1. Unit 2: Aggregate Demand and Supply and Fiscal Policy

2. Topic 1: Aggregate Demand

3. What is Aggregate Demand?
Aggregate Demand is all the goods and services that buyers are willing and able to purchase at different price levels.
Aggregate means “added all together.”
The Demand for everything by everyone in the US.

4. Aggregate Demand Curve
Price
Level
Inverse relationship between price level and Quantity AD
Quantity of Real GDP (GDPR)

5. Shifters of Aggregate Demand

6. Shifts in Aggregate Demand Increase = RIGHT ; decrease = LEFT
Price
Level
AD1 AD
AD2
Quantity of Real domestic output (GDPR)

7. Shifters of Aggregate Demand
Change in Consumer Spending
Consumer Wealth (Boom in the stock market…) Wealth= assets that generate money (real estate, stock, property)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Income Taxes (Decrease in income taxes…)
* Important note: A change in WAGES does NOT impact C in AD because a change in nominal wages does NOT mean a change in REAL wages (Just because wages go up, does not mean you can purchase more)

8. Shifters of Aggregate Demand
2. Change in Investment Spending
(business puts $ back into the business)
I = capital stock, construction and inventory
Things that impact I spending
Interest Rates (Price of borrowing $)
Future Business Expectations (High expectations…)
Business Taxes (Higher corporate taxes means…)

9. Shifters of Aggregate Demand
Change in Government Spending
Infrastructure…
Nationalized Heath Care…
defense spending…
Change in Net Exports
can be influenced by a change in FOREIGN INCOME
If dollar depreciates, more Europeans will buy US products causing Net Exports to increase
** General rule: An increase in spending (any type) shifts AD right, and decrease in spending(any type)shifts it left
AD = GDP = C + I + G + Xn

10. Which way will AD shift???
1. There is an increase in the wealth of American households.
2. The government increases income taxes.
3. There is a decrease in interest rates
4. The government increases spending on the military
5. The government decreases income taxes
6. The government raises business taxes
7. Investment spending decreases.
8. Price level increases

11. Topic 2: The Multiplier Effect
Why do cities want the Superbowl in their stadium?

12. MULTIPLIER EFFECT
Someone’s spending (whether it be consumer, business, government etc) will always become someone else’s income
The person who receives the income will turn around and spend it and the cycle continues
Because of this there is a multiplied impact of spending on the economy.

13. Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
How much people consume rather than save when there is a change in income.
MPC=
Change in Consumption
Change in Income
Examples:
If you received $100 and spent $50. What is MPC?
If you received $100 and spent $80. What is MPC?
If you received $100 and spent $90. What is MPC? 13

14. Marginal Propensity to Save
Marginal Propensity to Save (MPS)
How much people save rather than consume when there is a change in income.
MPS=
Change in Saving
Change in Income
Examples:
If you received $100 and save $50. MPS?
If you received $100 and save $30. MPS? 14

15. Because people can either save or consume
MPC + MPS = 1
Why is this true?
Because people can either save or consume
If MPC is .8, what is MPS?
If MPS is .1, what is MPC?
If MPC is .6, what is MPS? 15

16. How is Spending “Multiplied”?
Assume the MPC is .6 for everyone - Assume the Super Bowl comes to town and there is an increase of $100 in spending at Ashley’s restaurant.
Ashley has $100 more income.
Ashley spends $ 60 (60% of 100) at Carl’s salon and saves $ ( )
Carl now has $ Carl spends $36 (60% of 60) at Dan’s fruit stand and saves $ (60 -36)
Dan now has $ Dan spends $21.60 (60% of 36) at Wendy’s and saves $ (36 – 21.60)

17. How multiplier effect works
New income of $100 ; MPC = .6
* remember someone’s spending becomes someone else’s income
Round
Income
Spending
Savings
1 (ashley)
$100
$60
$40
2 (carl)
$36
$24
3 (dan)
$21.60
$14.40

18. Spending multiplier
increase in spending = more $ goes into the economy (total GDP will increase)
1/MPS
decrease in spending = less $ goes into the economy(total GDP will decrease)
- 1/MPS

19. Practice
1. If MPC is .8, what is the spending multiplier if investment spending decreases???
2. If the MPS is .1, what is the spending multiplier if government spending increases???
The smaller the MPS, the greater the spending multiplier will be!!!

