Macroeconomics Lecture :)

8/10/2019 Macroeconomics Lecture :)

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MACROECONOMIC EQUILIBRIUM ANDFISCAL POLICY

Upon completing this lecture, students should understand the AD and AS model, Short-run and long-run equilibrium within the macroeconomy, and fiscal policy. Both theclassical and Keynesian s point of !iew will be presented.

OBJECTIVES

". Understand the AD and AS model.#. $ompare and contrast short-run and long-run equilibrium.%. &llustrate and define business cycles.

%. Define multiplier and its applications.'. (!aluate the effecti!eness of changes in fiscal policy. TOPICS

)lease read all the following topics.

AGGREGATE DEMAND

AGGREGATE SUPPLYSHORT RUN AND LONG RUN EQUILIBRIUMBUSINESS CYCLESCLASSICAL AND KEYNESIAN ECONOMICSSELF-REGULATING ECONOMYAGGREGATE EXPENDITURE MODELAN EXAMPLEFISCAL POLICY
http://elearn.mtsac.edu/fchan/busc1a/Lectures/3AD.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3AS.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3equilibrium.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3business%20cycles.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3business%20cycles.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3equilibrium.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3AS.htmhttp://elearn.mtsac.edu/fchan/busc1a/Lectures/3AD.htm


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Aggregate Demand The aggregate demand (AD) curve shows thereal output (real GDP) that people are willingand able to buy at diferent price levels,

ceteris paribus.

The AD curve shows an inverse relationshipbetween price level and domestic output(real GDP in billions). The e planation o! theinverse relationship is not the same as !ordemand o! a single product, which centeredon substitution and income efect. Thee planations are"#. Wealth and real balances efect " when price level !alls, purchasing power o! e isting$nancial assets rises, which can increase spending. People !ell wealthier when price level !alls andwill be encouraged to buy more goods and services.

%. Interest rate efect " when price level increases, businesses and households may have toborrow additional !unds to complete their planned purchases. As borrowing demand increases,the interest rate rises, reducing actual borrowing amount and curtail planned consumption andinvestment. A decline in price level means lower interest rates which can increase certain

spending.

&. F!re"#n $%rchases efect " when price level !alls, other things being e'ual, prices will !allrelative to !oreign prices, which will tend to increase spending on e ports and also decreaseimport spending in !avor o! products that compete with imports.

A change in the 'uantity demanded o! +eal GDP occurs because o! a change in the price level. This causes a movement along the AD curve, but not a shi!t o! the AD curve. A change in aneconomic variable other than price would be re'uired to shi!t the AD curve. The economy consistso! !our sectors" ousehold, -usiness, Government, and !oreign sector. very sector buys a portion


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Aggregate Demand/actors that change 0, 1, G, and 2n will change A and AD. These!actors are listed below"

#. 0onsumption " 3ealth, interest rate, income ta es, and e pectationsabout !uture prices and incomes will change 0 and shi!t AD curve.

%. 1nvestment " 1nterest rate, business ta es, and e pectation about!uture sales will change 1 and shi!t AD curve.

&. /oreign ector" /oreign real national income and e change rate willchange e port and import, causing AD curve to shi!t.

4. 5oney upply " The money supply afects interest rates. An increasein money supply will lower interest rate, causing the AD curve to shi!tto the right.


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Aggregate upplyAggregate upply (A ) curvebelow shows level o! real

domestic output (real GDP inbillions) available at eachpossible price level, ceterisparibus. The upward slope o! thecurve indicates that producersare willing and able to sell moreunits o! their goods as pricesincrease, and that theirwillingness to sell decreases asprices !alls.

The reasons listed belowe plaining the A 6s upwardsloping shape in the short run"

#. R"#"d Wa#es " conomists believe that wages tend to be $ ed by

contracts or other agreements. 3hen prices rise, but higher wages do notaccompany them , producers6 pro$ts will rise temporarily, and the $rm willproduce more.%. St"c*+ Pr"ces " Prices are costly to change in some industries (menucosts). 3here this is true, decreases in the general price level willnegatively afect sales, pro$ts, and output, causing producers to produce

less.


