1. Aggregate Demand, Aggregate Supply and Fiscal Policy
AP Economics
Chapters 11-12

2. BACKGROUND
Employment Act of 1946 stated that the government should promote maximum employment, production & purchasing power. Established 3 main goals:
Full Employment (natural level of unemployment)
Price Stability (no inflation or deflation)
Economic growth (increase greater than population increase = per capita improvement & a better standard of living
1978 law added: unemployment rate of 4 % & % inflation rate

3. BACKGROUND Classical Economic Theory ~
Market system operated at full employment
Temporary short periods of recession or inflation
Savings and investment were coordinated
Self correcting (P & Wages go up & down)
Say’s Law: “Supply creates its own demand”
Accepted view until 1930’s and the Great Depression

4. BACKGROUND Keynes “In the long run, we are all dead”
Keynesian economic theory ~
Cycles were not short
Corrections were not automatic
Savings and investment weren’t coordinated
Prices and wages were not flexible downward
GOV INTERVENTION WAS NEEDED

5. KEYNES Fiscal Policy is government’s way to stabilize the economy
Employment Act of power to Congress
Tools to use: taxing and spending
Expansionary F.P. – Decrease taxes &/or increase spending (Recession)
Contractionary F.P. – Increase taxes &/or decrease spending (Inflation)

6. Other Schools of Thought
Monetarism - the money supply should be increased by the % of GDP change to keep economy stable (controlled by FED)
Based on the quantity theory of money & velocity of money
Supported by Milton Friedman but not widely adopted

7. AD/AS Key analytical tool for understanding the macroeconomy
AD = quantity of real GDP that consumers, business & gov’t are willing and able to buy at each price level
AD = C + Ig + G + Xn
Price level and output (GDP) have inverse relationship

8. AD/AS AD slopes downward because:
Wealth (real balance) effect – purchasing power of money is less at higher price levels
Interest rate effect – price level changes impact interest rates – in turn this effects consumption & investment spending (inverse effect)
Foreign purchase effect – volume of imports/exports depend on relative price levels here & abroad
EX: If US PL is higher = we buy more M & sell fewer X

9. Consumption Component of GDP
INCOME IS NOT WEALTH
GDP & AD = C + Ig + G + Xn
C is largest component
DI = C + S if Income then C & S
MPC = % consumed of a in income
MPS = % saved of a in income
MPS + MPC = 1 (20% + 80% = 1)

10. MPC
MPC in Economics means Marginal Propensity to Consume. This refers to the means of measuring the proportion of how much is spent to how much is saved. This is known in business but is actually commonly used by individuals on their everyday lives and on how they budget.

11. Consumption Main determinant is income Other determinants:
Wealth (value of assets) if W C S
Expectations (for inflation or future wealth)
Debts (if D increases, C & S will decrease)
Taxes (if T increase, C & S decrease, etc)

12. Investment Component of GDP
Economic profit/cost = Rate of return
EX: $100 profit divided by $1000 cost = %
Interest must be less than rate of return to justify investment
Investment determinants:
Interest rate
Costs of capital & operating costs
Taxes
Technology
Excess capacity (inventories)

13. Investment Savings = Investment Investment is:
Business spending for capital stock
Most volatile component of AD/GDP
Assumed to require a loan
Decisions are based on marginal cost (interest) vs. marginal benefits (expected rate of return)

14. Market for Loanable Funds
Demand for Ig is DEMAND for loanable funds
Savings is SUPPLY of loanable funds
Equilibrium is the interest rate where
D for Ig=S i i S
D Ig D Q Q
Investments
Loanable Funds

15. Government Spending Multiplier
Change to any component of AD
(C + Ig + G + Xn) has a “ripple effect”
Results in a multiplied effect on GDP
Important as a small change in spending leads to a large change in GDP
Calculated by: or
MPS MPC

16. Government Spending Multiplier
Examples: 1/MPS
.25 MPS change = multiplier of 4
.33 MPS change = multiplier of 3
MPC of .75 = 1/.25 (MPS) = multiplier of 4
If gov spending increases by $20 X 4 = GDP increases by $80

17. Aggregate Supply
AS = quantity of output (real GDP) produced at each price level
Direct relationship between PL and output (high PL = more supply)
AS = P + I + G
Productivity
Input Costs
Gov Interactions

18. Aggregate Supply 3 ranges of AS:
Horizontal = recession – underutilized resources (LLC) – only output changes are possible
Vertical = full capacity economy – only PL changes
Intermediate = expansion eco – both output & PL changes are possible PL
GDP

19. AS PRICE LEVEL VERTICAL RANGE AD 3 INTERMEDIATE RANGE HORIZONTAL AD 2
OUTPUT OF REAL GDP

20. Determinants of AS: Change in input prices (cost of production)
Resource availability (LLCET)
Imported resources – cost & exchange rates
Market power – ability to set price above that of a competitive market
EX: OPEC, labor unions, etc

21. Determinants of AS:
2. Change in productivity – increase means can produce more with same resources
EX: more productivity = increase AS
Change in legal-institution environment
Taxes (sales, excise, payroll) = increase costs of production (AS decreases)
Subsidies – gov’t payment = lowers costs (AS increases)
Gov’t regulations = costs more to comply so AS decreases

