AP MACRO-Section 4
NATIONAL INCOME AND PRICE DETERMINATION
MODULES 16-21
• http://bcs.worthpublishers.com/Krugman_AP
_Econ2e/default.asp#944422__946152__
Warm Up
If I were to give you
$1,000,000 dollars, what
would you do with it?
World Record!?
• The Domino Effect?
• http://www.youtube.com/watch?v=vDjcJlDg_i
g
What we will cover in this Module:
• The multiplier, which shows how initial changes in
spending lead to further changes that literally multiply
thru the economy.
• The aggregate consumption function, which shows
how current disposable income affects consumer
spending
• How expected future income and aggregate wealth
affect consumer spending
• The determinants of investment spending
• Why investment spending is considered a leading
indicator of the future state of the economy
In 2009, US government
spent $787 billion in a
“stimulus package” through
the American Recovery and
Reinvestment Act of 2009.
Why did the US
Government want to do
this? Did it work?
Gross Pay: Income before
taxes
Net Pay: After deductions
Disposable Income: Income
after all fixed expenses are
paid.
Marg
inal
Single Taxable
Tax
Income
Rate[
18]
Married Filing
Jointly or
Qualified
Widow(er)
Taxable Income
Married Filing
Separately
Taxable Income
Head of
Household
Taxable Income
10%
$0 – $9,225
$0 – $18,450
$0 – $9,225
$0 – $13,150
15%
$9,226 –
$37,450
$18,451 –
$74,900
$9,226 –
$37,450
$13,151 –
$50,200
25%
$37,451 –
$90,750
$74,901 –
$151,200
$37,451 –
$75,600
$50,201 –
$129,600
28%
$90,751 –
$189,300
$151,201 –
$230,450
$75,601 –
$115,225
$129,601 –
$209,850
33%
$189,301 –
$411,500
$230,451 –
$411,500
$115,226 –
$205,750
$209,851 –
$411,500
35%
$411,501 –
$413,200
$411,501 –
$464,850
$205,751 –
$232,425
$411,501 –
$439,000
39.6
%
$413,201+
$464,851+
$232,426+
$439,001
Marginal Propensity (tendency) to Consume
(MPC)
•How much people consume rather than save when
there is an change in income.
•It is always expressed as a fraction (decimal).
MPC=
Change in Consumer Spending
Change in Disposable Income
Examples:
1. If you received $100 and spent $50.
2. If you received $100 and spent $80.
3. If you received $100 and spent $100.
10
Marginal Propensity to Save (MPS)
•How much people save rather than consume when
there is an change in income.
•It is always expressed as a fraction (decimal)
MPS=
Change in Saving
Change in Disposable Income
Examples:
1. If you received $100 and save $50.
2. If you received $100 your MPC is .7 what is
your MPS?
11
MPS = 1 - MPC
Why is this true?
Because people can either save or consume
12
Autonomous Change in Aggregate Spending
• This is the initial change in aggregate spending
before real GDP rises. It is the cause, not the
result, of the chain reaction.
• The multiplier is the ratio of the total change
in real GDP caused by AAS.
Multiplier = change in real GDP
change in AAS
Yd= 0 and people consume=autonomous
consumption
The size of the multiplier will depend on the MPC.
The higher the MPC the higher the multiplier.
{In other words, the more money spent the greater
the impact the multiplier will have}
How is Spending “Multiplied”?
Assume the MPC is .5 for everyone
•Assume that when the Super Bowl comes to town
there is an increase of $100 in Ashley’s restaurant.
•Ashley now has $100 more income.
•She saves $50 and spends $50 at Carl’s Salon
•Carl now has $50 more income
•He saves $25 and spends $25 at Dan’s fruit stand
•Dan now has $25 more income.
This continues until every penny is spent or saved
Change in
GDP
= Multiplier x
Initial Change
in Spending
15
If the MPC is .5 how much is the multiplier?
