Unit 4: National Income & Price Determination Modules 16-21 Read “From Boom to Bust”, pg. 158 & FYI pg. 162 (See Module 2 for more about the business cycle)

Module 16 Key Terms & Review Autonomous change in aggregate spending Disposable income Planned investment spending Inventory investment Unplanned inventory investment 1. 2. 3. 4. 5.

Spending Multiplier Autonomous (initial) changes in C, I, G, or Xn cause a ripple effect that changes GDP by a much larger factor How much larger?

Spending Multiplier cont.

Consumption Function

Consumer Spending (C) C = Autonomous consumer spending + (MPC x current disposable income) “For American households, the best estimate of the average household’s autonomous consumer spending is $17,484 and the best estimate of the MPC is 0.534.”

Shifts in the Consumption Function

What can cause the consumption function to shift? Read pgs. 165-166

Investment spending (I)

Investment cont. Planned investment spending is determined by

Interest rates

Inventory (pgs. 168-169) Inventory investment – value of the change in total inventories held in the economy during a given period

Module 17 Key Terms & Review Wealth effect Interest rate effect Fiscal policy Monetary policy 1. 2. 3. 4. 5.

Aggregate Demand

Why is AD downward-sloping? AD represents C + I + G + Xn G is constant (government decisions are not affected by the price level) Similar to the Law of Demand? No. You buy less Oreos when their price rises because you can switch to buying Moreos (a generic brand of Oreos produced on Mayberry Island)

AD cont. Downward-sloping due to the Wealth effect Interest rate effect

Shifts in Aggregate Demand

Factors that shift AD (17.1 pg. 176) Changes in expectations Changes in wealth Size of the existing stock of physical capital Government policies (fiscal policy) Use of G and/or taxes to stabilize the economy Federal Reserve policies (monetary policy) Use of changes in interest rates to stabilize the economy

Module 18 Key Terms & Review Nominal wage Sticky wages Commodity 1. 2. 3. 4. 5.

Aggregate Supply

Why is AS upward-sloping? Largest production cost for most suppliers is wages Profit = price per unit – production cost per unit Higher PL  Lower PL 

Shifts in AS

Factors that shift AS Factors that affect profit per unit

In the long run… Wages, as well as the cost of all inputs, are flexible Price level has no effect on AS

Long Run Aggregate Supply

Shifts in LRAS LRAS = PPC

SRAS  LRAS SRAS2 LRAS Price level SRAS1 Real GDP

SRAS  LRAS LRAS SRAS1 Price level SRAS2 Real GDP

Module 19 Key Terms & Review Demand shock Stagflation Recessionary gap Inflationary gap Output gap 1. 2. 3. 4. 5. Unemployment! Inflation!

The AD-AS Model

Shifts in AD

Shifts in AS

Long-run Macroeconomic Equilibrium

Negative Demand Shock

Positive Demand Shock

Module 20 Key Terms & Review Stabilization policy Social insurance Bush-era tax cuts - CBS news Colbert Report: trickle-down economics 1. 2. 3. 4. 5.

Stabilization Policy “In the long run we are all dead.” – John Maynard Keynes Advocated use of fiscal policy to smooth out the business cycle Negative demand shock:

Negative Supply Shocks Fiscal policy is not effective in increasing AS (return to original Yf) Solution: What problem does this fix? What problem does this cause?

Fiscal Policy Remember that pesky Circular Flow Diagram??? Read pgs. 204-206 to learn about the the different categories of taxes and spending

Fiscal Policy cont. GDP = C + I + G + Xn

Types of Fiscal Policy Recessionary gap  expansionary fiscal policy Taxes: Government spending: Transfer payments: Inflationary gap  contractionary fiscal policy Read about Lags in Fiscal Policy, pgs. 207-8

Module 21 Key Terms & Review Lump-sum taxes Automatic stabilizers Discretionary fiscal policy 1. 2. 3. 4. 5.

Fiscal Policy & the Multiplier Effect Autonomous (initial) change in government spending is magnified by the multiplier effect Changes to transfer payments & taxes have a lesser effect Tax multiplier =

Balanced Budget Multiplier Government collects taxes to cover its spending Add spending & tax multipliers together to get net impact on the economy

Example Increase in G by $50 requires and increase in taxes of $50. If the MPC is 0.8  Spending multiplier = Impact on the economy: Tax multiplier = Overall impact:

Who should the government target? Unemployed / poor have a higher MPC than the rich 

Taxes & the Multiplier Most taxes are positively correlated with RGDP  Acts as an automatic stabilizer for the economy

Automatic stabilizers Progressive taxes Transfer payments: Changes in government spending & taxes = discretionary fiscal policy Requires deliberate action by the legislative & executive branches

Unit 4 Review (pgs. 219-221) 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 21. 22. 23. 24. 25.

Inflation & the AD-AS Model SRAS2 LRAS Demand-pull AD increases  workers demand higher wages  SRAS decreases Long-run equilibrium: same output, higher price level Economy can only operate beyond full employment in the short-run Price level SRAS1 AD2 AD1 Real GDP

Inflation cont. Cost-push 2 choices SRAS2 LRAS Price level AS decreases > price level increases while output decreases > recession 2 choices Increase AD, could cause inflation Let the recession run its course Decreased demand for inputs will eventually lower their cost  AS will increase Price level SRAS1 AD2 ?? AD1 Real GDP

Recession & the AD-AS Model Decrease in AD causes lower output & price level Lower price level may eventually lead to lower wages  increase in AS End result: same output, lower price level Reality: Will wages actually fall? LRAS Price level SRAS1 SRAS2 AD1 AD2 Real GDP

When the magic happens… Permanent, long-run economic growth Rightward shift of LRAS = outward shift of PPC New, higher level of output without inflation LRAS LRAS1 Price level SRAS1 SRAS2 AD2 AD1 Real GDP