unit 3: aggregate demand and supply and fiscal policymacro+unit+3... · aggregate means “added...
TRANSCRIPT
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Unit 3:
Aggregate Demand and
Supply and Fiscal Policy
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Demand and Supply Review
1. Define Demand and the Law of Demand. 2. Identify the three concepts that explain
why demand is downward sloping. 3. Identify the difference between a change in
demand and a change in quantity demanded.
4. Identify the Shifters of Demand. 5. Define Supply and the Law of Supply. 6. Why is supply upward sloping? 7. Identify the Shifters of Supply. 8. What does it mean if there is a perfectly
inelastic supply curve? 9. Name 10 famous male actors. 2
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Aggregate Demand
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Aggregate means “added all together.”
When we use aggregates
we combine all prices and all quantities.
Aggregate Demand is all the goods and services
(real GDP) that buyers are willing and able to
purchase at different price levels.
The Demand for everything by everyone in the US. 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.
What is Aggregate Demand?
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Aggregate Demand Curve
Price
Level
Real domestic output (GDPR)
AD
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AD is the demand by consumers,
businesses, government, and
foreign countries
What definitely doesn’t shift
the curve?
Changes in price level cause
a move along the curve
= C + I + G + Xn
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Why is AD downward sloping?
1. Real-Balance Effect- • Higher price levels reduce the purchasing
power of money
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power
and increase expenditures Example:
• If the balance in your bank was $50,000, but inflation
erodes your purchasing power, you will likely reduce
your spending.
• So…Price Level goes up, GDP demanded goes down.
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2. 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. WHY?
• 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.
• Result…Price Level goes up, GDP demanded goes down (and Vice Versa).
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Why is AD downward sloping?
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Why is AD downward sloping?
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3. 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) • Example: If prices triple in the US, Canada will no
longer buy US goods causing quantity demanded of
US products to fall.
• Again, Price Level goes up, GDP demanded goes
down (and Vice Versa).
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Why is AD downward sloping?
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Shifters of
Aggregate Demand
GDP = C + I + G + Xn
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Shifts in Aggregate Demand
Price
Level
Real domestic output (GDPR)
AD
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An increase in spending shift AD right, and decrease in
spending shifts it left
= C + I + G + Xn
AD1
AD2
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Shifters of Aggregate Demand 1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending Real Interest Rates (Price of borrowing $)
(If interest rates increase…)
(If interest rates decrease…)
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes means…)
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Shifters of Aggregate Demand 3. Change in Government Spending
(War…)
(Nationalized Heath Care…)
(Decrease in defense spending…)
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4. Change in Net Exports (X-M) Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
“If the US get a cold, Canada gets Pneumonia”
AD = GDP = C + I + G + Xn
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How does this cartoon relate to Aggregate Demand?
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How does this cartoon relate to Aggregate Demand?
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Review
1. Define Aggregate. 2. Define Aggregate Demand. 3. Explain and give an example of the
Real Balances Effect. 4. Explain and give an example of the
Foreign Trade Effect. 5. Explain and give an example of the
Interest-Rate effect. 6. Identify the Shifters of AD. 7. Give examples for each shifter. 8. Name 10 famous actresses.
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Unit 3:
Aggregate Demand and
Supply and Fiscal Policy
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Aggregate Supply
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What is Aggregate Supply? Aggregate Supply is the amount of goods and
services (real GDP) that firms will produce in an
economy at different price levels.
The supply for everything by all firms. Aggregate Supply differentiates between short run and long-run and has two different curves.
Short-run Aggregate Supply •Wages and Resource Prices will not increase as price levels increase.
Long-run Aggregate Supply •Wages and Resource Prices will increase as price levels increase.
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Short-Run Aggregate Supply In the Short Run, 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?
