Unit 3: Aggregate Demand and Supply and Fiscal Policy 1

Shifters of Aggregate Demand Shifters of Aggregate Supply 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 Resource Prices Change in Actions of the Government Change in Productivity (Investment)

Practice 3

Answer and identify shifter: C.I.G.X or R.A.P B A D A D B A A C A major increase in productivity. A 4

Putting AD and AS together to get Equilibrium Price Level and Output

Inflationary and Recessionary Gaps 6

Example: Assume the government increases spending Example: Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 7

Inflationary Gap Output is high and unemployment is less than NRU LRAS Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 8

Stagnate Economy + Inflation Example: Assume the price of oil increases drastically. What happens to PL and Output? LRAS Price Level AS1 AS PL1 Stagflation Stagnate Economy + Inflation PLe AD Q1 QY GDPR 9

Recessionary Gap Output low and unemployment is more than NRU LRAS Price Level AS1 Actual GDP below potential GDP PL1 AD Q1 QY GDPR 10

How does this cartoon relate to Aggregate Demand? 11

Draw AD and AS at full employment LRAS AS Price Level P2 P1 AD2 AD=C+I+G+X Qf (Y*or FE) Q2 GDPR Output Increases PL Increases 12

Short Run and Long Run 13

Shifts in AD or AS change the price level and output in the short run LRAS Price Level AS PLe AD QY GDPR 14

Example: Assume consumers increase spending Example: Assume consumers increase spending. What happens to PL and Output? LRAS Price Level AS PL1 PLe AD1 AD QY Q1 GDPR 15

Now, what will happen in the LONG RUN? Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 16

AS increases as workers accept lower wages and production costs fall Example: Consumer expectations fall and consumer spending plummets. What happens to PL and Output in the Short Run and Long Run? Price Level LRAS AS AS1 AS increases as workers accept lower wages and production costs fall PLe Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment PL1 PL2 AD AD AD1 Q1 QY GDPR 17

A ratchet (socket wrench) tool forward but not backward. The Ratchet Effect A ratchet (socket wrench) permits one to crank a tool forward but not backward.

Does deflation (falling prices) often occur? Not as often as inflation. Why? If prices were to 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.) Like a ratchet, prices can easily move up but not down!

Released AP Exam Question An inflationary gap can be eliminated by all of the following EXCEPT An increase in personal income taxes An increase in the money supply A decrease in government spending A decrease in net exports

Released AP Exam Question 73% of the kids in 2000 got this one right An inflationary gap can be eliminated by all of the following EXCEPT An increase in personal income taxes An increase in the money supply A decrease in government spending A decrease in net exports

Released AP Exam Question 2. A contractionary supply shock would most likely result in A. An increase in aggregate demand B. An increase in national income C. An increase in gross domestic product D. A decrease in the general price level E. A decrease in employment

Released AP Exam Question 58% of the kids in 2000 got this one right 2. A contractionary supply shock would most likely result in A. An increase in aggregate demand B. An increase in national income C. An increase in gross domestic product D. A decrease in the general price level E. A decrease in employment