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QUICK REVIEW

QUICK REVIEW. LRAS. PRICE LEVEL. SRAS. AD. Qn. Q1. REAL GDP. LRAS. PRICE LEVEL. SRAS. AD. Qn. REAL GDP. P. r. i. c. e. L. e. v. e. l. L. R. A. S. S. R. A. S. S. h. o. r. t. -. r. u. n. e. q. u. i. l. i. b. r. i. u. m. L. o. n. g. -. r. u.

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QUICK REVIEW

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  1. QUICKREVIEW

  2. LRAS PRICE LEVEL SRAS AD Qn Q1 REAL GDP

  3. LRAS PRICE LEVEL SRAS AD Qn REAL GDP

  4. P r i c e L e v e l L R A S S R A S S h o r t - r u n e q u i l i b r i u m L o n g - r u n e q u i l i b r i u m A D 0 Q N N a t u r a l R e a l G D P

  5. Answer the following: • What is Say’s law? • What three things must be flexible in the Classical model? • What is the Classical solution for too much unemployment? • How does the self-regulating economy get out of a recessionary gap?

  6. Self-Regulating Economy

  7. KEYNESIAN ECONOMICS • J. M. Keynes wrote during the Great Depression • Keynes focused on the demand side of the economy • Keynes did not believe that the economy was necessarily self-correcting

  8. KEYNES ON WAGES AND PRICES • Keynes believed that wages and prices were STICKY DOWNWARD • The lack of wage and price flexibility suggested that the economy might get STUCK in a recessionary gap. • Keynes tended to focus on the short run because • “IN THE LONG RUN WE ARE ALL DEAD”

  9. KEYNES AND INCOME • Keynes focused his analysis on Total Expenditures in the economy • In particular, he focused on Consumption • CONSUMPTION is a function of DISPOSABLE INCOME • SAVING is also determined by DISPOSABLE INCOME

  10. CONSUMPTION AND SAVING TERMS • Autonomous Consumption - the portion of consumption that is not related to income (it is the amount of Cons. when income is 0). • MPC - marginal propensity to consume (it is change in C / change in Y) • MPS - marginal propensity to save (it is the change in saving / change in Y)

  11. CONSUMPTION AND SAVING TERMS • Break-even income - the level of disposable income where consumption spending is just equal to disposable income.  C = Yd  S must be zero

  12. EQUATION FOR C AND S • C = a + b(Yd) • Consumption = autonomous consumption + the MPC * (disposable income) • S = -a + (1-b)(Yd) • Saving = negative autonomous consumption + MPS * ( disposable income)

  13. EXAMPLE • C = 100 + .75 (Yd) • Find Aut. Cons., MPC, MPS, and C and S when Yd=1000. • Aut. Cons. = 100 • MPC = .75 MPS = .25 • C = 100 + .75 (1000) = 100 + 750 = 850

  14. CONSUMPTION FUNCTION

  15. Find MPC • Find MPS • Find Autonomous Consumption • Give the equation for consumption • Give the equation for saving • Find breakeven income • Find C and S when income is 700

  16. CONSUMPTION FUNCTION • A change in Disposable Income causes a MOVEMENT ALONG the Consumption Function • A change in Autonomous Consumption causes a SHIFT of the Consumption Function

  17. SAVING • SAVING is the unspent portion of a consumer’s income. • SAVING = Income - Consumption Exp.

  18. INVESTMENT2 components • Capital goods (producer durables) - goods used by businesses to produce other goods and services. They have an expected service life of more than one year. • Inventory investment - changes in the stocks of finished goods, goods in process, and in raw materials a firm keeps on hand.

  19. TOTAL EXPENDITURES • Total Expenditures = C + I + G + (X-M) • C depends on Disp. Y • S depends on Disp. Y • Disp. Y = C + S • I depends on the interest rate ( not Y ) • G is assumed to be autonomous

  20. EQUILIBRIUM • TOTAL EXPENDITURES • are equal to • TOTAL PRODUCTION • is equal to • INCOME

  21. DISEQUILIBRIUMTOTAL OUTPUT < TOTAL EXPENDITURES • unplanned inventories • production • employment • Real GDP • income

  22. DISEQUILIBRIUMTOTAL OUTPUT > TOTAL EXPENDITURES • unplanned inventories • production • employment • Real GDP • income

  23. C = 200 + .80(Yd)I = 300 • Find Autonomous Cons., MPC, and MPS • Find breakeven income • Find equilibrium income • In Qn=3000, identify the following: type of gap, size.

