Unit 2:
Aggregate Demand and Supply
and Fiscal Policy
Topic 1: Aggregate
Demand
What is Aggregate Demand?
Aggregate Demand is all the goods and services that
buyers are willing and able to purchase at different
price levels.
Aggregate means “added all together.”
The Demand for everything by everyone in the US.
Aggregate Demand Curve
Price
Level
Inverse relationship
between price level and
Quantity
AD
Quantity of Real GDP (GDPR)
4
Shifters of Aggregate
Demand
5
Shifts in Aggregate Demand
Increase = RIGHT ; decrease = LEFT
Price
Level
AD1
AD2
AD
Quantity of Real domestic output (GDPR)
Shifters of Aggregate Demand
1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Wealth= assets that generate money (real estate,
stock, property)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Income Taxes (Decrease in income taxes…)
* Important note: A change in WAGES does NOT
impact C in AD because a change in nominal wages
does NOT mean a change in REAL wages (Just
because wages go up, does not mean you can
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purchase more)
Shifters of Aggregate Demand
2. Change in Investment Spending
(business puts $ back into the business)
I = capital stock, construction and inventory
Things that impact I spending
Interest Rates (Price of borrowing $)
Future Business Expectations (High expectations…)
Business Taxes (Higher corporate taxes means…)
8
Shifters of Aggregate Demand
3. Change in Government Spending
Infrastructure…
Nationalized Heath Care…
defense spending…
4. Change in Net Exports
can be influenced by a change in FOREIGN
INCOME
** General rule: An increase in spending (any type) shifts
AD right, and decrease in spending(any type)shifts it left
AD = GDP = C + I + G + Xn
Which way will AD shift???
1. There is an increase in the wealth of American households.
2. The government increases income taxes.
3. There is a decrease in interest rates
4. The government increases spending on the military
5. The government decreases income taxes
6. The government raises business taxes
7. Investment spending decreases.
8. Price level increases
Topic 2: The Multiplier Effect
Why do cities want the Superbowl in
their stadium?
MULTIPLIER EFFECT
• Someone’s spending (whether it be
consumer, business, government etc) will
always become someone else’s income
• The person who receives the income will turn
around and spend it and the cycle continues
• Because of this there is a multiplied impact of
spending on the economy.
Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
•How much people consume rather than save when
there is a change in income.
MPC=
Change in Consumption
Change in Income
Examples:
1. If you received $100 and spent $50. What is MPC?
2. If you received $100 and spent $80. What is MPC?
3. If you received $100 and spent $90. What is MPC?
13
Marginal Propensity to Save
Marginal Propensity to Save (MPS)
•How much people save rather than consume when
there is a change in income.
MPS=
Change in Saving
Change in Income
Examples:
1. If you received $100 and save $50. MPS?
2. If you received $100 and save $30. MPS?
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MPC + MPS = 1
Why is this true?
Because people can either save or consume
If MPC is .8, what is MPS?
If MPS is .1, what is MPC?
If MPC is .6, what is MPS?
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How is Spending “Multiplied”?
Assume the MPC is .6 for everyone - Assume the
Super Bowl comes to town and there is an
increase of $100 in spending at Ashley’s
restaurant.
Ashley has $100 more income.
Ashley spends $ 60 (60% of 100) at Carl’s salon and saves $ 40
(100 -60)
Carl now has $60.
Carl spends $36 (60% of 60) at Dan’s fruit stand and saves $24
(60 -36)
Dan now has $36.
Dan spends $21.60 (60% of 36) at Wendy’s and saves $14.40
(36 – 21.60)
How multiplier effect works
• New income of $100 ; MPC = .6
* remember someone’s spending becomes
someone else’s income
Round
Income
Spending
Savings
1 (ashley)
$100
$60
$40
2 (carl)
$60
$36
$24
3 (dan)
$36
$21.60
$14.40
Spending multiplier
»increase in spending = more $ goes into
the economy (total GDP will increase)
1/MPS
» decrease in spending = less $ goes into
the economy(total GDP will decrease)
- 1/MPS
Practice
• 1. If MPC is .8, what is the spending multiplier
if investment spending decreases???
