation makes domestic exports more
expensive and hence reduces aggregate demand.

8 Output, Aggregate Supply and Its

Components
Gross domestic product measures aggregate economic activity as both expenditure and as
output. The previous section viewed the expenditure approach as aggregate demand.
Outputthe other side—represents the production of the goods and services that are
demanded. Now let us turn our attention to the role of production.

8.1 The Aggregate Supply Curve

In this section, we look at the elements that make up supply. The supply side of the
economy (production) consists of two elements:
1. inputs markets, consisting of labour, capital, and raw materials
2. production function, a technological relationship that relates inputs to output
while the manner in which they are combined is the technology.
At the microeconomic level, this is a vital managerial concern discussed in Block 5. From
a macroeconomic perspective, however, the availability and growth of the factors of
production determine the potential for growth by the overall economy.
The aggregate supply curve shows combinations of real output (Y) and the price level (P)
which are consistent with equilibrium in the production side of the economy. Figure 7-6
shows different aggregate supply curves. The price on the vertical axis of the aggregate
supply curve is the general price level. This contrasts with the industry supply curves in
Block 3, where price of the industry's output is on the vertical axis. The industry supply
effect arises because the price of the industry's output is defined relative to prices in other
sectors. All other prices are assumed to remain constant. In the case of the aggregate
supply curve, the general price level is defined relative to prices of productive factors
such as labour.

C5, Economic Environment of Business,Block 7 page 25 of 45

Your intuition may tell you that the price level and real output should be directly related,
giving the aggregate supply curve a positive slope. i.e., at higher price levels in the
economy, businesses are encouraged to produce more, whereas at lower prices businesses
may not be able to make a profit or break even in the short run, so they reduce output.
Indeed, this is typically the situation, in the short run. A rise in the general price level
relative to nominal wages has a positive effect on aggregate supply and the aggregate
supply curve will be positively sloping.
Contrarily if one believes that the price of labour (and other productive factors) is linked
to the general price level—because, say, employees demand higher pay to compensate for
inflation—there can be no relative price effect and the aggregate supply curve will tend to
be vertical. This is regarded as a long-run situation.
In summary, a vertical aggregate supply curve shows that a given level of real output, Yn,
is consistent with many possible price levels. A positively-sloped supply curve shows
that a rise in the price level from, say, P1 to P2, is consistent with a rise in output from Yn
to Y2—the short-run aggregates supply curve is upward sloping. This line of reasoning,
as you’ll see, has important implications for macroeconomic policy.

Figure 7--6
Long-run
Price aggregate supply Short-run
aggregate supply
P2

P1

— Yn — Y2 Y

Learning Tip
An alternative way of explaining the shape of the long-run aggregate
supply curve is by focussing on the factors that are behind the supply side
of the economy. In the long run, an economy’s production of goods and
services depends on its supplies of labour, capital, and natural resources
and the available technology used to turn these factors of production into
goods and services. These are given; the price level is not. As a result, the
long-run aggregate supply curve is vertical at the natural or full-
employment level of output.

C5, Economic Environment of Business,Block 7 page 26 of 45

A key distinction here is between actual GDP (output) and natural or potential GDP
(Yn), where natural GDP represents the output of goods and services that would be pro-
duced if the unemployment rate were at its natural, or normal, rate. The natural level of
output is the level of production toward which the economy gravitates in the long run.

The notion of natural output or full-employment output needs some clarification. The
concept of the normal (natural) unemployment rate does not, however, imply zero
unemployment, nor does ‘natural level of output’ imply the maximum output. If reading a
term that economists have used in the past, that of ‘full-employment unemployment rate,’
you may wonder at economists’ tolerance for apparent nonsense. Today, the term ‘natural
rate of employment’ has replaced this contradiction in terms, paired with ‘natural output’
for productivity. More light will be shed on this issue in Block 9.

