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Unit 4
Quiz 2
Review
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Aggregate- all together (total)
Price Level
Aggregate Supply (AS)
Measure
of
Inflation
The purpose of this graph is to look at countries.
Total supply and demand at full employment
Pe
Aggregate Demand (AD)
Qe
G.D.P real
Qy
employment
Qy= Quantity at full employment
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I + G + NX
You may find it amazing how a graph can be
interpreted in so many different ways.
Learning the basics of the graph will provide you
an opportunity to learn fiscal and monetary
policy in different ways.
Conflicting Views
Classical Views- Bottom Up (we cannot know everything!!)
F.A. Hayek
Less Government
Neo-Classical
Equilibrium of market
Austrian
Supply-siders
Increase consumer or
Real Production= real Investments
wealth
SAVINGS!!!!!
1. Prices and Wages are flexible – markets quickly and
efficiently achieve equilibrium. When applied to the
resource market full employment is maintainedunemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate
product of goods and service produces enough income to
exactly purchase all output
3. Savings-investment equality-any decrease in output
because of savings is offset an increase in the demand
for investment
This creates a different market – the money market
Investment is demand
Savings is Supply
Interest rates create equilibrium- Monetarist
4.
Individualism
5. Savings leads to investments, which lead to stronger business,
which leads to investments in capital and to more supply and more
employment. Stronger econ. in the Long Run
Keynesian Views- Top Down (government has a larger view)
John M. Keynes
More Government
Macro not Micro
Keynesians
Neo-Keynesians
Demand-siders
Multiplier
Increase Gov’t
spending!!!!!!!!
Fiscal Policy
1. Prices and Wages are Sticky- Prices and wages respond
slowly to changes in supply and demand and this results in
shortages and surplus- especially with labor.
2. Increase Aggregate Demand to increase GDP- is
influenced by a host of economic decisions both public and
private.- savings hurt The paradox of thrift
3. “In the Long Run we are all dead”- care more about
Short run and not so much about the long run. Changes in
AD have greater short run effect on real GDP and
employment but not as much on price. What is true in the
short run isn’t always true in the long run
4. The multiplier- increases in spending will increase
consumption and increase output- which will lead to more
spending
5. Steer the Market- advocated stabilization policies such
as tax, government spending, laws, and regulation in order
to defend against the sudden and unpredictable changes in
the business cycle
6. The Animal Spirits- believed growth and contraction had
much to do with confidence and trust
Summary
To Hayek:
Only real savings should lower interest rates, not the Fed. Interest rates drop as private savings
increase.
During recession: We will stay at full employment if prices and wages are allowed to be flexible.
Runaway inflation is a wealth destroyer that lowers the standard of living, this must be feared
during the boom. Inflation hurts those who have money.
To Keynes:--Spending!!!!!!!
During a recession: Only prices and wages will stay (prices and wages are sticky) and
employment drops. Government spending during a recession will increase employment, GDP,
and AD and will not have an impact on price level until full employment is reached.
Cyclical unemployment and underproduction is the biggest concern. Free Markets can not be
trusted to provide full employment.
Economies can suffer from insufficient aggregate demand because people want to acquire liquid
assets (stocks, bonds, etc.) rather than real goods.
Aggregate Supply – So what Model is correct?
They Both have some
valid points
LRAS
P.L.
Classical
Phase
When in the Classical Phase
The economy is operating at full employment
Pe
Any and all increase in AD will result in an
increase in price and in increase in inflation
Intermediate
Phase
Keynesian
Phase
AD
AD
AD
Qy
full
G.D.P real
When in the Keynesian Phase
When in the Intermediate Phase
Output can increase with no change in price.
No increase in price level, no inflationary
pressure, spare room to grow.
As AD approaches the curve
An increase in AD and decrease in
unemployment
Result in a gradual increase of price and
some inflationary pressure
Inflationary and Recessionary Gaps- Steering the Market
Economic
Activity
Potential
GDP
Inflationary Gap
(Full Employment)
Recessionary Gap
Time (years)
The Government can steer the economy in different ways
1. Laws and Regulations- stabilizers
2. Fiscal Policy- changes in government spending or taxation to influence the economy
3. Monetary policy- changes in monetary supply to influence the interest rates that influence economy
Summary
Recessionary Gap and what Keynesians think the government should do.
Actual GDP < Potential GDP
Output is below full employment
High unemployment
Government wants to limit unemployment by increasing demand
Fiscal Policy:
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Congress
Monetary Policy: Federal Reserve can increase money supply or decrease interest rates.
