AP MACRO-Section 4 MODULES 16-21

AP MACRO-Section 4 MODULES 16-21
NATIONAL INCOME AND PRICE DETERMINATION MODULES 16-21 Describe the multiplier process by which initial changes in spending lead to further changes in spending. Use the consumption function to show how current disposable income affects consumer spending. Explain how expected future income and aggregate wealth affect consumer spending. Identify the determinants of investment spending. Explain why investment spending is considered a leading indicator of the future state of the economy.

If I were to give you $1,000,000 dollars, what would you do with it?
Warm Up If I were to give you $1,000,000 dollars, what would you do with it?

World Record!? The Domino Effect?

What we will cover in this Module:
The multiplier, which shows how initial changes in spending lead to further changes that literally multiply thru the economy. The aggregate consumption function, which shows how current disposable income affects consumer spending How expected future income and aggregate wealth affect consumer spending The determinants of investment spending Why investment spending is considered a leading indicator of the future state of the economy

In 2009, US government spent $787 billion in a “stimulus package” through the American Recovery and Reinvestment Act of 2009. Why did the US Government want to do this? Did it work?

Gross Pay: Income before taxes
Net Pay/Disposable income: Income after tax deductions. Discretionary Income: Income after all fixed expenses are paid.

Marginal Tax Rate[18] Single Taxable Income Married Filing Jointly or Qualified Widow(er) Taxable Income Married Filing Separately Taxable Income Head of Household Taxable Income 10% $0 – $9,225 $0 – $18,450 $0 – $13,150 15% $9,226 – $37,450 $18,451 – $74,900 $13,151 – $50,200 25% $37,451 – $90,750 $74,901 – $151,200 $37,451 – $75,600 $50,201 – $129,600 28% $90,751 – $189,300 $151,201 – $230,450 $75,601 – $115,225 $129,601 – $209,850 33% $189,301 – $411,500 $230,451 – $411,500 $115,226 – $205,750 $209,851 – $411,500 35% $411,501 – $413,200 $411,501 – $464,850 $205,751 – $232,425 $411,501 – $439,000 39.6% $413,201+ $464,851+ $232,426+ $439,001

Marginal Propensity (tendency) to Consume (MPC)
How much people consume rather than save when there is an change in income. It is always expressed as a fraction (decimal). MPC= Change in Consumer Spending Change in Disposable Income Examples: If you received $100 and spent $50. If you received $100 and spent $80. If you received $100 and spent $100. 10

Marginal Propensity to Save (MPS)
How much people save rather than consume when there is an change in income. It is always expressed as a fraction (decimal) MPS= Change in Saving Change in Disposable Income Examples: If you received $100 and save $50. If you received $100 your MPC is .7 what is your MPS? 11

Because people can either save or consume
MPS = 1 - MPC Why is this true? Because people can either save or consume 12

Autonomous Change in Aggregate Spending
This is the initial change in aggregate spending before real GDP rises. It is the cause, not the result, of the chain reaction. The multiplier is the ratio of the total change in real GDP caused by AAS. Multiplier = change in real GDP change in AAS Yd= 0 and people consume=autonomous consumption

The size of the multiplier will depend on the MPC
The size of the multiplier will depend on the MPC. The higher the MPC the higher the multiplier. {In other words, the more money spent the greater the impact the multiplier will have}

= x How is Spending “Multiplied”? Assume the MPC is .5 for everyone
Assume that when the Super Bowl comes to town 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 Change in GDP = Multiplier x Initial Change in Spending 15

= = x or If the MPC is .5 how much is the multiplier? 1 Simple
MPS 1 - MPC If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? How much will a decrease of $3 in spending decrease GDP? MPC = .5 the multiplier is 2 Change in GDP = Multiplier x initial change in spending 16

= The Multiplier Effect or
Practice calculating the spending multiplier Simple Multiplier = or 1 MPS 1 - MPC If MPC is .9, what is multiplier? If MPC is .8, what is multiplier? If MPC is .5, and consumption increased $2M. How much will GDP increase? If MPC is 0 and investment increases $2M. How much will GDP increase? Conclusion: As the Marginal Propensity to Consume falls, the Multiplier Effect is less 17

Warm Up: Why do you think the MPC is higher in poorer countries compared to richer countries?

What determines how much consumers spend?

