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)
If dollar depreciates, more Europeans will buy US products causing Net Exports to increase
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. Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
How much people consume rather than save when there is a change in income.
MPC=
Change in Consumption
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. Marginal Propensity to Save
Marginal Propensity to Save (MPS)
How much people save rather than consume when there is a change in income.
MPS=
Change in Saving
Change in Income
Examples:
If you received $100 and save $50. MPS?
If you received $100 and save $30. MPS? 13

14. Because people can either save or consume
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
Round
Income
Spending
Savings 1
$100
$50 2
$25 3
$12.50

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 multiplier if 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 Supply26

27. What is Aggregate Supply? The supply for everything by all firms.
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
Price
Level AS
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
Price
Level AS
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
John Maynard Keynes 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. 1. AS is horizontal at low output
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 get Equilibrium Price Level and Output48

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

51. Unemployment
Inflation
GDP Growth
Good
less than 6%
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less

52. Inflationary and Recessionary Gaps52

53. Full employment equilibrium Economy at FE with acceptable price level

54. Inflationary Gap Output is high and employment is greater than FE LRAS
Price Level AS
Actual GDP above FE/potential GDP
PL1
AD1 QY Q1
GDPR 54

55. Recessionary Gap Output low and employment is less than FE LRAS
Price Level
AS1
Actual GDP below FE/potential GDP
PL1 AD Q1 QY
GDPR 55

56. STAGFLATION
if both inflation and unemployment are high STAGFLATION will occur
What curve shift illustrates this problem?
This problem is represented by a DECREASE in SRAS

57. What economic problem does this cause???
The economy begins at FE and the G increases spending. Shift the curve on the graph
What economic problem does this cause???

58. The economy begins at FE and net export spending decreases.
Shift the curve on the graph
What economic problem does this cause???

59. Topic 8: Short Run and Long Run59

60. Shifts in AD or AS change the price level and output in the SR, but only price level in the LR
LRAS
Price Level AS
PLe AD QY
GDPR 60

61. Example: Assume inflation is occurring in the economy
Price Level
LRAS AS
PL1
AD1 AD QY Q1
GDPR 61

62. Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and wages increase (shifts AS to LEFT)
LRAS
Price Level
AS1 AS
PL2
Back to full employment with higher price level
PL1 AD QY Q1
GDPR 62

63. LRAS Price Level AS PL1 AD AD AD1 Q1 QY
Example: Assume a recession is occurring in the economy
Price Level
LRAS AS
PL1 AD AD
AD1 Q1 QY
GDPR 63

64. AS increases as workers accept lower wages and production costs fall
What happens in the Long Run? Due to recession, workers accept lower wages. As WAGES go down, SRAS shifts to the right
Price Level
LRAS AS
AS1
AS increases as workers accept lower wages and production costs fall
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
PL1
PL2 AD Q1 QY
GDPR 64

65. A ratchet (socket wrench) tool forward but not backward.
The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward. 65

66. Does deflation (falling prices) often occur?
Not as often as inflation. Why?
Prices and wages are more flexible upward as opposed to downward
Like a ratchet, prices can easily move up but not down! 66

67. Topic 9: The Phillips Curve
SRPC Shows tradeoff between inflation and unemployment.

68. Short Run Phillips Curve
When the economy is overheating, there is low unemployment but high inflation (A)
Inflation
When there is a recession, unemployment is high but inflation is low (B) 5% A
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% B
SRPC 2% 9%
Unemployment 68

69. Shifts of Short run Phillip’s curve
inflation and unemployment move in the SAME direction, there will be a SHIFT of the SRPC
-If inflation and unemployment both go up; SRPC shifts to the RIGHT
- If both go down, SRPC shifts to the LEFT
Change in inflationary expectations
if these increase, SRPC shifts RIGHT
if these decrease, SRPC shifts LEFT