22. Other Details: Gov Spending Multiplier effect is:
greatest in the horizontal AS range (much ability to increase GDP)
less in the intermediate range (increasing PL leads to inflation)
None in the vertical range ( GDP does not change – only price level)

23. Other Details: RATCHET EFFECT (or “sticky wages”)
Prices don’t always go down when AD shifts left due to: wage contracts, worker morale, minimum wage laws, “menu costs” – costs to change prices up & down frequently & fear of “price wars” with competition.
SHORT RUN – period when wages & other costs are FIXED (suppliers need time to adjust to change in AD/AS)
LONG RUN – period when suppliers can make adjustments in LLC due to a change in AD/AS

24. AD/AS Equilibrium Intersection of AD & AS
Shift results in change of PL and real GDP AS PL
AD 2
E PL 1
AD 1
E O 1
Real GDP - Output
FE or Y

25. Discretionary Fiscal Policy
Goal is to restore economic stability
Tools – increase/decrease government spending or increase/decrease taxes
If recession – need expansionary policy
(increase spending &/or decrease taxes)
If inflation – need contractionary policy (decrease spending &/or increase taxes)

26. Fiscal Policy Shifts ADAS PL
AD1
AD 2
GDP OUTPUT
RECESSION – AD SHIFTS RIGHT WHEN GOV SPENDING INCREASES OR TAXES DECREASE (more C & Ig)

27. Fiscal Policy Shifts ADAS PL
AD1
AD2
GDP
INFLATION – AD SHIFTS LEFT WHEN GOV SPENDING DECREASES OR TAXES INCREASE (less C or Ig)

28. Automatic Stabilizers
Government actions that were NOT done to help economy, but cause positive effects
In an expansion cycle – tax revenue increases & the surplus slows inflation
In a recession cycle – deficit spending stimulates the economy & creates jobs

29. Problems with Fiscal Policy
Timing: Recognition Lag, Administrative Lag & Operational Lag
Crowding Out Effect – deficit spending drives interest rates up and private Ig decreases so AD decreases
Net Export Effect – reduces Fiscal Policy effects

30. Crowding Out Effect
Government spending is often “deficit spending” (spending tax revenue)
Gov borrows in the “Loanable Funds” Mkt
by selling gov’t bonds & other securities
This drives up the price of borrowing (i) making it more expensive for Ig to occur
Gov borrowing has “crowded out” business spending lowering GDP (output) in the long run (less capital stock = less future output)

31. Net Export Effect
If Recession = F.P. Gov deficit spending will drive interest up
Foreign demand for US assets goes up in foreign exchange market
Dollar appreciates
Xn because imports are greater than X
AD shifts left (lessens effect of F.P.)

32. Net Export Effect
If Inflation – F.P. gov decreases spending & interest rates drop
Foreign demand for US assets decreases in the foreign exchange market
Dollar depreciates
Xn because exports are greater than M
AD shifts right (lessens effect of F.P.)

33. Supply Side Fiscal Policy
Theory to cut taxes to increase AS
Encourages savings to give businesses an incentive to expand investments
Lower income taxes encourage workers to work more & earn more
Entrepreneurs are more willing to take risks when they get more rewards

34. Last but NOT Least Part of Problem – Congress is in control of Fiscal Policy
THE END!

35. AD/AS GRAPH PRACTICE AD shifts when there are changes in:
C = consumer spending
Ig = business investment spending (for capital stock)
G = government spending
Xn = actions Net export spending (X minus M)
AS shifts when there are changes in:
P - productivity
I – inputs costs
G – government

36. VOCAB LIST
DEFICIT – spending more than available in tax revenue in one year
DEBT – total amount of all deficit spending over many years
Current U.S. DEBT is: $17 trillion & counting

37. Problem Areas in AP Economics
Investment – term defined as business spending for capital equipment, machinery, factories, inventories, etc.
Personal investment is NOT used in Macro (except in Global FOREX)
Investment decisions are MB vs MC
MB = rate of return business will receive (profit motive = revenue – cost = profit)
MC = interest rate that must be paid to borrow funds for Ig (gross private investment)

38. Problem Areas in AP Economics
Investment Demand Curve shows amount of Ig at each real interest rate amount
Ig Demand Curve shifts (left or right) when other factors change:
Costs of production
Business taxes
Technology changes
Excessive inventories (no need for new production)
Expectations for future business conditions

39. Problem Areas in AP Economics
Real Interest rate – cost of borrowing the money to buy the capital goods (machinery)
If rate of return is greater than the cost of the interest, the investment will be profitable
Ex: 10% rate of return is greater than 7% interest = profitable decision
Even if capital is financed by savings, it gives up interest earned on $$$savings
REAL interest is used – inflation adjusted $$ (nominal rate – inflation rate = real interest rate) “Fisher Effect”

40. MULTIPLIERS:
Investment Multiplier = 1/1-MPC or 1/MPS (change in GDP = change in Ig X multiplier)
Use when there is a change in investment
Gov Spending Multiplier = 1/1-MPC or 1/MPS (change in GDP = change in G X multiplier)
Use when there is a change in government spending
Tax Multiplier = -MPC/1-MPC = - MPC/MPS (change in GDP = change in T X multiplier)
Use when there is a change in lump-sum taxes; the tax muliplier has a negative sign (GDP change = chg in tax X multiplier)