8.2 Determination of Natural Level of Output

Figure 7-7
Real Wage Supply of labour
— —
(W/P)

(a) (W1/P1) A

(W1/P2) B Demand for labour

Ln L2 L (employment)
Output (Y)
Y2
Production function
Yn

(b)

Ln L2 L (employment)
Two steps are involved in determining natural level of GDP, Yn: first to determine the
natural level of employment, Ln and second to read off the level of output from the
production function. Natural level of employment is the employment counterpart of
natural output. The natural level of employment is by definition attained when the labour
market clears: i.e., where demand and supply cross each other, Figure 7-7. Also
determined at this intersection point, indicated in Panel (a), is equilibrium real wage.
Second, having determined equilibrium of employment (Ln) and equilibrium real wage,

C5, Economic Environment of Business,Block 7 page 27 of 45

you can read off the level of output from the production function, Panel (b). The
production function—more correctly the short-run production function—indicates the
level of output that can be produced by each level of labour input, assuming it is
combined with a fixed capital stock (K), technology and other factors. Thus, it shows that
an output of Yn can be produced by the input of labour, Ln.
The equilibrium real wage in Figure 7-7 is represented by (W1/P1). Note that the real
wage is the ratio of the market or nominal wage (monthly or weekly pay), W, to the price
level, P, which in this equilibrium are assumed to be W1 and P1, respectively. The real
wage, W/P, is a measure of the purchasing power of workers’ income. The reason behind
having the real wage appear on the vertical axis in the panel (a) is that both workers—
who are behind the supply of labour curve—and firms—which are behind the demand for
labour curve—behave rationally. They calculate, bargain, and decide if and how much to
work on the basis of the real wage, not the nominal money wage. In technical jargon, all
market participants are assumed to be free from money illusion.

Learning Tip
Figure 7-7 can make the role of the money illusion clearer. Starting from the equilibrium
point (represented by point A in Figure 7-7) consider the effect of an increase in the price
level from its initial level, from P1 to P2. Initially, this rise in the price level increases the
demand for labour, represented by a downward movement along the demand for labour
curve. This happens because firms will observe that price of output has increased relative
to nominal pay. Profits will increase and firms will want to hire more labour. However, if
workers were ignorant or unconcerned about the fact that prices had gone up, a new
equilibrium could happen at point B. At B, more labour would be employed (L2) and the
real wage would fall to (W1/P2)- with the denominator risen while the numerator stays the
same.

9 Short-run vs. Long-run Aggregate Supply

Curve
The distinction is often drawn between the long-run aggregate supply curve (LRAS),
which is vertical, and the short-run aggregate supply curve (SRAS), which is upward-
sloping, as in Figure 7-6 above. The proof of this, however, is provided by Figure 7-7.
Accordingly, a rise in prices could lead to higher output if (nominal) wages did not
change, or (put differently) if wages were sticky. As shown in Panel (a), when the price
increases to P2, the amount of labour employed increases to L2. Corresponding to this
rise, as shown in panel (b), is an increase in output to Y2. Therefore, a new equilibrium
point is reached at output Y2 and price P2. The increase in price has brought about an
increase in output. Put differently, a change in price has a real effect on that the quantity
of output produced, in the short run. Tracking the effects of different price levels and
joining the points together produces an upward-sloping SRAS curve.

C5, Economic Environment of Business,Block 7 page 28 of 45

Learning Tip

Note that, in reality, the SRAS curve is not linear (a straight line) but
rather a curvilinear relationship between P and Y which becomes steeper
as full employment is approached (moving from left to right).

The wage stickiness, in the above analysis, might be present because the rise in price was
unanticipated, or because of fixed-term pay deals. Employees might require time to
absorb the implications of the rise in price and may react more slowly than firms do to
the new price level. For these reasons, price changes can have real effects on output and
employment in the short term.
The existence of rigidities and short-term wage stickiness may be intuitively acceptable
as a working assumption of how the labour market operates in the short run. But such
irrational behaviour cannot be sustained indefinitely. Eventually, employees will respond
in a rational manner. That still leaves open the question of how long it will take them to
respond. The length of the short run is not generally agreed upon; it is likely to vary from
country to country, and even from region to region.

9.1 Changes in Aggregate Supply

As discussed above, the short-run aggregate supply curve is an upward-sloping function
of price. However, other factors in addition to the price level can influence real output.
These factors change real output at all price levels. In other words, they shift the
aggregate supply curve. Once again, as we examine each in turn, we must assume other
factors remain constant (ceteris paribus).
9.1.1 Input Prices
Aggregate supply assumes steady input prices for the businesses that are producing the
output. Changes in input prices—an increase in wages, for example, or increased prices
for imported raw materials—give rise to a rise in production costs. These changes can
occur frequently over brief periods of time. When a rise in the price of an input pushes up
production costs, businesses reduce their real output and the short-run aggregate supply
curve shifts to the left. Note, however, that unless input price increases happen to be
long-lasting, no changes will happen to the economy's potential output. That is, the long-
run aggregate supply curve remains unchanged.
Conversely, if the price of an input decreases, production costs fall. Businesses then raise
their real out put, causing the aggregate supply curve to shift to the right.
9.1.2 Resources Supplies
Over the long term, supplies of resources in an economy—especially human and capital
resources—tend to grow. With any such increase, businesses produce more real output at
every price level. In other words, more inputs over the long run increase aggregate supply
as well as the economy's potential output. The reverse is also possible. With a long-run