Consumption Function: equation showing how household’s consumer spending varies with the household’s current disposable income. c= a + MPC x y d

c= individual household consumer spending
a= individual autonomous consumer spending (how much individual household would spend if no disposable income) y = disposable income d

Aggregate Consumption Function:
C = A + MPC x Y **Remember that factors that change the aggregate consumption function are similar b/c they increase or decrease at all levels of current disposable income. D

Two factors can change Aggregate Consumption Function
1. Changes in expected future disposable income (higher expected future income tends to lead to lower savings today…this is known as the permanent income hypothesis) 2. Changes in aggregate wealth (wealth has an effect on consumer spending and consumers generally plan their spending over their lifetime and not just based on current disposable income…the life-cycle hypothesis).

Answer these questions in your notebook as we listen to the broadcast:
Why do we want people to spend versus save? What are some problems that she cites? Why are they nervous about investment? As an economist, what would you advise the Federal Reserve?

Do you understand Monetary Policy?
Do you understand Monetary Policy? Now might be a good time to start reading articles on what monetary policy does. Take a listen to video at the top of the page. Summarize what you learn.

Investment Spending Planned Investment is what firms intend to undertake in a given period but it will depend on three (3) factors: 1- interest rates 2-expected future GDP 3- current level of production capacity Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. Most recessions start with a fall in investment spending. Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in investment spending.

Interest Rates If a firm predicts high interest rates, then they will invest less and vice versa = a negative relationship between interest rates and investment

Investment Spending Expected return on the investment=expected economic profit from the factory= (total revenue minus total cost)/investment cost.

Conditions which a business will invest even with high interest rates.
Expected Future Real GDP *If firms predict a rise in GDP, they are more likely to invest and vice versa Production Capacity *….only if production capacity is taken into account: the maximum they can produce and how close to it are they?

Perfect Storm Production is near capacity and expectations of strong real GDP in the future

Inventories Firms that increase inventories are engaging in a form of investment spending. Higher than anticipated inventories due to a unplanned decrease in sales is known as unplanned inventory investment. Rising inventories typically indicates a slowing economy and falling inventories usually indicates a growing economy since sales are better than what was forecast.

Actual Investment Spending
= the sum of planned investment and unplanned inventory investment  Investment (I) = I unplanned + I planned

The Tax Multiplier Recipients of a tax decrease treat it as an increase in disposable income. A typical household increases consumption by a factor of the MPC and increases savings by a factor of the MPS. Keep in mind that less than a 100% of this increase in disposable income circulates through the economy- WHY? Because most households save a proportion of it. Example: If the MPC is equal to .90 and the govt. transfers back tax revenue to consumers by sending each taxpayer a $200 check. With an MPC =.90, (.9 x 200) = $180 is consumed and $20 is saved. The multiplier kicks in, but not on the entire $200. Only on the consumed portion of the $180. The multiplier is 1/.10 = 10, GDP increases by $1800. Summary: A $200 change in tax policy ( tax rebate in this example) caused an $1800 change in real GDP. This tax multiplier of 9 measures the magnitude of the multiplier process when there is a change in taxes. The tax multiplier is found by : Tm= is (∆GDP)/(∆ taxes) Tm= MPC*M= MPC/MPS The tax multiplier is shown as a negative number.

Be prepared to respond to a free-response question that asks you to explain why the tax multiplier is smaller than the spending multiplier With an MPC =.90 the spending multiplier is 10, so why is the tax multiplier Tm smaller? The Spending multiplier begins to work as soon as there is a change in autonomous spending (C,I, G, Xn) but the tax multiplier but first go through a person’s consumption function as disposable income. In our $200 example some of the injected dollars are leakages in the form of savings. Therefore the final multiplier effect is smaller. Tm= MPC*(Spending multiplier)= .90 * (1/.10)= 9 in our example.

Example #2 The MPC =.80 and the government decides to impose a $50 increase in taxes. Tm=.80*Multiplier =.80 *(1/.20 = 4 B/cause the tax multiplier is equal to 4 we determine that GDP falls by $ x 4= 200. Taxes were increases-disposable income falls, consumption falls, causing GDP to fall, in this case by a factor of 4.

