Transcript National Income and Price Determination: Aggregate Supply

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 + Xn
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
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)