Unit 2: Aggregate Demand and Supply and Fiscal Policy 1

Unit 2:Aggregate Demand and Supply and Fiscal Policy

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Topic 1: Aggregate Demand

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Aggregate Demand is all the goods and services that buyers are willing and able to purchase at different

price levels.

Aggregate means “added all together.”

The Demand for everything by everyone in the US.

What is Aggregate Demand?

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Aggregate Demand Curve

Price Level

Real domestic output (GDPR)4

AD is the demand by consumers, businesses, government, and

foreign countries

AD

There is an inverse relationship between

price level and Real GDP.

Shifters of Aggregate Demand

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Shifts in Aggregate Demand

Price Level

Real domestic output (GDPR)

AD

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** General rule: An increase in spending shifts AD right, and decrease in spending shifts it left

AD1

AD2

Shifters of Aggregate Demand1. Change in Consumer Spending

Consumer Wealth (Boom in the stock market…)Consumer Expectations (People fear a recession…)Household Indebtedness (More consumer debt…)Income Taxes (Decrease in income taxes…)

Wealth= assets that generate money (real estate, stock, property)

* Important note: A change in WAGES does NOT impact C in AD because a change in nominal wages does mean a change in REAL wages (purchasing power)

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Shifters of Aggregate Demand

2. Change in Investment Spending business puts $ back into the business

Interest Rates (Price of borrowing $)Future Business Expectations (High expectations…)Business Taxes (Higher corporate taxes means…)Capital stock, construction and inventory

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Shifters of Aggregate Demand3. Change in Government Spending

(infrastructure…)(Nationalized Heath Care…)(defense spending…)

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4. Change in Net Exports (foreign income)

AD = GDP = C + I + G + Xn

Topic 2: The Multiplier Effect

Why do cities want the Superbowl in their stadium?

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MULTIPLIER EFFECT

• Someone’s spending (whether it be consumer, business, government etc) will always become someone else’s income

• The person who receives the income will turn around and spend it and the cycle continues

• Because of this there is a multiplied impact of spending on the economy.

Marginal Propensity to ConsumeMarginal Propensity to Consume (MPC)•How much people consume rather than save when there is a change in income.

MPC= Change in Consumption Change in Income

Examples: 1. If you received $100 and spent $50.2. If you received $100 and spent $80.3. If you received $100 and spent $90.

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Marginal Propensity to Save

MPS= Change in Saving Change in Income

Marginal Propensity to Save (MPS)•How much people save rather than consume when there is a change in income.

Examples: 1. If you received $100 and save $50. MPS? 2. If you received $100 and save $30. MPS?

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Why is this true?Because people can either save or consume

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MPC + MPS = 1

How is Spending “Multiplied”?Assume the MPC is .5 for everyone

•Assume the Super Bowl comes to town and there is an increase of $100 in Ashley’s restaurant.

•Ashley now has $100 more income.

•She saves $50 and spends $50 at Carl’s Salon

•Carl now has $50 more income

•He saves $25 and spends $25 at Dan’s fruit stand•Dan now has $25 more income.

This continues until every penny is spent or saved15

How multiplier effect works

• New income of $100 ; MPC = .5 * remember someone’s spending becomes

someone else’s income

Round Income Spending Savings

1 $100 $50 $50

2 $50 $25 $25

3 $25 $12.50 $12.50

Spending multiplier

» If an increase in spending = more $ goes into the economy (total GDP will increase)

1/MPS

» If a decrease in spending = less $ goes into the economy(total GDP will decrease)

- 1/MPS

Practice

• 1. If MPC is .8, what is the spending multiplier if investment spending decreases???

• 2. If the MPS is .1, what is the spending multiplier if government spending increases???

The smaller the MPS, the greater the spending multiplier will be!!!

How to use the spending multiplier

If Consumer Spending increases by $3 million, and the MPC is .8 How much will the GDP change by?

spending multiplier X change in spending

How figured: 1. find spending multiplier

1/MPS = 1/.2 = 5

2. Multiply the spending multiplier by the change in spending: 3 X 5 = $15

GDP will increase by a total of $15 million (5 X 15)

Tax Multiplier

• looks at the impact of taxes on the entire economy

If taxes go down: If taxes go down, people have more $ to spend MPC/MPS (if decrease in taxes)

If taxes go up: If taxes go up, people have less money to spend

- MPC/MPS (if increase in taxes)

Practice

• MPC is .9, and taxes go up, what is the TAX multiplier???

