Transcript Aggregate Demand, Supply and Fiscal Policy

Aggregate Demand,
Aggregate Supply
and Fiscal Policy
AP Economics
Chapters 11-12
BACKGROUND
Classical Economic Theory • Market system operated at full employment
• Temporary short periods of recession or
inflation
• Self correcting (P & Wages go up & down)
• Say’s Law: “Supply creates its own
demand”
• Accepted view until 1930’s and the Great
Depression
BACKGROUND
Keynes “In the long run, we are all dead”
Keynes believed ~
• Cycles were not short
• Corrections were not automatic
• Savings and investment weren’t
coordinated
• Prices and wages were not flexible
downward
GOV INTERVENTION WAS NEEDED
KEYNES
• Fiscal Policy is government’s way to
stabilize the economy
• Employment Act of 1946 - power to
Congress
• Tools to use: taxing and spending
• Expansionary F.P. – Decrease taxes &/or
increase spending (Recession)
• Contractionary F.P. – Increase taxes &/or
decrease spending (Inflation)
AD/AS
• Key analytical tool for understanding the
macroeconomy
• AD = quantity of real GDP that consumers,
business & gov’t are willing and able to buy
at each price level
• AD = C + Ig + G + Xn
• Price level and output (GDP) have inverse
relationship
AD/AS
• AD slopes downward because:
• Wealth (real balance) effect – purchasing
power of money is less at higher price levels
• Interest rate effect – price level changes
impact interest rates – in turn this effects
consumption & investment spending (inverse
effect)
• Foreign purchase effect – volume of
imports/exports depend on relative price levels
here & abroad
EX: If US PL is higher = we buy more M & sell
fewer X
Consumption
• INCOME IS NOT WEALTH
•
•
•
•
•
•
GDP & AD = C + Ig + G + Xn
C is largest component
DI = C + S if Income then C & S
MPC = % consumed of a
in income
MPS = % saved of a
in income
MPS + MPC = 1 (80% + 20% = 1)
Consumption
• Main determinant is income
• Other determinants:
•
•
•
•
Wealth (value of assets) if W
C
S
Expectations (for inflation or future wealth)
Debts (if D increases, C & S will decrease)
Taxes (if T increase, C & S decrease, etc)
Investment
• Savings = Investment
• Investment is:
•
•
•
•
Business spending for capital stock
Most volatile component of AD/GDP
Assumed to require a loan
Decisions are based on marginal cost
(interest) vs. marginal benefits (expected
rate of return)
Investment
• Economic profit/cost = Rate of return
EX: $100 profit divided by $1000 cost = 10%
• Interest must be less than rate of return to
justify investment
• Investment determinants:
•
•
•
•
•
Interest rate
Costs of capital & operating costs
Taxes
Technology
Excess capacity (inventories)
Market for Loanable Funds
• Demand for Ig is DEMAND for loanable
funds
• Savings is SUPPLY of loanable funds
• Equilibrium is the interest rate where
S
Ig=S
i
i
D Ig
D
Q
Investments
Q
Loanable Funds
Spending Multiplier
• Change to any component of AD
(C + Ig + G + Xn) has a “ripple effect”
• Results in a multiplied effect on GDP
• Important as a small change in spending
leads to a large change in GDP
• Assumes that change occurs first to Ig
• Calculated by: 1
or
1
MPS
1- MPC
Spending Multiplier
• Examples: 1/MPS
.25 MPS change = multiplier of 4
.33 MPS change = multiplier of 3
MPC of .75 = 1/.25 (MPS) = multiplier of 4
If gov spending increases by $20 X 4 = GDP
increases by $80
Aggregate Supply
• AS = quantity of output (real GDP)
produced at each price level
• Direct relationship between PL and
output (high PL = more supply)
• 3 ranges of AS:
• Horizontal = recession – underutilized
resources (LLC) – only output changes are
possible
• Vertical = full capacity economy – only PL
changes
• Intermediate = expansion eco – both output
& PL changes are possible
AS
VERTICAL
RANGE
PRICE
LEVEL
AD 3
INTERMEDIATE
RANGE
HORIZONTAL
AD
1
AD 2
OUTPUT OF
REAL GDP
Determinants of AS:
1. Change in input prices (cost of
production)
• Resource availability (LLCET)
• Imported resources – cost &
exchange rates
• Market power – ability to set price
above that of a competitive market
EX: OPEC, labor unions, etc
Determinants of AS:
2. Change in productivity – increase means can
produce more with same resources
EX: more productivity = increase AS
3. Change in legal-institution environment
Taxes (sales, excise, payroll) = increase costs
of production (AS decreases)
Subsidies – gov’t payment = lowers costs (AS
increases)
Gov’t regulations = costs more to comply so
AS decreases
Other Details:
• Multiplier effect is:
• greatest in the horizontal AS range
(much ability to increase GDP)
• less in the intermediate range (increasing
PL leads to inflation)
• None in the vertical range ( GDP does not
change – only price level)
Other Details:
• RATCHET EFFECT (or “sticky wages”)
• Prices don’t always go down when AD shifts
left due to: wage contracts, worker morale,
minimum wage laws, “menu costs” – costs to
change prices up & down frequently & fear of
“price wars” with competition.
