Unit 2:Aggregate Demand and Supply and Fiscal Policy

Topic 1: Aggregate Demand

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?

Aggregate Demand Curve

Price Level

Quantity of Real GDP (GDPR)4

AD

Inverse relationship between price level and

Quantity

Shifters of Aggregate Demand

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Shifts in Aggregate Demand

Price Level

Quantity of Real domestic output (GDPR)

AD

Increase = RIGHT ; decrease = LEFT

AD1

AD2

Shifters of Aggregate Demand1. Change in Consumer Spending

Consumer Wealth (Boom in the stock market…) Wealth= assets that generate money (real estate, stock, property)

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

* Important note: A change in WAGES does NOT impact C in AD because a change in nominal wages does NOT mean a change in REAL wages (Just because wages go up, does not mean you can purchase more) 7

Shifters of Aggregate Demand

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

business) I = capital stock, construction and inventory

Things that impact I spending Interest Rates (Price of borrowing $)Future Business Expectations (High expectations…)Business Taxes (Higher corporate taxes means…)

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Shifters of Aggregate Demand3. Change in Government Spending

Infrastructure…Nationalized Heath Care…defense spending…

4. Change in Net Exports can be influenced by a change in FOREIGN INCOME

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

AD = GDP = C + I + G + Xn

Which way will AD shift??? 1. There is an increase in the wealth of American households.

2. The government increases income taxes.

3. There is a decrease in interest rates

4. The government increases spending on the military

5. The government decreases income taxes

6. The government raises business taxes

7. Investment spending decreases.

8. Price level increases

Topic 2: The Multiplier Effect

Why do cities want the Superbowl in their stadium?

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. What is MPC? 2. If you received $100 and spent $80. What is MPC? 3. If you received $100 and spent $90. What is MPC?

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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

If MPC is .8, what is MPS? If MPS is .1, what is MPC? If MPC is .6, what is MPS?

How is Spending “Multiplied”?Assume the MPC is .6 for everyone - Assume the Super Bowl comes to town and there is an increase of $100 in spending at Ashley’s restaurant.

Ashley has $100 more income.

Ashley spends $ 60 (60% of 100) at Carl’s salon and saves $ 40 (100 -60) Carl now has $60.

Carl spends $36 (60% of 60) at Dan’s fruit stand and saves $24 (60 -36)

Dan now has $36. Dan spends $21.60

(60% of 36) at Wendy’s and saves $14.40 (36 – 21.60)

How multiplier effect works

• New income of $100 ; MPC = .6 * remember someone’s spending becomes

someone else’s income

Round Income Spending Savings

1 (ashley) $100 $60 $40

2 (carl) $60 $36 $24

3 (dan) $36 $21.60 $14.40

Spending multiplier

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

1/MPS

» 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 that taxes have on the entire economy (taxes also impact spending!)

If taxes go down: people have MORE $ to spend – GDP will INCREASE

MPC/MPS (if decrease in taxes)

If taxes go up: people have LESS money to spend – GDP will DECREASE

- 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 spending multiplier and the tax multiplier combine to form the BALANCED BUDGET MULTIPLIER

BALANCED BUDGET MULTIPLIER = 1

1 X change in SPENDING = impact on the total economy

How to use the balanced budget multiplier

Rule: if both taxes and spending change by the same amount, they DON’T cancel each other out – spending will always have the bigger impact on the economy

Example: 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

Balanced budget multiplier

Investment spending decreases spending by $5 million and at the same time, the government lowers taxes by $5million. If MPS is .1, how does this change the total GDP of the economy?

1 X -5 = - $ 5 million

Topic 3: Aggregate Supply

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What is Aggregate Supply?

Aggregate Supply is the supply for everything by all firms.

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

Short Run Aggregate Supply Curve

Price Level

Real domestic output (GDPR)

AS

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Direct relationship between price level

and Quantity

Shifters of SR Aggregate Supply

Shifts in SR Aggregate Supply

Price Level

Real domestic output (GDPR)

AS

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Increase = RIGHTWARD SHIFTdecrease = LEFTWARD SHIFT

AS1

AS2

Shifters of SR Aggregate Supply

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

wages (price of labor)

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

Shifters of SR Aggregate Supply

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

Subsides Government Regulations

3. Change in Productivity

4. Change in Technology 34

Which direction will SRAS shift???

1. There is an improvement in technology2. The government decreases business taxes 3. Worker wages decrease4. There is an increase in the price of resources

used in production5. Productivity declines for 3rd month in a row 6. Price level increases 7. Worker wages increase

AD and SRAS macroeconomic equilibrium price and quantity

Short run Macroeconomic equilibrium

If there is a shift in AD or SRAS, price level and quantity of real GDP will change Investment spending increases:

Price level _______ Q of GDPr _______

Wages increase causing the Cost of production to increase

Price level ___

Q of GDP ____

Practice WS : AD and SRAS

AD shifters

Change in Consumer spending (income, income taxes, wealth, confidence)

Change in Investment spending (interest rates, business taxes)

Change in Government spending

Change in Net export spending(foreign incomes)

SRAS shiftersChange in legalities (subsidies, business taxes)

Change in Resources (wages, resource prices & Q)

Change in productivity

Change in Technology

Topic 4: Short Run to LONG RUN

In the SHORT RUN – wages are STICKY; they DO NOT adjust to price changes

In the LONG RUN – wages are FLEXIBLE; they DO adjust to changes in prices

Short Run: 100 units sell for $1 each, TR = $100

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

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

100 units sell for $2, TR=$200.