• MPS is .2, and taxes go down, what is the TAX MULTIPLIER???

How to use the tax mutiplier• If the government decreases taxes by $50 million, and the

MPC is .8 by how much will the GDP change by? Tax multiplier X change in TAXES

How figured: 1. Find Tax multiplier

.8/.2 = 4

2. Multiple tax multiplier by change in taxes 4X50 = $200

GDP will increase by $200 million

Balanced Budge Multiplier

• Spending multiplier will always have a bigger impact on the economy than tax multiplier if spending and taxes both change by the same amount!

Balanced Budget Multiplier

• The G attempts to balance the budget by changing taxes and spending at the same time

• The spending multiplier and the tax multiplier combine to from the BALANCED BUDGET MULTIPLIER

BALANCED BUDGET MULTIPLIER = 1 1 X change = impact on the economy

How to use the balanced budget multiplier

• In order to balance the budget, the G increases spending by $20 million while at the same time raising taxes by $20 million.

$20 X 1 = $20 • GDP will INCREASE by: $20 million

Topic 3: Aggregate Supply

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What is Aggregate Supply?Aggregate Supply is the amount of goods and

services that firms will produce in an economy at different price levels.

The supply for everything by all firms.

Aggregate Supply differentiates between short run and long-run and has two different curves.

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Short Run Aggregate Supply Curve

Price Level


AS

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AS is the production of all the firms in

the economy

Shifters of SR Aggregate Supply

Shifts in SR Aggregate Supply

Price Level


AS

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An increase or decrease in national production can shift the curve right or left

AS1

AS2


1. Change in Resources Prices and quantity of Domestic and ImportedResources

Nominal wages

Supply Shocks(Negative Supply shock…)(Positive Supply shock…)


2. Legalities * Business taxes (shifts AD too!)

Subsides Government Regulations

3. Change in Productivity

4. Change in Technology 32

Adam Smith1723-1790

John Maynard Keynes1883-1946 33

Topic 4: Classical

vs. Keynesian

view of SRAS

CLASSICAL THEORY

• 1. AS is VERTICAL (at FE) • 2. WAGES are FLEXIBLE (both upward and

downward) AND ADJUST QUICKLY TO PRICE CHANGES

• 3. Economy can self adjust• 4. No G intervention in economy is necessary

Debates Over Aggregate SupplyClassical Theory – AS is vertical

Price level

Real domestic output, GDP

AS

Qf35

Debates Over Aggregate SupplyClassical Theory Due to wages being flexible, a change in AD will not change

quantity, only price level

Price level


AS

Qf

AD

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Keynesian Theory

1. AS is horizontal at low output

2. Wages are STICKY – they do NOT quickly adjust to price changes

3. G intervention is necessary to return economy to FE

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Keynesian Theory- Horizontal ASRecession will be persistent because wages are not

flexible (they will not go down to return the economy to FE)

Price level


AS

Q38

Q

Debates Over Aggregate Supply

Keynesian TheoryA change in AD effects output only not inflation

Price level


AS

Qf

AD2

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AD1

Q1

Three Ranges of Aggregate Supply1. Keynesian Range- Horizontal at low output2. Intermediate Range- Upward sloping3. Classical Range- Vertical at FE

Price level


AS

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Keynesian Range

IntermediateRange

ClassicalRange

Topic 5: LONG RUN Aggregate Supply

In the Short Run, wages haven’t had the time to adjust to price changes

Example: • If a firm currently makes 100 units that are sold for $1

each. The only cost is $80 of labor. How much is profit?

Profit = $100 - $80 = $20What happens in the SHORT-RUN if price level doubles?

• Now 100 units sell for $2, TR=$200. How much is profit? Wages haven’t had the time to

adapt to the change in prices Profit = $120

With higher profits, the firm has the incentive to increase production.

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Long-Run Aggregate SupplyIn the Long Run, wages do have time to adjust

to price changesSame Example:

• The firm has TR of $100 and uses $80 of labor. Profit = $20.