  24. THE MULTIPLIER A dollar injected into the economy (i.e. investment) has an impact beyond the initial expenditures. The dollar continues to be spent multiplying its impact on the economy. The number of times it circulates through the economy is known as THE MULTIPLIER.

  25. THE MULTIPLIER cont. The rate of circulation is related to the MPC and MPS. The larger the MPC, the more consumption rises as a result of an increase in income. This will result in a larger MULTIPLIER.

  26. Autonomous Government Spending & the Multiplier Exhibit 12 ( 2 ) ( 3 ) C H A N G E I N C H A N G E I N R E A L ( 5 ) ( 1 ) A U T O N O M O U S N A T I O N A L I N C O M E C H A N G E I N E X P E N D I T U R E G O V E R N M E N T O R R E A L G D P ( 4 ) C O N S U M P T I O N R O U N D S P E N D I N G ( $ m i l l i o n s ) M P C ( $ m i l l i o n s ) R o u n d 1 $ 6 0 . 0 0 $ 6 0 . 0 0 $ 4 8 . 0 0 . 8 0 R o u n d 2 4 8 . 0 0 3 8 . 4 0 . 8 0 R o u n d 3 3 8 . 4 0 3 0 . 7 2 . 8 0 R o u n d 4 3 0 . 7 2 2 4 . 5 7 . 8 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A l l o t h e r 1 2 2 . 8 8 . 8 0 9 8 . 8 8 T O T A L $ 3 0 0 . 0 0 $ 2 4 0 . 0 0 ( A p p r o x .

  27. THE FORMULA MULTIPLIER = 1 or 1 1 - MPC MPS

  28. EXPANSIONARY FISCAL POLICYTO ADDRESS A RECESSIONARY GAP policy aimed at increasing economic activity through increasing G &/or decreasing T to increase AD or increase SRAS

  29. CONTRACTIONARY FISCAL POLICYTO ADDRESS AN INFLATIONARY GAP policy aimed at decreasing economic activity through decreasing G &/or increasing T to decrease AD or decrease SRAS

  30. Fiscal Policy in Keynesian Theory: Ridding the Economy of Recessionary Gaps

  31. Fiscal Policy in Keynesian Theory: Ridding the Economy of Inflationary Gaps Exhibit 2 (2 of 2)

  32. THE MULTIPLIER EFFECT both G and T are subject to the multiplier effect SO a change in either will lead to an even greater change in equilibrium real output (which is equilibrium Y)

  33. THE EXPENDITURE MULTIPLIER • 1 / 1- MPC or 1 / MPS • Change in Real GDP = multiplier x (change in G)

  34. COMMON MULTIPLIERS

  35. EXAMPLE • Qe = 800 while Qn = 1000 • MPC = .75 • find the G necessary to bring the economy to natural real GDP

  36. THE TAX MULTIPLIER • - MPC / MPS or ( 1 - exp. mult.) • Change in Real GDP = tax multiplier x (change in T)

  37. EXAMPLE • Qe = 1200 while Qn = 800 • MPC = .66 • find the T necessary to bring the economy to full employment GDP

  38. BALANCED BUDGET MULTIPLIER if both G & T increase (or decrease) by the same amount, then equilibrium real GDP will increase by the amount of the increase (or decrease) in G

  39. C = 200 + .80(Yd)I = 300 • Find equilibrium income • In Qn=3000, identify the following: type of gap, size, fiscal policy options to close it.

  40. Should Fiscal Policy be Used? NOT NECESSARILY Crowding Out Lags

  41. CROWDING OUT increases in G may lead to decreases in private sector spending ( C or I )

  42. CROWDING OUT may occur due to: • direct substitution more on public libraries  fewer books at bookstores • interest rate effects more on social programs and defense budget deficit increases  government’s demand for credit rises  interest rate rises  investment drops

  43. Lags and Discretionary Fiscal Policy • The data lag: not aware of changes in the economy as soon as they happened • The wait-and-see lag: adopt a more cautious attitude • The legislative lag • The transmission lag: take time to be put into effect • The effectiveness lag: take time to affect the economy

  44. KEYNESIAN PERSPECTIVE • fiscal policy is effective • crowding out is relatively small • lags are short

  45. CLASSICAL PERSPECTIVE • fiscal policy is ineffective • crowding out is significant • lags are long

  46. FISCAL POLICY • Discretionary Fiscal Policy

  47. DISCRETIONARY FISCAL POLICY • deliberate changes in G and/or T to achieve particular objectives • requires new action by Congress

  48. FISCAL POLICY • Discretionary Fiscal Policy • Automatic Stabilizers

  49. AUTOMATIC STABILIZERS • changes in G and/or T that occur automatically as economic conditions change • these changes do not require new action by Congress

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