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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)