• 2. If the MPS is .1, what is the spending
multiplier if government spending
increases???
The smaller the MPS, the greater the spending
multiplier will be!!!
How to use the spending multiplier
If Consumer Spending increases by $3 million, and the MPC is .8
How much will the GDP change by?
spending multiplier X change in spending
How figured:
1. find spending multiplier
1/MPS = 1/.2 = 5
2. Multiply the spending multiplier by the change in
spending:
3 X 5 = $15
GDP will increase by a total of $15 million (5 X 15)
Tax Multiplier
• looks at the impact that taxes have on the entire economy (taxes
also impact spending!)
If taxes go down: people have MORE $ to spend – GDP will INCREASE
MPC/MPS (if decrease in taxes)
If taxes go up: people have LESS money to spend – GDP will
DECREASE
- MPC/MPS (if increase in taxes)
Practice
• MPC is .9, and taxes go up, what is the TAX
multiplier???
• MPS is .2, and taxes go down, what is the TAX
MULTIPLIER???
How to use the tax mutiplier
•
If the government decreases taxes by $50 million, and the
MPC is .8 by how much will the GDP change by?
Tax multiplier X change in TAXES
How figured:
1. Find Tax multiplier
.8/.2 = 4
2. Multiple tax multiplier by change in taxes
4X50 = $200
GDP will increase by $200 million
Balanced Budge Multiplier
• Spending multiplier will always have
a bigger impact on the economy than
tax multiplier if spending and taxes
both change by the same amount!
Balanced Budget Multiplier
• The spending multiplier and the tax multiplier
combine to form the BALANCED BUDGET
MULTIPLIER
BALANCED BUDGET MULTIPLIER = 1
1 X change in SPENDING = impact on the total economy
How to use the balanced budget
multiplier
Rule: if both taxes and spending change by the
same amount, they DON’T cancel each other out –
spending will always have the bigger impact on the
economy
Example: The G increases spending by $20 million
while at the same time raising taxes by $20 million.
$20 X 1 = $20
• GDP will INCREASE by: $20 million
Balanced budget multiplier
Investment spending decreases spending by $5
million and at the same time, the government
lowers taxes by $5million.
If MPS is .1, how does this change the total GDP
of the economy?
1 X -5 = - $ 5 million
Topic 3: Aggregate
Supply
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What is Aggregate Supply?
Aggregate Supply is the supply for
everything by all firms.
Aggregate Supply differentiates between short run
and long-run and has two different curves.
Short Run Aggregate Supply Curve
AS
Price
Level
Direct relationship
between price level
and Quantity
Real domestic output (GDPR)
30
Shifters of SR Aggregate
Supply
Shifts in SR Aggregate Supply
Price
Level
Increase = RIGHTWARD SHIFT
decrease = LEFTWARD SHIFT
AS2 AS
AS1
Real domestic output (GDPR)
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Shifters of SR Aggregate Supply
1. Change in Resources
Prices and quantity of Domestic and Imported
Resources
wages (price of labor)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)
Shifters of SR Aggregate Supply
2. Legalities
* Business taxes (shifts AD too!)
Subsides
Government Regulations
3. Change in Productivity
4.
Change in Technology
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Which direction will SRAS shift???
1.
2.
3.
4.
