Unit 3 Aggregate Demand and Aggregate Supply: Fluctuations in Outputs and Prices

Keynesian Model Purpose of this lesson is to develop a simple model of the economy GDP = C+Ig+G+Xn Planned consumption, Gov’t spending, & net exports always occur Planned investment does not necessarily occur Sometimes inventories accumulate more than businesses plan, and sometimes businesses draw down inventories more than planned

What to do with your income? You can do three things Consume or Save Y = C + S Y = Income C = Consumption S = Savings What about taxes? Disposable Income = Income - Taxes

Propensities to Consume or Save Average Propensity to Consume (APC) APC = C / DI Average Propensity to Save (APS) APS = S / DI Marginal Propensity to Consume (MPC) MPC = ΔC / ΔDI Marginal Propensity to Save (MPS) MPS = ΔS / ΔDI APC + APS = 1 and MPC + MPS = 1

Multiplier Effect Effect on equilibrium GDP of a change in aggregate expenditures or aggregate demand (caused by a change in the consumption schedule, investment, government purchases, or net exports)

Investment To an economist, investment is Spending on plant and equipment: the machinery and the buildings that a firm uses to produce output Investment is not the purchase of stocks and bonds or any other financial instrument

Determinants of Investment Output Real GDP determines investment because it is a measure of the level of demand for a product Businesses will calculate expected profitability of the investment alternatives Interest Rate Represents the opportunity cost of using the money to buy investment goods

When should businesses invest? Expected profit > Interest Rate INVEST Expected profit < Interest Rat DON’T INVEST As the interest rate goes down, the level of investment goes up. (Investment is an inverse function of the interest rate)

Aggregate Demand Aggregate Demand The sum of planned consumption, investment, government and export minus import expenditures on final goods and services The aggregate demand function is an inverse function between the price level and output As the price level rises, the level of output demanded decreases As the price level falls, the level of output demanded increases

Factors that affect Aggregate Demand Interest-rate effect Tendency for increases in the price level to increase the demand for money, raise interest rates, and as a result, reduce total spending and real output Wealth effect (Real-Balances Effect) Tendency for increases in the price level to lower the real value of financial assets with fixed money value and, as a result, to reduce total spending and real GDP, and conversely for decreases in the price level Net export effect (Foreign Purchase Effect) The inverse relationship between the net exports of an economy and its price level relative to foreign price levels

Changes in expectations of future income, inflation or profits Determinants of Aggregate Demand: Factors that shift the Aggregate Demand Curve Changes in expectations of future income, inflation or profits Changes in government spending or taxes Changes in the money supply Changes in the foreign exchange rate or foreign income

Aggregate Supply Aggregate Supply Aggregate Supply Curve The total supply of all goods and services in the economy Aggregate Supply Curve Shows the relationship between total quantity of output supplied by all firms and the overall price level It is NOT the sum of individual firm supply curves Sometimes called a price-output adjustment curve

Aggregate Supply (con’t) Aggregate Supply depends on the quantity of labor, the quantity of capital and the level of technology In the short-run, the capital & level of technology are fixed, and only the quantity of labor changes A short-run aggregate supply (SRAS) curve assumes the money wage, resource prices & potential GDP are constant With these items being constant, as the overall price level rises, firms will produce more output

Shapes of short-run aggregate supply curve (SRAS) Horizontal Line Price level remains constant as real output varies Vertical Line Real output is constant at full capacity & only the price level can vary Positively sloped (*usually draw it this way) Real output and the price level are variable

Long-run aggregate supply (LRAS) curve Vertical at full employment, or potential GDP If there is an increase in the overall price level that is matched by equal percentage increases in the money-wage rate and other resource prices, the economy will remain at potential GDP Following adjustments, the SRAS and AD curves will intersect along the LRAS curve

Determinants of Aggregate Supply: Factors that shift the SRAS Curve Per-unit production costs (average production cost of of a particular level of output) Changes that decrease per-unit production costs shift the SRAS curve to the right Changes that increase per-unit production costs shift the SRAS curve to the left

Change in productivity Change in legal-institutional environment Determinants of Aggregate Supply: Factors that shift the SRAS Curve (con’t) Change in input prices Domestic Resource Availability Land , Labor, Capital, Entrepreneurial Ability Price of imported resources Market Power Change in productivity Change in legal-institutional environment Business Taxes & Subsidies, Gov’t regulations

Explain and Illustrate Top Portion of Visual 3.11 Unit III Lesson 5 Explain and Illustrate Top Portion of Visual 3.11

