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Unit 2: Aggregate Demand and Supply and Fiscal Policy. Topic 1: Aggregate Demand. What is 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. ”

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slide3

What is 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.
slide4

Aggregate Demand Curve

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

Price

Level

There is an inverse relationship between

price level and Real GDP.

AD

Real domestic output (GDPR)

slide6

Shifts in Aggregate Demand

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

Price

Level

AD1

AD

AD2

Real domestic output (GDPR)

6

slide7

Shifters of Aggregate Demand

  • 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)
slide8

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
slide9

Shifters of Aggregate Demand

  • Change in Government Spending
    • (infrastructure…)
    • (Nationalized Heath Care…)
    • (defense spending…)
  • Change in Net Exports
  • (foreign income)

AD = GDP = C + I + G + Xn

9

topic 2 the multiplier effect

Topic 2: The Multiplier Effect

Why do cities want the Superbowl in their stadium?

10

multiplier effect
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.
slide12

MPC=

Change in Consumption

Change in Income

Marginal Propensity to Consume

  • Marginal Propensity to Consume (MPC)
  • How much people consume rather than save when there is a change in income.
  • Examples:
  • If you received $100 and spent $50.
  • If you received $100 and spent $80.
  • If you received $100 and spent $90.

12

slide13

MPS=

Change in Saving

Change in Income

Marginal Propensity to Save

  • Marginal Propensity to Save (MPS)
  • How much people save rather than consume when there is a change in income.
  • Examples:
  • If you received $100 and save $50. MPS?
  • If you received $100 and save $30. MPS?

13

slide14

MPC + MPS = 1

Why is this true?

Because people can either save or consume

14

slide15

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 saved

15

how multiplier effect works
How multiplier effect works
  • New income of $100 ; MPC = .5

* remember someone’s spending becomes someone else’s income

spending multiplier
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
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
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
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)

practice1
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
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
Balanced Budge Multiplier
  • Spending multiplier will always have a bigger impact on the economy than tax multiplierif spending and taxes both change by the same amount!
balanced budget multiplier
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
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
slide27

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.

27

slide28

Short Run Aggregate Supply Curve

AS

Price

Level

AS is the production of all the firms in the economy

Real domestic output (GDPR)

28

slide30

Shifts in SR Aggregate Supply

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

AS2

AS

Price

Level

AS1

Real domestic output (GDPR)

30

slide31

Shifters of SR Aggregate Supply

  • 1. Change in Resources
    • Prices and quantity of Domestic and Imported
    • Resources
    • Nominal wages
    • Supply Shocks
    • (Negative Supply shock…)
    • (Positive Supply shock…)
slide32

Shifters of SR Aggregate Supply

Legalities

* Business taxes (shifts AD too!)

Subsides

Government Regulations

Change in Productivity

Change in Technology

32

slide33

Topic 4: Classical

vs.

Keynesian view of SRAS

Adam Smith

1723-1790

John Maynard Keynes

1883-1946

33

classical theory
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
slide35

Debates Over Aggregate Supply

Classical Theory – AS is vertical

AS

Price level

Qf

Real domestic output, GDP

35

slide36

Debates Over Aggregate Supply

Classical Theory

Due to wages being flexible, a change in AD will not change quantity, only price level

AS

Price level

AD

Qf

Real domestic output, GDP

36

slide37

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

37

slide38

Keynesian Theory- Horizontal AS

Recession will be persistent because wages are not flexible (they will not go down to return the economy to FE)

Price level

AS

Q

Q

Real domestic output, GDP

38

slide39

Debates Over Aggregate Supply

Keynesian Theory

A change in AD effects output only not inflation

Price level

AS

AD2

AD1

Q1

Qf

Real domestic output, GDP

39

slide40

Three Ranges of Aggregate Supply

1. Keynesian Range- Horizontal at low output

2. Intermediate Range- Upward sloping

3. Classical Range- Vertical at FE

AS

Price level

Classical

Range

Keynesian

Range

Intermediate

Range

Real domestic output, GDP

40

slide41

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 = $20
  • What 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.

41

slide42

Long-Run Aggregate Supply

  • In the Long Run, wages do have time to adjust to price changes
  • Same 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

slide43

Long run Aggregate Supply

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

LRAS

Price level

Long-run

Aggregate

Supply

Full-Employment

(Trend Line)

QY

GDPR

43

shifters of lras
Shifters of LRAS

LRAS similar to PPC!!!

  • Change in technology
  • 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

which curve will shift ad sras lras
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 7 economic stability
Topic 7: Economic Stability
  • A stable economy is represented by:
  • Economic growth
  • Price stability
  • Full employment
economic instability
Economic Instability
  • Recession
  • High unemployment
  • Inflation
  • Stagflation
slide51

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

slide54

Inflationary Gap

Output is high and employment is greater than FE

LRAS

Price Level

AS

Actual GDP above FE/potential GDP

PL1

AD1

QY

Q1

GDPR

54

slide55

Recessionary Gap

Output low and employment is less than FE

LRAS

Price Level

AS1

Actual GDP below FE/potential GDP

PL1

AD

Q1

QY

GDPR

55

stagflation
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

slide57

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

What economic problem does this cause???

slide58

The economy begins at FE and net export spending decreases.