AD = C + I + G + NE
Summary
Inflationary Gap and what Keynesians think the government should do.
Actual GDP > Potential GDP
Output is beyond full employment
Unemployment very low
Prices very high
Government wants to limit inflation by reducing demand
Fiscal Policy:
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Congress
Monetary Policy: Federal Reserve can decrease money supply or increase interest rates.
AD = C + I + G + NE
Fiscal Policy (Demand side)
Keynesians and Democrats
Keynesian economics
President sets the budget, Congress develops programs- they can tax and borrow
Commerce clause – etc.
Raising Revenue- Tax or Borrow
Spending- increase of Decrease (discretionary and nondiscretionary)
Deficit Spending- annually – When the government spends more that it brings in as tax
revenue.
Deficits make good politics, why?
Surplus- when revenue exceeds spending (annually)
It is popular to cut taxes and to increase spending.
How do we pay for the deficit? Borrowing
Debt- Accumulation of Deficits over the years
What is the Fiscal Cliff?
To balance the budget many Republicans proposed cutting programs and not raising taxes.
To balance the budget many Democrats proposed raising taxes and not cutting programs.
This was a game of chicken.
http://money.msn.com/investment-advice/fiscal-cliff-worst-case-scenarios
Monetary Policy (Demand side)
Who- the Federal Reserve
What- increasing or decreasing the amount of money in circulation
Goal- full employment, stability, and growth
Easy Money Supply- increasing money supply and decreasing interest rates
Open Market OperationsDiscount RatesReserve Requirements-
buy securities
lower discount rate
lessen requirements
Decrease interest rates
Tight Money Supply – decreasing the money supply and increasing interest rates
Open Market operationsDiscount RatesReserve Requirements-
sell securities
increase discount rates
increase requirements
Leading advocates- Monetarist
Monetary Policy (Demand side)
Milton Friedman showed that people’s annual consumption is a
function of their “permanent income,” a term he introduced as a
measure of the average income people expect over a few years.
Monetarist believe that price level depends on money supply
Friedman stated that in the long run, increased monetary growth increases prices but has little
or no effect on output. In the short run, he argued, increases in money supply growth cause
employment and output to increase, and decreases in money supply growth have the opposite
effect.
Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and
real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to
increase the money supply at the same rate as real GDP increased, he argued, inflation would
disappear.
He argued that the Great Depression was caused by the Federal Reserves poor management of
money. Most monetarist do not support the idea of using money supply to fix the economy- too
much lag
To keep unemployment permanently lower, he said, would require not just a higher, but a
permanently accelerating inflation rate – increase with rate of increase of real GDP
Milton Friedman’s money-supply rule
Growth of the Money Supply < rate of Growth of real GDP= Recession
There is not enough money to buy what has been produced this leads to inventory and layoffs
Growth of the Money Supply > rate of Growth of real GDP= Inflation
There is an abundance of money and not enough goods- prices will rise
Growth of Money Supply = rate of Growth of real GDP= equilibrium
Supply-side theory in AS/AD/LRAS
LRAS 1
v
v
LRAS 2
AS 1
LRAS 3
AS 2
v
P1
P2
AD
Supply side economics
Q1
Q2
Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.
This increases potential output (Increase abundance, decreases price).
Price drops= Increase in demand
Supply creates its own demand
There are a number of methods
a. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefits
b. Invest in education
c. Advancements in technology – lowers production cost and creates new markets
d. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)
e. Lower corporate tax rates
f. Invest in infrastructure
g. reduce regulations and oversight
h. Remove barriers of entry (licenses, certs. Etc.)
Eliminate safety nets and allow for profit and loss
How to fix the economy? According to . . .
Fiscal Policy
Increase Government
Spending
During a
Recession
Decrease Taxes
With high
unemployment
Decrease Government
Spending
During
Expansion Increase Tax
With high
inflation
Monetary Policy
Supply Side Policy
Buy Securities from banks Cut tax on Business
or dealers
Reduce Regulation
Decrease Discount Rate
Give business a chance to
Reduce Reserve
expand and hire
requirements
No capital gains tax or
All ideas intended to
marginal (progressive
lower interest rate
income tax)
Sell securities to banks
Increase Discount Rate
Increase Reserve
Requirements
All ideas intended to
increase interest rates
Do nothing the market
will take care of itself.
Progressive Tax
Laffer Curve