20. How to use the spending multiplier
If Consumer Spending increases by $3 million, and the MPC is .8 How much will the GDP change by?
spending multiplier X change in spending
How figured:
1. find spending multiplier
1/MPS = 1/.2 = 5
2. Multiply the spending multiplier by the change in spending:
3 X 5 = $15
GDP will increase by a total of $15 million (5 X 15)

21. Tax Multiplier
looks at the impact that taxes have on the entire economy (taxes also impact spending!)
If taxes go down: people have MORE $ to spend – GDP will INCREASE
MPC/MPS (if decrease in taxes)
If taxes go up: people have LESS money to spend – GDP will DECREASE
- MPC/MPS (if increase in taxes)

22. Practice MPC is .9, and taxes go up, what is the TAX multiplier???
MPS is .2, and taxes go down, what is the TAX MULTIPLIER???

23. How to use the tax mutiplier
If the government decreases taxes by $50 million, and the MPC is .8 by how much will the GDP change by?
Tax multiplier X change in TAXES
How figured:
1. Find Tax multiplier
.8/.2 = 4
2. Multiple tax multiplier by change in taxes
4X50 = $200
GDP will increase by $200 million

24. Balanced Budge Multiplier
Spending multiplier will always have a bigger impact on the economy than tax multiplier if spending and taxes both change by the same amount!

25. Balanced Budget Multiplier
The spending multiplier and the tax multiplier combine to form the BALANCED BUDGET MULTIPLIER
BALANCED BUDGET MULTIPLIER = 1
1 X change in SPENDING = impact on the total economy

26. How to use the balanced budget multiplier
Rule: if both taxes and spending change by the same amount, they DON’T cancel each other out – spending will always have the bigger impact on the economy
Example: The G increases spending by $20 million while at the same time raising taxes by $20 million.
$20 X 1 = $20
GDP will INCREASE by: $20 million

27. Balanced budget multiplier
Investment spending decreases spending by $5 million and at the same time, the government lowers taxes by $5million.
If MPS is .1, how does this change the total GDP of the economy?
1 X -5 = - $ 5 million

28. Topic 3: Aggregate Supply28

29. What is Aggregate Supply?
Aggregate Supply is the supply for everything by all firms.
Aggregate Supply differentiates between short run and long-run and has two different curves.

30. Short Run Aggregate Supply Curve
Price
Level AS
Direct relationship between price level and Quantity
Real domestic output (GDPR) 30

31. Shifters of SR Aggregate Supply

32. Shifts in SR Aggregate Supply
Increase = RIGHTWARD SHIFT
decrease = LEFTWARD SHIFT
AS2
Price
Level AS
AS1
Real domestic output (GDPR) 32

33. Shifters of SR Aggregate Supply
1. Change in Resources
Prices and quantity of Domestic and Imported
Resources
wages (price of labor)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)

34. Shifters of SR Aggregate Supply
Legalities
* Business taxes (shifts AD too!)
Subsides
Government Regulations
Change in Productivity
Change in Technology 34

35. Which direction will SRAS shift???
There is an improvement in technology
The government decreases business taxes
Worker wages decrease
There is an increase in the price of resources used in production
Productivity declines for 3rd month in a row
Price level increases
Worker wages increase

36. AD and SRAS macroeconomic equilibrium price and quantity

37. Short run Macroeconomic equilibrium
If there is a shift in AD or SRAS, price level and quantity of real GDP will change Investment spending increases: Price level _______ Q of GDPr _______

