Aggregate Demand and
Supply and Fiscal Policy
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The Collapse of 2008 - Causes
There is no consensus (and we are not
economists) but some common beliefs are:
• Deregulation over the past couple of decades was based on
beliefs that markets can correct themselves – the recent
collapse suggests that if they can it is only after severe
consequences.
• There was a housing bubble  prices increased rapidly before
retreating to more reasonable levels.
• There was too much debt.
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The Collapse of 2008 - Causes
There is no consensus (and we are not
economists) but some common beliefs are:
• There was too much debt backed by housing of declining value.
• There was a legacy of subprime lending.
• There was inflation in the commodity markets.
• There was mismanagement at many financial institutions.
• The crisis accelerated as major financial institutions lost massive
amounts of money, some became insolvent and credit became very hard
to get.
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A Perfect Storm
A Very Scary Outlook and Fear
of Another Great Depression
The 2008 Financial
Collapse
Credit
Crunch
Housing
Collapse
Global
Economy
Job
Loss
Commodity
Prices
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The Collapse of 2008 
Fiscal Policy Responses
• There has been something of a rebirth in Keynesian
economics and the use of fiscal policy.
• The national deficit has skyrocketed.
• Targeted spending did things such as bail out or federalize
financial institutions and automakers.
• The federal government bought bad debt.
• The federal government extended unemployment benefits.
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The Collapse of 2008 
Fiscal Policy Responses
• Job creation programs have been initiated.
• Certain tax rebates have been enacted.
• There have been financial transfers to states.
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How Was the Collapse Limited?
• The collapse was limited by the belief that
governments should intervene.
• There were policy options both monetary and fiscal.
• Global institutions were involved and cooperated.
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How Successful Were the
Interventions?
• The situation did not turn into another “Great
Depression.”
• But, the situation is still not healthy.
• It does seem clear that the aggressive use of
monetary and fiscal policies limited the impact of the
collapse.
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The Car Analogy
The economy is like a car…
• You can drive 120mph but it is not sustainable.
(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.
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(Shift the PPC outward)
How does the Government Stabilizes the
Economy?
The Government has
two different tool
boxes it can use:
1. Fiscal PolicyActions by Congress to
stabilize the economy.
OR
2. Monetary PolicyActions by the
Federal Reserve Bank
to stabilize the
economy.
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For now we will only focus on Fiscal Policy.
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Fiscal Policy
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Two Types of Fiscal Policy
Discretionary Fiscal Policy-
• Congress creates a new bill that is 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 increase spending.
Non-Discretionary Fiscal Policy
•AKA: Automatic Stabilizers
•Permanent spending or taxation laws enacted to
work counter cyclically to stabilize the economy
•Ex: Welfare, Unemployment, Min. Wage, etc.
•When there is high unemployment, unemployment
benefits to citizens increase consumer spending.
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Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease GDP
(Close a Inflationary Gap)
• Decrease Government Spending
• Tax Increases
• Combinations of the Two
Expansionary Fiscal Policy (The GAS)
Laws that reduce unemployment and increase
GDP (Close a Recessionary Gap)
• Increase Government Spending
• Decrease Taxes on consumers
• Combinations of the Two
How much should the Government Spend?
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Price level
• 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?
LRAS
AS
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:
WHY?
P1
AD2
AD1
$400 $500
FE
Real GDP (billions)
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The Multiplier Effect
Why do cities want the Superbowl in their stadium?
An initial change in spending will set off a spending chain
that is magnified in the economy.
Example:
•
•
•
•
Bobby spends $100 on Jason’s product
Jason now has more income so he buys $100 of Nancy’s product
Nancy now has more income so she buys $100 of Tiffany’s product.
The result is an $300 increase in consumer spending
The Multiplier Effect shows how spending is
magnified in the economy.
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Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
LRAS
Price level
AS
P1
AD2
$500
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much initial
government spending
is needed to close gap?
AD1
$100 Billion
$1000FE
Real GDP (billions)
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Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
LRAS
Price level
AS
P2
AD1
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
AD
-$20 Billion
$80FE $100
Real GDP (billions)
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What about taxing?
•The multiplier effect also applies when the government
cuts or increases taxes.
•But, changing taxes has less of an impact then
government spending. Why?
Expansionary Policy (Cutting Taxes)
•Assume the MPC is .75 so the multiplier is 4
•If the government cuts taxes by $4 million how much
will consumer spending increase?
•NOT 16 Million!!
•When they get the tax cut, consumers will save $1
million and spend $3 million.
•The $3 million is the amount magnified in the
economy.
•$3 x 4 = $12 Million increase in consumer spending
.20
Cutting Tax Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
LRAS
Price level
AS
1. What two options does
the government have?