C5, Economic Environment of Business,Block 7 page 29 of 45

reduction in the amounts of any resource, businesses will produce lower real output at all
prices, thereby causing a long-run decrease in aggregate supply which is accompanied by
a reduction in the economy's potential output. In such cases, both the long-run and the
short-run aggregate supply curve shift.
9.1.3 Technological Knowledge
One of the most important reasons the economy today produces more than it did a
generation ago is that our technological knowledge has advanced. The invention of the
computer and more recently the Internet, for instance, have allowed us to produce more
goods and services from any given amounts of labour, capital, and natural resources. A
technological innovation raises productivity: i.e., the same amount of economic resources
can produce more real output at every price level and hence can shift the long-run
aggregate-supply curve to the right.
9.1.4 Government Policies
Government policies can also influence aggregate supply through their effects on the
business environment in an economy. For example, suppose that taxes rise for businesses
and households. Because the after-tax returns on supplying economic resources are
reduced, businesses and households may reduce the resources they supply at every price
level. As a result, real output falls, causing a long-run decrease in aggregate supply.
Conversely, lower taxes may encourage businesses and households to increase their
supply of economic resources, leading to a rise in real output and a long-run increase in
aggregate supply.
Government regulations, such as environmental and safety standards, typically raise per-
unit costs for some businesses while lowering it for others (especially those that have
been adversely affected by lax regulations). Hence, more regulation causes some
businesses to produce less and, at the same time, other businesses to produce more output
at every price level. Therefore, the effect on aggregate supply is ambiguous. This
continues to be a controversial issue.

Learning Tip
Because production tends to adjust less rapidly than spending, changes in
aggregate supply tend to be slower to occur than changes in aggregate
demand. Input prices, which may change quickly, often take time to affect
real output. Changes in resource supplies and the other long-run
determinants of aggregate supply tend to occur even more gradually.
Though aggregate supply is more stable than aggregate demand over the
short run, the long-run effect of aggregate supply on the economy can be
profound.

C5, Economic Environment of Business,Block 7 page 30 of 45

9.1.5 Factors Causing the Short-Run Aggregate Supply Curve
to Slope Upward
‘Stickiness’: The Sticky Wage and Price Theory
Because nominal wages are slow to adjust (sticky) in the short run, long-term
employment contracts affect changes in product prices experienced by firms; these price
changes do not immediately translate to changes in money wages.

The sticky price theory regards the slow adjustment in prices as the cause of the upward
sloping supply curve, because of the implicit agreement between vendors and their
customers or because of large costs of adjusting the price. For examples, newspapers do
not adjust their prices periodically, despite economic conditions.
Table 7-4 Stickiness Factors Causing the Short-Run Aggregate Supply Curve to Slope Upward
Wage stickiness
Wage impact Cost of hiring Effect on production
When the price . . . then the real wage …pushing costs of …therefore, forcing the firms to
level falls  (W/P) rises, hiring labour to firms hire less labour and produce
higher and, Â less goods and services.
A rise in P has the …so that the real wage …reducing firms’ costs …causing firms to hire more
opposite effect (W/P) falls, of hiring labour and produce more.
and…Â

Price stickiness
Demand impact Revenue impact Effect on production
Change in economic Reduced purchas- Less revenue to firms Reducing sales and
condition other than price ing power  production
Change in economic Increased purchas- More revenue to firms Increasing sales and
condition other than price ing power production

With prices being sticky in the short run, a change in economic condition which reduces
the overall purchasing power of buyers will cause a drop in sales and production, whereas
an opposite situation will have a positive effect on sales and production in the short run.

The Imperfect Information Theory

Both firms and workers may in fact base their decisions on incomplete information or
misperceptions in the short run. Firms may misinterpret market signals. That is, they may
temporarily mistake a general increase or decrease in the overall price (P) for a change in
the price in individual markets (relative to other markets). Workers may also misinterpret
the situation. Since they tend to notice a change in their (nominal) wage before they
notice a change in the price level, they may mistake the former for a change in their real
wage and act accordingly.