What happens in the LONG-RUN if price level doubles?• TR still =$200 (100 x $2)• BUT…In the LONG RUN workers demand higher wages

to match prices. Wages have had the time to adjust to price changes - So labor costs double to $160

Profit = $40, but REAL profit is unchanged.If REAL profit doesn’t change

the firm has no incentive to increase output. 42

Long run Aggregate Supply

Price level

GDPR

In Long Run: Q at FE on LRAS; price level can be any level

LRAS

Long-runAggregate

Supply

QY

Full-Employment(Trend Line)

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Shifts of LRAS

Shifters of LRAS

LRAS similar to PPC!!!

1. Change in technology 2. Change in QUANTITY of resources

* General rule: LRAS will never shift by itself (SRAS will shift with it) However, SRAS can shift without LRAS shifting

Practice

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Which curve will shift??? AD, SRAS, LRAS

• 1. An increase in consumer confidence • 2. An increase in incomes of U.S. trading partners • 3. A large decrease in the price of imported oil which

impacts the resource cost of business • 4. An increase in business taxes • 5. An improvement in technology• 6. 25% stock market increase over a two month period

which increases household wealth • 7. a decrease in interest rates • 8. A increase in wages

Topic 6: Putting AD and AS together to getEquilibrium Price Level and Output

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Topic 7: Economic Stability

• A stable economy is represented by: 1. Economic growth 2. Price stability 3. Full employment

Economic Instability

• Recession

• High unemployment

• Inflation

• Stagflation

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Unemployment Inflation GDP Growth

Good less than 6% 1%-4% 2.5%-5%

Worry 6.5%-8% 5%-8% 1%-2%

Bad 8.5 % or more 9% or more .5% or less

Inflationary and Recessionary Gaps

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Full employment equilibriumEconomy at FE with acceptable price level

Price Level

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AS

Inflationary Gap

GDPR

LRAS

QY

AD1

PL1

Q1

Output is high and employment is greater than FE

Actual GDP above

FE/potential GDP

Price Level

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AD

GDPRQY

PL1

Q1

LRAS AS1

Recessionary Gap

Output low and employment is less than FE

Actual GDP below

FE/potential GDP

STAGFLATION

• if both inflation and unemployment are high STAGFLATION will occur

• What curve shift illustrates this problem? This problem is represented by a DECREASE in SRAS

The economy begins at FE and the G increases spending. Shift the curve on the

graph

What economic problem does this cause???

The economy begins at FE and net export spending decreases.

Shift the curve on the graph

What economic problem does this cause???

Topic 8: Short Run and Long Run

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Price Level

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AD

AS

Shifts in AD or AS change the price level and output in the SR, but only price level in the

LR

GDPRQY

PLe

LRAS

Price Level

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AD

AS

Example: Assume inflation is occurring in the economy

GDPR

LRAS

QY

AD1

PL1

Q1

Price Level

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AS

Now, what will happen in the LONG RUN?

GDPRQY

AD

PL1

Q1

LRAS

Inflation means workers seek higher wages and wages increase (shifts AS to LEFT)

AS1

PL2

Back to full employment with higher price level

Price Level

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AD

AS

GDPR

LRAS

QY

ADAD1

Q1

PL1

Example: Assume a recession is occurring in the economy

Price Level

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AS

What happens in the Long Run? Due to recession, workers accept lower wages. As WAGES go down, SRAS shifts to

the right

GDPR

LRAS

QY

AD

PL1

Q1

AS1

PL2

AS increases as workers accept lower wages and production

costs fall

The Ratchet EffectA ratchet (socket wrench)

permits one to crank a tool forward but not backward.

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Does deflation (falling prices) often occur?Not as often as inflation. Why?

Prices and wages are more flexible upward as opposed to downward

Like a ratchet, prices can easily move up but not down!

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Topic 9: The Phillips Curve

SRPC Shows tradeoff between inflation and unemployment.

