Presentation on theme: "National Income and Price Determination: Aggregate Supply and Aggregate Demand By: Darshana Balasubramaniam, Kristina Bogardy, Spencer Cappelli, Ryan Lawler."— Presentation transcript:
National Income and Price Determination: Aggregate Supply and Aggregate Demand By: Darshana Balasubramaniam, Kristina Bogardy, Spencer Cappelli, Ryan Lawler
Aggregate Demand Aggregate Demand is the relationship between all spending on domestic output (real GDP) and the average price level of that output. Real GDP and price level are inversely proportional. AD= C + I + G + X n
Why is AD Downward Sloping? Real-Balance Effect: Higher price levels reduce the purchasing power of money and decrease the quantity of expenditures. (also known as the Wealth Effect) Interest Rate Effect: When the price level increases lenders need to charge higher interest rates to get a real return on loans. Higher interest rates discourage spending. Foreign Trade Effect: When U.S. price level increases, exports fall and imports rise causing GDP to fall, and vice versa.
Shifters of Aggregate Demand An increase in spending shift AD to the right. 1. Change in Consumer Spending (ex. Taxes, Consumer Expectations) 2. Change in Investment Spending (ex. Interest rates) 3. Change in Government Spending (ex. War) 4. Change in Net Exports (ex. Exchange Rates)
Multiplier Effect: Discretionary Fiscal Policy Describes how a change in any component of aggregate expenditures creates a larger change in GDP. MPS = Marginal Propensity to Save: How much people save rather than consume when there is a change in income. It is described as a fraction MPS = Change in Savings/Change in Income
Marginal Propensity to Consume MPC: How much people consume rather than save when there is a change in income. Also expressed as a fraction: MPC = change in consumer spending/change in income MPS + MPC = 1
Spending Multiplier Spending is “multiplied” until every dollar is consumed or saved. Spending Multiplier=1/MPS= 1/(1-MPC) Total Change in GDP= Spending Multiplier x Initial Change in Spending As the MPC decreases, the multiplier effect becomes less.
Tax Multiplier The multiplier effect also applies when the government cuts or increases taxes. (effect is less than that of the spending multiplier) Tax Multiplier: -(MPC/MPS) If the government increases taxes spending will decrease and the TM will be negative and vice versa if taxes are cut. Total change in spending = Initial Tax Change x Tax Multiplier
Balanced Budget Multiplier When a change in government spending is offset by a change in lump sum taxes, real GDP changes by the amount of the change in government spending. Balanced Budget Multiplier: 1/MPS + (- MPC/MPS) = 1
Crowding Out Effect http://www.youtube.com/watch?v=hucfT z4sPfUhttp://www.youtube.com/watch?v=hucfT z4sPfU The deficit spending of the government causes the real interest rate to increase which leads to the “crowding out” of investment spending.
Aggregate Supply The amount of goods and services (real GDP) that firms produce in an economy at different price levels. Short Run AS: Wages and resource prices will not increase as price levels increase. Long Run AS: Wages and resource prices will increase as price levels increase.
Sticky vs. Flexible Wages/Prices Sticky: The case when price levels do not change. (Keynesian Theory) Flexible: The case when price levels do change.
Shifters of Aggregate Supply 1. Change in inflationary expectations. (ex. If increase in AD leads people to expect greater prices, labor and resource costs increase which decreases AS). 2. Change in Resource Prices: Prices of Domestic and Imported Resources. –Supply Shock: negative-shift AS to left/positive-shifts AS to the right.
Shifters of AS cont. 3. Change in Action of the Government. (ex. Taxes on producers, subsidies, government regulations). 4. Changes in Productivity (ex. Technology)