Eco 6351 Economics for Managers Chapter 11b. Aggregate Supply and Demand

1. Eco 6351Economics for ManagersChapter 11b. Aggregate Supply and Demand Prof. Vera Adamchik

2. Competing Theories of Short-Run Instability • Economists are not in complete agreement about how to achieve desired macro outcomes. • Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

3. Demand-Side Theories • Keynesian Theory • Monetary Theories

4. Keynesian Theory • Keynes argues that if people demand a product, producers will supply it.

5. Measuring GDP:Expenditure approach • GDP = C + I + G + NX • Spendings not included in GDP: • on intermediate goods and services • on used goods • on financial securities (firms often sell financial assets to finance purchases of new capital goods. GDP includes the amount spent on new capital, not the amount spent on pieces of paper.)

6. GDP = C + I + G + NX • Personal Consumption Expenditures (C) are the expenditures by households on goods and services produced in the U.S. and the rest of the world. They do not include the purchase of new homes, which is counted as part of investment.

7. GDP = C + I + G + NX • Gross Private Domestic Investment (I) is expenditure by firms on buildings and capital equipment produced in the U.S. and the rest of the world PLUS expenditure on new homes by households. It also includes the change in business inventories.

8. GDP = C + I + G + NX • Government purchases of goods and services (G) are the purchases of goods and services (produced in the U.S. and the rest of the world) by all levels of government. But it does not include transfer payments. These payments, such as medical aid and social security benefits, are not purchases of goods and services. They are transfers of funds from government to households.

9. GDP = C + I + G + NX • Net Exports (NX) are the value of exports (X) minus the value of imports (M).

10. Keynesian Theory • Keynes’ theory was that depression and high unemployment result from insufficient private spending and that to cure these problems, the government must increase its spending (in order to increase aggregate demand).

11. Monetary Theories • Monetary theories focus on the control of the quantity of money in circulation and interest rates as mechanisms for shifting the aggregate demand curve.

12. Monetary Theories • Low interest rates increase aggregate demand, which speeds real GDP growth and inflation. • High interest rates decrease aggregate demand, which slows real GDP growth and inflation.

13. Supply-Side Theories • Supply-side theories focus on incentives that will increase AS. Supply-side policies include cutting tax rates, deregulation, and other production enhancing mechanisms.

14. Eclectic Explanations • Shifts in both supply and demand curves may occur.

15. Policy Options • Fiscal policyis the government’s attempt to influence the economy by setting and changing taxes, governmentpurchases of goods and services, and transfer payments. • Monetary policy is conducted by the Federal Reserve and includes adjusting the quantity of money in circulation and interest rates.

16. Supply-Side Policy • Supply-side policies seek to increase the ability and willingness to produce goods and services. • Supply-side policies include cutting tax rates, deregulation, and other production enhancing mechanisms.

17. Government policies that increase AD and GDP are called expansionary policies. • Government policies that decrease AD and GDP are called contractionary policies.

18. The Changing Choice of Policy Levers Before the 1930s • A ‘do nothing’ approach prevailed until the Great Depression. • The Great Depression spurred a desire for a more active government role.

19. The Changing Choice of Policy Levers The 1930s • The Keynesian economics was born in 1936. However, during the 1930s, politician did not believe in it, largely because they feared the consequences of government budget deficits.

20. The Changing Choice of Policy Levers The 1940s • Although Keynesian fiscal policy was not deliberately used during the 1930s, the growth in military spending at the onset of World War II increased total demand and helped to pull the economy out of its long decade of poor performance.

21. The Changing Choice of Policy Levers The 1960s • Fiscal policy dominated the economic debate in the 1960s. The top individual tax rate was 91% (40% today), corporate tax rate was 52% (35% today). Pres. Kennedy and Johnson. Tax cut in 1964.Rapid growth of real GDP and consumption: over 4%.

22. The Changing Choice of Policy Levers The 1960s • The promise of fiscal policy was tarnished by its failure to control inflation in the late 1960s. In 1968, a temporary one-year tax surcharge of 10% was enacted. Moderate impact on consumption.

23. The Changing Choice of Policy Levers The 1970s • During the 1970s, there were many changes in taxes and spending but no major changes in overall fiscal policy. There was a tax rebate and other tax incentives in 1975 following the recession in 1973. However, these tax changes were mild. • Monetary policy dominated macro policy in the 1970s. The heavy reliance on monetary policy ended with a recession in the late 1970s.

24. The Changing Choice of Policy Levers The 1980s • Supply-side policies prevailed in 1980’s with Ronald Reagan. The 1981 tax cuts was designed to increase the supply of output. Nonetheless, the tax cuts did appear to increase consumer demand and helped the economy recover from the back-to-back recessions in the early 1980s.

25. The Changing Choice of Policy Levers The 1990s • By the mid-1980s, large government budget deficits began to emerge. As deficits grew, there was no longer interest in using Keynesian fiscal policy to manage the economy. The George H. Bush administration pursued a less activist approach in the early 1990s.

26. The Changing Choice of Policy Levers The 1990s • Bill Clinton pursued a contractionary fiscal policy in the mid-1990s. The fiscal restraint of the late 1990's helped the federal budget move from deficits to surpluses. • One of the biggest points of debate during the 2000 presidential campaign was whether to use the surplus to cut taxes, increase government spending, or pay down the debt.

27. The Changing Choice of Policy Levers The 1990s • This fiscal policy retreat cleared the way for a reemergence of monetary policy. The job of fighting inflation in the 1990s was left to the Fed's monetary policy.