38. Wages increase causing the Cost of production to increase
Price level ___
Q of GDP ____

39. Practice WS : AD and SRAS
AD shifters Change in Consumer spending (income, income taxes, wealth, confidence) Change in Investment spending (interest rates, business taxes) Change in Government spending Change in Net export spending (foreign incomes)
SRAS shifters Change in legalities (subsidies, business taxes) Change in Resources (wages, resource prices & Q) Change in productivity Change in Technology

40. Topic 4: Short Run to LONG RUN
In the SHORT RUN – wages are STICKY; they DO NOT adjust to price changes
In the LONG RUN – wages are FLEXIBLE; they DO adjust to changes in prices

41. 100 units sell for $1 each, TR = $100 The only cost is $80 of labor.
Short Run:
100 units sell for $1 each, TR = $100
The only cost is $80 of labor.
How much is profit?
$100 - $80 = $20
What happens in the SHORT-RUN if price level doubles?
100 units sell for $2, TR=$200.
Wages haven’t had the time to adapt to the change in prices (WAGES are STICKY – they are still $80)
How much is profit? $200 – 80 = $120
With higher prices, the firm has the incentive to increase production (because their profits will increase)

42. Long-Run Aggregate Supply
100 units sell for $1 each; TR = $100
Cost to produce is $80 of labor
Profit = $20.
What happens in the LONG-RUN if price level doubles?
100 units sell for $2.00 each; TR =$200
In the LONG RUN workers demand higher wages to match prices. Wages have had the time to adjust to price changes – Eventually, labor costs double too(wages are FLEXIBLE and adjust to price changes)
Cost to produce is now $160 (instead of $80)
Profit: =$40
*** REAL profit is unchanged.

43. If REAL profit doesn’t change the firm has no incentive to increase output. So… LONG RUN AS is VERTICAL

44. Long run Aggregate Supply
The economy is at FULL Employment
LRAS
Price level QY
GDPR 44

45. LRAS compares to PPC On curve: Economy at FULL EMPLOYMENT
All resources being used

46. Shifts of LRAS: Increase RIGHT; Decrease LEFT

47. Shifters of LRAS Shifts for Same reasons PPC shifts:
Change in technology
Change in QUANTITY of resources
* General rule: LRAS will never shift by itself (SRAS will shift with it) However, SRAS can shift without LRAS shifting

48. Practice 48

49. Which curve will shift??? AD, SRAS, LRAS
1. An increase in consumer confidence
2. An increase in incomes of U.S. trading partners
3. A large decrease in the price of imported oil which impacts the resource cost of business
4. An increase in business taxes
5. An improvement in technology
6. 25% stock market increase over a two month period which increases household wealth
7. a decrease in interest rates
8. A increase in wages

50. Topic 5: Putting AD, SRAS and LRAS together to get Equilibrium Price Level and Output

51. Putting AD, SRAS and LRAS together Practice WS : AD, SRAS and LRAS
AD shifters
1 Change in Consumer spending
(income, income taxes, wealth, confidence)
2 Change in Investment spending (interest rates, business taxes)
3 Change in Govt spending
4 Change in Net export spending
(foreign incomes)
SRAS shifters 1Change in legalities (subsidies, business taxes) 2Change in Resources (prices of resources, quantity of resources, wages, energy prices, “supply shocks” ) 3Change in productivity 4Change in Technology
LRAS shifters
1Change in technology
2Change in quantity of resources

52. Topic 6 : Economic Stability
A stable economy is represented by:
Economic growth
Price stability
Full employment

53. Economics Statistics Economic growth Unemployment Inflation
Measured by
Real GDP
People not working but looking
CPI (consumer price index)
Acceptable
Over 2.5%
Under 6%
Up to 4%

54. Economic Instability High unemployment/Recession High Inflation
Stagflation – high unemployment and inflation AT SAME TIME