Wages haven’t had the time to adapt to the change in prices (WAGES are STICKY – they are still $80)

How much is profit? $200 – 80 = $120

With higher prices, the firm has the incentive to increase production (because their profits will increase)

Long-Run Aggregate Supply100 units sell for $1 each; TR = $100 Cost to produce is $80 of labor

Profit = $20.What happens in the LONG-RUN if price level doubles?

100 units sell for $2.00 each; TR =$200 In the LONG RUN workers demand higher wages to match prices. Wages have had the time to adjust to price changes – Eventually, labor costs double too(wages are FLEXIBLE and adjust to price changes) Cost to produce is now $160 (instead of $80)

Profit: 200-80 =$40 *** REAL profit is unchanged.

If REAL profit doesn’t changethe firm has no incentive to increase

output.

So… LONG RUN AS is VERTICAL

Long run Aggregate Supply

Price level

GDPR

The economy is at FULL Employment

LRAS

QY

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LRAS compares to PPC

On curve: Economy at FULL EMPLOYMENT All resources being used

Shifts of LRAS: Increase RIGHT; Decrease LEFT

Shifters of LRAS

Shifts for Same reasons PPC shifts:

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 5: Putting AD, SRAS and LRAS together to getEquilibrium Price Level and Output

Putting AD, SRAS and LRAS together Practice WS : AD, SRAS and LRAS

AD shifters 1 Change in Consumer spending (income, income taxes, wealth, confidence)

2 Change in Investment spending (interest rates, business taxes)

3 Change in Govt spending

4 Change in Net export spending (foreign incomes)

SRAS shifters1Change in legalities (subsidies, business taxes)

2Change in Resources (prices of resources, quantity of resources, wages, energy prices, “supply shocks” )

3Change in productivity

4Change in Technology

LRAS shifters 1Change in technology 2Change in quantity of resources

Topic 6 : Economic Stability

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

Economics Statistics

Economic growth

Unemployment

Inflation

Measured by

Real GDP People not working but looking

CPI (consumer price index)

Acceptable Over 2.5%

Under 6% Up to 4%

Economic Instability

• High unemployment/Recession

• High Inflation

• Stagflation – high unemployment and inflation AT SAME TIME

Graphs showing Inflationary and Recessionary Gaps

Full employment equilibriumEconomy at FE with acceptable price level

Price Level

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AS

Inflationary Gap

GDPR

LRAS

AD

PL

Q

Output is high and employment is greater than FE

Actual GDP above

FE/potential GDP

Economy is here, But should be At FE

Inflationary Gap

How can we be beyond the FE line???

In the SR, economy can overuse resources, but CANNOT be sustained in the LONG RUN (ex. pulling all –nighters to study…)

Price Level

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AD

GDPR

PL

Q

LRAS AS

Recessionary Gap

Output low and employment is less than FE

Actual GDP below

FE/potential GDPEconomy is here,

But should be at FE

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

Stagflation – high inflation and high unemployment AT SAME TIME

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 7: Self adjusting economy

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Flexible wages in the Long run

The economy can adjust to FE equilibrium over time as wages change to adjust to price changes

Price Level

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AD

AS

Assume inflation is occurring in the economy

GDPR

LRAS

AD1

PL

Q

Price Level

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AS

If inflation occurs, what will happen in the LONG RUN?

GDPRQ1

AD

PL

Q

LRAS

workers seek higher wages and wages increase. An increase in wages SHIFTS AS to LEFT

AS1

PL1

Back to full employment with higher price level

Price Level

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AD

AS

GDPR

LRAS

ADAD

Q

PL

Assume a recession is occurring in the economy

Price Level

69

AS

If recession occurs, what happens in the Long Run? workers accept lower wages so wages decrease

When wages decrease, SRAS shifts to the right

GDPR

LRAS

Q1AD

PL

Q

AS1

PL1

AS increases as workers accept lower wages and production

costs fall

Topic 8: 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

82Unemployment2% 9%

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 9: Economic theories

CLASSICAL VIEW OF ECONOMY:Does not distinguish between short run and long run.

wages as being flexible and that they QUICKLY adjust to changes in price level

The economy does not need intervention to adjust

View the Short Run AS as VERTICAL

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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Keynesian View of EconomyUnlike the classical view, Keynesians don’tthink the economy can quickly adjust to fix itself (at least

in times of recession; due to the ratchet effect)

View aggregate supply as horizontal at low output

Wages are STICKY – they do NOT quickly adjustto price changes

THEREFORE…. Government intervention in the economy is necessary to fix it!!!

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

Real domestic output, GDP

AS

Three Ranges of Aggregate Supply1. Keynesian Range- Horizontal 2. Intermediate Range- Upward sloping3. Classical Range- Vertical

Price level

Real domestic output, GDP

AS

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Keynesian Range

IntermediateRange

ClassicalRange

Topic 10: Fiscal Policy

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Fiscal Policy

Fiscal Policy: Actions by Congress to speed up or slow down the economy (rather than waiting for the economy to self adjust) Based on: Keynesian theory- Wages are sticky, so economy does not quickly self adjustGovernment intervention is NECESSARY to return the economy to stability

A stable economy should have: 1. stable prices 2. full employment 3. economic growth

Two Types of Fiscal Policy: Discretionary and Automatic

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

ex. Congress votes to implement a tax cut

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.

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

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.

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.

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

17-120

Countries with largest debt as compared to GDPs

Ownership of the Debt

Situation:

GDP: -1.2%

Inflation rate= -.5%

Unemployment Rate=25%

Solution???

Situation:

GDP :8%

Inflation rate= 4.1%

Unemployment Rate=1.2%

Solution???

Situation:• GDP: -0.3%• Inflation rate= 13.5%• Unemployment Rate=7.1%

Solution??

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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