Balanced Budget Multiplier
The government collects and spends tax revenue IF the dollars spent equals the dollars collected the budget is balanced. The spending and tax multipliers are different Here’s an example of the balanced-budget multiplier The govt wants to spend $100 on a federal program and pay for it by collecting $100 in additional taxes. The MPC = .9 in this case. Spending multiplier= 10 implies that $100 of new spending (G) creates a $1000 increase in real GDP. Taxation effect: The Tm=.9 implies that a $100 increase in taxes decreases real GDP by $900. Balanced budget effect: Change in real GDP= $1000 -$900 = +100 So, a $100 increase in spending, financed by a $100 increase in taxes, created only $100 in new GDP. The balanced-budget multiplier is always equal to one, regardless of the MPC. Balanced-Budget Multiplier =1

Current Events Unemployment Article

You are an economic advisor to Congress
After reading the article, create a proposal for what the government should do in regards to unemployment benefits.  include the positives and negatives for extending/cutting the benefits.  include what you think will happen to the MPC and MPS for people who are unemployed and people who are afraid they may be unemployed in the near future. Predict what you think will happen to aggregate supply and demand as well (this is what we are learning about today)

Aggregate Demand: Module 17
When we use aggregates we combine all prices and all quantities. Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. There is an inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases.

This is Simple Demand

This is Aggregate Demand

Demand and Supply Review
Define the Law of Demand. Explain why demand is downward sloping. Identify the difference between a change in demand and a change in quantity demanded. Define the Law of Supply. Why is supply upward sloping?

Answers to Review Define the Law of Demand.
Higher price equals less demand Explain why demand is downward sloping. Lower price equals greater quantity demanded Identify the difference between change in demand and change in quantity demanded. Shift in curve vs. movement along the curve Define the Law of Supply. P and Q are positively related Why is supply upward sloping? higher price equals greater quantity supplied

Aggregate Demand Curve
AD is the demand by consumers, businesses, government, and foreign countries Price Level Changes in price level cause a move along the curve not a shift of the curve AD = C + I + G + Xn Real domestic output (GDPR)

Aggregate Demand The wealth effect The interest rate effect
The aggregate demand curve shows the output of goods and services (real GDP) demanded at different price levels. The aggregate demand curve slopes down due to: The wealth effect The interest rate effect

2 Reasons Why is AD downward sloping
Wealth Effect Higher prices reduce purchasing power of $ This decreases the quantity of expenditures Lower price levels increase purchasing power and increase expenditures Example: 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.

2. Interest-Rate Effect As 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. Ex: 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).

Higher Inflation brings higher interest rates

Agenda Warm up Current Events Brief Notes Shifting Graphs Practice
Aggregate Supply-Long and short run notes Homework: Module 18 in SG

How does this cartoon relate to Aggregate Demand?

Shifts of the Aggregate Demand Curve
∆C, ∆I, ∆G, ∆X - ∆M ∆Expectations ∆Wealth ∆Existing Stock of Capital ∆Fiscal Policy ∆Monetary Policy There are shifts of the aggregate demand curve, changes in the quantity of goods and services demanded at any given price level. An increase in aggregate demand means a shift of the aggregate demand curve to the right, as shown in the figure below. A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level. A decrease in aggregate demand means that the AD curve shifts to the left. A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level. Whether AD shifts to the right or to the left, the multiplier effect increases, or decreases, total spending throughout the economy. 1. Changes in Expectations When consumers and firms are more optimistic about their future economic prospects, they will increase consumption and investment spending. This shifts AD to the right. 2. Changes in Wealth We discussed in the last module that the consumption function increased if consumer wealth increased. When the value of accumulated household assets goes up, consumers respond by increasing current consumption. This is one reason why a weak stock market or real estate market has a negative ripple effect in the economy by shifting AD to the left. 3. Size of the Existing Stock of Physical Capital Firms plan to invest in physical capital when the stock is being depleted or is insufficient to meet demand for their products. If firms have plenty of physical capital already, investment spending will slow down. C. Government Policies and Aggregate Demand Note: prepare the students for future chapters on fiscal and monetary policy by getting them to think about how the government can affect AD. Government can have a powerful influence on aggregate demand and that, in some circumstances, this influence can be used to improve economic performance. The two main ways the government can influence the aggregate demand curve are through fiscal policy and monetary policy. 1. Fiscal Policy Congress and the President control fiscal policy. Fiscal policy is the use of either government spending—government purchases of final goods and services and government transfers—or tax policy to stabilize the economy. Suppose the economy was in a recession. The government can intervene directly or indirectly. If the government increases spending (G), it will have a direct impact on AD by shifting AD to the right. If the government decreased taxes, this would increase disposable income, and this would increase consumption spending. The increase in C would shift the AD curve to the right, helping to indirectly reverse the recession. 2. Monetary Policy The Federal Reserve controls monetary policy—the use of changes in the quantity of money or the interest rate to stabilize the economy. This drives the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending. When the Fed increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. Thus increasing the quantity of money shifts the aggregate demand curve to the right. Note: the students will be exposed in great detail to monetary policy in upcoming chapters of the text.

