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Unit 2: Aggregate Demand and Supply and Fiscal Policy

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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Unit 2: Aggregate Demand and Supply and Fiscal Policy

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  1. Unit 2:Aggregate Demand and Supply and Fiscal Policy

  2. Topic 1: Aggregate Demand

  3. 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.

  4. 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)

  5. Shifters of Aggregate Demand

  6. 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

  7. 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)

  8. 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

  9. 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

  10. Topic 2: The Multiplier Effect Why do cities want the Superbowl in their stadium? 10

  11. 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.

  12. 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

  13. 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

  14. MPC + MPS = 1 Why is this true? Because people can either save or consume 14

  15. 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

  16. How multiplier effect works • New income of $100 ; MPC = .5 * remember someone’s spending becomes someone else’s income

  17. 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

  18. 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!!!

  19. 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)

  20. 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)

  21. 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???

  22. 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

  23. 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!

  24. 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

  25. 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

  26. Topic 3: Aggregate Supply 26

  27. 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

  28. Short Run Aggregate Supply Curve AS Price Level AS is the production of all the firms in the economy Real domestic output (GDPR) 28

  29. Shifters of SR Aggregate Supply

  30. 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

  31. 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…)

  32. Shifters of SR Aggregate Supply Legalities * Business taxes (shifts AD too!) Subsides Government Regulations Change in Productivity Change in Technology 32

  33. Topic 4: Classical vs. Keynesian view of SRAS Adam Smith 1723-1790 John Maynard Keynes 1883-1946 33

  34. 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

  35. Debates Over Aggregate Supply Classical Theory – AS is vertical AS Price level Qf Real domestic output, GDP 35

  36. 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

  37. 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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

  44. Shifts of LRAS

  45. 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

  46. Practice 46

  47. 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

  48. Topic 6: Putting AD and AS together to getEquilibrium Price Level and Output 48

  49. Topic 7: Economic Stability • A stable economy is represented by: • Economic growth • Price stability • Full employment

  50. Economic Instability • Recession • High unemployment • Inflation • Stagflation

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