1
1
Simple
or 1 - MPC
MPS
Multiplier
=
•If the multiplier is 4, how much will an initial
increase of $5 in Government spending increase
the GDP?
•How much will a decrease of $3 in spending
decrease GDP?
Change in
GDP
= Multiplier x
initial change
in spending
16
The Multiplier Effect
Practice calculating the spending multiplier
1
1
Simple
or 1 - MPC
MPS
Multiplier
1. If MPC is .9, what is multiplier?
2. If MPC is .8, what is multiplier?
3. If MPC is .5, and consumption increased $2M.
How much will GDP increase?
4. If MPC is 0 and investment increases $2M.
How much will GDP increase?
=
Conclusion: As the Marginal Propensity to
Consume falls, the Multiplier Effect is less
17
Warm Up: Why do you think
the MPC is higher in poorer
countries compared to richer
countries?
Current Events: Housing Market
Bubble
What
determines
how much
consumers
spend?
Consumption Function:
equation showing how
household’s consumer spending
varies with the household’s
current disposable income.
c= a + MPC x y d
c= individual household
consumer spending
a= individual
autonomous consumer
spending (how much
individual household
would spend if no
disposable income)
yd = disposable income
Aggregate Consumption
Function:
C = A + MPC x YD
Two factors can change Aggregate Consumption Function
• 1. Changes in expected future disposable
income
– (higher expected future income tends to lead to
lower savings today…this is known as the
permanent income hypothesis)
• 2. Changes in aggregate wealth
– (wealth has an effect on consumer spending
and consumers generally plan their spending
over their lifetime and not just based on
current disposable income…the life-cycle
hypothesis).
Answer these questions in your
notebook as we listen to the broadcast:
• Why do we want people to spend versus
save?
• What are some problems that she cites?
• Why are they nervous about
investment?
• As an economist, what would you advise
the Federal Reserve?
http://www.cnn.com/videos/business/2015/09/17/fed-underthe-hood-lake-pkg.cnn
• Do you understand Monetary Policy?
• Now might be a good time to start reading
articles on what monetary policy does.
• Take a listen to video at the top of the page.
Summarize what you learn.
Investment Spending
• Planned Investment is
what firms intend to
undertake in a given
period but it will depend
on three (3) factors:
• 1- interest rates
• 2-expected future GDP
• 3- current level of
production capacity
Interest Rates
• If a firm predicts high interest rates,
then they will invest less and vice
versa
= a negative relationship between
interest rates and investment
Investment Spending
Expected return on the
investment=expected economic profit from
the factory= (total revenue minus total
cost)/investment cost.
Expected future REAL GDP
• If firms predict a rise in GDP, they are more
likely to invest and vice versa
• ….only if production capacity is taken into
account: the maximum they can produce and
how close to it are they?
Perfect Storm
Production is
near
capacity and
expectations
of strong
real GDP in
the future
Inventories
• Firms that increase inventories are engaging in
a form of investment spending. Higher than
anticipated inventories due to a unplanned
decrease in sales is known as unplanned
inventory investment.
• Rising inventories typically indicates a slowing
economy and falling inventories usually
indicates a growing economy since sales are
better than what was forecast.
Actual Investment Spending
= the sum of planned
investment and unplanned
inventory investment 
Investment (I) = I unplanned + I
planned
The Tax Multiplier
•
•
•
•
•
•
•
•
Recipients of a tax decrease treat it as an increase in disposable income.
A typical household increases consumption by a factor of the MPC and increases
savings by a factor of the MPS.
Keep in mind that less than a 100% of this increase in disposable income circulates
through the economy- WHY? Because most households save a proportion of it.
Example: If the MPC is equal to .90 and the govt. transfers back tax revenue to
consumers by sending each taxpayer a $200 check. With an MPC =.90, (.9 x 200) =
$180 is consumed and $20 is saved. The multiplier kicks in, but not on the entire
$200.
Only on the consumed portion of the $180. The multiplier is 1/.10 = 10, GDP
increases by $1800.
