Question

Each of the following events caused a shift in the AD or AS curve in Canada. Identify which curve was affected and describe the effect of equilibrium real GDP and the price level.

a) The end of the Cold War in 1990 led to large declines in Defense spending in many countries (including Canada)

b) The federal government and (many) provincial governments reduced corporate income-tax rates between 2000 and 2011.

c) The federal government increased its level of government purchases (G) in 2009 and 2010, amidst a global recession.

d) World commodity prices increased sharply from 2002 and 2008. Many of these commodities are both produced in Canada and used as important inputs for Canadian firms.

e) The beginning of a strong recovery in the United States in 2014 led to a large increase in the demand for many Canadian exports.

Answer 1

The aggregate demand curve is the summation of all individual demands in all the sectors in the economy, viz., consumer, investment, government and foreign. It represents the demand for all the final goods and services produced within an economy during a given period of time. Thus, aggregate demand represents the inverse relationship between level of price and the quantity of final goods and service demanded in an economy during a given period of time.

The aggregate demand in the economy changes due to

• Changes in the real wealth of the consumer prompted the consumer to change their consumption and the aggregate demand in the economy changes.
• Changes in real interest rate makes the investment and consumption goods cheaper or expensive. The consumers and producers change their demand for these goods according to this change. The cheaper investment and consumption goods due to fall in interest rate increases the aggregate demand.
• Changes in expectation about the future state of the economy changes the aggregate demand of the economy. The increase in the optimism about the future state or future expansion in the economy prompted the consumer to buy goods and services that increases consumption demand. The optimism also prompted the producers to invest more as they will see expanding economy will lead to higher profit. The increase in both consumption and investment demand will increase the aggregate demand.
• Changes in the expectation about the future price level will change aggregate demand. If the consumer and producer expect a higher price level in future they will tend to spend more on current period, increasing the aggregate demand.
• A rise in income of the trading partners will tend to increase export and thus aggregate demand.
• Changes in exchange rate influence the relative prices of the export and import. An appreciation of home currency will lead to cheaper imports and expensive export. This will decline export and increase import leading to fall in net export and aggregate demand.

----------------------------------------------------------------------------------------------------------------------------------

The aggregate supply curve depicts the positive relationship between quantity supplied and the aggregate price level in the economy. There are two different supply curves: long run supply curve and short run supply curve. The short run supply curve given the quantity the domestic firms will supply at any given level of prices. The long run supply curve gives the potential output of the economy that can be produced given the efficient use of all its resources.

The factors that changes long run aggregate supply curve are

• Changes in supply of resources.
• Changes in the technology.
• Changes in the efficient use of resources.

The factors that changes the short run aggregate supply are

• Changes in resource prices change the cost of production and aggregate supply changes accordingly.
• Changes in expected rate of inflation changes the aggregate supply in the short run. If the producers’ think that price will go up in future, they will simply hold back the supply in order to get higher prices in the next period. This will decrease the aggregate supply in the short run. Similarly, a decrease in expectation about future prices will increase short run supply.
• The supply shocks, such as change in weather or change in price of the imported resources will change the supply in the short run.

-----------------------------------------------------------------------------------------------------------------------------

1. The decrease in defence spending decreases government expenditure and hence aggregate expenditure in the economy. This inturn decreases aggregate demand in the economy downward.
2. The fall in income tax decreases the cost of resources, namely labor. This in turn increases short run aggregate supply in the economy. On the other hand the fall in taxes indirectly affects consumption through rise in disposable income and increases aggregate demand as well.
3. The increase in government expenditure increases aggregate expenditure and hence aggregate demand.
4. The rise in global commodity prices makes firm profitable to produce more of these products and as these goods are also used as inputs the resource prices of the firms also rises. Thus the effect tend to have opposite effect on aggregate supply. The relative strength of the factors determine the position of aggregate supply. On the other hand rise in price decreases demand for export and consumption and hence aggregtae demand falls as well.
5. The increase in demand for export increases aggregate demand of the economy.