21. The modern tools of macroeconomic policy are: Monetary and Fiscal Policy
3Aggregate Demand Curve AD is downward sloping:PriceLevelNegative relationship between PL and OutputChanges in price level cause a move along the curveAD= C + I + G + XnReal domestic output (GDPR)
4Aggregate Demand Curve AD shows the relationship between aggregate PL and Aggregate demand by households, businesses, government, and the rest of the worldPriceLevelAD= C + I + G + XnReal domestic output (GDPR)
5Why is AD downward sloping? Wealth EffectHigher price levels reduce the purchasing power of moneyThis decreases the quantity of expendituresLower price levels increase purchasing power and increase expendituresExample:If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.So…Price Level goes up, GDP demanded goes down.
6Why is AD downward sloping? 2. Interest-Rate EffectWhen the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.Higher interest rates discourage consumer spending and business investment. WHY?Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.Result…Price Level goes up, GDP demanded goes down (and Vice Versa).
7What is Aggregate Supply? The supply for everything by all firms. Aggregate Supply is the amount of goods and services (real GDP) 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.Short-run Aggregate SupplyWages and Resource Prices will not increase as price levels increase.Long-run Aggregate SupplyWages and Resource Prices will increase as price levels increase.7
8Aggregate Supply Curve PriceLevelASAS is the production of all the firms in the economyReal domestic output (GDPR)8
9Shifters of Aggregate Supply Change in Inflationary ExpectationsIf an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS.(If people expect lower prices…)2. Change in Resource PricesPrices of Domestic and Imported Resources(Increase in price of Canadian lumber…)(Decrease in price of Chinese steel…)Supply Shocks(Negative Supply shock…)(Positive Supply shock…)9
10Shifters of Aggregate Supply (NOT Government Spending) Change in Actions of the Government(NOT Government Spending)Taxes on Producers(Lower corporate taxes…)Subsidies for Domestic Producers(Lower subsidies for domestic farmers…)Government Regulations(EPA inspections required to operate a farm…)Change in ProductivityTechnology(Computer virus that destroy half the computers…)(The advent of a teleportation machine…)10
11Shifts in Aggregate Demand An increase in spending shift AD right, and decrease in spending shifts it leftPriceLevelAD1AD= C + I + G + XnAD2Real domestic output (GDPR)11
20The Multiplier Effect The Multiplier Effect The Multiplier Effect The limiting factor is savings.For every additional dollar spent a portion of it will be saved (the MPS).The multiplier is the reciprocal of the MPS or 1/MPS.The larger the MPC (the smaller the MPS) the larger the multiplier will be.
21Tax MultipliersTax MultipliersTax MultipliersTax Multiplier (note: it’s negative because tax increases reduce spending)-MPC/1-MPC or -MPC/MPSIf there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow
22KeynesianGovernment Spending during a recession or depression and can improve an economy by injecting money into households.Recessions are inevitable.Many government programs like Social Security, Medicare, Unemployment, and Welfare were begun as Keynesian economic stimulus.Aggregate Demand must be stimulated in order to recover from a recession.
23Classical Free Markets will lead to full employment Keynesian Economics causes price bubbles, (inflation.)When the bubbles break, a recession (hangover) incurs.The booms and busts of the business cycle are natural and are self-correcting.Competition is the invisible handGovernment should be limited to preventing monopolies or unions
24MonetaryA non-political agency can regulate banks, the money supply, and interest rates. It will be especially effective when painful and unpopular decisions need to be made and will make them in a timely manner. This can be the central banking system.During recessions, impact the overall investment demand through tools that increase the incentive to borrow. This will be lower interest rates.During inflation, impact the overall investment demand through tools that decrease the incentive to borrow. This will be higher interest rates.