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Transcript
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