Transcript AP Review wk 4

AP Macroeconomics
Mr. Graham
Unit Four
National Income and Price Determination
Do Now.
1. Why did economists originally devise the
multiplier?
2. What happened to consumer and investment
spending during the Great Depression?
3. Is it less likely for a depression to occur
today? Why?
Module 16:
Income and Expenditure
3
The Multiplier:
An Informal Introduction
• 3 Simplifying Assumptions for this analysis
(i.e. ceteris paribus conditions):
1. We assume that changes in overall spending
(C and I) translate into changes in RGDP.
2. We assume there is no government spending
and no taxes (i.e. “private”).
3. We assume that net exports are zero (i.e. “closed”).
The Multiplier:
An Informal Introduction
$100 billion increase in investment spending
leads to increase in aggregate output (GDP)
leads to increase in disposable income
leads to a rise in consumer spending
Leads to an increase in aggregate output…
The Multiplier:
An Informal Introduction
• How large is the total effect on aggregate
output if we sum the effect from all these
rounds of spending increases?
• Marginal Propensity to Consume (MPC)
– The increase in consumer spending when
disposable income rises by $1
12-6
The Multiplier:
An Informal Introduction
• Recall that there are two things you can do
with disposable income…
• Marginal Propensity to Save (MPS)
– The increase in household savings when
disposable income rises by $1
MPS = 1 - MPC
12-7
The Multiplier:
An Informal Introduction
• Some relationships
– Marginal propensity to consume and marginal
propensity to save must sum to 100% of the
change in income (i.e. MPC + MPS = 1).
 Complete Activity 24: “What Is An MPC?”
12-8
The Multiplier:
An Informal Introduction
• Question
– So…How can a $100 billion increase in investment
generate a $500 billion increase in equilibrium
real GDP?
• Answer
– The multiplier process
The Multiplier:
An Informal Introduction
• It is possible that a relatively small change in investment
can trigger a much larger change in real GDP
The Multiplier:
An Informal Introduction
• The total effect of a $100 billion increase in investment
spending, I, taking into account all the subsequent
increases in consumer spending (and assuming no taxes
and no international trade), is given by:
• Let’s consider a numerical example where the marginal
propensity to consume is 0.6:
The Multiplier:
An Informal Introduction
• We’ve described the effects of a change in
investment spending, but the same analysis
can be applied to any other autonomous
change in aggregate spending.
• So the multiplier is:
The Multiplier:
An Informal Introduction
• By taking a few numerical examples, you can
demonstrate to yourself an important
property of the multiplier
– The smaller the MPS, the larger the multiplier
– The larger the MPC, the larger the multiplier
Consumer Spending
• Consumption
– Spending on new goods and services out of a
household’s current income
• Saving
– The act of not consuming all of one’s
current income
– Whatever is not consumed out of disposable
income is, by definition, saved.
Consumer Spending
• You can do only two things with income (in
absence of taxes): consume it or save it
Consumption + Saving = Disposable Income
and
Saving = Disposable Income – Consumption
Investment and Consumption explained
Consumer Spending
• Consumption choices have a
powerful effect on the economy.
• What determines how much
consumers spend?
Consumer Spending
• The most important factor affecting a family’s
consumer spending is disposable income (DI).
Consumer Spending
• Consumption Function
– The relationship between amount consumed
and disposable income
– A consumption function tells us how much people
plan to consume at various levels of disposable
income.
– Let’s first recall our understanding of slope.
Consumption Function
 c = MPC x y + a
 Where c is individual household consumer
spending.
 y is individual household current disposable
income*.
 a is a constant term—individual household
autonomous consumer spending
 MPC for an individual household as :
 MPC = change in c / change in y
Consumption Function
Consumption Function
 In reality, the actual data never fit the
equation perfectly…
Aggregate Consumption Function
 Although Figure 16.3 shows a microeconomic
relationship, macroeconomists assume a similar
relationship holds for the economy as a whole:
 C = A + MPC x Y
 Where C is (aggregate) consumer spending.
 Y is (aggregate) disposable income*.
 A is aggregate autonomous consumer spending.
Shifts of the
Aggregate Consumption Function
• A change besides real disposable income will
cause the consumption function to shift.
• Changes in Population
• Changes in Expected Future Disposable Income
• Changes in Expected Future Prices
• Changes in Aggregate Wealth
12-23
Shifts of the
Aggregate Consumption Function
• Aggregate Wealth
– The stock of assets owned by a person,
household, firm or nation
– For a household, wealth can consist of a house,
cars, personal belongings, stocks, bonds, bank
accounts, and cash.
