Aggregate Demand, Aggregate Supply and Fiscal Policy

1. Aggregate Demand, Aggregate Supply and Fiscal Policy AP Economics Chapters 11-12

2. BACKGROUND Classical Economic Theory - • Market system operated at full employment • Temporary short periods of recession or inflation • Self correcting (P & Wages go up & down) • Say’s Law: “Supply creates its own demand” • Accepted view until 1930’s and the Great Depression

3. BACKGROUNDKeynes “In the long run, we are all dead” Keynes believed ~ • Cycles were not short • Corrections were not automatic • Savings and investment weren’t coordinated • Prices and wages were not flexible downward GOV INTERVENTION WAS NEEDED

4. KEYNES • Fiscal Policy is government’s way to stabilize the economy • Employment Act of 1946 - power to Congress • Tools to use: taxing and spending • Expansionary F.P. – Decrease taxes &/or increase spending (Recession) • Contractionary F.P. – Increase taxes &/or decrease spending (Inflation)

5. AD/AS • Key analytical tool for understanding the macroeconomy • AD = quantity of real GDP that consumers, business & gov’t are willing and able to buy at each price level • AD = C + Ig + G + Xn • Price level and output (GDP) have inverse relationship

6. AD/AS • AD slopes downward because: • Wealth (real balance) effect – purchasing power of money is less at higher price levels • Interest rate effect – price level changes impact interest rates – in turn this effects consumption & investment spending (inverse effect) • Foreign purchase effect – volume of imports/exports depend on relative price levels here & abroad EX: If US PL is higher = we buy more M & sell fewer X

7. Consumption • INCOME IS NOT WEALTH • GDP & AD = C + Ig + G + Xn • C is largest component • DI = C + S if Income then C & S • MPC = % consumed of a in income • MPS = % saved of a in income • MPS + MPC = 1 (80% + 20% = 1)

8. Consumption • Main determinant is income • Other determinants: • Wealth (value of assets) if W C S • Expectations (for inflation or future wealth) • Debts (if D increases, C & S will decrease) • Taxes (if T increase, C & S decrease, etc)

9. Investment • Savings = Investment • Investment is: • Business spending for capital stock • Most volatile component of AD/GDP • Assumed to require a loan • Decisions are based on marginal cost (interest) vs. marginal benefits (expected rate of return)

10. Investment • Economic profit/cost = Rate of return EX: $100 profit divided by $1000 cost = 10% • Interest must be less than rate of return to justify investment • Investment determinants: • Interest rate • Costs of capital & operating costs • Taxes • Technology • Excess capacity (inventories)

11. Market for Loanable Funds • Demand for Ig is DEMAND for loanable funds • Savings is SUPPLY of loanable funds • Equilibrium is the interest rate where Ig=S i i S D Ig D Q Q Investments Loanable Funds

12. Spending Multiplier • Change to any component of AD (C + Ig + G + Xn) has a “ripple effect” • Results in a multiplied effect on GDP • Important as a small change in spending leads to a large change in GDP • Assumes that change occurs first to Ig • Calculated by: 1 or 1 MPS 1- MPC

13. Spending Multiplier • Examples: 1/MPS .25 MPS change = multiplier of 4 .33 MPS change = multiplier of 3 MPC of .75 = 1/.25 (MPS) = multiplier of 4 If gov spending increases by $20 X 4 = GDP increases by $80

14. Aggregate Supply • AS = quantity of output (real GDP) produced at each price level • Direct relationship between PL and output (high PL = more supply) • 3 ranges of AS: • Horizontal = recession – underutilized resources (LLC) – only output changes are possible • Vertical = full capacity economy – only PL changes • Intermediate = expansion eco – both output & PL changes are possible

15. AS VERTICAL RANGE PRICE LEVEL AD 3 INTERMEDIATE RANGE HORIZONTAL AD 2 AD 1 OUTPUT OF REAL GDP

16. Determinants of AS: • Change in input prices (cost of production) • Resource availability (LLCET) • Imported resources – cost & exchange rates • Market power – ability to set price above that of a competitive market EX: OPEC, labor unions, etc

17. Determinants of AS: 2. Change in productivity – increase means can produce more with same resources EX: more productivity = increase AS • Change in legal-institution environment Taxes (sales, excise, payroll) = increase costs of production (AS decreases) Subsidies – gov’t payment = lowers costs (AS increases) Gov’t regulations = costs more to comply so AS decreases

18. Other Details: • Multiplier effect is: • greatest in the horizontal AS range (much ability to increase GDP) • less in the intermediate range (increasing PL leads to inflation) • None in the vertical range ( GDP does not change – only price level)

19. Other Details: • RATCHET EFFECT (or “sticky wages”) • Prices don’t always go down when AD shifts left due to: wage contracts, worker morale, minimum wage laws, “menu costs” – costs to change prices up & down frequently & fear of “price wars” with competition. SHORT RUN – period when wages & other costs are FIXED (suppliers need time to adjust to change in AD/AS) LONG RUN – period when suppliers can make adjustments in LLC due to a change in AD/AS

20. AD/AS Equilibrium • Intersection of AD & AS • Shift results in change of PL and real GDP AS PL AD 2 E PL 1 AD 1 E O 1 Real GDP - Output FE

21. Discretionary Fiscal Policy • Goal is to restore economic stability • Tools – increase/decrease government spending or increase/decrease taxes • If recession – need expansionary policy (increase spending &/or decrease taxes) • If inflation – need contractionary policy (decrease spending &/or increase taxes)

22. Fiscal Policy Shifts AD AS PL AD1 AD 2 GDP OUTPUT RECESSION – AD SHIFTS RIGHT WHEN GOV SPENDING INCREASES OR TAXES DECREASE (more C & Ig)

23. Fiscal Policy Shifts AD AS PL AD1 AD2 GDP INFLATION – AD SHIFTS LEFT WHEN GOV SPENDING DECREASES OR TAXES INCREASE (less C or Ig)

24. Automatic Stabilizers • Government actions that were NOT done to help economy, but cause positive effects • In an expansion cycle – tax revenue increases & the surplus slows inflation • In a recession cycle – deficit spending stimulates the economy & creates jobs

25. Problems with Fiscal Policy • Timing: Recognition Lag, Administrative Lag & Operational Lag • Crowding Out Effect – deficit spending drives interest rates up and private Ig decreases so AD decreases • Net Export Effect – reduces Fiscal Policy effects

26. Net Export Effect • If Recession = F.P. Gov deficit spending will drive interest up • Foreign demand for US assets goes up in foreign exchange market • Dollar appreciates • Xn goes down (X - M = -Xn) • AD shifts left (lessens effect of F.P.)

27. Net Export Effect • If Inflation – F.P. gov decreases spending & interest rates drop • Foreign demand for US assets decreases in the foreign exchange market • Dollar depreciates • Xn goes up (X – M = +Xn) • AD shifts right (lessens effect of F.P.)

28. Crowding Out Effect • Government spending is often “deficit spending” (spendingtax revenue) • Gov borrows in the “Loanable Funds” Mkt by selling gov’t bonds & other securities • This drives up the price of borrowing (i) making it more expensive for Ig to occur • Gov borrowing has “crowded out” business spending lowering GDP (output) in the long run (less capital stock = less future output)

29. Supply Side Fiscal Policy • Theory to cut taxes to increase AS • Encourages savings to give businesses an incentive to expand investments • Lower income taxes encourage workers to work more & earn more • Entrepreneurs are more willing to take risks when they get more rewards

30. Last but NOT Least Problem – Congress is in control of Fiscal Policy THE END!