55. Graphs showing Inflationary and Recessionary Gaps

56. Full employment equilibrium Economy at FE with acceptable price level

57. Inflationary Gap Output is high and employment is greater than FE LRAS
Price Level AS
Actual GDP above FE/potential GDP PL
Economy is here,
But should be
At FE AD Q
GDPR 57

58. Inflationary Gap How can we be beyond the FE line???
In the SR, economy can overuse resources, but CANNOT be sustained in the LONG RUN (ex. pulling all –nighters to study…)

59. Recessionary Gap Output low and employment is less than FE LRAS
Price Level AS
Actual GDP below FE/potential GDP PL
Economy is here,
But should be at FE AD Q
GDPR 59

60. STAGFLATION
If both inflation and unemployment are high STAGFLATION will occur
What curve shift illustrates this problem?
This problem is represented by a DECREASE in SRAS

61. Stagflation – high inflation and high unemployment AT SAME TIME

62. What economic problem does this cause???
The economy begins at FE and the G increases spending. Shift the curve on the graph
What economic problem does this cause???

63. The economy begins at FE and net export spending decreases.
Shift the curve on the graph
What economic problem does this cause???

64. Topic 7: Self adjusting economy64

65. Flexible wages in the Long run
The economy can adjust to FE equilibrium over time as wages change to adjust to price changes

66. Assume inflation is occurring in the economy
Price Level
LRAS AS PL
AD1 AD Q
GDPR 66

67. If inflation occurs, what will happen in the LONG RUN?
workers seek higher wages and wages increase. An increase in wages SHIFTS AS to LEFT
LRAS
Price Level
AS1 AS
PL1
Back to full employment with higher price level PL AD Q1 Q
GDPR 67

68. Assume a recession is occurring in the economy
Price Level
LRAS AS PL AD AD AD Q
GDPR 68

69. LRAS If recession occurs, what happens in the Long Run?
workers accept lower wages so wages decrease
When wages decrease, SRAS shifts to the right
Price Level
LRAS AS
AS1
AS increases as workers accept lower wages and production costs fall
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 PL
PL1 AD Q Q1
GDPR 69

70. Topic 8: The Phillips Curve
SRPC Shows tradeoff between inflation and unemployment.

71. Short Run Phillips Curve
When the economy is overheating, there is low unemployment but high inflation (A)
Inflation
When there is a recession, unemployment is high but inflation is low (B) 5% A
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 1% B
SRPC 2% 9%
Unemployment 71

72. Shifts of Short run Phillip’s curve
inflation and unemployment move in the SAME direction, there will be a SHIFT of the SRPC
-If inflation and unemployment both go up; SRPC shifts to the RIGHT
- If both go down, SRPC shifts to the LEFT
Change in inflationary expectations
if these increase, SRPC shifts RIGHT
if these decrease, SRPC shifts LEFT

73. Assume stagflation occurs Draw an AD/AS graph showing this
SRAS SHIFTS TO THE LEFT
In the Short run, what happens
Price level? increases
Unemployment? increases
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 73

74. What is impact on SRPC? Shifts to the right
Inflation
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
SRPC1
SRPC
Unemployment 74

75. Consumers begin to save more money. Draw an AD/AS graph that shows this
AD SHIFTS TO THE LEFT In the short run, what happens to Price level? Decreases Unemployment? INcreases

76. Movement down along original curve
What is impact on SRPC?
Movement down along original curve
Inflation A B
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
SRPC
Unemployment 76

77. The prices of resources decrease. Draw an AD/AS graph showing this
SRAS SHFITS TO THE RIGHT What happens in the short run to price level? decreases unemployment? decreases

78. What is impact on SRPC? Shifts to the left
Inflation
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
SRPC
SRPC 1
Unemployment 78

79. From Short run Phillips curve to Long run Phillips curve
Because the SRPC is continually shifting in the LONG RUN, there is no trade off between inflation and unemployment