• 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. 20
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Aggregate Supply Curve
Price
Level
Real domestic output (GDPR)
AS
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AS is the
production of all
the firms in the
economy
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Long-Run Aggregate Supply
In the Long Run, 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 change
the firm has no incentive to increase output. 22
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Long run Aggregate Supply
Price level
GDPR
In Long Run, price level increases but GDP doesn’t
LRAS
Long-run
Aggregate
Supply
QY
Full-Employment
(Trend Line)
We also assume that in the long run the economy
will be producing at full employment. 23
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Shifters Aggregate Supply
I. R. A. P.
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Shifts in Aggregate Supply
Price
Level
Real domestic output (GDPR)
AS
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An increase or decrease in national production can shift
the curve right or left
AS1
AS2
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Shifters of Aggregate Supply
1. Change in Inflationary Expectations If an increase in AD leads people to expect higher
prices in the future. This increases labor and
resource costs and decreases AS.
(If people expect lower prices…)
2. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…) 26
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Shifters of Aggregate Supply 3. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Subsides for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
4. Change in Productivity
Technology
(Computer virus that destroy half the computers…)
(The advent of a teleportation machine…)
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Practice
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B A
D
A
D
B
A
A
C A major increase in productivity. A
Answer and identify shifter: C.I.G.X or R.A.P
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Shifters of Aggregate Demand
Change in Consumer Spending
Change in Investment Spending
Change in Government Spending
Net EXport Spending
AD = C + I + G + X
Shifters of Aggregate Supply
AS = I + R + A + P
Change in Resource Prices
Change in Actions of the Government
Change in Productivity (Investment) 30
Change in Inflationary Expectations
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Putting AD and AS together to get
Equilibrium Price Level and Output
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Inflationary and
Recessionary Gaps
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Price
Level
33
AD
AS
Example: Assume the government increases
spending. What happens to PL and Output?
GDPR
LRAS
QY
AD1
PLe
PL1
Q1
PL and Q will
Increase
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Price
Level
34
AS
Inflationary Gap
GDPR
LRAS
QY
AD1
PL1
Q1
Output is high and unemployment is less than NRU
Actual GDP
above potential
GDP
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Price
Level
35
AD
AS
GDPR QY
PLe
PL1
Q1
LRAS AS1
Stagflation Stagnate Economy
+ Inflation
Example: Assume the price of oil increases
drastically. What happens to PL and Output?
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Price
Level
36
AD
GDPR QY
PL1
Q1
LRAS AS1
Recessionary Gap
Output low and unemployment is more than NRU
Actual GDP
below potential
GDP
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AD and AS Practice
Worksheet
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How does this cartoon relate to Aggregate Demand?
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Pri
ce L
evel
GDPR
AS
AD=C+I+G+X
P2
P1
AD2
Qf
(Y*or FE)
LRAS
Q2
Draw AD and AS at full employment
Output Increases PL Increases
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Short Run and
Long Run
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Price
Level
41
AD
AS
Shifts in AD or AS change the price level and
output in the short run
GDPR QY
PLe
LRAS
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Price
Level
42
AD
AS
Example: Assume consumers increase
spending. What happens to PL and Output?
GDPR
LRAS
QY
AD1
PLe
PL1
Q1
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Price
Level
43
AD
AS
Now, what will happen in the LONG RUN?
GDPR QY
AD1
PLe
PL1
Q1
LRAS
Inflation means workers seek higher wages and production costs increase
AS1
PL2
Back to full
employment with
higher price level
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Price
Level
44
AD
AS
Example: Consumer expectations fall and
consumer spending plummets. What happens to PL
and Output in the Short Run and Long Run?
GDPR
LRAS
QY
AD AD1
PL1
Q1
AS1
PL2
PLe
AS increases as
workers accept lower
wages and production
costs fall
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1. Explain the results of
Calvin’s proposal
using AS and AD.
2. Draw an Inflationary
Gap.
3. Draw a Recessionary
Gap.
4. Define Stagflation.
5. Explain the Ratchet
Effect.
6. Name 10 College
Majors.
Review
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Adam Smith
1723-1790
John Maynard Keynes
1883-1946 46
Classical
vs.
Keynesian
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Video:
Classical vs. Keynesian
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Debates Over Aggregate Supply
Classical Theory 1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.