Summary: A $200 change in tax policy ( tax rebate in this example) caused an
$1800 change in real GDP. This tax multiplier of 9 measures the magnitude of the
multiplier process when there is a change in taxes.
The tax multiplier is found by : Tm= is (∆GDP)/(∆ taxes)
Tm= MPC*M= MPC/MPS
Be prepared to respond to a free-response question
that asks you to explain why the tax multiplier is
smaller than the spending multiplier
• With an MPC =.90 the spending multiplier is 10, so why is the
tax multiplier Tm smaller?
• The Spending multiplier begins to work as soon as there is a
change in autonomous spending (C,I, G, Xn) but the tax
multiplier but first go through a person’s consumption
function as disposable income.
• In our $200 example some of the injected dollars are leakages
in the form of savings.
• Therefore the final multiplier effect is smaller.
• Tm= MPC*(Spending multiplier)= .90 * (1/.10)= 9 in our
example.
Example #2
• The MPC =.80 and the government decides to impose a $50
increase in taxes.
• Tm=.80*Multiplier =.80 *(1/.20 = 4
• B/cause the tax multiplier is equal to 4 we determine that
GDP falls by $200. 50 x 4= 200.
• Taxes were increases-disposable income falls, consumption
falls, causing GDP to fall, in this case by a factor of 4.
Balanced Budget Multiplier
•
•
•
•
•
•
•
•
•
•
•
The government collects and spends tax revenue
IF the dollars spent equals the dollars collected the budget is balanced.
The spending and tax multipliers are different
Here’s an example of the balanced-budget multiplier
The govt wants to spend $100 on a federal program and pay for it by
collecting $100 in additional taxes.
The MPC = .9 in this case.
Spending multiplier= 10 implies that $100 of new spending (G) creates a
$1000 increase in real GDP.
Taxation effect: The Tm=.9 implies that a $100 increase in taxes decreases
real GDP by $900.
Balanced budget effect: Change in real GDP= $1000 -$900 = +100
So, a $100 increase in spending, financed by a $100 increase in taxes,
created only $100 in new GDP. The balanced-budget multiplier is always
equal to one, regardless of the MPC.
Balanced-Budget Multiplier =1
Warm Up
Do you like to be judged
on one action or your
overall actions? Why?
Current Events
Eyes Turn To The Fed As Unemployment Rate
Falls To 5-Year Low
December 06, 2013 8:40 AM
The nation's unemployment rate dropped to
7 percent — the lowest mark in five years —
and employers added 203,000 jobs to payrolls
last month, the Bureau of Labor Statistics
Friday.
The latest data could build anticipation that
the Federal Reserve might taper its stimulus
program.
Current Events
• Unemployment Article
• http://blogs.wsj.com/briefly/2015/11/06/octo
ber-jobs-report-the-numbers-2/
You are an economic advisor to Congress
After reading the article, create a proposal for what
the government should do in regards to
unemployment benefits.
 include the positives and negatives for
extending/cutting the benefits.
 include what you think will happen to the MPC
and MPS for people who are unemployed and
people who are afraid they may be unemployed in
the near future.
Predict what you think will happen to aggregate
supply and demand as well (this is what we are
learning about today)
Aggregate Demand: Module 17
When we use aggregates
we combine all prices and all quantities.
Aggregate Demand is all the goods and services (real
GDP) that buyers are willing and able to purchase at
different price levels.
There is an inverse relationship between
price level and Real GDP.
If the price level:
•Increases (Inflation), then real GDP demanded falls.
•Decreases (deflation), the real GDP demanded increases.
44
This is Simple Demand
This is Aggregate Demand
46
Demand and Supply Review
1. Define the Law of Demand.
2. Explain why demand is downward
sloping.
3. Identify the difference between a
change in demand and a change in
quantity demanded.
4. Define the Law of Supply.
5. Why is supply upward sloping?
47
Answers to Review
Define the Law of Demand.
Higher price equals less demand
Explain why demand is downward sloping.
