Aim: What can the government do to bring

stability to the economy?

Two Views of Government Policy

Classical – “government is best that governs least”

Keynesian – government role is to safeguard the economy – “in the long-run we are all dead”

Classical Economic Theory

• Adam Smith – laissez-faire– competitive markets, flexible prices

– limited role of govt– demand is more influential than price

–supply in the short-run is fixed

Great Depression

- foundation for an activist government

Pre 1945 ￫ booms and busts for “natural” economic reasons

Post 1945 ￫ managed government

John Maynard Keynes

The General Theory of Employment, Interest and Money

Keynesians look to demand to manage the economy

Safeguarding the economy

Fiscal Policy

- govt uses taxes and spending to achieve macroeconomic goals

Expansionary Fiscal Policy

• used in recessionary economy

• decrease taxes

• increase spending

Contractionary Fiscal Policy

• used in demand side inflation

• increase taxes

• decrease spending

Role of govt is to provide for the public good – protect quality of life- persuasion- regulation- subsidies- taxation- services- transfer payments

Key TermsConsumption – refers to the

willingness of people to purchase goods and services

Disposable income – is the income available to consumers, after taxes to spend

Savings – is money not used for consumption

Planned investment – which equals savings in equilibrium, is the amount firms intend to spend on investment in capital goods for future production

Actual investment – is the money spent, in reality, on investment goods

Inventories – represent the difference between planned investment and actual investment

National Income – in equilibrium, represents Real GDP

Transfer payments – are monies spent by the government without corresponding provisions of goods and services

Consumption function – the relationship between expenditure and income

Determinants of Consumer Spending

• the past/the lag

• wealth

• price level

• inflation rate

• expectations about the future

Aim: How is equilibrium in the

market for goods and services analyzed graphically?

What is the role of savings, consumption and investment?

Do Now

(1) If the economy is expanding too quickly and prices are rising, how should government officials adjust taxes?

(2) If there is growing unemployment and business inventories, how should government officials adjust taxes?

Income-Expenditure Diagram

• 45° line marks all the points at which output and spending are equal – all the points at which the economy can possibly be in equilibrium

Reaction to price levels

• higher prices lead to lower consumer spending

• a rise in price level leads to a reduction in the consumption function

The effect of the price level on the expenditure schedule

• a rise in price level leads to a lower equilibrium level of real aggregate quantity demanded

• a fall in prices leads to a higher equilibrium aggregate quantity demanded

• When equilibrium GDP falls above full employment, the economy will probably be plagued by inflation.

• When equilibrium falls below full employment, there will be unemployment and recession

Recessionary Gap – amount at which the equilibirum level of GDP fall short of potential GDP

Inflationary Gap – the amount by which equilibrium level of GDP exceeds the full employment level of GDP

Aim: How will consumers respond to a tax cut – a $1 increase in disposable income?

The primary tool that the govt can use to stabilize the economy is the personal income tax – personal consumption makes up 65% - 75% of GDP

Marginal Propensity to Consume

• Basis for Keynesian Expenditure Analysis

• MPC states that consumers will spend a fraction of each additional dollar of income on goods and services and save the rest

GDP = Y

Aggregate output = real GDP

Y = savings + consumption

Y = S + C

MPC = Change in Consumption

Change in disposable income

MPC = ∆C

∆Y

MPS = Change in Savings Change in disposable

income

MPS = ∆S ∆Y

MPC + MPS = 1

Expenditure Multiplier

1/MPS = 1/1-MPC

the greater the MPC the greater the multiplier

Aim:How has the Keynesian model been modified to include aggregate price levels?

• Keynesian model could not accurately forecast GDP, employment & price levels in an inflationary environment.

• AD/AS Model

Aggregate Demand

• accounts for the purchases of all consumers, businesses, governments and foreign trade in the entire domestic economy

Reasons for negative slope of the Aggregate Demand Curve

• Interest rate effect – increased prices lead to an increasing demand for money – this increased demand for money leads to higher interest rates which leads to a decrease in output

• Real Wealth Effect - as prices increase, the value of consumer wealth falls – this fall leads to a decrease in consumption, which leads to a decrease in output

• Foreign sector substitution – as prices for domestic goods rise, consumers begin to substitute with foreign sector goods which are less expensive – this results in less consumption of domestic goods which leads to a decrease in production

Aggregate Supply

• Relationship between the quantity of output supplied by all firms in an economy and the overall price level

Along the AS Curve

• Horizontal range – unused capacity, supply can increase without increasing the price – this can occur when there is excess capacity in terms of raw materials or labor

• Mid-range – illustrates tightening of resource availability and therefore impacts price level as more products are demanded – occurs when demand for the product increases and the resources needed to produce more products are scarce and thus more costly

• Vertical range – situation where all resources are being used and no more products can be produced – the only thing that can happen is that suppliers raise their prices – it is the Long Run AS Curve

Graphs