Price
level
Real domestic output, GDP
AS
Qf
AD
49
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Debates Over Aggregate Supply
Classical Theory 1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.
Price
level
Real domestic output, GDP
AS
Qf
AD
50
Recessions caused by a fall
in AD are temporary.
Price level will fall and
economy will fix itself.
No Government Involvement
Required
AD1
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Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
Real domestic output, GDP
AS
Qf
AD
51
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Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
Real domestic output, GDP
AS
Qf
AD
52
Q1
“Sticky Wages” prevents
wages to fall.
The government should
increase spending to
close the gap
AD1
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Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
Real domestic output, GDP
AS
Qf
AD2
53
AD1
Q1
When there is high
unemployment, an
increase in AD doesn’t
lead to higher prices
until you get close to full
employment
AD3
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Three Ranges of Aggregate Supply
1. Keynesian Range- Horizontal at low output
2. Intermediate Range- Upward sloping
3. Classical Range- Vertical at Physical Capacity
Price
level
Real domestic output, GDP
AS
Qf 54
Keynesian
Range Intermediate
Range
Classical
Range
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2006B Practice FRQ
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2006B Practice FRQ
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The Phillips Curve Shows tradeoff between inflation and
unemployment.
What happens to inflation and unemployment
when AD increase?
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58
In general, there is an inverse relationship
between unemployment and inflation
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Inflation
59
SRPC
Short Run Phillips Curve
Unemployment 2% 9%
1%
5%
When the economy is overheating, there is low unemployment but high inflation
When there is a recession, unemployment is high but
inflation is low
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Inflation
60
SRPC
Short Run Phillips Curve
Unemployment 2% 9%
1%
5%
What happens when AS falls causing stagflation? Increase in unemployment and inflation
SRPC1
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Inflation
61
SRPC
Short Run vs. Long Run
Unemployment 2% 9%
1%
5%
What happens when AD increases?
SRPC1
3%
5%
Long Run Phillips Curve
In the long run, wages
and resource prices
increase. AS falls.
SRPC shifts right.
What happens in the long run?
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Inflation
62
Short Run vs. Long Run
Unemployment 2% 9%
1%
5%
3%
5%
Long Run Phillips Curve
In the long run there is no tradeoff between inflation
and unemployment
The LRPC is vertical at
the Natural Rate of
Unemployment
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Inflation
63
SRPC
Short Run vs. Long Run
Unemployment 2% 9%
1%
5%
What happens when AD falls?
SRPC1
3%
5%
Long Run
Phillips Curve
In the long run wages
fall and there is no
tradeoff between
inflation and
unemployment
What happens in the long run?
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AD/AS and the
Phillips Curve
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Price
Level
65
AD
AS
AD/AS and the Phillips Curve
GDPR QY
PLe
LRAS Inflation
SRPC
Unemployment
UY
LRPC
Show what happens on both graphs if AD increases
AD1
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Price
Level
66
AD
AS
AD/AS and the Phillips Curve
GDPR QY
PLe
LRAS Inflation
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?
AD1
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Price
Level
67
AD
AS
AD/AS and the Phillips Curve
GDPR QY
PLe
LRAS Inflation
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?
AS1
SRPC1
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Price
Level
68
AD
AS
AD/AS and the Phillips Curve
GDPR QY
PLe
LRAS Inflation
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up?
AS1
SRPC1
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Price Level
69
SRAS
GDPR QY
LRAS Inflation
SRPC
Unemployment UY
LRPC
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AD
Price Level
70
SRAS
GDPR QY
LRAS Inflation
SRPC
Unemployment UY
LRPC
AD2
AD3
PLe
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AD
Price Level
71
SRAS
GDPR QY
LRAS Inflation
SRPC
Unemployment UY
LRPC AS1
PLe
AS2
SRPC1
SRPC2
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AD
Price Level
72
AS
GDPR QY
LRAS Inflation
SRPC
Unemployment UY
LRPC AS2
PLe
SRPC1 AD2
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Analyzing the Economy
Graphically
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Use the following models to show full
employment, a recessionary gap, and an
inflationary gap.