80. Example: The economy is at FE and interest rates increase
What problem does this create? RECESSION
What happens in the long run to…
Price level DECREASES
Unemployment DECREASES
What will happen to the SRPC in the Long Run?
SHIFTS to the LEFT

81. Example: The economy is at FE and consumer spending increases
What problem does this create? INFLATION
What happens in the long run to…
Price level? INCREASES
Unemployment INCREASES
What will happen to the SRPC in the Long Run?
SHIFTS TO the RIGHT

82. The LRPC is vertical at the Natural Rate of Unemployment
In the long run there is no tradeoff between inflation and unemployment due to SRPC continually shifting
LRPC
Inflation 5%
The LRPC is vertical at the Natural Rate of Unemployment 3%
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 1% 2% 5% 9%
Unemployment 82

83. SHIFTS OF LRPC
LRPC can shift if there is a change in the Natural rate of unemployment
LRPC will never shift by itself (if you shift LRPC, shift SRPC too!)

84. Phillips curve at FE equilibrium
LRPC
The unemployment rate is at the NATURAL RATE
and
inflation rate is at the EXPECTED RATE
Inflation
SRPC UY
Unemployment 84

85. Inflationary Gap on Phillips Curve
LRPC
Inflation
SRPC UY
Unemployment 85

86. Recessionary Gap on the Phillips Curve
LRPC
Inflation
SRPC UY
Unemployment 86

87. Topic 9: Economic theories
CLASSICAL VIEW OF ECONOMY: Does not distinguish between short run and long run. wages as being flexible and that they QUICKLY adjust to changes in price level The economy does not need intervention to adjust View the Short Run AS as VERTICAL

88. 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. 88

89. Does deflation (falling prices) often occur?
Not as often as inflation. Why?
Prices and wages are more flexible upward as opposed to downward
Like a ratchet, prices can easily move up but not down! 89

90. Keynesian View of Economy
Unlike the classical view, Keynesians don’t
think the economy can quickly adjust to fix itself (at least in times of recession; due to the ratchet effect)
View aggregate supply as horizontal at low output
Wages are STICKY – they do NOT quickly adjust
to price changes
THEREFORE…. Government intervention in the economy is necessary to fix it!!!

91. Keynesian Theory- Horizontal AS
Recession will be persistent because wages are not flexible (they will not go down to return the economy to FE)
Price level AS
Real domestic output, GDP

92. Three Ranges of Aggregate Supply
1. Keynesian Range- Horizontal
2. Intermediate Range- Upward sloping
3. Classical Range- Vertical AS
Price level
Classical
Range
Keynesian
Range
Intermediate
Range
Real domestic output, GDP 92

93. Topic 10: Fiscal Policy 93

94. Fiscal Policy
Fiscal Policy: Actions by Congress to speed up or slow down the economy (rather than waiting for the economy to self adjust)
Based on: Keynesian theory- Wages are sticky, so economy does not quickly self adjust
Government intervention is NECESSARY to return the economy to stability
A stable economy should have:
stable prices
full employment
economic growth

95. Two Types of Fiscal Policy: Discretionary and Automatic
1. Discretionary Fiscal Policy-
Congress creates and passes a new bill
ex. Congress votes to implement a tax cut

96. 2. Automatic Stabilizers
Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy
Ex: Welfare, Unemployment, Min. Wage, etc.
When there is high unemployment, unemployment benefits to citizens increase consumer spending.

