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Aggregate Demand,
Aggregate Supply
and Fiscal Policy
AP Economics
Chapters 11-12
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 % &
0% inflation rate
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
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
KEYNES
• Fiscal Policy is government’s way to
stabilize the economy
• Employment Act of 1946 - 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)
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
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
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
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)
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.
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)
Investment Component of GDP
• Economic profit/cost = Rate of return
EX: $100 profit divided by $1000 cost =
10%
• 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)
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)
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
S
i
i
D Ig
D
Q
Investments
Q
Loanable Funds
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: 1
or
1
MPS
1- MPC
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
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
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
AS
PRICE
LEVEL
VERTICAL
RANGE
AD 3
INTERMEDIATE
RANGE
HORIZONTAL
AD 1
AD 2
OUTPUT OF
REAL GDP
Determinants of AS:
1. 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
Determinants of AS:
2. Change in productivity – increase means can
produce more with same resources
EX: more productivity = increase AS
3. 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
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)
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
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
EO1
FE or Y
Real GDP Output
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)
Fiscal Policy Shifts AD
AS
PL
AD1
AD 2
RECESSION – AD SHIFTS RIGHT
WHEN GOV SPENDING INCREASES
OR TAXES DECREASE (more C & Ig)
GDP
OUTPUT
Fiscal Policy Shifts AD
PL
AS
AD1
AD2
GDP
INFLATION – AD SHIFTS LEFT WHEN
GOV SPENDING DECREASES OR
TAXES INCREASE (less C or Ig)
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
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
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)
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.)
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.)
•
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
Last but NOT Least Part of Problem
– Congress is in control of
Fiscal Policy
THE END!
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
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
• http://www.usdebtclock.org/
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)
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
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”
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)