1. PPC
2. Business Cycle
3. AD/AS
4. Phillips Curve
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The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less
75
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1. Draw an Inflationary Gap with your
fingers.
2. Draw a Recessionary Gap with your
fingers.
3. Explain the difference between the
Classical and Keynesian philosophies.
4. Explain why the Aggregate supply
curve is shaped like a backwards “L.”
5. Name 10 Universities in California.
Review
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Fiscal Policy
78
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The Car Analogy The economy is like a car…
• You can drive 120mph but it is not sustainable. (Extremely Low unemployment)
• Driving 20mph is too slow. The car can easily go faster. (High unemployment)
• 70mph is sustainable. (Full employment)
• Some cars have the capacity to drive faster then others. (industrial nations vs. 3rd world nations)
• If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS)
The government’s job is to brake or speed up when needed as well as promote things that will improve the engine.
(Shift the PPC outward) 79
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How does the Government Stabilizes the
Economy?
The Government has two different tool boxes it can use:
1. Fiscal Policy-
Actions by Congress to stabilize the economy.
OR
2. Monetary Policy-Actions by the
Federal Reserve Bank to stabilize the
economy. 80
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For now we will only focus on Fiscal Policy.
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Two Types of Fiscal Policy
Discretionary Fiscal Policy- • Congress creates a new bill that is designed to change AD through government spending or taxation. •Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increase spending.
Non-Discretionary Fiscal Policy •AKA: 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.
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Laws that reduce inflation, decrease GDP
(Close a Inflationary Gap)
• Decrease Government Spending
• Tax Increases
• Combinations of the Two
Contractionary Fiscal Policy (The BRAKE)
Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)
• Increase Government Spending • Decrease Taxes on consumers • Combinations of the Two
Expansionary Fiscal Policy (The GAS)
How much should the Government Spend? 83
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Pri
ce
lev
el
Real GDP (billions)
The government should
increasing spending
which would increase AD
They should NOT spend 100
billion!!!!!!!!!!
If they spend 100 billion, AD
would look like this:
AD1
AD2
• What type of gap and what type of policy is best?
• What should the government do to spending? Why?
• How much should the government spend?
P1
$400 $500
AS
LRAS
FE
WHY?
84
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The Multiplier Effect Why do cities want the Superbowl in their stadium? An initial change in spending will set off a spending chain
that is magnified in the economy. Example: • Bobby spends $100 on Jason’s product • Jason now has more income so he buys $100 of Nancy’s product • Nancy now has more income so she buys $100 of Tiffany’s product. • The result is an $300 increase in consumer spending
The Multiplier Effect shows how spending is magnified in the economy.
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1. Explain how to show full employment, inflation,
and unemployment on the PPC.
2. Explain how to show full employment, inflation,
and unemployment on the Business Cycle.
3. Draw an Inflationary Gap with your elbow.
4. Draw a Recessionary Gap with your foot.
5. Explain why the economy is like a car.
6. Identify what Congress can do to put on the
brakes.
7. Identify what Congress can do to put on the gas.
8. Explain the difference between discretionary and
non-discretionary Fiscal Policy.
9. Name 10 Universities outside California.
Review
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Effects of Government Spending
If the government spends $5 Million, will AD
increase by the same amount?
• No, AD will increase even more as spending becomes income for consumers.
• Consumers will take that money and spend, thus increasing AD.
How much will AD increase? • It depends on how much of the new income
consumers save. • If they save a lot, spending and AD will increase
less. • If the save a little, spending and AD will be
increase a lot. 87
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Marginal Propensity to Consume Marginal Propensity to Consume (MPC)
•How much people consume rather than save
when there is an change in income.
•It is always expressed as a fraction (decimal).
MPC= Change in Consumption
Change in Income Examples:
1. If you received $100 and spent $50.
2. If you received $100 and spent $80.
3. If you received $100 and spent $100. 88
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Marginal Propensity to Save
MPS= Change in Saving
Change in Income
Marginal Propensity to Save (MPS) •How much people save rather than consume
when there is an change in income.