There is an improvement in technology
The government decreases business taxes
Worker wages decrease
There is an increase in the price of resources
used in production
5. Productivity declines for 3rd month in a row
6. Price level increases
7. Worker wages increase
AD and SRAS macroeconomic
equilibrium price and quantity
Short run Macroeconomic equilibrium
If there is a shift in AD or SRAS, price level and
quantity of real GDP will change
Investment spending increases:
Price level _______
Q of GDPr _______
Wages increase causing the Cost of
production to increase
Price level ___
Q of GDP ____
Practice WS : AD and SRAS
AD shifters
Change in Consumer spending
(income, income taxes, wealth,
confidence)
Change in Investment spending
(interest rates, business taxes)
Change in Government spending
Change in Net export spending
(foreign incomes)
SRAS shifters
Change in legalities
(subsidies, business taxes)
Change in Resources
(wages, resource prices & Q)
Change in productivity
Change in Technology
Topic 4: Short Run to LONG RUN
In the SHORT RUN –
wages are STICKY;
they DO NOT adjust
to price changes
In the LONG RUN –
wages are FLEXIBLE;
they DO adjust to
changes in prices
Short Run:
100 units sell for $1 each, TR = $100
The only cost is $80 of labor.
How much is profit?
$100 - $80 = $20
What happens in the SHORT-RUN if price level doubles?
100 units sell for $2, TR=$200.
Wages haven’t had the time to adapt to the change in
prices (WAGES are STICKY – they are still $80)
How much is profit? $200 – 80 = $120
With higher prices, the firm has the incentive to increase
production (because their profits will increase)
Long-Run Aggregate Supply
100 units sell for $1 each; TR = $100
Cost to produce is $80 of labor
Profit = $20.
What happens in the LONG-RUN if price level doubles?
100 units sell for $2.00 each; TR =$200
In the LONG RUN workers demand higher wages to
match prices. Wages have had the time to adjust to
price changes – Eventually, labor costs double
too(wages are FLEXIBLE and adjust to price changes)
Cost to produce is now $160 (instead of $80)
Profit: 200-80 =$40
*** REAL profit is unchanged.
If REAL profit doesn’t change
the firm has no incentive to increase
output.
So… LONG RUN AS is VERTICAL
Long run Aggregate Supply
The economy is at FULL Employment
Price level
LRAS
QY
GDPR
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LRAS compares to PPC
On curve: Economy at FULL EMPLOYMENT
All resources being used
Shifts of LRAS:
Increase RIGHT; Decrease LEFT
Shifters of LRAS
Shifts for Same reasons PPC shifts:
1. Change in technology
2. Change in QUANTITY of resources
* General rule: LRAS will never shift by itself
(SRAS will shift with it) However, SRAS can shift
without LRAS shifting
Practice
48
Which curve will shift??? AD, SRAS,
LRAS
• 1. An increase in consumer confidence
• 2. An increase in incomes of U.S. trading partners
• 3. A large decrease in the price of imported oil which
impacts the resource cost of business
• 4. An increase in business taxes
• 5. An improvement in technology
• 6. 25% stock market increase over a two month period
which increases household wealth
• 7. a decrease in interest rates
• 8. A increase in wages
Topic 5: Putting AD, SRAS and LRAS
together to get
Equilibrium Price Level and Output
Putting AD, SRAS and LRAS together
Practice WS : AD, SRAS and LRAS
SRAS shifters
AD shifters
1Change in legalities
1 Change in Consumer spending
(subsidies, business taxes)
(income, income taxes, wealth,
confidence)
2 Change in Investment spending
(interest rates, business taxes)
3 Change in Govt spending
2Change in Resources
(prices of resources, quantity of
resources, wages, energy prices,
“supply shocks” )
3Change in productivity
4 Change in Net export spending
4Change in Technology
(foreign incomes)
LRAS shifters
1Change in technology
2Change in quantity of resources
Topic 6 : Economic Stability
A stable economy is represented
by:
1. Economic growth
2. Price stability
3. Full employment
Economics Statistics
Measured
by
Economic Unemploy
growth ment
Real GDP People not
working but
looking
Acceptable Over
2.5%
Under 6%
Inflation
CPI
(consumer
price
index)
Up to 4%
Economic Instability
• High unemployment/Recession
• High Inflation
• Stagflation – high unemployment and inflation
AT SAME TIME
Graphs showing
Inflationary and
Recessionary Gaps
Full employment equilibrium
Economy at FE with acceptable price
level
Inflationary Gap
Output is high and employment is greater than FE
Price
Level
LRAS
AS
Actual GDP
above
FE/potential
GDP
PL
Economy is here,
But should be
At FE
AD
Q
GDPR
57
Inflationary Gap
How can we be beyond
the FE line???
