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.” The Demand for everything by everyone in the US.

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)

Shifters of Aggregate Demand

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

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)

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

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

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

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.

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

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

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

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

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

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

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!!!

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)

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)

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???

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

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!

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

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

Topic 3: Aggregate Supply 26

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

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

Shifters of SR Aggregate Supply

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

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…)

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

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

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

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

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

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

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

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

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

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

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

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

Shifts of LRAS

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

Practice 46

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

Topic 6: Putting AD and AS together to get Equilibrium Price Level and Output 48

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

Economic Instability Recession High unemployment Inflation Stagflation

  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

Inflationary and Recessionary Gaps 52

Full employment equilibrium Economy at FE with acceptable price level

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

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

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

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???

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

Topic 8: Short Run and Long Run 59

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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!)

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

Inflationary Gap on Phillips Curve LRPC Inflation SRPC UY Unemployment 82

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

Topic 10: Fiscal Policy 84

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

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

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

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

Video example of expansionary fiscal policy

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

* 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

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

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

* 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

Problems With Fiscal Policy 95

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

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

Topic 11: Focus on National Debt

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?

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

Where does the Federal Government get its money???

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

EXAMPLE OF PAYCHECK STUB 103

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

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 $400,000 *Source: CNBC

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

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

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

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

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!!!!!

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

Countries with largest debt as compared to GDPs

Ownership of the Debt

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

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.

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

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)

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)