Lower price equals greater quantity demanded
Identify the difference between change in
demand and change in quantity demanded.
Shift in curve vs. movement along the curve
Define the Law of Supply.
P and Q are positively related
Why is supply upward sloping?
higher price equals greater quantity supplied
48
Aggregate Demand Curve
Price
Level
AD is the demand by consumers,
businesses, government, and
foreign countries
Changes in price level cause a
move along the curve not a
shift of the curve
AD = C + I + G + Xn
Real domestic output (GDPR)
49
Aggregate Demand
• The aggregate demand curve shows the
output of goods and services (real GDP)
demanded at different price levels. The
aggregate demand curve slopes down due to:
–The wealth effect
–The interest rate effect
2 Reasons Why is AD downward sloping
1. Wealth Effect
• Higher prices reduce purchasing power of $
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power
and increase expenditures
Example:
• If the balance in your bank was $50,000, but inflation
erodes your purchasing power, you will likely reduce
your spending.
• So…Price Level goes up, GDP demanded goes down.
51
2. Interest-Rate Effect
• As price level increases, lenders need to
charge higher interest rates to get a REAL
return on their loans.
• Higher interest rates discourage consumer
spending and business investment.
• Ex: Increase in prices leads to an increase in the
interest rate from 5% to 25%. You are less likely to
take out loans to improve your business.
• Result…Price Level goes up, GDP demanded goes
down (and Vice Versa).
52
Higher Inflation brings higher interest rates
53
Agenda
• Warm up
• Current Events
• Brief Notes
• Shifting Graphs
• Practice
• Aggregate Supply-Long and short run notes
Homework: Module 18 in SG
How does this cartoon relate to Aggregate Demand?
55
Shifts of the Aggregate Demand
Curve
• ∆C, ∆I, ∆G, ∆X - ∆M
•∆Expectations
•∆Wealth
•∆Existing Stock of
Capital
•∆Fiscal Policy
•∆Monetary Policy
GDP= C+ I+ G+(X-M)
• GDP = private consumption + gross
investment + government spending +
(exports − imports),
How the Government Stabilizes the Economy
The Government
has two different
tool boxes it can
use:
1. Fiscal PolicyActions by Congress &
the President
OR
2. Monetary PolicyActions by the
Federal Reserve
Bank (aka Central
Bank actions)
58
Fiscal Policy Changes to AD Curve
• Direct: The Government’s purchases of final
goods and services.
• Indirect: A change in either tax rates or
transfers to households.
Monetary Policy Changes to AD Curve
• Federal Reserve Bank’s change in the
quantity of money or interest rates will shift
the curve.
• Increasing the quantity of money shifts the
AD curve to the right
• Reducing the quantity of money supply will
shift the AD curve to the left.
• If one of these components of
aggregate spending changes, the
aggregate demand curve will shift.
–A rightward shift of the curve is an
increase in aggregate demand.
–A leftward shift of the curve is a
decrease in aggregate demand.
From Khan: https://www.khanacademy.org/economics-financedomain/macroeconomics/aggregate-supply-demand-topic/aggregate-supplydemand-tut/v/shifts-in-aggregate-demand
Acronym?-turn and talk to your
partner to create an acronym for our
shifters:
Wealth, expectations, existing
physical capital, fiscal and monetary.
Write down your suggestion on the
flashcard
Aggregate Price Level (P)
Shifts in Aggregate Demand
A shift of aggregate demand
to the right means that
more real output will
be demanded at each
price level. If AD shifts
left, less real output
is demanded at
each price level.
P0
AD1
AD2
Q2
Q0
Output (Q)
AD0
Q1
An increase in spending shifts AD right, a decrease in
spending shifts AD left
Price
Level
AD1
AD2
Real domestic output (GDPR)
65
How does this cartoon relate to Aggregate Demand?
66
How does this cartoon relate to Aggregate Demand?