Short-Run Equilibrium Unit III Lesson 5 Short-run macroeconomic equilibrium occurs when real GDP demanded equals real GDP supplied

Unit III Lesson 5 If the price level is above equilibrium, then aggregate supply is greater than aggregate demand Firms experience an accumulation of inventory; they cut production & employment; output decreases towards equilibrium level

Unit III Lesson 5 If the price level is below equilibrium, then aggregate demand is greater than aggregate supply Firms experience Inventory reduction; they increase production & employment; output increases toward equilibrium level

Explain and Illustrate Bottom Portion of Visual 3.11 Unit III Lesson 5 Explain and Illustrate Bottom Portion of Visual 3.11

Unit III Lesson 5 Use Visual 3.12 to illustrate AD and AS shifts and the effects on Price Level and Real GDP

Complete Activity 25 and review answers Unit III Lesson 5 Complete Activity 25 and review answers

Unit III Lesson 5 Review Beginning of Activity 26 w/ students Complete Activity 26 and review answers

Review: Aggregate Supply and Aggregate Demand Analysis Continued Unit III Lesson 6 Review: Aggregate Supply and Aggregate Demand Analysis Continued Factors that shift AD *Changes in expectations of future income, inflation or profits *Changes in government spending or taxes *Changes in the money supply *Changes in the foreign exchange rate or foreign income Factors that shift SRAS *Change in input prices Domestic Resource Availability Price of imported resources Market Power *Change in productivity *Change in legal-institutional environment Business taxes & subsidies, Gov’t regulations

Complete Activity 27 and review answers Unit III Lesson 6 Complete Activity 27 and review answers

We now turn to the long-run. Explain and Illustrate Visual 3.13 Unit III Lesson 6 We now turn to the long-run. Explain and Illustrate Visual 3.13

Complete Activity 28 and review answers Unit III Lesson 6 Complete Activity 28 and review answers

Unit III Lesson 7 The Long-Run Economy Here we explore the LRAS and it’s relationship with the economy’s PPC Factors that will shift he LRAS curve to the right Productivity of labor (education) Increases in technology (research & development expenditures) Increases in capital stock of the economy (low, stable interest rates)

Explain and Illustrate Visual 3.14 Unit III Lesson 7 Explain and Illustrate Visual 3.14

Complete Activity 29 and review answers Unit III Lesson 7 Complete Activity 29 and review answers

Fiscal Policy Two primary fiscal policy tools Government spending Unit III Lesson 8 Fiscal Policy Two primary fiscal policy tools Government spending Taxes

Government Spending Unit III Lesson 8 Gov’t spending affects the economy directly by increasing the demand for goods and services As soon as the gov’t increases its spending, it initiates a multiplier process that results in a greater increase in total spending than the initial increase in gov’t spending The increase in gov’t spending increases aggregate demand, shifting the AD curve to the right In the short run, the usual effects are an increase in real GDP and the price level

Unit III Lesson 8 Taxes Changes in taxes do not directly change real GDP Changes in taxes affect the disposable income of households or businesses These changes are felt through consumption and investment spending An increase in taxes decreases disposable income, a decrease in disposable income decrease consumption, but by less than the increase in taxes Some of the additional tax bill is paid from savings

Complete Activity 30 and review answers Unit III Lesson 8 Complete Activity 30 and review answers

Automatic Stabilizers Unit III Lesson 8 Automatic Stabilizers Tools in the economy that respond to different phases of the business cycle They are automatic, because they adjust without an action by Congress or the president They serve as stabilizers because they limit the increase in real GDP during expansions and reduce the decrease in real GDP during a recession

Unit III Lesson 8 Income tax system As an individual’s nominal income increases, he or she moves into higher tax brackets and pays more taxes, thus limiting the increase in disposable income and consumption

Unemployment compensation Unit III Lesson 8 Unemployment compensation As the economy slows and unemployment increases, the income of the unemployed does not fall to zero, which would leave a significant negative effect on the economy Unemployment compensation provides a base level of income, and the negative impact on real GDP is lessened

Unit III Lesson 8 Stock and Bond returns Many corporations establish the dividends they pay on shares of stock and maintain this payout for several years. Thus dividends do not follow the swings of the business cycle Bond payments are established at the time the bond is issued and remain throughout the life of the bond

Complete Activity 31 and review answers Unit III Lesson 8 Complete Activity 31 and review answers

Complete Activity 32 and review answers Unit III Lesson 8 Complete Activity 32 and review answers

Complete Activity 33 and review answers Unit III Lesson 8 Complete Activity 33 and review answers

REVIEW FOR UNIT III EXAM