C5, Economic Environment of Business,Block 7 page 31 of 45

Table 7-5: Factors Causing a Shift in the Long-Run Aggregate Supply Curve
• Technological changes

• Shifts arising from inputs:

Input Mechanism Shift
Capital Changes in capital stock of the Increased volume of goods and services causes a
economy affect labour rightward shift in the aggregate supply curve;
productivity decreased volume cause a leftward shift.

Natural Changes in supply With a rise (fall) in the supply of natural resources the
Resources aggregate supply curve shifts to the right (left).
Labour Changes in labour force size An increase in the size of the labour force increases
the supply of output of the economy—a rightward
shift in the aggregate supply curve—and vice versa.

9.1.6 Factors Causing a Shift in the Short-run Aggregate Supply Curve

The short-run aggregate supply curve shifts arise from:

• The same factors that caused a shift in the along-run aggregate supply curve. If
the long-run aggregate supply curve shifts to the right (left), the short-run
aggregate supply curve shifts along with it to the right (left).

• Changes in people’s expectations of the price level. The short-run supply of goods
and services also shifts with changes in expectations of the price level, which in
turn depends on perceptions of wages and prices. An increase (decrease) in the
expected price level causes a leftward (rightward) shift in the short-run aggregate
supply curve.

9.2 General Equilibrium

Long-run equilibrium occurs when aggregate demand and supply are put together (Figure
7-8). You then obtain the equilibrium price and income levels in the economy at Yn and
P1, point E1. At that point (E1), national expenditure equals national income and also
equals national output. And this is where AD crosses LRAS. Note however, that the
short-run and long-run equilibrium points coincide with each other. By the time the
economy has reached this long-run equilibrium, there will have been adjustments in
perceptions, wages, and prices so that the short-run aggregate supply curve crosses this
point as well.

C5, Economic Environment of Business,Block 7 page 32 of 45

Figure 7-8

Price level LRAS SRAS

E
P

AD
— — Yn GDP

Learning Tip
Note that the economy is always in a short-run equilibrium situation but
not necessarily in a long-run one. Long run, as defined earlier, is the state
of affairs where all the obstacles and imperfections that may appear in the
short run are overcome. Therefore, our main task is to analyze the
situation within which the economy is operating in relation to the long-run
benchmark. This analysis has serious and important policy implications
that will be explored below.

9.3 Short-Run and Business Cycles

The business cycle occurs because aggregate demand and short-run aggregate supply
fluctuate but the money wage rate does not adjust quickly enough to keep actual GDP at
potential GDP. Figure 7-9 shows two types of short-run macroeconomic equilibrium.

Panel (a) shows an above-full-employment (over-employment) equilibrium situation. This

type of equilibrium is a short-run macroeconomic equilibrium in which actual GDP, Y2,
exceeds potential GDP, Yn. The amount by which actual GDP exceeds potential GDP is
called an inflationary gap, (Y2 — Yn)>0. As the name suggests, this gap is poised to
create inflation. This gap occurs either because the economy has experienced a boom or
because actual GDP, while growing, has grown faster than potential GDP.

Panel (b) shows a below-full-employment (or underemployment) equilibrium situation. A

below-full-employment (underemployment) equilibrium is a short-run macroeconomic
equilibrium in which actual GDP falls short of potential GDP. The gap between actual
GDP and potential GDP is called a recessionary gap, (Y1 -Yn) <0. As the name suggests
this occurs either because the economy has experienced a recession or because actual
GDP, while growing, has grown more slowly than potential GDP.

C5, Economic Environment of Business,Block 7 page 33 of 45

Figure 7-9 (a) (b)
(
Price level LRAS Price level LRAS
—
— SRAS SRAS

— — A
— — B

AD1 AD1

— Yn Y2 Y — Y1 Yn Y

Learning Tip
A third possibility has already been presented by Figure 7-8 and need not
be repeated. This possibility is a long-run equilibrium situation where all
three curves cross each other at the same point, point E. At this point,
actual GDP equals natural GDP. Therefore, there is no gap to speak of.