GDP= C+ I+ G+(X-M) GDP = private consumption + gross investment + government spending + (exports − imports),

How the Government Stabilizes the Economy
The Government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress & the President OR 2. Monetary Policy-Actions by the Federal Reserve Bank (aka Central Bank actions)

Fiscal Policy Changes to AD Curve
Direct: The Government’s purchases of final goods and services. Indirect: A change in either tax rates or transfers to households.

Monetary Policy Changes to AD Curve
Federal Reserve Bank’s change in the quantity of money or interest rates will shift the curve. Increasing the quantity of money shifts the AD curve to the right Reducing the quantity of money supply will shift the AD curve to the left.

If one of these components of aggregate spending changes, the aggregate demand curve will shift.
A rightward shift of the curve is an increase in aggregate demand. A leftward shift of the curve is a decrease in aggregate demand.

From Khan: https://www. khanacademy

Acronym?-turn and talk to your partner to create an acronym for our shifters:
Wealth, expectations, existing physical capital, fiscal and monetary. Write down your suggestion on the flashcard

Shifts in Aggregate Demand
A shift of aggregate demand to the right means that more real output will be demanded at each price level. If AD shifts left, less real output is demanded at each price level. Aggregate Price Level (P) P0 AD1 AD2 AD0 Q2 Q0 Q1 Output (Q)

An increase in spending shifts AD right, a decrease in spending shifts AD left
Price Level AD1 AD2 Real domestic output (GDPR) 62

Review:

Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward). Then, in a correctly labeled graph, show how each of the following will affect the AD curve. a. Business owners are less optimistic about the health of the economy. b. The government decreases welfare and veteran’s benefits. c. The Federal Reserve increases interest rates. d. A rising price level decreases the value of money held for purchases. e. The government lowers personal income taxes. f. Consumers expect the job market to be much stronger in the next few months. g. The stock market has reached new records high levels of value. h. The stock of physical capital has been falling for nearly a year.

a. Leftward shift in AD (a decrease in AD)
a. Leftward shift in AD (a decrease in AD). Weak business optimism will decrease business spending and capital investment. b. Leftward shift in AD. Less government spending on these transfer payments means less income received by those who qualify for them, thus less consumer spending. c. Leftward shift in AD. Higher interest rates decrease borrowing for both capital investment and large consumer spending. d. Upward movement along the AD curve. The rising price level will reduce spending because each dollar held by households and firms is worth less than it used to be. e. Rightward shift in AD. Lower taxes put more income in the hands of consumers so consumer spending rises. f. Rightward shift in AD. Stronger consumer optimism will increase consumer spending. g. Rightward shift in AD. Higher value of household wealth causes consumer spending to rise h. Leftward shift in AD. A. lower level of physical capital is an indicator that investment spending has fallen.

Change in Consumer Spending
Consumer Wealth (Boom in the stock market…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Taxes (Decrease in income taxes…) 2. Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase…) (If interest rates decrease…) Future Business Expectations (High expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

“If the US get a cold, Canada gets Pneumonia”
Change in Government Spending (War…) (Nationalized Heath Care…) (Decrease in defense spending…) Change in Net Exports (X-M) Exchange Rates (If the us dollar depreciates relative to the euro…) National Income Compared to Abroad (If a major importer has a recession…) (If the US has a recession…) If dollar depreciates, more Europeans will buy US products causing Net Exports to increase “If the US get a cold, Canada gets Pneumonia” AD = GDP = C + I + G + Xn 69

Current Events

Warm Up: What do you think the Consumer Confidence Index measures. Why
Warm Up: What do you think the Consumer Confidence Index measures? Why? How does this tie into aggregate demand?

Agenda: Warm Up Graphing Shifters Practice Graphing

Current Events:

Aggregate Supply: Module 18
The amount of goods and services (real GDP) that firms produce in an economy at different price levels. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply Wages and Resource Prices will not increase as price levels increase. Long-run Aggregate Supply Wages and Resource Prices will increase as price levels increase.