Inflation

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SRPC

Short Run Phillips Curve

Unemployment2% 9%

1%

5%

When the economy is overheating, there is low unemployment but high inflation (A)

When there is a recession, unemployment is high but

inflation is low (B)

A

B

Shifts of Short run Phillip’s curve

1. inflation and unemployment move in the SAME direction, there will be a SHIFT of the SRPC

-If inflation and unemployment both go up; SRPC shifts to the RIGHT

- If both go down, SRPC shifts to the LEFT 2. Change in inflationary expectations

if these increase, SRPC shifts RIGHT if these decrease, SRPC shifts LEFT

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Assume stagflation occurs Draw an AD/AS graph showing this

SRAS SHIFTS TO THE LEFT

In the Short run, what happens Price level? increasesUnemployment? increases

Inflation

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SRPC

Unemployment

What is impact on SRPC? Shifts to the right

SRPC1

Consumers begin to save more money. Draw an AD/AS graph that shows this

AD SHIFTS TO THE LEFT

In the short run, what happens to Price level? DecreasesUnemployment? INcreases

Inflation

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A

B

SRPC

Unemployment

What is impact on SRPC? Movement down along original curve

The prices of resources decrease.Draw an AD/AS graph showing this

SRAS SHFITS TO THE RIGHT What happens in the short run to

price level? decreases unemployment? decreases

Inflation

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SRPC 1

Unemployment

What is impact on SRPC? Shifts to the left

SRPC

From Short run Phillips curve to Long run Phillips curve

• Because the SRPC is continually shifting in the LONG RUN, there is no trade off between inflation and unemployment

Example: The economy is at FE and interest rates increase

What problem does this create? RECESSION

What happens in the long run to…– Price level DECREASES– Unemployment DECREASES

What will happen to the SRPC in the Long Run?SHIFTS to the LEFT

Example: The economy is at FE and consumer spending increases

What problem does this create? INFLATION

What happens in the long run to…– Price level? INCREASES – Unemployment INCREASESWhat will happen to the SRPC in the Long Run?

SHIFTS TO the RIGHT

Inflation

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1%

5%

3%

5%

LRPC

In the long run there is no tradeoff between inflation and unemployment due to SRPC continually shifting

The LRPC is vertical at the Natural Rate of Unemployment

SHIFTS OF LRPC

LRPC can shift if there is a change in the Natural rate of unemployment

• LRPC will never shift by itself (if you shift LRPC, shift SRPC too!)

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Phillips curve at FE equilibrium

Inflation

SRPC

UnemploymentUY

LRPCThe unemployment rate is at the NATURAL RATE

and

inflation rate is at the EXPECTED RATE

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Inflationary Gap on Phillips Curve

Inflation

SRPC

UnemploymentUY

LRPC

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Recessionary Gap on the Phillips Curve

Inflation

SRPC

UnemploymentUY

LRPC

Topic 10: Fiscal Policy

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Fiscal Policy- Based on Keynesian theory

Fiscal Policy: Actions by Congress to speed up or slow down the economy

A stable economy should have: 1. stable prices 2. full employment

3. economic growth

Two Types of Fiscal Policy

1. Discretionary Fiscal Policy-• Congress creates and passes a new bill

ex. Congress votes to implement a tax cut

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Two Types of Fiscal Policy

2. Automatic Stabilizers Permanent spending or taxation laws enacted to work

counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc.

•When there is high unemployment, unemployment benefits to citizens increase consumer spending.

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Expansionary Fiscal Policy

• Implemented during RECESSION

• Goal is to SPEED UP economy without causing too much inflation

• Need to increase AD

Video example of expansionary fiscal policy

How can the government speed up the economy????

1. Increase government spending (public works, roads, schools etc.) *need to account for the SPENDING MULTIPLIER

2. Decrease personal income taxes (Consumers will have more $, so they will spend

more) *need to account for the TAX MULTIPLIER

• * government can increase its spending, decrease taxes or do both – any of these actions increase AD

• Expansionary policy will result in a DEFICIT BUDGET

• Deficit Budget: the government spends more $ than what they take in

Contractionary Fiscal Policy

Implemented during INFLATION

Goal is to SLOW DOWN economy without causing recession

Want to decrease AD

How can the government slow down the economy???