– Those who have accumulated a lot of wealth will,
other things equal, spend more on goods and
services than those who still need to save…
12-24
Shifts of the
Aggregate Consumption Function
12-25
Do Now.
• Which makes up a larger portion of the GDP?
– Consumption spending or investment spending
• Which drives the business cycle more? Why?
Investment Spending
• Although consumer spending is much greater than
investment spending, booms and busts in investment
spending tend to drive the business cycle.
Investment Spending
• Planned Investment Spending
– Amount firms intend to invest during a given period.
– Depends on three principal factors:
• the interest rate
• the expected future level of real GDP
• the current level of production capacity
The Interest Rate and
Investment Spending
• Planned Investment Spending is negatively
related to the interest rate—investment projects
are typically funded through borrowing.
• Higher interest rates will
discourage borrowing.
• Lower interest rates will
encourage borrowing.
Expected Future Real GDP and
Investment Spending
• Planned Investment Spending is positively
related to expected future real GDP.
– Higher expected real GDP and, in turn, expected
sales for firms, will encourage an increase in
planned investment spending.
– Lower expected real GDP and, in turn, expected
sales for firms, will encourage an decrease in
planned investment spending.
Current Production Capacity and
Investment Spending
• Planned Investment Spending is negatively
related to production capacity.
– Higher than necessary production capacity will
discourage planned investment spending.
– Lower than necessary production capacity will
encourage planned investment spending.
Inventories and
Investment Spending
• Inventories
– Stocks of goods held to satisfy future sales.
• Inventory Investment—Value of change in total
inventories held in the economy during a period.
– Firms, anticipating higher future sales, can increase
their inventories as a form of investment spending.
Inventories and
Unplanned Investment Spending
• Firms cannot always accurately predict sales
• Unplanned Inventory Investment
– Actual sales are more or less than expected,
leading to unplanned decreases or increases in
inventories.
Combining Consumption and Investment
• The equilibrium level of GDP is determined by the intersection of
the aggregate expenditures schedule and 45-degree line
• At this output ($11T), C is $9T and I is 2T
Inventories and
Unplanned Investment Spending
• No levels of GDP above the equilibrium level
are sustainable because C+I fall short.
• At the $12T GDP level, for example, C+I is only
$11.5T; this underspending causes inventories
to rise, prompting firms to readjust production
downward, in the direction of the $11T output
Module 17:
Aggregate Demand:
Introduction and Determinants
36
The Aggregate Demand Curve
• When a demand curve is derived, we are
looking at a single product in one market only
(Microeconomics).
• When the aggregate demand curve is derived,
we are looking at the entire circular flow of
income and product (Macroeconomics).
Aggregate Demand Curve
• Aggregate Demand Curve
– Shows the relationship between the aggregate
price level and the quantity of aggregate output
demanded by households, firms, the government,
and the rest of the world
– Depicts the relationship between real GDP
demanded and the price level in the economy
– Slopes downward from left to right
Aggregate Demand Curve
Aggregate Demand Curve
• Why is the AD curve downward sloping?
• What happens when the price level rises or falls?
– The real-balance effect (or wealth effect)
– The interest rate effect
– The open economy effect
Aggregate Demand Curve
• The Real-Balance (a.k.a. Wealth) Effect
– There is an inverse relationship between
the price level and real wealth
• As the price level increases, the purchasing power of
money decreases and you spend less because of the
negative wealth effect
• As the price level decreases, the purchasing power of
money increases and you spend more because of the
positive wealth effect
Aggregate Demand Curve
• The Interest Rate Effect
– There is a direct relationship between
the price level and interest rates
• Increasing price levels indirectly increase the interest
rate, which causes a reduction in borrowing/spending
• Decreasing price levels indirectly decrease the interest
rate, which stimulates the economy
Aggregate Demand Curve
• The Open Economy Effect
(a.k.a. Foreign Sector Substitution)
– There is an inverse relationship between
the price level and net exports
• Higher price levels result in foreigners’ desiring to buy
fewer American-made goods while Americans desire
more foreign-made goods (i.e. net exports fall).
• Lower price levels result in a greater desire for
American-made goods (i.e. net exports rise)
Shifts in the Aggregate Demand Curve
• The AD curve will shift when the components
of spending change (AD=C + I + G + X)
– Any non-price-level change that increases
aggregate spending (on domestic goods) shifts
AD to the right.