In the SR, economy can
overuse resources, but
CANNOT be sustained in
the LONG RUN (ex.
pulling all –nighters to
study…)
Recessionary Gap
Output low and employment is less than FE
LRAS
Price
Level
AS
Actual GDP
below
FE/potential
GDP
PL
Economy is here,
But should be at
FE
AD
Q
GDPR
59
STAGFLATION
If both inflation and unemployment are high
STAGFLATION will occur
What curve shift illustrates this problem?
This problem is represented by a DECREASE in
SRAS
Stagflation – high inflation and high
unemployment AT SAME TIME
The economy begins at FE and the G
increases spending. Shift the curve on the
graph
What economic problem does this cause???
The economy begins at FE and net export
spending decreases.
Shift the curve on the graph
What economic problem does this cause???
Topic 7: Self adjusting
economy
64
Flexible wages in the Long run
The economy can adjust to FE equilibrium over
time as wages change to adjust to price
changes
Assume inflation is occurring in the economy
Price
Level
LRAS AS
PL
AD
Q
GDPR
AD1
66
If inflation occurs, what will happen in the LONG RUN?
workers seek higher wages and wages increase.
An increase in wages SHIFTS AS to LEFT
LRAS AS1
Price
AS
Level
PL1
Back to full
employment with
higher price level
PL
AD
Q1 Q
GDPR
67
Assume a recession is occurring in the
economy
Price
Level
LRAS
AS
PL
AD
Q
AD
GDPR
68
If recession occurs, what happens in the Long Run?
workers accept lower wages so wages decrease
When wages decrease, SRAS shifts to the right
Price
Level
LRAS
AS
AS1
AS increases as workers accept
lower wages and production
costs fall
PL
PL1
AD
Q Q1
GDPR
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Topic 8: The Phillips
Curve
SRPC Shows tradeoff between
inflation and unemployment.
Short Run Phillips Curve
When the economy is overheating, there is low
unemployment but high inflation (A)
Inflation
5%
A
When there is a recession,
unemployment is high but
inflation is low (B)
B
1%
SRPC
2%
9%
Unemployment
71
Shifts of Short run Phillip’s curve
1. inflation and unemployment move in the SAME
direction, there will be a SHIFT of the SRPC
-If inflation and unemployment both go up;
SRPC shifts to the RIGHT
- If both go down, SRPC shifts to the LEFT
2. Change in inflationary expectations
if these increase, SRPC shifts RIGHT
if these decrease, SRPC shifts LEFT
Assume stagflation occurs
Draw an AD/AS graph showing this
SRAS SHIFTS TO THE LEFT
In the Short run, what happens
Price level? increases
Unemployment? increases
73
What is impact on SRPC?
Shifts to the right
Inflation
SRPC1
SRPC
Unemployment
74
Consumers begin to save more money.
Draw an AD/AS graph that shows this
AD SHIFTS TO THE LEFT
In the short run, what happens to
Price level? Decreases
Unemployment? INcreases
What is impact on SRPC?
Movement down along original curve
Inflation
SRPC
Unemployment
76
The prices of resources decrease. Draw
an AD/AS graph showing this
SRAS SHFITS TO THE RIGHT
What happens in the short run to
price level? decreases
unemployment? decreases
What is impact on SRPC?