67
Review:
Determine the effect on aggregate demand of each of the
following events. Explain whether it represents a movement along
the aggregate demand curve (up or down) or a shift of the curve
(leftward or rightward). Then, in a correctly labeled graph, show
how each of the following will affect the AD curve.
a. Business owners are less optimistic about the health of the
economy.
b. The government decreases welfare and veteran’s benefits.
c. The Federal Reserve increases interest rates.
d. A rising price level decreases the value of money held for
purchases.
e. The government lowers personal income taxes.
f. Consumers expect the job market to be much stronger in the
next few months.
g. The stock market has reached new records high levels of value.
h. The stock of physical capital has been falling for nearly a year.
a. Leftward shift in AD (a decrease in AD). Weak business optimism will
decrease business spending and capital investment.
b. Leftward shift in AD. Less government spending on these transfer payments
means less income received by those who qualify for them, thus less
consumer spending.
c. Leftward shift in AD. Higher interest rates decrease borrowing for both
capital investment and large consumer spending.
d. Upward movement along the AD curve. The rising price level will reduce
spending because each dollar held by households and firms is worth less than
it used to be.
e. Rightward shift in AD. Lower taxes put more income in the hands of
consumers so consumer spending rises.
f. Rightward shift in AD. Stronger consumer optimism will increase consumer
spending.
g. Rightward shift in AD. Higher value of household wealth causes consumer
spending to rise
h. Leftward shift in AD. A. lower level of physical capital is an indicator that
investment spending has fallen.
1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Real Interest Rates (Price of borrowing $)
(If interest rates increase…)
(If interest rates decrease…)
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes means…)
71
3. Change in Government Spending
(War…)
(Nationalized Heath Care…)
(Decrease in defense spending…)
4. Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
“If the US get a cold, Canada gets Pneumonia”
AD = GDP = C + I + G + Xn
72
Current Events
• http://www.npr.org/2013/12/17/251796694/
year-in-numbers-the-federal-reserves-85billion-question
Warm Up: What do you
think the Consumer
Confidence Index
measures? Why? How
does this tie into
aggregate demand?
Agenda:
Warm Up
Graphing Shifters
Practice Graphing
Current Events:
http://www.bbc.co.uk/news/busin
ess-25299683
http://www.bbc.co.uk/news/busin
ess-25440142
http://www.bbc.co.uk/news/busin
ess-25415501
Aggregate Supply: Module 18
The amount of goods and services (real GDP) that
firms produce in an economy at different price
levels.
Aggregate Supply differentiates between short run
and long-run and has two different curves.
Short-run Aggregate Supply
•Wages and Resource Prices will not increase as
price levels increase.
Long-run Aggregate Supply
•Wages and Resource Prices will increase as price
levels increase.
77
This is Supply
This is Aggregate Supply
79
Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT
increase as price levels increase.
Example:
• If a firm currently makes 100 units that are sold for
$1 each and the only cost is $80 of labor how much is
profit?
• Profit = $100 - $80 = $20
What happens in the SHORT-RUN if price level doubles?
• Now 100 units sell for $2 so total return=$200.
How much is profit?
• Profit = $120
With higher profits, the firm has the incentive to
increase production.
80
The SRAS curve is upward sloping..
But why?
If the price of a unit of output is rising faster
than the cost of producing that unit, that unit
of output will be produced.
(some input prices are “sticky” meaning they
don’t rise of fall very quickly in response to a
change in demand for them.)
Aggregate Supply Curve
Price
Level
AS
AS is the production
of all the firms in
the economy
Real domestic output (GDPR)
82
The Shifters for Aggregate Supply can
be remembered as
I. R. A. P.
Shifts in Aggregate Supply
An increase or decrease in national production can shift
the curve right or left
Price
AS2 AS
Level
AS1
Real domestic output (GDPR)
84
Graph Shifters:
1.Commodity Prices:
standardized input bought
and sold in bulk quantities
2. Nominal Wages
3. Productivity:
increasing/decreasing output
Long-Run Aggregate Supply
In the Long Run, wages and resource prices
WILL increase as price levels increase.