– Any non-price-level change that decreases
aggregate spending (on domestic goods) shifts
AD to the left.
Shifts in the Aggregate Demand Curve
• The AD curve will shift when the components
of spending change (AD=C + I + G + X)
– Changes in Expectations
– Changes in Wealth
– Size of the Existing Stock of Physical Capital
– Fiscal Policy
– Monetary Policy
Determinants of Aggregate Demand
Shifts in the Aggregate Demand Curve
Do Now.
• Watch this video:
– http://www.criticalcommons.org/Members/fsusta
vros/clips/stossel-2007-oil-supplies
– What will happen to the world economy if the
supply oil decreases significatly?
Module 18:
Aggregate Supply:
Introduction and Determinants
49
Aggregate Supply Curve
• Economists like to look at aggregate supply in
two different ways:
– The short run refers to the period of time in which
firms haven’t yet made price changes in response
to an economic shock
– The long run refers to the period of time after
which firms have made all necessary price
changes in response to an economic shock
• The shape of the AS curve depends on
whether one is looking at a long-run AS
(LRAS) curve or a short-run (SRAS) curve
Short-Run Aggregate Supply Curve
• Short-Run Aggregate Supply Curve
– Shows the relationship between the aggregate
price level and the quantity of aggregate output
supplied that exists in the short run
(i.e. the time period when many production costs
can be taken as fixed).
– Slopes upward from left to right
Short-Run Aggregate Supply Curve
Short-Run Aggregate Supply Curve
• Why is the SRAS upward sloping?
• What happens when the price level rises or falls?
– Misperception Theory
– “Sticky Wages”
Short-Run Aggregate Supply Curve
Profit = Price – Production Cost
• The Misperception Theory
– As the price level increases, individual markets’
producers may “misperceive” the rising prices as
specific to their industry.
• Sticky Prices
– As the price level increases, production costs,
particularly wages, are temporarily “sticky” (unions,
contracts, etc.)
Shifts in the
Short-Run Aggregate Supply Curve
• The SRAS curve will shift when producers reduce
the quantity of aggregate output they are willing
to produce at any given aggregate price level
– Changes in Commodity Prices
– Changes in Nominal Wages
– Changes in Productivity
Determinants of
Short-Run Aggregate Supply
Shifts in the Aggregate Supply Curve
Long-Run Aggregate Supply Curve
• Long-Run Aggregate Supply Curve
– Shows the relationship between the aggregate
price level and the quantity of aggregate output
supplied in the long-run
– Production costs, including wages, are fully flexible
(unions, contracts, etc.).
– In the long run, the aggregate price level has no
effect on the quantity of aggregate output
supplied.
– Fixed, vertical line.
Long-Run Aggregate Supply Curve
Long-Run Aggregate Supply Curve
• It represents the economy’s potential output
– is the level of real GDP the economy would produce
if all prices, including nominal wages, were flexible.
– Drawn above the point on the horizontal axis that
represents the full-employment output.
– In reality, the actual level of real GDP is almost
always either above or below potential output, but it
is still an important number because it defines the
trend around which actual aggregate output
fluctuates from year to year.
Long-Run Aggregate Supply Curve
Shifts in the
Long-Run Aggregate Supply Curve
• The LRAS curve will shift when we experience the
factors attributed to long-run economic growth:
– Increases in the quantity of resources
(i.e. land, labor, capital, and entrepreneurship)
– Increases in the quality of resources
(i.e. education)
– Technological progress
Shifts in the
Long-Run Aggregate Supply Curve
From the Short-Run to the Long-Run
• As we saw earlier, the economy normally
produces more or less than potential output.
• So the economy is normally on its short-run
aggregate supply curve—but not on its longrun aggregate supply curve.
From the Short-Run to the Long-Run
 We’ll examine in Module 19 how and why shifts of the SRAS
curve will return economy to potential output in the long run.
Module 19:
Equilibrium in the
AD/AS Model
66
AD-AS Model
• To understand the behavior of the economy,
we must put the aggregate supply curve and
the aggregate demand curve together.
• The result is the AD-AS Model—the basic model
we use to understand economic fluctuations.
Short-Run Macroeconomic Equilibrium
• Short-Run Macroeconomic Equilibrium (ESR)
– the quantity of aggregate output supplied is equal to
the quantity demanded.