97. Expansionary Fiscal Policy
Implemented during RECESSION
Goal is to SPEED UP economy without causing too much inflation
Need to increase AD

98. Video example of expansionary fiscal policy

99. How can the government speed up the economy????
1. Increase government spending (public works, roads, schools etc.) *need to account for the SPENDING MULTIPLIER 2. Decrease personal income taxes (Consumers will have more $, so they will spend more) *need to account for the TAX MULTIPLIER

100. * government can increase its spending, decrease taxes or do both – any of these actions increase AD
Expansionary policy will result in a DEFICIT BUDGET
Deficit Budget: the government spends more $ than what they take in

101. Contractionary Fiscal Policy
Implemented during INFLATION Goal is to SLOW DOWN economy without causing recession Want to decrease AD

102. How can the government slow down the economy???
1. Decrease government spending
* need to account for spending multiplier
2. Raise personal income taxes
*need to consider tax multiplier

103. * Government can decrease its spending, raise income taxes or both – any of these actions will slow down the economy/decrease AD
Contractionary Policy results in a SURPLUS BUDGET
Surplus Budget: the government spends less $ than what they take in

104. Problems With Fiscal Policy

105. Problems With Fiscal Policy
1. Deficit Spending!!!!
A Budget Deficit – government spending exceeds its revenue.
The National Debt is the accumulation of all the budget deficits over time.
Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy.

106. Additional Problems with Fiscal Policy
2 Problems of Timing
Recognition Lag- Congress must react to economic indicators before it’s too late
Administrative Lag- Congress takes time to pass legislation
3. Politically Motivated Policies
Politicians may use economically inappropriate policies to get reelected.

107. Topic 11: Focus on National Debt

108. The National Debt: CNBC explains
1. What is the difference between deficit spending and the national debt?
2. What is the DEBT CEILING?
3. If the government borrows $, how does it get the money it needs?
4. Who/what is the largest holder of U.S. debt?

109. Where does the State and local government get $ from???

110. Where does the Federal Government get its money???

111. Income taxes Tax based on the “income” a person earns
Americans pay an income tax to:
1. The federal government
2. The state government
3. The local government
These taxes appear on a person’s pay check stub
The purpose of filing taxes at the end of the year is to determine
if a person has overpaid or underpaid their taxes
111

112. EXAMPLE OF PAYCHECK STUB
112

113. Stossel goes to Washington: segment 1
(7:40)

114. Countries with the highest income tax rates
Country
Tax rate
Kicks in at….
Aruba
58.9%
$165,000
Sweden
56.6%
$81,000
Denmark
55.4%
$76,000
Netherlands
52%
$72,000
Austria
50%
$80,000
Belgium
$46,900
Japan
$217,000
United Kingdom
$231,000
Finland
49.2%
$91,000
Ireland
48%
$43,900
U.S. = 23rd; at 39.6% at $400, *Source: CNBC

115. Where does the State and local government spend money???

116. Where does the federal government spend money ?
everything else includes education, veterans benefits, national resources, foreign aid, Immigration, response to natural disasters

117. Military spending around the world http://www. sipri

118. What is the national debt???
Debt occurs when government revenue (primarily from taxes) is less than government spending.
Therefore debt will rise whenever..
revenue falls
spending increases

119. Debt in the past decade DEBT CLOCK
2001: $5.8 trillion
2002: $6.2 trillion
2003: $6.8 trillion
2004: $7.4 trillion
2005: $7.9 trillion
2006: $8.5 trillion
2007: $9.0 trillion
2008: $10.0 trillion
2009: $11.9 trillion
2010: $13.6 trillion
DEBT CLOCK
It would take 200,000 years to count to 1 trillion!!!!!

120. Countries with the largest debts
Source: David Colander - Macroeconomics
17-120

121. Countries with largest debt as compared to GDPs

122. Ownership of the Debt

123. Situation:
GDP: %
Inflation rate= -.5%
Unemployment Rate=25%
Solution???

124. Situation:
GDP :8%
Inflation rate= 4.1%
Unemployment Rate=1.2%
Solution???

125. Situation:
GDP: -0.3%
Inflation rate= 13.5%
Unemployment Rate=7.1%
Solution??

126. 4.) 2003 Situation: GDP fell 0.5% Inflation rate= 1.5%
Unemployment Rate=12.0%
Your Solution:
What actually happened:
Congress voted to give tax cuts to citizens. (Bush Tax Cuts)