70. Assume stagflation occurs Draw an AD/AS graph showing this
SRAS SHIFTS TO THE LEFT
In the Short run, what happens
Price level? increases
Unemployment? increases
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 70

71. What is impact on SRPC? Shifts to the right
Inflation
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1
SRPC
Unemployment 71

72. Consumers begin to save more money. Draw an AD/AS graph that shows this
AD SHIFTS TO THE LEFT In the short run, what happens to Price level? Decreases Unemployment? INcreases

73. Movement down along original curve
What is impact on SRPC?
Movement down along original curve
Inflation A B
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC
Unemployment 73

74. The prices of resources decrease.Draw an AD/AS graph showing this
SRAS SHFITS TO THE RIGHT What happens in the short run to price level? decreases unemployment? decreases

75. What is impact on SRPC? Shifts to the left
Inflation
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC
SRPC 1
Unemployment 75

76. From Short run Phillips curve to Long run Phillips curve
Because the SRPC is continually shifting in the LONG RUN, there is no trade off between inflation and unemployment

77. Example: The economy is at FE and interest rates increase
What problem does this create? RECESSION
What happens in the long run to…
Price level DECREASES
Unemployment DECREASES
What will happen to the SRPC in the Long Run?
SHIFTS to the LEFT

78. Example: The economy is at FE and consumer spending increases
What problem does this create? INFLATION
What happens in the long run to…
Price level? INCREASES
Unemployment INCREASES
What will happen to the SRPC in the Long Run?
SHIFTS TO the RIGHT

79. The LRPC is vertical at the Natural Rate of Unemployment
In the long run there is no tradeoff between inflation and unemployment due to SRPC continually shifting
LRPC
Inflation 5%
The LRPC is vertical at the Natural Rate of Unemployment 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9%
Unemployment 79

80. SHIFTS OF LRPC
LRPC can shift if there is a change in the Natural rate of unemployment
LRPC will never shift by itself (if you shift LRPC, shift SRPC too!)

81. Phillips curve at FE equilibrium
LRPC
The unemployment rate is at the NATURAL RATE
and
inflation rate is at the EXPECTED RATE
Inflation
SRPC UY
Unemployment 81

82. Inflationary Gap on Phillips Curve
LRPC
Inflation
SRPC UY
Unemployment 82

83. Recessionary Gap on the Phillips Curve
LRPC
Inflation
SRPC UY
Unemployment 83

84. Topic 10: Fiscal Policy 84

85. Fiscal Policy- Based on Keynesian theory
Fiscal Policy: Actions by Congress to speed up or slow down the economy
A stable economy should have:
1. stable prices
2. full employment
3. economic growth

86. Two Types of Fiscal Policy
1. Discretionary Fiscal Policy-
Congress creates and passes a new bill
ex. Congress votes to implement a tax cut 86

87. Two Types of Fiscal Policy
2. Automatic Stabilizers
Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy
Ex: Welfare, Unemployment, Min. Wage, etc.
When there is high unemployment, unemployment benefits to citizens increase consumer spending. 87

88. Expansionary Fiscal Policy
Implemented during RECESSION
Goal is to SPEED UP economy without causing too much inflation
Need to increase AD

89. Video example of expansionary fiscal policy

90. How can the government speed up the economy????
1. Increase government spending (public works, roads, schools etc.) *need to account for the SPENDING MULTIPLIER 2. Decrease personal income taxes (Consumers will have more $, so they will spend more) *need to account for the TAX MULTIPLIER

91. * government can increase its spending, decrease taxes or do both – any of these actions increase AD
Expansionary policy will result in a DEFICIT BUDGET
Deficit Budget: the government spends more $ than what they take in

92. Contractionary Fiscal Policy
Implemented during INFLATION Goal is to SLOW DOWN economy without causing recession Want to decrease AD

93. How can the government slow down the economy???
1. Decrease government spending
* need to account for spending multiplier
2. Raise personal income taxes
*need to consider tax multiplier