Shifts to the left
Inflation
SRPC
SRPC 1
Unemployment
78
From Short run Phillips curve to Long
run Phillips curve
• Because the SRPC is continually shifting in the
LONG RUN, there is no trade off between
inflation and unemployment
Example: The economy is at FE and
interest rates increase
What problem does this create? RECESSION
What happens in the long run to…
– Price level DECREASES
– Unemployment DECREASES
What will happen to the SRPC in the Long Run?
SHIFTS to the LEFT
Example: The economy is at FE and
consumer spending increases
What problem does this create? INFLATION
What happens in the long run to…
– Price level? INCREASES
– Unemployment INCREASES
What will happen to the SRPC in the Long Run?
SHIFTS TO the RIGHT
In the long run there is no tradeoff between inflation
and unemployment due to SRPC continually shifting
Inflation
LRPC
5%
The LRPC is vertical at the
Natural Rate of
Unemployment
3%
1%
2%
5%
9%
Unemployment
82
SHIFTS OF LRPC
LRPC can shift if there is a change in
the Natural rate of unemployment
• LRPC will never shift by itself (if you
shift LRPC, shift SRPC too!)
Phillips curve at FE equilibrium
LRPC
Inflation
The unemployment
rate is at the NATURAL
RATE
and
inflation rate is at the
EXPECTED RATE
SRPC
UY Unemployment
84
Inflationary Gap on Phillips Curve
LRPC
Inflation
SRPC
UY Unemployment
85
Recessionary Gap on the Phillips Curve
LRPC
Inflation
SRPC
UY
Unemployment
86
Topic 9: Economic theories
CLASSICAL VIEW OF ECONOMY:
Does not distinguish between
short run and long run.
wages as being flexible and that
they QUICKLY adjust to changes
in price level
The economy does not need
intervention to adjust
View the Short Run AS as
VERTICAL
The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward.
88
Does deflation (falling prices) often occur?
Not as often as inflation. Why?
Prices and wages are more flexible upward as
opposed to downward
Like a ratchet, prices can easily move up
but not down!
89
Keynesian View of Economy
Unlike the classical view, Keynesians don’t
think the economy can quickly adjust to fix itself (at least
in times of recession; due to the ratchet effect)
View aggregate supply as horizontal at low output
Wages are STICKY – they do NOT quickly adjust
to price changes
THEREFORE…. Government intervention in the
economy is necessary to fix it!!!
Keynesian Theory- Horizontal AS
Recession will be persistent because wages are not
flexible (they will not go down to return the
economy to FE)
Price
level
AS
Real domestic output, GDP
Three Ranges of Aggregate Supply
1. Keynesian Range- Horizontal
2. Intermediate Range- Upward sloping
3. Classical Range- Vertical
AS
Price
level
Classical
Range
Keynesian
Range
Intermediate
Range
Real domestic output, GDP
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Topic 10: Fiscal Policy
93
Fiscal Policy
Fiscal Policy: Actions by Congress to speed up or slow down
the economy (rather than waiting for the economy to self
adjust)
Based on: Keynesian theory- Wages are sticky, so economy
does not quickly self adjust
Government intervention is NECESSARY to return the
economy to stability
A stable economy should have:
1.
stable prices
2.
full employment
3.
economic growth
Two Types of Fiscal Policy:
Discretionary and Automatic
1. Discretionary Fiscal PolicyCongress creates and passes a new bill
ex. Congress votes to implement a tax cut
2. 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.
Expansionary Fiscal Policy
• Implemented during
RECESSION
• Goal is to SPEED UP
economy without
causing too much
inflation
• Need to increase AD
Video example of expansionary fiscal
policy
How can the government speed up the
economy????
1. Increase government spending (public works,
roads, schools etc.)