9.4 Adjustments to the Long Run

An important question that arises is whether the economy can forever produce in excess
of its potential GDP—illustrated in Figure 7-10 Panel (a)—or stay below that potential,
as in Panel (b). And are there forces that bring actual GDP back to its potential (natural)
level? These questions need to be addressed before we can tackle policy implications.
Remember that when the economy moves along its SRAS curve, the price level changes
while the wage level remains unchanged. This, therefore, causes an adjustment in the real
wage, W/P, which in turn tends to entail further adjustments.
Consider panel (a) below, which represents an overemployment equilibrium situation,
point B, and an inflationary gap of (Y2-Yn) magnitude. At point B relative to A, price has
risen while the nominal wage has remained constant. Therefore, workers have
experienced a fall in the buying power of their wages while the firms’ profits have
increased from the reduced real cost of workers. Eventually, workers will demand higher
(money) wages; firms, anxious to maintain their employment and output levels, will meet
those demands. If firms do not raise money wage rates, they will either lose workers or
end up hiring less productive ones.

As the money wage rate rises, the short-run aggregate supply curve shifts leftward from
SRAS1 towards SRAS2 and this produces a sequence of new equilibrium positions. The

C5, Economic Environment of Business,Block 7 page 34 of 45

economy moves up along its aggregate demand curve, AD1, as shown by the arrowheads
in the figure, as actual GDP decreases and the price level rises.
Figure 7-10
(a) (b)
Price level LRAS Price level LRAS
P P
— SRAS2 SRAS1

—— C SRAS1 A’—
— SRAS2
— B — B’

— A— AD1 — C’
AD1

— Yn Y1 Y Y2 — Yn— Y

Eventually, the money wage rate will have risen by the same percentage as the price
level. At this time, the aggregate demand curve AD1 intersects SRAS2 at a new long-run
equilibrium, point C, where actual GDP is equal to potential GDP once again.

In contrast, panel (b) represents an underemployment equilibrium situation, point B’, and
a recessionary gap of (Y1 — Yn) magnitude. At B’ relative to A’, price has fallen while
money wage has stayed constant. The lower price level has increased the purchasing
power of wages (real wage) and decreased firms' real costs. Eventually, the slack in the
economy will lead to a falling money wage rate: workers anxious to maintain their jobs
and the unemployed, anxious to find a job, will give in under pressure. The short-run
aggregate supply curve will then shift rightward, SRAS2. Eventually, the aggregate
demand curve (AD1) will intersect SRAS2 at a new long-run equilibrium, point C’, where
actual GDP is equal to potential GDP once again.

10 Causes of Economic Fluctuations

The model of aggregate demand and aggregate supply gives you the basic tools you need
to analyze fluctuations in economic activity. At this stage, let’s examine two basic causes
of short-run fluctuations and then, in the next block, you can refine your understanding of
how to use these tools.

10.2 Shifts in Aggregate Demand

Figure 7-11 shows an economy in long-run equilibrium. As expected, equilibrium output
and the price level are determined by the intersection of the AD curve and the LRAS
curve, shown as point A. The short-run aggregate-supply curve passes through this point

C5, Economic Environment of Business,Block 7 page 35 of 45

as well, indicating that perceptions, wages, and prices have fully adjusted to this long-run
equilibrium.
Suppose that a series of disappointing earnings depresses the stock market and a wave of
pessimism suddenly hits the economy. Because of these events, many people lose
confidence in the future and alter their plans. Households may cut back on their spending
and delay major purchases, firms may put off buying new equipment, or people may sell
equities in order to hold more of their wealth in the form of money.
As result of these developments, the aggregate demand for goods and services will be
reduced because of a drop both in consumer spending and spending by firms. As shown
in Figure 7-11, the aggregate-demand curve shifts to the left from AD1 to AD2. In the
short run, the economy moves along the initial short-run aggregate-supply curve, SRAS1,
from point A to point B, where output is reduced from Yn to Y2, and the price level
fallen from P1 to P2. The gap shown by (Y2 – Yn) indicates a recessionary gap.
Although the employment effect is not shown in the figure, firms respond to lower sales
and production by reducing employment. Thus, the pessimism that caused the shift in
aggregate demand is, to some extent, self-fulfilling: pessimism about the future leads to
falling incomes and rising unemployment.

Figure 7-11
Price level LRAS
SRAS1

P1 A SRAS2
P2 B
P3 C

AD1

AD2
Y2 Yn Y
In the absence of any action by policy-makers—i.e., a no-action or hands-off stance—the
recessionary gap will force the price level to fall. Eventually, expectations will adapt to
this new reality of rising unemployment and slowing economy. Perceptions, wages and
expected prices will all be revised downward, causing a shift in the short-run aggregate-
supply curve to the right towards SRAS2, in the above figure. Over time, the economy
will approach point C, where the new aggregate-demand curve (AD2) crosses the long-
run aggregate-supply curve.
The economy, in this case, has remedied itself over a period of time. In the new long-run
equilibrium, point C, output is back to its natural level. Even though the wave of
pessimism reduced aggregate demand, the price level has fallen sufficiently (to P3) to
offset the shift in the aggregate-demand curve.