94. * Government can decrease its spending, raise income taxes or both – any of these actions will slow down the economy/decrease AD
Contractionary Policy results in a SURPLUS BUDGET
Surplus Budget: the government spends less $ than what they take in

95. Problems With Fiscal Policy95

96. Problems With Fiscal Policy
1. Deficit Spending!!!!
A Budget Deficit – government spending exceeds its revenue.
The National Debt is the accumulation of all the budget deficits over time.
Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy. 96

97. Additional Problems with Fiscal Policy
2 Problems of Timing
Recognition Lag- Congress must react to economic indicators before it’s too late
Administrative Lag- Congress takes time to pass legislation
3. Politically Motivated Policies
Politicians may use economically inappropriate policies to get reelected. 97

98. Topic 11: Focus on National Debt

99. The National Debt: CNBC explains
1. What is the difference between deficit spending and the national debt?
2. What is the DEBT CEILING?
3. If the government borrows $, how does it get the money it needs?
4. Who/what is the largest holder of U.S. debt?

100. Where does the State and local government get $ from???

101. Where does the Federal Government get its money???

102. Income taxes Tax based on the “income” a person earns
Americans pay an income tax to:
1. The federal government
2. The state government
3. The local government
These taxes appear on a person’s pay check stub
The purpose of filing taxes at the end of the year is to determine
if a person has overpaid or underpaid their taxes
102

103. EXAMPLE OF PAYCHECK STUB
103

104. Stossel goes to Washington: segment 1
(7:40)

105. Countries with the highest income tax rates
Country
Tax rate
Kicks in at….
Aruba
58.9%
$165,000
Sweden
56.6%
$81,000
Denmark
55.4%
$76,000
Netherlands
52%
$72,000
Austria
50%
$80,000
Belgium
$46,900
Japan
$217,000
United Kingdom
$231,000
Finland
49.2%
$91,000
Ireland
48%
$43,900
U.S. = 23rd; at 39.6% at $400, *Source: CNBC

106. Where does the State and local government spend money???

107. Where does the federal government spend money ?
everything else includes education, veterans benefits, national resources, foreign aid, Immigration, response to natural disasters

108. Military spending around the world http://www. sipri

109. What is the national debt???
Debt occurs when government revenue (primarily from taxes) is less than government spending.
Therefore debt will rise whenever..
revenue falls
spending increases

110. Debt in the past decade DEBT CLOCK
2001: $5.8 trillion
2002: $6.2 trillion
2003: $6.8 trillion
2004: $7.4 trillion
2005: $7.9 trillion
2006: $8.5 trillion
2007: $9.0 trillion
2008: $10.0 trillion
2009: $11.9 trillion
2010: $13.6 trillion
DEBT CLOCK
It would take 200,000 years to count to 1 trillion!!!!!

111. Countries with the largest debts
Source: David Colander - Macroeconomics
17-111

112. Countries with largest debt as compared to GDPs

113. Ownership of the Debt

114. Congressional Committees
As a group, analyze the situation, identify the problem, and identify your solution
The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less

115. 1.) 1933 Situation: GDP fell -1.2% Inflation rate= -.5%
Unemployment Rate=25%
Your Solution:
What actually happened:
FDR increased public works via the New Deal programs.

116. 2.) 1944 Situation: GDP grew 8% Inflation rate= 3.7%
Unemployment Rate=1.2%
Your Solution:
What actually happened:
War ended the next year and government orders for war materials decreased.
Many public works programs were discontinued

117. 3.) 1980 Situation: GDP fell -0.3% Inflation rate= 13.5%
Unemployment Rate=7.1%
Your Solution:
What actually happened:
The next year, President Regan and congress lowered taxes on individuals and corporations by about 30%. (Supply-side Economics)

118. 4.) 2003 Situation: GDP fell 0.5% Inflation rate= 1.5%
Unemployment Rate=12.0%
Your Solution:
What actually happened:
Congress voted to give tax cuts to citizens. (Bush Tax Cuts)