• Short-Run Equilibrium Aggregate Price Level (PE)
– the aggregate price level in the short-run
macroeconomic equilibrium.
• Short-Run Equilibrium Aggregate Output (YE)
– the quantity of aggregate output produced in the
short-run macroeconomic equilibrium.
Short-Run Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
• Our microeconomic logic applies here as well…
If the aggregate price level is above its equilibrium
the quantity of aggregate output supplied exceeds the
quantity of aggregate output demanded
leads to a fall in the aggregate price level
and pushes it toward its equilibrium level.
Short-Run Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
• Our microeconomic logic applies here as well…
If the aggregate price level is below its equilibrium
the quantity of aggregate output supplied is less than
the quantity of aggregate output demanded
leads to a rise in the aggregate price level
and pushes it toward its equilibrium level.
Short-Run Macroeconomic Equilibrium
Shifts in the Aggregate Demand Curve
• Demand Shock: an “event” that shifts the
aggregate demand curve:
– Changes in Expectations
– Changes in Wealth
– Size of the Existing Stock of Physical Capital
– Fiscal Policy
– Monetary Policy
Shifts of Aggregate Demand:
Short-Run Effects
Shifts of the SRAS Curve
• Supply Shock: an “event” that shifts the
aggregate supply curve:
– Changes in Commodity Prices
– Changes in Nominal Wages
– Changes in Productivity
Shifts of the SRAS Curve
Long-Run Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
• Now suppose that for some reason AD falls
and the AD curve shifts leftward to AD₂
• Recessionary Gap
– The gap that exists whenever equilibrium real GDP
per year is less than full-employment real GDP as
shown by the position of the LRAS curve
Long-Run Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
• In the face of high unemployment, nominal wages
eventually fall, as do any other sticky prices,
ultimately leading producers to increase output
• As a result, SRAS gradually shifts to the right.
• Eventually, SRAS₁ reaches its new position at SRAS₂,
bringing the economy to equilibrium at E₃
• Back at potential output Y₁ but at a lower aggregate
price level, P₃, reflecting a long-run fall in the
aggregate price level.
Long-Run Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
• Now suppose that AD rises and the AD curve
shifts leftward to AD₂
• Inflationary Gap
– The gap that exists whenever equilibrium real GDP
per year is greater than full-employment real GDP
as shown by the position of the LRAS curve
Long-Run Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
• In the face of low unemployment, nominal wages
eventually rise, as do any other sticky prices,
ultimately leading producers to decrease output
• As a result, SRAS gradually shifts to the left.
• Eventually, SRAS₁ reaches its new position at SRAS₂,
bringing the economy to equilibrium at E₃
• Back at potential output Y₁ but at a higher aggregate
price level, P₃, reflecting a long-run rise in the
aggregate price level.
Long-Run Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
• So in the long-run, the economy is self-correcting
– Shocks to aggregate demand affect aggregate output
in the short-run but not in the long-run.
Do Now.
• Explain the difference between SRAS and LRAS
• Define: recessionary gap, inflationary gap
• What is the main idea behind government
stabilization of the economy?
• To what extend do you feel the government
should regulate the economy?
Module 20:
Economic Policy and
the AD/AS Model
89
Macroeconomic Policy
• We said earlier that the economy is
self-correcting in the long-run
– Most macroeconomists believe, however, that
the process takes a decade or more.
– During recessions, the economy can suffer an
extended period of depressed aggregate output
and high unemployment before it returns to
normal.
Stabilization Policy
• “In the long run we are all dead”
–John Maynard Keynes
• Keynes recommended we do not
wait for “self-correction”…
• The government should step in
to increase aggregate demand
and ward off recessions and
depressions
Stabilization Policy
Under active stabilization policy,
the U.S. economy returned to
potential output in 1996
after a 5-year recessionary gap
Under active stabilization policy,
the U.S. economy returned to
potential output in 2001
after a 4-year inflationary gap
Recall:
The
(Expanded)
Circular-Flow
Diagram
 Funds flow into the government in the form of taxes and
government borrowing;
 Funds flow out in the form of government purchases of
goods and services and government transfers to households.
The Government Budget
Inflows
Outflows
Stabilization Policy
• Let’s recall the basic equation of national
income accounting:
GDP = C+ I + G + X
• The government directly controls G.