•It is also always expressed as a fraction (decimal)
Examples:
1. If you received $100 and save $50.
2. If you received $100 your MPC is .7 what is
your MPS? 89
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Why is this true? Because people can either save or consume
90
MPS = 1 - MPC
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How is Spending “Multiplied”?
Change in
GDP = Multiplier x Initial Change
in Spending
Assume the MPC is .5 for everyone •Assume the Super Bowl comes to town and there is an
increase of $100 in Ashley’s restaurant.
•Ashley now has $100 more income.
•She saves $50 and spends $50 at Carl’s Salon
•Car now has $50 more income
•He saves $25 and spends $25 at Dan’s fruit stand
•Dan now has $25 more income.
This continues until every penny is spent or saved
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Calculating the Spending Multiplier
If the MPC is .5 how much is the multiplier?
Change in
GDP = Multiplier x initial change
in spending
Simple
Multiplier = or
1
MPS
1
1 - MPC
•If the multiplier is 4, how much will an initial
increase of $5 in Government spending increase
the GDP?
•How much will a decrease of $3 in spending
decrease GDP?
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The Multiplier Effect Let’s practice calculating the spending multiplier
Simple
Multiplier = or
1
MPS
1
1 - MPC
1. If MPC is .9, what is multiplier?
2. If MPC is .8, what is multiplier?
3. If MPC is .5, and consumption increased
$2M. How much will GDP increase?
4. If MPC is 0 and investment increases $2M.
How much will GDP increase?
Conclusion: As the Marginal Propensity to
Consumer falls, the Multiplier Effect is less 93
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Pri
ce l
evel
Real GDP (billions)
Fiscal Policy Practice
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much initial
government spending
is needed to close gap?
AD2 AD1 $100 Billion
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
P1
$500 $1000FE
AS
LRAS
94
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Pri
ce
lev
el
Real GDP (billions)
Fiscal Policy Practice
AD1 AD
P2
$80FE $100
AS
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
LRAS
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
-$10 Billion
95
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What about taxing? •The multiplier effect also applies when the government
cuts or increases taxes.
•But, changing taxes has less of an impact of changing
GDP. Why?
Expansionary Policy (Cutting Taxes) •Assume the MPC is .75 so the multiplier is 4
•If the government cuts taxes by $4 million how much
will consumer spending increase?
•NOT 16 Million!!
•When they get the tax cut, consumers will save $1
million and spend $3 million.
•The $3 million is the amount magnified in the
economy.
•$3 x 4 = $12 Million increase in consumer spending .96
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Pri
ce l
evel
Real GDP (billions)
Cutting Tax Practice
1. What to options does
the government have?
2. How much should they
increase government
spending?
$10 Billion 3. How much should they
cut taxes?
AD2 AD1 -$20 Billion
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
P1
$80 $100FE
AS
LRAS
97
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Multiplier Effect
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Non-Discretionary
Fiscal Policy
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Non-Discretionary Fiscal Policy
Legislation that act counter cyclically without explicit action by policy makers.
AKA: Automatic Stabilizers
The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy.
1. When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD.
2. When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD.
The more progressive the tax system, the
greater the economy’s built-in stability. 100
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Problems With
Fiscal Policy
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Problems With Fiscal Policy •When there is a recessionary gap what two options does
Congress have to fix it?
•What’s wrong with combining both?
Deficit Spending!!!! •A Budget Deficit is when the government’s
expenditures exceeds its revenue.
•The National Debt is the accumulation of all the budget
deficits over time.
•If the Government increases spending without
increasing taxes they will increase the annual deficit and
the national debt.
Most economists agree that budget deficits are a
necessary evil because forcing a balanced budget would
not allow Congress to stimulate the economy. 102
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Explain this cartoon
2003 104
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Who ultimately pays for excessive
government spending?
