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National Income and Price Determination

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1 National Income and Price Determination
Unit 3 AP MACROECONOMICS

2 Introduction to Aggregate Supply & Demand

3 Purpose of Aggregate Supply & Demand Studies
These studies seek to explain what is going on with rises and falls within the macroeconomy, which makes the theory of economic fluctuations super controversial. Within these studies, we must differentiate between the Long Term : The time frame in which various or all variables/factors can be changed in production and the Short Term : The time frame in which only one variable/factor can be changed in production

4 Aggregate Demand all the goods and services (real GDP) that all buyers in the U.S. are willing and able to purchase at different price levels. Price Level 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. AD = C + I + G + Xn Real Domestic Output (GDPR)

5 Aggregate Demand – Why does it slope downward?
Price Level The Wealth Effect Higher price levels reduce the purchasing power of money. This decreases the quantity of expenditures. Interest Rate Effect 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. Foreign Trade Effect When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods. Exports fall and imports rise causing real GDP demanded to fall. (XN Decreases) AD = C + I + G + Xn Wealth Effect : If the price level doubles, people are going to buy less stuff because they have less purchasing power. So…price level goes up, GDP demanded goes down. Interest Rate Effect : 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. Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. So…price level goes up, GDP demanded goes down Real Domestic Output (GDPR)

6 Aggregate Demand – Shifters Factors that influence your GDP formula will shift the Demand Curve
Change in Consumer Spending Change in Government Spending Change in Income (Higher incomes…) Government Expenditures (Decrease in defense spending…) (Increase in public works programs…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Change in Net Exports (X-M) Taxes (Decrease in income taxes…) Exchange Rates (If the us dollar depreciates relative to the euro…) Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase…) (If interest rates decrease…) National Income Compared to Abroad (If a major importer has a recession…) (If the US has a recession…) Future Business Expectations (High expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

7 With a partner determine
what happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right.

8 Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. Price Level Short-run Aggregate Supply (SRAS) 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. 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? Short Run : Now 100 units sell for $2, TR=$200. How much is profit? Profit = $120 With higher profits, the firm has the incentive to increase production. Real Domestic Output (GDPR)

9 Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. Price Level We assume that in the long run, the economy will be producing at full employment, SO, we call this quantity the natural rate of output Yn Long Run Aggregate Supply (LRAS) 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 TR=$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 changethe firm has no incentive to increase output. Real Domestic Output (GDPR)

10 Aggregate Supply – Shifters Use RAP to remember shifters for AS.
Change in Resource Prices Change in Actions of the Government (NOT Government Spending) Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Taxes on Producers (Lower corporate taxes…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) Inflationary Expectations (If people expect higher prices in the future…) Change in Productivity Technology (Computer virus that destroy half the computers…) (The advent of a teleportation machine…)

11 Headlines for AD/AS Select someone from your group to come collect 4 headlines from the basket. Glue each headline to your poster paper and respond to the following be prepared to explain your answers: Draw an AD/AS diagram with the relevant shift(s), be sure to label each curve. Explain why this shift has happened, or what shift this may cause. What is the consequence for real GDP and the price level? What are potential consequences for macroeconomics performance?

12 Classical VS Keynesian Theory
“In the midst of all the exactions of government, capital has been silently and gradually accumulated by the private frugality and good conduct of individuals, by their universal, continual, and uninterrupted effort to better their own condition.” -Adam Smith “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes. -J. M. Keynes Classical VS Keynesian Theory

13 Classical Economic Theory Adam Smith & Frederich Von Hayek
Laissez-Faire Economics Say’s Lay : supply creates its own demand Savings: If you were to decide to save instead of spend, prices would still adjust due to overproduction and QS Therefore, there will always be demand. Which in turn, means SUPPLY if the most important factor in the economy. Determined by resources and technology BASICALLY : the rapidly adjusting market ensures equilibrium, stability, and prosperity Fell out of favor during the Great Depression Output had dropped rapidly, but there had been no change in resources, not productivity/technology.

14 Keynesian Theory Keynes believed that spending motivated firms to supply goods and services. If consumers and firms were pessimistic about the future, firms would cut back production. Essentially – less spending would lead to less output. Basically : Business cycles are driven by how much people are prepared to spend. When demand falls, recessions follow. Blamed UE on “sticky wages” – resistant to changes If wages don’t adjust to match price levels full employment won’t exist until the government intervenes.

15 The Multiplier Effect Use your notes from class from the ACDC Economics Video! t=8&ved=0ahUKEwiwuM6z9vXXAhXOl- AKHdczD1cQyCkIKzAA&url=https%3A%2F%2Fwww.youtube.com%2Fwatch%3Fv%3DRq WYmQQzXxs&usg=AOvVaw2TpxuaFDTyHR7cW8mKd7Sl

16 The Crowding Out Effect
A decrease in investment that results from government borrowing If we have an expansionary fiscal policy, the interest rate is rising. This reduces investment spending, which impacts GDP/AD. Crowding Out VS The Multiplier?! In traditional economic theory, the crowding-out effect, to whatever extent it occurs, reduces the multiplier effect of deficit-funded government spending aimed at stimulating the economy. The crowding-out effect and the multiplier effect can be viewed as two contrary, or competing, possible impacts of government economic intervention funded by deficit spending.

17 Phillips Curve An economic model which shows that inflation and unemployment have a stable and inverse relationship

18 Phillips Curve Shifts in the AD corresponds to a movement along the Short Run Phillips Curve!  In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, OR increase unemployment to 5% to bring down the inflation levels to 2%. -Lumen

19 Phillips Curve In the long run, if we are at full output, this also implies full employment, SO our Phillips Curve would be a VERTICAL line! The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history.

20 Phillips Curve & Supply Shocks
Supply shocks can be caused by : natural disaster, technology failure, restrictions of resources Stagflation – supply shocks that move shifts the AS to the LEFT Phillips Curve to the RIGHT

21 Phillips Curve and Inflationary Expectations
If inflation is EXPECTED: Workers and firms will adjust prices and wages accordingly This facilitates inflation and pushes the PC RIGHT

22 Beggs, Jodi. "The Short Run Versus the Long Run in Economics
Beggs, Jodi. "The Short Run Versus the Long Run in Economics." ThoughtCo, Aug. 7, 2017, thoughtco.com/the-short-run-versus-the-long-run


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