Same Example:
• The firm has TR of $100 an uses $80 of labor.
• Profit = $20.
What happens in the LONG-RUN if price level doubles?
• Now Total Revenue=$200
•In the LONG RUN workers demand higher wages to
match prices. So labor costs double to $160
• Profit = $40, but REAL profit is unchanged.
If REAL profit doesn’t change
the firm has no incentive to increase output.
87
Long run Aggregate Supply
In Long Run, price level increases but GDP doesn’t
Price level
LRAS
Long-run
Aggregate
Supply
Full-Employment
(Trend Line)
QY or Yp
GDPR
Assume that in the long run the economy will be
producing at full employment.
89
Potential Output: the level
of Real GDP the economy
would produce if all prices,
including nominal wages,
were fully flexible
Given this, which way do you think
our long run aggregate supply curve
has been shifting?
Practice-CPTS!
a. Leftward shift in SRAS. This disruption would act as a short-term
decrease in a nation’s technology and hinder the nation’s ability to
produce goods and services.
b. Leftward shift in SRAS. When the price of a commodity such as
grain rises, it will increase production costs for many goods and
services; shifting SRAS to the left.
c. Rightward shift in SRAS. A population with higher levels of
education translates into a more productive workforce that is able
to produce more goods and services.
d. Downward movement along the SRAS curve. The SRAS curve is
upward sloping so that, all else equal, a lower aggregate price level
will reduce the level of GDP supplied.
e. Leftward shift in SRAS. Labor is a key resource in the production
of most goods and services so if labor is becoming more
expensive, the SRAS will shift to the left.
Module 19: Putting AD and AS together to
get Equilibrium Price Level and Output
93
How does this cartoon relate to Aggregate Demand?
94
Aggregate Price Level
• Macroeconomic equilibrium occurs at the
intersection of aggregate demand and
short-run aggregate supply.
LRAS
SRAS
AD
It can also happen that this
occurs at the long-run
equilibrium point, but not
necessarily.
Aggregate Output
• As we have learned a Demand Shock can
effect equilibrium:
– Great Depression
– Housing Market crash of 2007-2008
Shocks cause a shift in the Aggregate Demand
or Supply and can also lead
Recessionary Gaps or
Inflationary Gaps or
Stagflation
Shifters of Aggregate Demand
AD = C + I + G + X
Change in Consumer Spending
Change in Government Spending
Change in Investment Spending
Net EXport Spending
Shifters of Aggregate Supply
AS = I + R + A + P
Change in Inflationary Expectations
Change in
Change in
Change in
Resource Prices
Actions of the Government
Productivity (Investment)
97
Answer and identify shifter:
C.I.G.X or
R.A.P
B
A
D
A
D
B
A
A
C
A
A major increase in productivity.
98
Inflationary Gap
Output is high and unemployment is less than NRU
Price
Level
LRAS
AS
Actual GDP
above potential
GDP
PL1
AD1
QY Q1
GDPR
99
Recessionary Gap
Output low and unemployment is more than NRU
Price
Level
LRAS
AS1
Actual GDP
below potential
GDP
PL1
AD
Q1 QY
GDPR
100
Assume the price of oil increases drastically.
What happens to PL and Output?
Price
Level
LRAS
AS1
AS
PL1
Stagflation
PLe
Stagnate Economy
+ Inflation
AD
Q1 QY
GDPR
101
Assume the government increases spending.
What happens to PL and Output?
Price
Level
LRAS
AS
PL and Q will
Increase
PL1
PLe
AD
QY Q1
GDPR
AD1
102
Assume consumers increase spending. What
happens to PL and Output?
Price
Level
LRAS
AS
PL1
PLe
AD
QY Q1
GDPR
AD1
103
Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and
production costs increase
LRAS AS1
Price
AS
Level
PL2
Back to full
employment with
higher price level
PL1
PLe
AD
QY Q1
GDPR
AD1
104
Negative and Positive Aggregate Demand Shocks
Another Example
Negative and Positive Supply Shocks
Another Example
Long Term Equilibrium
• To summarize how an economy responds to
recessions/inflation we focus on Output Gap
which is the % difference between actual
aggregate output and potential output.