C5, Economic Environment of Business,Block 7 page 36 of 45

Learning Tip
In the long run, the shift in aggregate demand is reflected fully in the price
level and not at all in the level of output. In other words, the long-run
effect of a shift in aggregate demand is a nominal change (the price level
is lower) but not a real change (output is the same).

Alternatively, faced by the reality of economic hardship in the recessionary period—the

period that it takes for the economy to move from B to C in Figure 7-11—and the fact
that the transition towards long-run equilibrium may be long and painful for the economy
and the unemployed, policy-makers may choose to take action to accelerate the recovery
instead of waiting for the system to remedy itself. This action typically takes the form of
increasing money supply or government spending.
If policy-makers can act with sufficient speed and precision, they can offset the initial
shift in aggregate demand by increasing money supply or government spending to move
the aggregate demand curve back to AD1 and bring the economy back to point A.

10.3 Shifts in Aggregate Supply

As we know, the shift in the aggregate supply curve arises from a change in supply of
factors of production (inputs) or technology. Suppose once again an economy in its long-
run equilibrium. Now suppose that suddenly some firms experience an increase in their
costs of production: for example, due to an increase in the price of raw materials. A
standard textbook example in the 19th century was a crop failure due to bad weather; in
the 20th, the rising price of oil triggered by an oil cartel such as OPEC. The 21st century
example may return to such environmental or seismic disasters as an earthquake under a
microprocessor plant complex.
What is the macroeconomic impact of such an increase in production costs? For any
given price level, firms now want to supply a smaller quantity of goods and services.
Thus, as Figure 7-12 shows, the short-run aggregate-supply curve shifts to the left from
SRAS1 to SRAS2
Figure 7-12

Price level LRAS

P3 C SRAS2
B
P2 SRAS1
P1 A

AD1 AD2

C5, Economic Environment of Business,Block 7 page 37 of 45

 Y2 Yn Y
In the short run, the economy moves along AD1 to point B, where output of the economy
has fallen from Yn to Y2 and the price level has risen from P1 to P2. Because the economy
is experiencing both stagnation (falling output) and inflation (rising prices), such an event
is called stagflation.

Learning Tip
Depending on the event, the long-run aggregate-supply curve might also
shift. In this case, the economy’s production capacity will be altered. In
case of a long-lasting (permanent) event—say an increase in the cost of
production—the long-run aggregate supply as well as the short-run
aggregate supply curve shift to the left. Another example of a permanent
change in the supply conditions is a change in technology, in which case
both the short and long-run curves will shift to the right. The outcome of
this will be lower prices and expanded output (the opposite of stagflation).
However, if the event is temporary, the long-run curve stays invariant. To
keep things simple in the current analysis, we assume that all changes in
the supply side are temporary.

What should policy-makers do when faced with stagflation? Unfortunately, there are no
easy choices. One possibility is to do nothing. In this case, the output of goods and
services remains depressed at Y2 for a while. Eventually, however, the recession will
remedy itself as perceptions, wages, and prices adjust to the higher production costs. The
prevailing period of low output and high unemployment puts downward pressure on
workers' wages. Lower wages, in turn, increase the quantity of output supplied. Over
time, the short-run aggregate-supply curve shifts back toward SRAS1, the price level falls,
and the quantity of output approaches its natural level. In the long run, the economy
returns to point A, where the aggregate-demand curve crosses the long-run aggregate-
supply curve. In this case, policy-makers make the choice of maintaining a low price
level at the cost of temporarily lower output and employment.

Learning Tip
The disadvantage of this approach is that it might take several periods
before the economy makes a full adjustment to return to its initial position.
Economic hardship during the transition back to long-run equilibrium has
real and political repercussions. The latter is especially relevant to
countries whose governments are elected by popular vote.

Alternatively, policy-makers who control money supply and government spending and
taxes might attempt to offset some of the effects of the shift in the short-run aggregate-
supply curve by shifting the aggregate-demand curve. This possibility is shown in Figure
7-12, above. In this case, changes in policy shift the aggregate-demand curve to the right

C5, Economic Environment of Business,Block 7 page 38 of 45

to AD2, exactly enough to prevent the shift in aggregate supply from affecting output. The
economy moves to point C. Output remains at its natural level, but the price level rises
from P2 to P3. In this case, policy-makers are said to accommodate the shift in aggregate
supply because they allow the increase in costs to affect the level of prices permanently.
Policy-makers make the choice of maintaining a constant level of real output and
employment at the cost of a permanently higher price level.