This is Supply

This is Aggregate Supply

Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT increase as price levels increase. Example: If a firm currently makes 100 units that are sold for $1 each and 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 so total return=$200. How much is profit? Profit = $120 With higher profits, the firm has the incentive to increase production.

The SRAS curve is upward sloping..
But why? If the price of a unit of output is rising faster than the cost of producing that unit, that unit of output will be produced. (some input prices are “sticky” meaning they don’t rise of fall very quickly in response to a change in demand for them.)

Aggregate Supply Curve
Price Level AS AS is the production of all the firms in the economy Real domestic output (GDPR) 79

The Shifters for Aggregate Supply can be remembered as
I. R. A. P.

Shifts in 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) 81

Graph Shifters: 1.Commodity Prices: standardized input bought and sold in bulk quantities 2. Nominal Wages 3. Productivity: increasing/decreasing output

Long-Run Aggregate Supply
In the Long Run, wages and resource prices WILL increase as price levels increase. Same Example: The firm has TR of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now Total Revenue=$200 In the LONG RUN workers demand higher wages to match prices. 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.

Long run Aggregate Supply
In Long Run, price level increases but GDP doesn’t LRAS Price level Long-run Aggregate Supply Full-Employment (Trend Line) QY or Yp GDPR Assume that in the long run the economy will be producing at full employment.

Potential Output: the level of Real GDP the economy would produce if all prices, including nominal wages, were fully flexible Given this, which way do you think our long run aggregate supply curve has been shifting?

Practice-CPTS!

a. Leftward shift in SRAS
a. Leftward shift in SRAS. This disruption would act as a short-term decrease in a nation’s technology and hinder the nation’s ability to produce goods and services. b. Leftward shift in SRAS. When the price of a commodity such as grain rises, it will increase production costs for many goods and services; shifting SRAS to the left. c. Rightward shift in SRAS. A population with higher levels of education translates into a more productive workforce that is able to produce more goods and services. d. Downward movement along the SRAS curve. The SRAS curve is upward sloping so that, all else equal, a lower aggregate price level will reduce the level of GDP supplied. e. Leftward shift in SRAS. Labor is a key resource in the production of most goods and services so if labor is becoming more expensive, the SRAS will shift to the left.

Module 19: Putting AD and AS together to get Equilibrium Price Level and Output

91

Macroeconomic equilibrium occurs at the intersection of aggregate demand and short-run aggregate supply. LRAS SRAS It can also happen that this occurs at the long-run equilibrium point, but not necessarily. Aggregate Price Level AD Aggregate Output

As we have learned a Demand Shock can effect equilibrium:
Great Depression Housing Market crash of Shocks cause a shift in the Aggregate Demand or Supply and can also lead Recessionary Gaps or Inflationary Gaps or Stagflation

Shifters of Aggregate Demand Shifters of Aggregate Supply
AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply AS = I + R + A + P Change in Inflationary Expectations Change in Resource Prices Change in Actions of the Government Change in Productivity (Investment)

Answer and identify shifter: C.I.G.X or R.A.P
B A D A D B A A C A major increase in productivity. A 95

Inflationary Gap Output is high and unemployment is less than NRU LRAS
Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 96

Recessionary Gap Output low and unemployment is more than NRU LRAS
Price Level AS1 Actual GDP below potential GDP PL1 AD Q1 QY GDPR 97

Stagnate Economy + Inflation
Assume the price of oil increases drastically. What happens to PL and Output? LRAS Price Level AS1 AS PL1 Stagflation Stagnate Economy + Inflation PLe AD Q1 QY GDPR 98

Assume the government increases spending. What happens to PL and Output?
LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 99

Assume consumers increase spending. What happens to PL and Output?
LRAS Price Level AS PL1 PLe AD1 AD QY Q1 GDPR 100

Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 101

Negative and Positive Aggregate Demand Shocks
Another Example

Negative and Positive Supply Shocks
Another Example

Long Term Equilibrium To summarize how an economy responds to recessions/inflation we focus on Output Gap which is the % difference between actual aggregate output and potential output. Actual Aggregate Output-Potential Output x 100 Potential Output In the Long Run the economy is self-correcting but many times Governments are not willing to wait that long which brings about Macroeconomic Policy (Module 20)

Short-Run Versus Long-Run Effects of a Positive Demand Shock and a return to Equilibrium via self- correcting economy.