Actual Aggregate Output-Potential Output x 100
Potential Output
In the Long Run the economy is self-correcting but many
times Governments are not willing to wait that long which
brings about Macroeconomic Policy (Module 20)
Short-Run Versus Long-Run Effects of a Positive Demand Shock and a return to Equilibrium via selfcorrecting economy.
MODULE 20
Classical
vs.
Keynesian
Adam Smith
1723-1790
Economic Theory
John Maynard Keynes
109
1883-1946
110
Debates Over Aggregate Supply
Classical Theory
1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.
Price
level
AS
Recessions caused by a fall in AD are
temporary.
Price level will fall and economy will fix
itself.
No Government Involvement Required
AD
AD1
Qf
Real domestic output, GDP
111
Debates Over Aggregate Supply
Keynesian Theory
1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
AS
Price
level
AD1
“Sticky Wages” prevents wages to
fall.
The government should increase
spending to close the gap
AD
Q1
Qf
Real domestic output, GDP
112
Debates Over Aggregate Supply
Keynesian Theory
1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
AS
Price
level
AD1
When there is high
unemployment, an increase in AD
doesn’t lead to higher prices until
you get close to full employment
AD3
AD2
Q1
Qf
Real domestic output, GDP
113
The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward.
Like a ratchet, prices can easily move up
but not down!
114
Deflation (falling prices) does not often happen
•If prices fall, the cost of resources must fall or
firms would go out of business.
•The cost of resources (especially labor) rarely fall
because:
•Labor Contracts (Unions)
•Wage decrease results in poor worker morale.
•Firms must pay to change prices (ex: re-pricing
items in inventory, advertising new prices to
consumers, etc.)
115
Module 21:
Fiscal Policy & The Multiplier
116
The Car Analogy
The economy is like a car…
• You can drive 120mph but not for long.
(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.
118
(Shift the PPC outward)
Two Types of Fiscal Policy
Discretionary Fiscal Policy• Congress creates a law 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 increases spending.
Non-Discretionary Fiscal Policy
•AKA: Automatic Stabilizers
•Permanent spending or tax laws enacted to counter
cyclical problem to stabilize the economy
•Ex: Welfare, Unemployment, Min. Wage, etc.
•When there is high unemployment, unemployment
benefits to citizens increase consumer spending.
119
Contractionary Fiscal Policy
(The BRAKE)
Laws that reduce inflation, decrease GDP
Either Decrease Government Spending or Enact
Tax Increases
• Combinations of the Two
Expansionary Fiscal Policy
(The GAS)
Laws that reduce unemployment and increase GDP
• Increase Government Spending or Decrease Taxes
on consumers
• Combinations of the Two
How much should the Government Spend?
120
Example of Expansionary Fiscal Policy
• increase G
• decrease T
• increase transfers
Expansionary Policy: The Stimulus Package
Example of Contractionary Fiscal Policy
• decrease G
• increase T
• decrease transfers
The Multiplier Effect
Spending
Multiplier
OR
As the Marginal Propensity to Consume falls, the
Multiplier Effect becomes less effective
124
Effects of Government Spending
If the government spends $5 Million, will AD
increase by the same amount?
• No, AD will increase even more as spending
becomes income for consumers.
• Consumers will take that money and spend, thus
increasing AD.
How much will AD increase?
• It depends on how much of the new income
consumers save.
• If they save a lot, spending and AD will increase
less.
• If they save a little, spending and AD will be
increase a lot.
125
Problems With
Fiscal Policy
126
Explain this cartoon About Fiscal Policy
2003
127
Who ultimately pays for excessive
government spending?
128
Practice Problem to Draw
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)
129
Practice Problem to Draw
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)
130
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)
131
Answers to Practice FRQ
132