*need to account for the SPENDING
MULTIPLIER
2. Decrease personal income taxes
(Consumers will have more $, so they will spend
more)
*need to account for the TAX MULTIPLIER
• * government can increase its spending, decrease
taxes or do both – any of these actions increase AD
• Expansionary policy will result in a DEFICIT BUDGET
• Deficit Budget: the government spends more $ than
what they take in
Contractionary Fiscal Policy
Implemented during
INFLATION
Goal is to SLOW DOWN
economy without
causing recession
Want to decrease AD
How can the government slow down the
economy???
1. Decrease government spending
* need to account for spending multiplier
2. Raise personal income taxes
*need to consider tax multiplier
• * Government can decrease its spending, raise income taxes
or both – any of these actions will slow down the
economy/decrease AD
• Contractionary Policy results in a SURPLUS BUDGET
• Surplus Budget: the government spends less $ than what
they take in
Problems With
Fiscal Policy
Problems With Fiscal Policy
1. Deficit Spending!!!!
•A Budget Deficit – government spending exceeds its
revenue.
•The National Debt is the accumulation of all the budget
deficits over time.
Most economists agree that budget deficits are a
necessary evil because forcing a balanced budget would
not allow Congress to stimulate the economy.
Additional Problems with Fiscal Policy
2 Problems of Timing
• Recognition Lag- Congress must react to
economic indicators before it’s too late
• Administrative Lag- Congress takes time to pass
legislation
3. Politically Motivated Policies
• Politicians may use economically inappropriate
policies to get reelected.
Topic 11: Focus on National Debt
The National Debt: CNBC explains
• 1. What is the difference between deficit
spending and the national debt?
• 2. What is the DEBT CEILING?
• 3. If the government borrows $, how does it
get the money it needs?
• 4. Who/what is the largest holder of U.S.
debt?
Where does the State and local
government get $ from???
• Where does the Federal
Government get its
money???
Income taxes
Tax based on the “income” a person earns
Americans pay an income tax to:
1. The federal government
2. The state government
3. The local government
These taxes appear on a person’s pay check stub
The purpose of filing taxes at the end of the year is to determine
if a person has overpaid or underpaid their taxes
EXAMPLE OF PAYCHECK STUB
• Stossel goes to Washington: segment 1
(7:40)
Countries with the highest income tax
rates
Country
Tax rate
Kicks in at….
Aruba
58.9%
$165,000
Sweden
56.6%
$81,000
Denmark
55.4%
$76,000
Netherlands
52%
$72,000
Austria
50%
$80,000
Belgium
50%
$46,900
Japan
50%
$217,000
United Kingdom
50%
$231,000
Finland
49.2%
$91,000
Ireland
48%
$43,900
U.S. = 23rd; at 39.6% at $400,000
*Source: CNBC
• Where does the
State and local
government spend
money???
Where does the federal government
spend money ?
• everything else includes
education, veterans
benefits, national
resources, foreign aid,
Immigration, response
to natural disasters
Military spending around the world
http://www.sipri.org/research/armaments/milex/factsheet2010
What is the national debt???
• Debt occurs when government revenue
(primarily from taxes) is less than government
spending.
• Therefore debt will rise whenever..
– revenue falls
– spending increases
Debt in the past decade
•
•
•
•
•
•
•
•
•
•
2001: $5.8 trillion
2002: $6.2 trillion
2003: $6.8 trillion
2004: $7.4 trillion
2005: $7.9 trillion
2006: $8.5 trillion
2007: $9.0 trillion
2008: $10.0 trillion
2009: $11.9 trillion
2010: $13.6 trillion
• DEBT CLOCK
It would take 200,000
years to count to 1
trillion!!!!!
Countries with the largest debts
17-120
Countries with largest debt as
compared to GDPs
Ownership of the Debt
Situation:
GDP: -1.2%
Inflation rate= -.5%
Unemployment Rate=25%
Solution???
Situation:
GDP :8%
Inflation rate= 4.1%
Unemployment Rate=1.2%
Solution???
Situation:
• GDP: -0.3%
• Inflation rate= 13.5%
• Unemployment Rate=7.1%
Solution??
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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