Question

How does fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP?

Answer 1

Short-Run Aggregate Supply
Short-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.
A rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied.
The short-run aggregate supply curve (SAS) is upward sloping.

In the short run, the quantity of real GDP supplied increases if the price level rises.
The SAS curve slopes upward.
A rise in the price level with no change in the money wage rate induces firms to increase production.

Changes in Potential GDP
When potential GDP increases, both the LAS and SAS curves shift rightward.
Potential GDP increases if:

• The full employment quantity of labour increases.
• The quantity of capital increases
• An advance in technology occurs.

Changes in the Money Wage Rate

• Short-run AS decreases and shifts leftward

Aggregate Demand

The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy.
This quantity is the sum of consumption expenditures, C, investment, I, government expenditure, G, and net exports, X – M.
That is,
Y = C + I + G + X – M

The Aggregate Demand Curve Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.

The AD curve slopes downward for two reasons:

• Wealth effect
• Substitution effects

Wealth Effect
A rise in the price level, other things remaining the same, decreases the quantity of real wealth (money, stocks, etc.).
The quantity of real GDP demanded decreases.

Similarly, a fall in the price level, other things remaining the same, increases the quantity of real wealth and increases the quantity of real GDP demanded increases

Substitution Effects
Intertemporal substitution effect:
A rise in the price level, other things remaining the same, decreases the real value of money and raises the interest rate.
When the interest rate rises, people borrow and spend less, so the quantity of real GDP demanded decreases.
Similarly, a fall in the price level increases the real value of money and lowers the interest rate.
When the interest rate falls, people borrow and spend more, so the quantity of real GDP demanded increases.

Aggregate Demand

When aggregate demand increases, the AD curve shifts rightward …
… and when aggregate demand decreases, the AD curve shifts leftward.