• The government indirectly influences C
– Increase/Decrease in Taxes
– Decrease/Increase in Transfers
Decrease/Increase
Disposable Income
Fiscal Policy
• The discretionary changes in government
expenditures and/or taxes…
• The automatic changes in transfer payments…
In order to achieve certain national economic
goals such as:
– High employment (low unemployment)
– Price stability
– Economic growth
Expansionary Fiscal Policy
• Fiscal policy that increases aggregate demand:
– an increase in
government purchases
of goods and services
– a cut in taxes
– an increase
government transfers
Contractionary Fiscal Policy
• Fiscal policy that decreases aggregate demand:
– an reduction in
government purchases
of goods and services
– an increase in taxes
– a reduction in
government transfers
Expansionary and Contractionary Fiscal Policy
• Questions
– Would the increase/decrease in government
spending equal the size of the gap?
– What impact would expansionary/contractionary
fiscal policy have on the price level?
Fiscal Policy Analysis
Indicate whether each of the following actions of
the government is expansionary or contractionary:
1. The government cuts personal income taxes.
2. The government increases its orders for a new missile
defense system.
3. The government eliminates tax incentives for business.
4. In response to world pressure, the government drops
its order for new missiles.
5. The government increases personal income taxes in
response to a budget deficit.
Videos
• http://www.youtube.com/watch?v=1qhJPqyJR
o8
• http://www.youtube.com/watch?v=7rpvxZphZ
Zc
Fiscal Policy Analysis
Indicate how you would solve the problems below
using fiscal policy:
1. The national unemployment rate has increased by
1 percent for the last three years.
2. Inflation has been steadily on the rise, increasing
2 percent for the last three quarters.
3. The overall consumer confidence is falling.
4. Consumer sales continue to grow, and businesses
continue to produce more goods to meet the
stronger demand.
5. Inflation continues to grow, and unemployment
remains at a high rate.
Do Now.
• Watch this video:
• http://www.criticalcommons.org/Members/fs
ustavros/clips/fight-of-the-century-keynes-vshayek-round-two
Module 21:
Fiscal Policy and the Multiplier
104
Fiscal Policy
• Fiscal policy can be used to increase/decrease
aggregate demand by…
– Increasing/decreasing government spending
– Increasing/decreasing taxes
– Increasing/decreasing transfer payments
• Which fiscal policy option has a greater impact
on an economy? Why?
Multiplier Effects: Government Spending
• We learned in Module 16 about the concept of
the multiplier.
• An increase in government spending is an
example of an autonomous increase in aggregate
spending.
• Therefore, any change in government spending
will lead to an even greater change in real GDP.
Multiplier Effects: Government Spending
Government decides to spend $50 billion building bridges and roads.
The government’s purchases of goods and services will directly
increase total spending on final goods and services by $50 billion.
The firms producing the goods and services purchased by the
government will earn revenues that flow to households in the form
of wages, profit, interest, and rent.
Increase in disposable income leads to rise in consumer spending.
Rise in consumer spending, in turn, will induce firms to increase
output, leading to a further rise in disposable income, which will
lead to another round of consumer spending increases, and so on.
Multiplier Effects: Government Spending
• Government increases spending by $50 billion.
• MPC is .5
• Multiplier:
Multiplier Effects: Tax Cuts and Transfers
• Government hands out $50 billion in (lump-sum)
tax cuts or transfers.
• MPC is .5 (i.e. households only consume half of
those first tax cuts or transfers).
Taxes: Automatic Stabilizers?
• In reality, the great majority of tax revenue is
raised via tax rates that are changed
proportionately to changes in real GDP.
• In a recessionary gap:
– Incomes and profits fall when business activity
slows down, and the government’s tax revenues
drop as well.
– Some economists consider this an automatic tax
cut, which therefore stimulates aggregate demand
Taxes and the Multiplier
• Taxes reduce the effect of the multiplier.
– The government siphons off some of any increase in
real GDP at each stage of the multiplier process.
– As a result, the increase in consumer spending is
smaller than it would be if taxes weren’t part of the
picture.
What Do We Really Know
About Fiscal Policy?
• Fiscal policy during abnormal times
– Fiscal policy can be effective
– The Great Depression—fiscal policy may be able
to stimulate aggregate demand
– Wartime—during World War II real GDP increased
dramatically
What Do We Really Know
About Fiscal Policy?
• Fiscal policy during normal times
– Congress ends up doing too little too late to help
in a minor recession
– Fiscal policy that generates repeated tax changes
(as has happened) creates uncertainty