Learning Tip
Shifts in aggregate supply have two important implications: a combination
of recession (falling output) and inflation (rising prices)—stagflation.
Policy-makers who can influence aggregate demand cannot offset both of
these adverse effects simultaneously. There is a trade-off and a price to
pay, whatever option is chosen. The question is which problem (inflation
or unemployment) is deemed more unacceptable to policy and the society.
This issue is explored in detail in the next unit.

11 Summary and Review

1. Aggregate demand is the relationship between the price level and total spending in
the economy. This relationship can be expressed in an aggregate demand schedule or
on an aggregate demand curve (AD).

2. Total spending in the economy, adjusted for inflation, is known as real expenditures,
and includes the spending of households, businesses, governments, and foreigners.

3. The general price level and total spending in the economy have an inverse
relationship, thereby giving the aggregate demand curve a negative slope.

4. Both the wealth effect and the foreign trade effect, which arise from price level
changes, cause movements along the aggregate demand curve.

5. Anything other than the price level that changes consumption spending, investment,
government purchases, or net exports shifts the aggregate demand curve.

6. Aggregate supply is a relationship between the price level and real output produced in
the economy. This relationship can be expressed in an aggregate supply schedule or
on an aggregate supply curve.

7. Because higher prices encourage increased real output and vice versa, the price level
and real output have a direct relationship, thereby giving the aggregate supply a
positive slope.

8. Since real output may not reflect the full rise of all resources—for example, labour—
an economy may not reach its potential output.

C5, Economic Environment of Business,Block 7 page 39 of 45

9. While changes in the price level cause movement along the aggregate supply curve,
aggregate supply factors—changes in input prices, supplies of economic resources,
productivity, and government policies—shift the curve.

10. An economy's equilibrium price level and real output occur at the intersection of the
aggregate demand and aggregate supply curves.

11. The economy moves towards equilibrium through the workings of positive and
negative unplanned investment—in other words, surpluses and shortages.

12. When equilibrium output is less than potential output, the difference between the two
is a recessionary gap. When equilibrium output exceeds potential output, the
discrepancy in the output levels is an inflationary gap.

13. Real output rarely equals potential output. Instead, output and expenditures generally
follow a cycle of expansions and contractions which together make up the business
cycle.

12 Self-Test Questions
1. What component of aggregate demand is related to disposable income?

2. What does marginal propensity to consume represent?

3. What are the key determinants of investment spending?

4. What is the role of exchange rates in determining aggregate demand? Which

component of AD is influenced?

5. Explain why AD is a downward-sloping function of the price level.

6. What factors cause a movement along the AD curve; what factors are responsible for a
shift in that curve?

7. Why is potential GDP independent of the price level?

8. What curves, AD, SRAS and LRAS, are the determinants of output (GDP) and the
price in the short run?

9. What is the determinant of price in the long run—AD, LRAS, or SRAS?

10. What is stagflation?

11. What is the link between money market and aggregate demand?

C5, Economic Environment of Business,Block 7 page 40 of 45

12. What are the causes of business cycles?

13. What is money supply? How might it be controlled by the authorities? What forces
in the economy tend to bring money supply and money demand into equilibrium?

13 Review Problems
1. What sectors are least affected by a downturn?
2. Identify the impact of each of the following trends on aggregate demand. In each
case, draw a graph to show the effect on the aggregate demand curve as well as on
the equilibrium price level and real output.
a. Consumers become more confident about the prospects for output growth
in the economy.
b. Interest rates rise.
c. Political pressure causes an increase in tax rates on households earning
high incomes.
d. Oil prices rise everywhere.
e. The local currency rises in value against the currency of the trading
partners.
3. Assume that your economy has the following aggregate demand and supply
schedules:

Real GDP Demanded Real GDP Supplied Price Level

in the short run
(billions of dollars) (billions of dollars)

520 120 100

440 140 110
360 160 120
280 180 130
200 200 140
120 220 150
40 240 160
a. In a figure, draw the aggregate demand and short-run aggregate supply curve.
b. What are the short-run equilibrium values of real GDP and the price level in
your economy, based on this information?
c. If your economy is capable of producing 220 billion dollars at its potential,
what is the size of the output gap? Is there a recessionary gap or inflationary
gap? Draw the long-run aggregate supply curve.