SHORT RUN – period when wages & other
costs are FIXED (suppliers need time to adjust
to change in AD/AS)
LONG RUN – period when suppliers can make
adjustments in LLC due to a change in AD/AS
AD/AS Equilibrium
• Intersection of AD & AS
• Shift results in change of PL and real GDP
AS
PL
AD 2
E PL 1
AD 1
EO1
FE
Real GDP Output
Discretionary Fiscal Policy
• Goal is to restore economic stability
• Tools – increase/decrease government
spending or increase/decrease taxes
• If recession – need expansionary policy
(increase spending &/or decrease taxes)
• If inflation – need contractionary policy
(decrease spending &/or increase taxes)
Fiscal Policy Shifts AD
AS
PL
AD1
AD 2
RECESSION – AD SHIFTS RIGHT
WHEN GOV SPENDING INCREASES
OR TAXES DECREASE (more C & Ig)
GDP
OUTPUT
Fiscal Policy Shifts AD
PL
AS
AD1
AD2
GDP
INFLATION – AD SHIFTS LEFT WHEN
GOV SPENDING DECREASES OR
TAXES INCREASE (less C or Ig)
Automatic Stabilizers
• Government actions that were NOT done
to help economy, but cause positive
effects
• In an expansion cycle – tax revenue
increases & the surplus slows inflation
• In a recession cycle – deficit spending
stimulates the economy & creates jobs
Problems with Fiscal Policy
• Timing: Recognition Lag,
Administrative Lag & Operational Lag
• Crowding Out Effect – deficit spending
drives interest rates up and private Ig
decreases so AD decreases
• Net Export Effect – reduces Fiscal Policy
effects
Net Export Effect
• If Recession = F.P. Gov deficit spending
will drive interest up
• Foreign demand for US assets goes up in
foreign exchange market
• Dollar appreciates
• Xn goes down (X - M = -Xn)
• AD shifts left (lessens effect of F.P.)
Net Export Effect
• If Inflation – F.P. gov decreases spending
& interest rates drop
• Foreign demand for US assets decreases in
the foreign exchange market
• Dollar depreciates
• Xn goes up (X – M = +Xn)
• AD shifts right (lessens effect of F.P.)
•
Crowding Out Effect
• Government spending is often “deficit
spending” (spending
tax revenue)
• Gov borrows in the “Loanable Funds” Mkt
by selling gov’t bonds & other securities
• This drives up the price of borrowing (i)
making it more expensive for Ig to occur
• Gov borrowing has “crowded out” business
spending lowering GDP (output) in the
long run (less capital stock = less future output)
Supply Side Fiscal Policy
• Theory to cut taxes to increase AS
• Encourages savings to give businesses an
incentive to expand investments
• Lower income taxes encourage workers to
work more & earn more
• Entrepreneurs are more willing to take risks
when they get more rewards
Last but NOT Least Problem –
Congress is in control of Fiscal
Policy
THE END!