Unit 3 Macroeconomic Models & Fiscal Policy

1. Unit 3 Macroeconomic Models & Fiscal Policy Chapter 12 Aggregate Demand & Aggregate Supply

2. Aggregate demand • A schedule or curve that shows the amounts of real output (real GDP) that buyers collectively want to buy at each price • Why AD curve slopes downward: • Aggregate demand curve • Real-balances effect • Higher price levels reduce the real value or purchasing power of the public’s accumulated savings • Interest-rate effect • A higher price level increases the demand for money. • Foreign purchases effect • When the U.S. price level rises relative to foreign levels, foreigners buy fewer US goods & Americans buy more foreign goods

3. Changes in aggregate demand • Movements along a fixed aggregate demand curve represent changes in real GDP • If one or more of the things listed below changes, the entire aggregate demand curve will shift • Changes in aggregate demand involve two components: • Change in one of the determinants of AD that directly changes the amount of real GDP demanded • A multiplier effect that produces a greater ultimate change in AD than the initial change in spending

4. Consumer spending • Consumer wealth • Includes both financial assets (stocks) & physical assets (houses) • Consumer expectations • Re: income, inflation, etc. • Household debt • Spending increase debt (AD to the right) • Personal taxes • Less income tax raises take-home pay

5. Investment spending • Purchase of capital goods • Real interest rates • Increase in real interest rates will lower investment spending & reduce AD • Expected returns • Higher expected returns on investment projects will increase demand for capital goods & shift AD curve to right. • Expected returns are influenced by several factors: • Expectations about future business conditions • Technology • Degree of excess capacity • Business taxes

6. Changes in AD (cont.) • Government spending • Increase in government purchases will shift the AD curve to the right as long as tax collections & interest rates don’t change • Net export spending • Increased foreign demand for US goods. A rise in net exports shifts the AD curve to the right. • What causes net exports to change? • National income abroad • Exchange rates

7. Aggregate supply • Schedule or curve showing the level of real GDP that firms will produce at each price level • Aggregate supply in the long run • AS curve is vertical at the economy’s full-employment output. • In the long run, wages and other input prices rise & fall to match changes in the price level. So price-level changes do not affect firms profits and thus they create no incentive for firms to alter their output.

8. AS in the short-run • Short-Run AS curve • A rise in the price level increases real output • Positive or direct relationship • When economy is operating below full-employment (inside curve) • Lots of idle resources • Can be put back to use by firms at little or not increase in per-unit production costs • When beyond the curve • Resources are already employed • Adding more workers to capital resources creates congestion (inefficiency) • Adding capital leaves equipment idle & reduces efficiency

9. Determinants of aggregate supply • Factors that shift the AS curve • Input prices • Domestic resource prices • Wages & salaries make up about 75% of all business costs • Prices of imported resources • Market power – ability to set prices of inputs can affect input prices and AS

10. Factors that shift AS (cont) • Productivity • A measure of the relationship between a nation’s level of real output & the amount of resources used to produce that output Total output/total inputs = productivity Increase in productivity enable economy to obtain more real output from its limited resources If productivity is able to reduce the per-unit production cost, the AS curve will shift to the right

11. Sources of productivity advancements • Main source: • Improved production technology • New plant & equipment replaces old plant & equipment • Other sources of productivity increases • Better-educated & trained workforce • Improved forms of business enterprises • Reallocation of labor resources from lower-to-higher productivity uses

12. Last AS determinant • Legal-institutional environment • Changes may alter the per-unit costs of output and shift the AS Curve • Business taxes & subsidies • Higher taxes on sales & payroll raise per-unit costs & reduce AS • Subsidies lower production costs & increase AS • Government regulation • Costly for businesses • More regulation increases per-unit costs & decreases AS

13. Equilibrium & changes in equilibrium • Equilibrium • Occurs at the price level that equalizes the amounts of real output demanded & supplied (intersection of AS & AD curve) • Increases in AD: Demand-Pull Inflation • Increases in spending (either C, I, G, or x) will shift the AD curve to the right causing demand-pull inflation. • Also, observe that the increase in demand expands real output from Qf to Q1. The distance in between is a positive GDP gap. Actual GDP exceeds Potential GDP. • Multiplier effect – increase in AD rises real output only to Q1, not to Q2, because part of the increase in AD is absorbed as inflation rises price from P1 to P2. • If price had stayed at P1, output would have increased from Qf to Q2 & the multiplier would have been at full strength

14. Decreases in AD: Recession & Cyclical Unemployment • Decrease in AD that causes a recession • Output declines with no change in price level • Constitutes a recession and since fewer workers are needed to produce the lower output, cyclical unemployment arises. • Negative GDP gap

15. Why are prices inflexible? • Fear of price wars • Large firms are concerned about price wars if they lower prices • Instead, they choose to reduce production and layoff workers • Menu costs • Lowering prices creates other costs (I.e. printing new menus at a restaurant!) • Additional costs: length of recession, repricing items in inventory, printing new catalogs, advertising • Wage contracts • Firms rarely profit from cutting product prices unless wages drop too • Morale, effort, & productivity • Lower wages will probably lower productivity due to poor worker morale & effort • Minimum wage • Legal price floor that cannot be reduced

16. Decreases in AS: Cost-push inflation • Higher resource prices drive up production & distribution costs on a wide variety of goods • Increase in price-level causes cost-push inflation and a recession • Increase in price level and decline in real output

17. Increases in AS: Full employment with price-level stability • Increases in AD along with increases in productivity which shifted the AS curve to the right as well. • Result…increase in real GDP along with only small increases in price level (inflation)