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2008 Practice FRQ
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2008 Practice FRQ
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1. Identify the two types of tool boxes the
government has to fix the economy
2. Explain and give examples of Expansionary
Fiscal Policy
3. Explain and give examples of Contractionary
Fiscal Policy
4. Explain the Multiplier Effect
5. Explain how to calculate the spending
multiplier
6. Name 10 University Mascots
Review
108
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Pri
ce
le
ve
l
Real GDP (billions)
Draw and Practice
AD1 AD
P2
$50FE $100
AS
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
LRAS
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .9)
-$5 Billion
109
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Pri
ce
lev
el
Real GDP (billions)
Draw and Practice
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much initial
government spending
is needed to close gap?
AD2 AD1 +$40 Billion
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
P1
$800 $1000FE
AS
LRAS
110
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Paul Solomon Video:
Deficit and Debt
111
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Video:
Government Stages Coup
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Additional Problems with Fiscal Policy
1. Problems of Timing • Recognition Lag- Congress must react to
economic indicators before it’s too late
• Administrative Lag- Congress takes time to
pass legislation
• Operational Lag- Spending/planning takes time
to organize and execute ( changing taxing is
quicker)
2. Politically Motivated Policies • Politicians may use economically inappropriate
policies to get reelected. • Ex: A senator promises more welfare and public
works programs when there is already an
inflationary gap. 115
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3. Crowding-Out Effect • In basketball, what is “Boxing Out”?
• Government spending might cause unintended
effects that weaken the impact of the policy. Example:
• We have a recessionary gap
• Government creates new public library. (AD increases)
• Now but consumer spend less on books (AD decreases)
Another Example:
• The government increases spending but must borrow
the money (AD increases)
• This increases the price for money (the interest rate).
• Interest rates rise so Investment to fall. (AD decrease)
The government “crowds out” consumers
and/or investors 116
Additional Problems with Fiscal Policy
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4. Net Export Effect
International trade reduces the effectiveness
of fiscal policies. Example:
• We have a recessionary gap so the government
spends to increase AD.
• The increase in AD causes an increase in price
level and interest rates.
• U.S. goods are now more expensive and the US
dollar appreciates…
• Foreign countries buy less. (Exports fall)
• Net Exports (Exports-Imports) falls, decreasing
AD. 117
Additional Problems with Fiscal Policy
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Explain this cartoon
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Activity
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Congressional Committees
As a group, analyze the situation, identify the problem, and identify your solution
120
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less
The Good, the Bad, and the Ugly
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1.) 1933
Situation:
• GDP fell -1.2%
• Inflation rate= -.5%
• Unemployment Rate=25%
Your Solution:
What actually happened:
• FDR increased public works via the New
Deal programs.
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2.) 1944
Situation:
• GDP grew 8%
• Inflation rate= 3.7%
• Unemployment Rate=1.2%
Your Solution:
What actually happened:
• War ended the next year and government
orders for war materials decreased.
• Many public works programs were
discontinued 122
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3.) 1980 Situation:
• GDP fell -0.3%
• Inflation rate= 13.5%
• Unemployment Rate=7.1%
Your Solution:
What actually happened:
• The next year, President Regan and
congress lowered taxes on individuals and
corporations by about 30%. (Supply-side
Economics) 123
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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)
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1. Aggregate Demand
2. Real Balance Effect
3. Interest Rate Effect
4. Foreign Trade Effect
5. Shifters of AD
(C,I,G,X)
6. Aggregate Supply
7. Shifter of AS (R.A.P.)
8. Short Run AS
9. Long Run AS
10.Two Types of Inflation
11.Ratchet Effect
12.Classic vs. Keynesian
13.Three Ranges of AS
List the 25 Concepts we have covered 14. Fiscal Policy
15. Discretionary vs. Non-
Discretionary
16. Expansionary Policy
17. Contractionary Policy
18. The Car Analogy
19. Multiplier Effect
20. Calculating the
Spending Multiplier
21. MPC and MPS
22. Deficit Spending
23. Timing Problems
24. Crowding-Out Effect
25. Net Exports Effect 125