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Aggregate upplyA change in the general price level will change the 'uantity supplied o!the domestic output, this is a change along the A curve. 8ther economicvariables will change the +A curve and shi!t the curve to a newposition. ome o! these !actors are listed below"

#. ,he Wa#e Rate " igher wage rates means higher labor cost. Givenconstant prices, higher production costs reduce the pro$t per unit andlowering the number o! goods produced. There!ore, higher wage rateshi!ts the +A curve to the le!t.%. Pr"ces !- N!n lab!r "n$%ts " nergy, land, capital and other non9labor inputs also have a signi$cant impact on +A . An increase in theprice o! these inputs shi!ts the +A curve to the le!t.

&. Pr!d%ct"."t+ " This is the output produced per unit o! input used over aperiod o! time. igher productivity o! labor or any other inputs will shi!tthe +A to the right.4. S%$$l+ Sh!c* " 5a:or natural or institutional changes will afect A .

hoc7s li7e the 1ra' 3ar and ;


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'uilibriumSh!rt R%n E/%"l"br"%0Putting AD and +A together, twocurves will intercept at a point. Thispoint is the short run e'uilibrium. Thisprice level is the e'uilibrium pricelevel, Pe? this 'uantity is thee'uilibrium 'uantity, =e. At any otherprice level, the economy is either insurplus or in shortage.L!n# R%n E/%"l"br"%0

The interception point o! AD and+A may be on the >+A , creating a

long run e'uilibrium where real GDPis e'ual to potential real GDP. 1! thepotential GDP is at @ , then the!ollowing graph shows that the +e'uilibrium is on the >+A curve,creating a >+ e'uilibrium.owever, short9run e'uilibrium (realGDP) may occur on a level above orbelow the potential GDP, creating a

dise'uilibrium in the economy.


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GDP GapsRecess"!nar+ #a$1! real GDP B Potential real GDP (!ullemployment GDP), then a recessionary gape ist. At the same time" nemployment rate C

natural rate o! unemployment.

ince more :ob see7ers are in the mar7et, theytend to settle with a lower wage. >ower wagewill increase the A curve, causing the price todecrease. >ower price will increase consumption.

This process will continue until the economyreaches the long run e'uilibrium (potential realGDP).

1! the potential GDP is at , graph on the rightpresented a recessionary gap between +e'uilibrium and the >+A curve.

In1at"!nar+ #a$1! real GDP C Potential real GDP (!ull employmentGDP), then an inEationary gap e ist. At the sametime" nemployment rate B natural rate o!unemployment.

ince :ob see7ers are less than :ob openings in themar7et, employers are !orced to raise the wage toattract new wor7ers. igh wage will decrease theA , and raise the price. igher price will lowerconsumption. This process will repeat until the longrun e'uilibrium is reached.

1! the potential GDP is at F , le!t graph presentedan inEationary gap between + e'uilibrium and the


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0lassical and eynesianconomics

CLASSICAL ECONOMICS

According to ayHs law, supply creates its own demand. cess income(savings) should be matched by an e'ual amount o! investment bybusiness. 1nterest rates, wages and prices should be Ee ible. Theclassical economists believe that the mar7et is always clear becauseprice would ad:ust through the interactions o! supply and demand. incethe mar7et is sel!9regulating, there is no need to intervene. conomistswho advocate this approach to macroeconomic policy are said toadvocate a laisseI9!aire approach. The mar7et will reach !ullemployment by itsel!.

KEYNESIAN ECONOMICS

The great depression is #;& s seemed to re!ute the classical idea thatmar7ets were sel!9correcting and should provide !ull employment.

eynes provided some e planations" #) savings and investments are notalways e'ual? %) producers may lower output instead o! prices to reduceinventories? &) >ower production may increase unemployment rate and

decrease incomes? 4) monopoly power on the part o! producers andlabor unions would prevent prices and wages to ad:ust downward !reely.


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el!9+egulating conomy0lassical economists believe in sel!9regulating economy. 3age rate andprices are Ee ible. Through the mar7et mechanism, economy will movetowards long run e'uilibrium.

Recess"!nar+ #a$

1! real GDP B Jatural real GDP (!ull employment GDP), then a recessionarygap e ist. At the same time" nemployment rate C natural rate o!

unemployment. ince more :ob see7ers are in the mar7et, they tend to settlewith a lower wage. >ower wage will raise the short run A curve and causingthe price to decrease. >ower price will increase consumption. This processwill continue until the economy reaches the long run e'uilibrium (natural realGDP).

In1at"!nar+ #a$

1! real GDP C Jatural real GDP (!ull employment GDP), then an inEationarygap e ist. At the same time" nemployment rate B natural rate o!unemployment. ince :ob see7ers are less than :ob openings in the mar7et,employers are !orced to raise the wage to attract new wor7ers. igh wagewill decrease the short run A , and raise the price. igher price will lowerconsumption. This process will repeat until the long run e'uilibrium isreached.