2. How much should they
increase government
spending?
P1
$10 Billion
AD2
$80
3. How much should they
cut taxes?
AD1
-$20 Billion
$100FE
Real GDP (billions)
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Multiplier Effect
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Non-Discretionary
Fiscal Policy
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Non-Discretionary Fiscal Policy
Legislation that act counter cyclically without
explicit action by policy makers.
AKA: Automatic Stabilizers
The U.S. Progressive Income Tax System acts
counter cyclically to stabilize the economy.
1. When GDP is down, the tax burden on
consumers is low, promoting consumption,
increasing AD.
2. When GDP is up, more tax burden on consumers,
discouraging consumption, decreasing AD.
The more progressive the tax system, the
greater the economy’s built-in stability.
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Review
1. Identify the two types of tool boxes the
government has to fix the economy
2. Explain and give examples of Expansionary
Fiscal Policy
3. Explain and give examples of Contractionary
Fiscal Policy
4. Explain the Multiplier Effect
5. Explain how to calculate the spending
multiplier
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Draw and Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .9)
LRAS
Price level
AS
P2
AD1
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
AD
-$5 Billion
$50FE $100
Real GDP (billions)
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Draw and Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
LRAS
Price level
AS
P1
AD2
$800
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much initial
government spending
is needed to close gap?
AD1
+$40 Billion
$1000FE
Real GDP (billions)
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Problems With
Fiscal Policy
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Problems With Fiscal Policy
•When there is a recessionary gap what two options does
Congress have to fix it?
•What’s wrong with combining both?
Deficit Spending!!!!
•A Budget Deficit is when the government’s
expenditures exceeds its revenue.
•The National Debt is the accumulation of all the budget
deficits over time.
•If the Government increases spending without
increasing taxes they will increase the annual deficit and
the national debt.
Most economists agree that budget deficits are a
necessary evil because forcing a balanced budget would
not allow Congress to stimulate the economy.
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Explain this cartoon
2003
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Who ultimately pays for excessive
government spending?
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Additional Problems with Fiscal Policy
1. Problems of Timing
• Recognition Lag- Congress must react to
economic indicators before it’s too late
• Administrative Lag- Congress takes time to
pass legislation
• Operational Lag- Spending/planning takes time
to organize and execute ( changing taxing is
quicker)
2. Politically Motivated Policies
• Politicians may use economically inappropriate
policies to get reelected.
• Ex: A senator promises more welfare and public
works programs when there is already an
inflationary gap.
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Additional Problems with Fiscal Policy
3. Crowding-Out Effect
• In basketball, what is “Boxing Out”?
• Government spending might cause unintended
effects that weaken the impact of the policy.
Example:
• We have a recessionary gap
• Government creates new public library. (AD increases)
• Now consumers spend less on books (AD decreases)
Another Example:
• The government increases spending but must borrow
the money (AD increases)
• This increases the price for money (the interest rate).
• Interest rates rise so Investments fall. (AD decrease)
The government “crowds out” consumers
and/or investors
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Additional Problems with Fiscal Policy
4. Net Export Effect
International trade reduces the effectiveness
of fiscal policies.
•
•
•
•
•
Example:
We have a recessionary gap so the government
spends to increase AD.
The increase in AD causes an increase in price
level and interest rates.
U.S. goods are now more expensive and the US
dollar appreciates…
Foreign countries buy less. (Exports fall)
Net Exports (Exports-Imports) falls, decreasing
AD.
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Explain this cartoon
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Activity
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Congressional Committees
As a group, analyze the situation, identify the
problem, and identify your solution
The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less
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1.) 1933
Situation:
• GDP fell -1.2%
• Inflation rate= -.5%
• Unemployment Rate=25%
Your Solution:
What actually happened:
• FDR increased public works via the New
Deal programs.
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2.) 1944
Situation:
• GDP grew 8%
• Inflation rate= 3.7%
• Unemployment Rate=1.2%
Your Solution:
What actually happened:
• War ended the next year and government
orders for war materials decreased.
• Many public works programs were
discontinued
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3.) 1980
Situation:
• GDP fell -0.3%
• Inflation rate= 13.5%
• Unemployment Rate=7.1%
Your Solution:
What actually happened:
• The next year, President Reagan and
congress lowered taxes on individuals and
corporations by about 30%. (Supply-side
Economics)
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4.) 2003
Situation:
• GDP fell 0.5%
• Inflation rate= 1.5%
• Unemployment Rate=12.0%
Your Solution:
What actually happened:
• Congress voted to give tax cuts to
citizens. (Bush Tax Cuts)
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