MODULE 20 Classical vs. Keynesian
Economic Theory Adam Smith John Maynard Keynes

Debates Over Aggregate Supply
Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Recessions caused by a fall in AD are temporary. Price level Price level will fall and economy will fix itself. No Government Involvement Required AD AD1 Qf Real domestic output, GDP 108

Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level “Sticky Wages” prevents wages to fall. The government should increase spending to close the gap AD AD1 Q1 Qf Real domestic output, GDP 109

Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment Price level AD3 AD1 AD2 Q1 Qf Real domestic output, GDP 110

The Ratchet Effect A ratchet (socket wrench) permits one to crank a tool forward but not backward. Like a ratchet, prices can easily move up but not down! 111

Deflation (falling prices) does not often happen
If prices fall, the cost of resources must fall or firms would go out of business. The cost of resources (especially labor) rarely fall because: Labor Contracts (Unions) Wage decrease results in poor worker morale. Firms must pay to change prices (ex: re-pricing items in inventory, advertising new prices to consumers, etc.) 112

Module 21: Fiscal Policy & The Multiplier
113

The Car Analogy The economy is like a car…
You can drive 120mph but not for long. (Extremely Low unemployment) Driving 20mph is too slow. The car can easily go faster. (high unemployment) 70mph is sustainable. (Full employment) Some cars have the capacity to drive faster then others. (industrial nations vs. 3rd world nations) If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS) The government’s job is to brake or speed up when needed as well as promote things that will improve the engine. (Shift the PPC outward)

Two Types of Fiscal Policy
Discretionary Fiscal Policy- Congress creates a law designed to change AD through government spending or taxation. Problem is time lags due to bureaucracy. Takes time for Congress to act. Ex: In a recession, Congress increases spending. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Permanent spending or tax laws enacted to counter cyclical problem to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc. When there is high unemployment, unemployment benefits to citizens increase consumer spending. 116

Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease GDP Either Decrease Government Spending or Enact Tax Increases Combinations of the Two Expansionary Fiscal Policy (The GAS) Laws that reduce unemployment and increase GDP Increase Government Spending or Decrease Taxes on consumers Combinations of the Two How much should the Government Spend? 117

Example of Expansionary Fiscal Policy
increase G decrease T increase transfers

Expansionary Policy: The Stimulus Package

Example of Contractionary Fiscal Policy
decrease G increase T decrease transfers

The Multiplier Effect Spending Multiplier OR As the Marginal Propensity to Consume falls, the Multiplier Effect becomes less effective

Effects of Government Spending
If the government spends $5 Million, will AD increase by the same amount? No, AD will increase even more as spending becomes income for consumers. Consumers will take that money and spend, thus increasing AD. How much will AD increase? It depends on how much of the new income consumers save. If they save a lot, spending and AD will increase less. If they save a little, spending and AD will be increase a lot.

Problems With Fiscal Policy
123

Explain this cartoon About Fiscal Policy
2003

Who ultimately pays for excessive government spending?

Practice Problem to Draw
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .9) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much needed to close gap? AS P2 Price level AD1 AD -$5 Billion $50FE $100 Real GDP (billions) 126

Practice Problem to Draw
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much initial government spending is needed to close gap? AS Price level P1 AD2 AD1 +$40 Billion $ $1000FE Real GDP (billions) 127

WHY? What type of gap and what type of policy is best?
What should the government do to spending? Why? How much should the government spend? The government should increasing spending which would increase AD They should NOT spend 100 billion!!!!!!!!!! If they spend 100 billion, AD would look like this: LRAS AS Price level WHY? P1 AD2 AD1 $ $500 Real GDP (billions) 128 FE

Answers to Practice FRQ
129

Current Events: Housing Market Bubble: What really led to the 2008 Financial Crisis?

Eyes Turn To The Fed As Unemployment Rate Falls To 5-Year Low
Current Events Eyes Turn To The Fed As Unemployment Rate Falls To 5-Year Low December 06, :40 AM The nation's unemployment rate dropped to 7 percent — the lowest mark in five years — and employers added 203,000 jobs to payrolls last month, the Bureau of Labor Statistics Friday. The latest data could build anticipation that the Federal Reserve might taper its stimulus program.

AP MACRO-Section 4 MODULES 16-21

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