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Aggregate penditure5odel

A##re#ate e2$end"t%re 3AE4 is the sum o! consumption, investment,government purchases, and net e port. 8! these !our sectors, the consumptionrepresents the largest share.

The consumption !unction" 0 K 0o L 5P0 (Md)0 K total consumption0o K autonomous consumption whose amount is independent o! disposable income5P0 K marginal propensity to consume. This is a !raction between and #? and 5P0

is e'ual to change in consumption brought about by a change in disposable income.(5P0 K change in 0 < change in Md ) Md K disposable income.

A similar concept as 5P0 is 5P " marginal propensity to save. 1t is e'ual to change insavings ( ) brought about by a change in disposable income.(5P K change in < change in Md )

ince all income must be either consumed or saved, then any change in income mustalso be consumed or saved. There!ore" 5P0 L 5P K #

The average propensity to consume (AP0) is the portion o! income spent onconsumption. ( AP0 K 0 < Md )

The average propensity to save (AP ) is the portion o! income saved. ( AP K < Md )Again, AP0 L AP K #


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'uilibrium GDPEQUILIBRIUM (DP

'uilibrium GDP is the level o! output whose production will create total spending :ust suNcientto purchase that output. 1! the economy produces an amount o! goods that difers to the amountthat the !our sectors o! the economy buy (A ), A and aggregate production ( AP) are not e'ual?

then the economy is in dise'uilibrium.

3hen A B AP, $rms will involuntarily accumulate inventory. This will signal $rms that they haveoverproduced. As a result, $rms will cut bac7 on production and


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An ample1n this e ample, the e'uilibrium between A and AP is illustrated. Data in thistable is used to construct the graph below.

*D) $+ SU ) &+ *D)/$0& SA1& * & 1(S (

#'2 #'' #3' -' #2#32 #32 #42 2 #2

#42 #53 #63 ' #2

%22 #6# %"# 4 #2

%#2 %24 %#4 "# #2

%'2 %#' %'' "3 #2

%32 %'2 %32 #2 #2

%42 %73 %53 #' #2

'22 %5# %6# #4 #2

As you can see !rom the graph in the ne t page, investment has increased thee'uilibrium GDP, (!rom the intersection o! red and blue curves to the new intersectiono! red and yellow curves).

The same e'uilibrium GDP can be obtained by observing the 1nvestment and avingschedule.

1n both graphs, we can see that e'uilibrium GDP is at &@ .Another approach to get the e'uilibrium GDP is by using the multiplier.

The e'uilibrium GDP, GDPe, be!ore the investment is %@ . 5P0 !or this data set is

. .5ultiplier K # < #95P0 K # < (#9 . ) K F


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/iscal PolicyGovernment may change its e penditures and ta ation to achieve particularmacroeconomic goals. /iscal policy is one o! the most important economic tools available tothe !ederal government.

a. E2$ans"!nar+ 5scal $!l"c+ " policy adopted during recession, aiming to increase ADthrough increases in government spending or decreases in ta es.b. C!ntract"!nar+ 5scal $!l"c+ " policy adopted during inEation, aiming to decrease ADthrough decreases in government spending or increases in ta es.

A!ter the second 'uarter o! % #, the . . economy has entered into a recession phrase. 1norder to counter the recession, the -ush administration has started to impose thee pansionary $scal policy. ouseholds got ta re!unds. Government has increasede penditure in various sectors such as national de!ense (especially a!ter eptember ##Hsattac7).

The efect o! e pansionary or contractionary $scal policy will be multiplied by the multiplier./or e ample, government has decided to provide a O4 - aid !or the airline industry a!ter

eptember ##, % #. This O4 - increase in government spending will increase theaggregate e penditure by O# - (!or 5 K %.F).

owever, the efect o! $scal policy is limited by certain !actors" such as the crowding outefect, !oreign loanable !unds efect and time lag problems. Cr!6d"n# !%t efect7 0rowding out efect is 'uite important because it can completelyerase $scal policy6s intention to correct the mar7et. As the government tried to spend moreto correct the recessionary gap in our economy, they compete with private sector !orresources and goods and services. As government e penditure increases, consumption andinvestment decreases causing the inefectiveness o! the $scal policy 8n the other hand in

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Macroeconomics Lecture :)