Shift the curve on the graph

What economic problem does this cause???

slide60

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

LRAS

Price Level

AS

PLe

AD

QY

GDPR

60

slide62

Now, what will happen in the LONG RUN?

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

LRAS

Price Level

AS1

AS

PL2

Back to full employment with higher price level

PL1

AD

QY

Q1

GDPR

62

slide63

Example: Assume a recession is occurring in the economy

Price Level

LRAS

AS

PL1

AD

AD

AD1

Q1

QY

GDPR

63

slide64

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

Price Level

LRAS

AS

AS1

AS increases as workers accept lower wages and production costs fall

PL1

PL2

AD

Q1

QY

GDPR

64

the ratchet effect

The Ratchet Effect

A ratchet (socket wrench)

permits one to crank a

tool forward but not backward.

65

slide66

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!

66

topic 9 the phillips curve

Topic 9: The Phillips Curve

SRPC Shows tradeoff between inflation and unemployment.

slide68

Short Run Phillips Curve

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

Inflation

When there is a recession, unemployment is high but inflation is low (B)

5%

A

1%

B

SRPC

2%

9%

Unemployment

68

shifts of short run phillip s curve
Shifts of Short run Phillip’s curve
  • 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

  • Change in inflationary expectations

if these increase, SRPC shifts RIGHT

if these decrease, SRPC shifts LEFT

slide70

Assume stagflation occurs

Draw an AD/AS graph showing this

SRAS SHIFTS TO THE LEFT

In the Short run, what happens

Price level? increases

Unemployment? increases

70

slide71

What is impact on SRPC? Shifts to the right

Inflation

SRPC1

SRPC

Unemployment

71

consumers begin to save more money draw an ad as graph that shows this
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? Decreases

Unemployment? INcreases

slide73

What is impact on SRPC?

Movement down along original curve

Inflation

A

B

SRPC

Unemployment

73

the prices of resources decrease draw an ad as graph showing this
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

slide75

What is impact on SRPC?

Shifts to the left

Inflation

SRPC

SRPC 1

Unemployment

75

from short run phillips curve to long run phillips curve
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
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
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 INCREASES

What will happen to the SRPC in the Long Run?

SHIFTS TO the RIGHT

slide79

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

LRPC

Inflation

5%

The LRPC is vertical at the Natural Rate of Unemployment

3%

1%

2%

5%

9%

Unemployment

79

shifts of lrpc
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!)
slide81

Phillips curve at FE equilibrium

LRPC

The unemployment rate is at the NATURAL RATE

and

inflation rate is at the EXPECTED RATE

Inflation

SRPC

UY

Unemployment

81

slide82

Inflationary Gap on Phillips Curve

LRPC

Inflation

SRPC

UY

Unemployment

82

slide83

Recessionary Gap on the Phillips Curve

LRPC

Inflation

SRPC

UY

Unemployment

83

fiscal policy based on keynesian theory
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

slide86

Two Types of Fiscal Policy

  • 1. Discretionary Fiscal Policy-
    • Congress creates and passes a new bill
    • ex. Congress votes to implement a tax cut

86

slide87

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.

87

expansionary fiscal policy
Implemented during RECESSION

Goal is to SPEED UP economy without causing too much inflation

Need to increase AD

Expansionary Fiscal Policy
how can the government speed up the economy
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

slide91

* 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
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
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

slide94

* 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
slide96

Problems With Fiscal Policy

  • 1. Deficit Spending!!!!
  • A Budget Deficit– governmentspending 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.

96

slide97

Additional Problems with Fiscal Policy

  • 2 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.

97

the national debt cnbc explains
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?
income taxes
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 determine

if a person has overpaid or underpaid their taxes

countries with the highest income tax rates
Countries with the highest income tax rates

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

where does the federal 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 world http www sipri org research armaments milex factsheet2010
Military spending around the worldhttp://www.sipri.org/research/armaments/milex/factsheet2010
what is the national debt
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
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!!!!!

congressional committees

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

Congressional Committees

The Good, the Bad, and the Ugly

As a group, analyze the situation, identify the problem, and identify your solution

1 1933
1.) 1933

Situation:

  • GDP fell -1.2%
  • Inflation rate= -.5%
  • Unemployment Rate=25%

Your Solution:

What actually happened:

  • FDR increased public works via the New Deal programs.
2 1944
2.) 1944

Situation:

  • 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 discontinued
3 1980
3.) 1980

Situation:

  • 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)
4 2003
4.) 2003

Situation:

  • 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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