1. Decrease government spending * need to account for spending multiplier

2. Raise personal income taxes *need to consider tax multiplier

• * Government can decrease its spending, raise income taxes or both – any of these actions will slow down the economy/decrease AD

• Contractionary Policy results in a SURPLUS BUDGET

• Surplus Budget: the government spends less $ than what they take in

Problems With Fiscal Policy

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Problems With Fiscal Policy

1. Deficit Spending!!!!•A Budget Deficit – government spending exceeds its revenue. •The National Debt is the accumulation of all the budget deficits over time.

Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would

not allow Congress to stimulate the economy.

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Additional Problems with Fiscal Policy2 Problems of Timing

• Recognition Lag- Congress must react to economic indicators before it’s too late

• Administrative Lag- Congress takes time to pass legislation

3. Politically Motivated Policies• Politicians may use economically inappropriate

policies to get reelected.

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Topic 11: Focus on National Debt

The National Debt: CNBC explains

• 1. What is the difference between deficit spending and the national debt?

• 2. What is the DEBT CEILING? • 3. If the government borrows $, how does it

get the money it needs? • 4. Who/what is the largest holder of U.S.

debt?

Where does the State and local government get $ from???

• Where does the Federal Government get its money???

Income taxes Tax based on the “income” a person earns

Americans pay an income tax to: 1. The federal government 2. The state government 3. The local government

These taxes appear on a person’s pay check stub

The purpose of filing taxes at the end of the year is to determineif a person has overpaid or underpaid their taxes

EXAMPLE OF PAYCHECK STUB

• Stossel goes to Washington: segment 1(7:40)

Countries with the highest income tax rates

Country Tax rate Kicks in at….

Aruba 58.9% $165,000

Sweden 56.6% $81,000

Denmark 55.4% $76,000

Netherlands 52% $72,000

Austria 50% $80,000

Belgium 50% $46,900

Japan 50% $217,000

United Kingdom 50% $231,000

Finland 49.2% $91,000

Ireland 48% $43,900

U.S. = 23rd; at 39.6% at $400,000 *Source: CNBC

• Where does the State and local government spend money???

Where does the federal government spend money ?

• everything else includes education, veterans benefits, national resources, foreign aid, Immigration, response to natural disasters

Military spending around the worldhttp://www.sipri.org/research/armaments/milex/factsheet2010

What is the national debt???

• Debt occurs when government revenue (primarily from taxes) is less than government spending.

• Therefore debt will rise whenever..– revenue falls– spending increases

Debt in the past decade

• 2001: $5.8 trillion• 2002: $6.2 trillion• 2003: $6.8 trillion• 2004: $7.4 trillion• 2005: $7.9 trillion• 2006: $8.5 trillion• 2007: $9.0 trillion• 2008: $10.0 trillion• 2009: $11.9 trillion• 2010: $13.6 trillion

• DEBT CLOCK

It would take 200,000 years to count to 1 trillion!!!!!

Countries with the largest debts

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Countries with largest debt as compared to GDPs

Ownership of the Debt

Congressional CommitteesAs a group, analyze the situation, identify the

problem, and identify your solution

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Unemployment Inflation GDP Growth

Good 6% or less 1%-4% 2.5%-5%

Worry 6.5%-8% 5%-8% 1%-2%

Bad 8.5 % or more 9% or more .5% or less

The Good, the Bad, and the Ugly

1.) 1933Situation:• GDP fell -1.2%• Inflation rate= -.5%• Unemployment Rate=25%

Your Solution:

What actually happened:• FDR increased public works via the New

Deal programs.

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2.) 1944Situation:• GDP grew 8%• Inflation rate= 3.7%• Unemployment Rate=1.2%

Your Solution: What actually happened: • War ended the next year and government

orders for war materials decreased.• Many public works programs were

discontinued116

3.) 1980Situation:• GDP fell -0.3%• Inflation rate= 13.5%• Unemployment Rate=7.1%

Your Solution:

What actually happened:• The next year, President Regan and congress

lowered taxes on individuals and corporations by about 30%. (Supply-side Economics)

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4.) 2003Situation:• GDP fell 0.5%• Inflation rate= 1.5%• Unemployment Rate=12.0%

Your Solution:

What actually happened:• Congress voted to give tax cuts to

citizens. (Bush Tax Cuts)

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Documents

Unit 2: Aggregate Demand and Supply and Fiscal Policy 1