AP Macroeconomics

1. The modern tools of macroeconomic policy are:
Monetary and Fiscal Policy

AD is downward sloping:
Price
Level
Negative relationship between PL and Output
Changes in price level cause a move along the curve
AD = C + I + G + Xn
Real domestic output (GDP
R
)
3

Price
Level
AD shows the relationship between aggregate PL and
Real GDP or output
Aggregate demand by households, businesses, government, and the rest of the world
AD = C + I + G + Xn
Real domestic output (GDP
R
)
4

•
Higher price levels reduce the purchasing power of money and 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.
5

•
When the 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. WHY?
• Example: An 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).
6

Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels.
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
•
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.
7

Price
Level
AS
AS is the production of all the firms in the economy
Real domestic output (GDP
R
)
8

AD = GDP = C + I + G + X
Change in
C onsumer Spending
Change in
G overnment Spending
Change in
I nvestment Spending
Net E
X port Spending
AS = I + R + A + P
Change in
I nflationary Expectations
Change in
R esource Prices
Change in
A ctions of the Government
Change in
P roductivity
9

An increase in spending shifts AD right, and decrease in spending shifts it left
Price
Level
AD
1
AD = C + I + G + Xn
AD
2
Real domestic output (GDP
R
)
10

1. Change in Inflationary Expectations
If an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS.
(If people expect lower prices…)
2. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)
11

3. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Subsidies for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
4. Change in Productivity
Technology
(Computer virus that destroy half the computers…)
(The advent of a teleportation machine…)
12

Output is high and unemployment is less than FE
LRAS
Price
Level AS
PL
1
Actual GDP above potential
GDP
Q
Y
Q
1
GDP
R
AD
1
13

Output low and unemployment is more than FE
LRAS
Price
Level
AS
1
PL
1
Actual GDP below potential
GDP
Q
1
Q
Y
AD
GDP
R 14

• The fraction of any change in disposable income that is consumed.
• MPC= Change in Consumption
Change in Disposable
Income
• MPC = ΔC /
ΔDI

• The fraction of any change in disposable income that is saved.
• MPS= Change in Savings
Change in Disposable
Income
• MPS = ΔS /
ΔDI

• The limiting factor is savings.
• For every additional dollar spent a portion of it will be saved (the MPS ).
• The multiplier is the reciprocal of the MPS or 1/MPS.
• The larger the MPC (the smaller the MPS) the larger the multiplier will be.

• Tax Multiplier (note: it’s negative because tax increases reduce spending)
-
MPC /
1-MPC or
-
MPC /
MPS
• If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow





Government Spending during a recession or depression and can improve an economy by injecting money into households.
Recessions are inevitable.
Many government programs like Social
Security, Medicare, Unemployment, and
Welfare were begun as Keynesian economic stimulus.
Aggregate Demand must be stimulated in order to recover from a recession.







Free Markets will lead to full employment
Keynesian Economics causes price bubbles,
(inflation .)
When the bubbles break , a recession
( hangover ) incurs.
The booms and busts of the business cycle are natural and are self-correcting.
Competition is the invisible hand
Government should be limited to preventing monopolies or unions




A non-political agency can regulate banks, the money supply, and interest rates. It will be especially effective when painful and unpopular decisions need to be made and will make them in a timely manner. This can be the central banking system.
During recessions, impact the overall investment demand through tools that increase the incentive to borrow. This will be lower interest rates.
During inflation, impact the overall investment demand through tools that decrease the incentive to borrow. This will be higher interest rates.