C5, Economic Environment of Business,Block 7 page 41 of 45

 1. Using the aggregate supply relation, explain how each of the following events
will affect the price level and output. Make sure you explain the relevant shifts in
the supply relationships, if any, first.
a. 10% increase in wages.
b. 5% increase in the price of a key raw material.
c. Increase in technology
2. Suppose Y > Yn.
a. What type of an output gap does this represent?
b. What does this mean for prices and GDP in the future?
c. What will happen to the expected price next year?
d. What will happen to nominal wages next year?
3. Answer all parts of question 5, if Y < Yn this time.
4. Assume the economy is initially operating at Yn. Now suppose the Central Bank
increases money supply.
a. Use a graph of AD-SRAS to illustrate the initial equilibrium situation.
b. What are the initial effects of the increase in money supply on P, M/P, interest
rate, and GDP? You may find it useful to sketch a money market diagram in
the background first.
c. Does Y return to Yn? And if so, what does this suggest about the price and the
expected price?
5. Explain what happens to money demand and bond demand as a result of each of
the following events:
a. A 10% increase in real GDP.
b. A reduction in interest rates.

6. Use the space provided below to answer this question.

Interest Rate

MS

i
Md

C5, Economic Environment of Business,Block 7 page 42 of 45

 a. How much money do individuals hold at the initial interest rate (i)? Show this
in the graph.
b. Suppose there is a reduction in the money supply. What effect will this have
on the money supply curve and on the interest rate? Show this graphically.
c. At the initial interest rate of i, what has happened to the actual quantity of
money?
d. What must happen to the interest rate to restore equilibrium?
e. As i changes, what happens to money demand?
f. How much money do individuals hold at this new interest rate? Compare your
answer here with your answer to part (a).
7. The September 11, 2001 attacks on the World Trade Centre in New York are an
example of events that affect business around the world. Briefly discuss the
impact of “9/11” on export industries in your country and hence on the overall
level of economic activity in your locale.

14 Answer Key to Review Problems

1. The sectors that are less sensitive to changes in income are least affected by a
downturn. That includes food industry (agriculture), government-regulated
industries, low-price transportation, basic services and necessities.

2. a. AD shifts to the right, AD'. Price and GDP rise.

Price AD AD' SRAS

AD''

GDP
b. AD shifts to the left, AD''. Price and GDP fall.

c. AD shifts to the left same as b. P and GDP fall.

d. AS shifts to the left, no shift in AD. Price increases, GDP falls.

e. AD shifts left as in c. Price and output fall.

C5, Economic Environment of Business,Block 7 page 43 of 45

 2. a. LRAS SRAS
Price AD

140

200 Yn = 220 Y

b. P = 140, GDP = 200

c. Output gap = 220 −200 = 20, a recessionary gap.

4. a. AS shifts to the left. Cost rises and hence price level rises. GDP falls.
b. AS shifts to the left (the same as part a). Price rises. GDP falls.
c. AS shifts to the right. GDP increases and price falls.

5. a. Inflationary gap.
b. Price rises, GDP falls back to Yn.
c. Expected price will rise next year, because of inflationary pressure.
d. Nominal wages will rise to catch up with the increases in price.

6. This is the opposite of 5.

a. Deflationary gap.
b. Price falls, GDP rises to return to Yn.
c. Expected price will fall.
d. Nominal wages will fall.

7. a. Price

SRAS

AD AD’

b. AD shifts to the right, P rises, M P increases initially, interest rates drop and
GDP increases.
c. Yes, Y returns to Yn since in the next period Pe (expected price) increases
(money wage increase), SRAS shifts back and the economy returns to Yn.

8. a. A 10% increase in GDP causes demand for bonds and demand for money to
increase.

C5, Economic Environment of Business,Block 7 page 44 of 45

 b. Money demand rises, bond demand falls.

9. i
Ms ’ Ms
i2
C
i1 B A

Md

a. At the initial level of i, Md is equal to Ms (point A).

b. The Ms curve shifts leftward to Ms'.
c. At the initial interest rate (i1), there is an excess demand for money (AB).
d. The interest rate must rise to i2 to restore equilibrium.
e. As the interest rate rises toward i2, Md diminishes (a movement along the Md
curve), to meet M s' at C.
f. Md = Ms at the new equilibrium interest rate i2 . As Ms decreases, so does Md.

C5, Economic Environment of Business,Block 7 page 45 of 45