Macroeconomics Unit 3 Aggregate Demand,Aggregate Supply, and Fiscal Policy

Unit 3: Aggregate Demand, Aggregate Supply, and Fiscal Policy AD, AS, and LRAS Draw the economy at full employment Short Run vs. Long Run Aggregate Supply 1. In the short run, wages and resource prices will NOT increase as price levels increase 2. In the long run, wages and resource prices will increase____ as price levels increase Shifters of AD and AS Shifters of Aggregate Demand 1. Consumer Spending 2. Investment Spending 3. Government Spending 4. Net Exports (Exports Ð Imports) Shifters of Aggregate Supply 1. Resource Prices 2. Actions of the Government (ex: taxes, regulations) 3. Productivity Recessionary Gap Draw an economy in a recession Price Level LRAS AS PLe Actual GDP is below full employment GDP. A recession with high unemployment. Inflationary Gap Draw an economy with an inflationary gap Price Level LRAS AS Actual GDP is above full employment GDP. The economy is over heating PLe AD AD Qe QFE Real GDP Graphing Practice Draw an economy at full employment. Show what happens to price level and GDP if consumption falls QFE Qe Real GDP Define Key Terms Negative Supply ShockAn unexpected decrease in the availability of a key resource that temporarily decreases productivity Positive Supply ShockAn unexpected increase in the availability of a key resource that temporarily increases productivity StagflationWhen there is high inflation and a sluggish economy. Usually accompanies a negative supply shock. Autonomous ConsumptionThe minimum amount of consumer spending when people have no income Disposable IncomeThe amount of money households have to spend or save after taxes Classical vs. Keynesian Economics What is classical economic theory? The belief that the economy self corrects and government intervention will do more harm than good What is Keynesian economic theory? The belief that the government should actively manipulate the economy to reach full employment Three Ranges of the Aggregate Supply Curve Draw and label the three ranges of the AS curve Price Level Classical Fiscal Policy Define Discretionary Fiscal PolicyCongress creates a new bill that is designed to change AD through government spending or taxation. Define Non-Discretionary Fiscal PolicyPermanent spending or taxation laws enacted to work counter cyclically to stabilize the economy Government Spending and Taxation Expansionary Fiscal Policy- Laws to increase output 1. Increase Government Spending 2. Decrease Taxes (Increases disposable income) Contractionary Fiscal Policy- Laws to reduce inflation 1. Decrease Government Spending Beyond full 2. Increase Taxes (Decreases disposable income) employment, In a recession, price The Multiplier Effect short-run output level doesnÕt fall cannot increase so What is the Multiplier Effect? because wages are The idea that an initial change in spending will set off prices must rise ÒstickyÓ. a spending chain that is magnified in the economy. Intermediate The strength of multiplier depends on the amount that Keynesian consumers spend of new income. Define Marginal Propensity to Consume (MPC)QFE Real GDP How much people consume rather than save when Simple Spending Multiplier Tax Multiplier there is a change in income Define Marginal Propensity to Save (MPS)How much people save rather than consume when there is a change in income Policy and Multiplier Practice 1. Is there a recessionary or inflationary gap? Recessionary 2. If the government does no policy and resource prices are flexible, in the long run wages will __fall___ and aggregate supply will ____increase___ 3. If fiscal policy is used to close they gap the government could increase spending or decrease taxes on consumers Assume the MPC is .5: (multiplier is 2) 4. What is the least amount of government spending that could potentially close the gap? $20 billion 5. How much could the government cut taxes to close the gap? $40 billion tax cut (consumers only spend half) Now assume that the MPC is .8: (multiplier is 5) 6. What is the least amount of government spending that could potentially close the gap? $8 billion Problem with Fiscal Policy Inflationary Expectations 1. Deficit Spending-if the government increases spending without What happens to aggregate supply increasing taxes they will increase the annual deficit and the national debt when people expect inflation? 2. Time Lags-Congress takes time to write, debate, pass, and implement If people expect inflation, workers legislation will seek higher wages and costs 3. Crowding out- Government spending might cause unintended effects for businesses will increase. This that weaken the impact of the policy. Ex: deficit spending to increase AD causes the aggregate supply to decrease would increase interest rates and decrease investment Short Run and Long Run Phillips Curve Draw and label the short and long run Phillips curve. Label points A, B, and C based on the changes in AD LRAS Inflation Phillips Curve AS Long-Run PC Price Level PL1 B PL PL2 PL1 PL A= NRU/Full Employment (4-6% Unemployment) B= Inflationary Gap C= Recessionary Gap A A C AD1 AD2 Price Level Shifts in AD, cause movements along the SRPC B C AD Short-Run PC QY Real GDP U1 NRU U2 Unemployment Draw and label the short and long run Phillips curve and label point A. Show the result of a negative supply shock on both graphs Shifts in AS, cause the LRAS AS1 Inflation Phillips Curve SRPC to shift. AS LRPC B B In this case there is higher inflation and higher unemployment A A AD Q 1 QY Real GDP Economic Growth Practice 1. If interest rates fall, investment __↑__ causing capital stock to __↑__ and economic growth to __↑__. 2. If interest rates go up, investment __↓__ causing capital stock to __↓__ and economic growth to __↓__. True or False 3. An increase in consumer spending leads to more economic growth in the long run. False 4. Crowding out due to deficit spending causes less economic growth. True 5. When the long run aggregate supply shifts right the natural rate of unemployment increases. False 6. A sustained increase in productivity causes both the long run aggregate supply curve and production possibilities curve to shift right. True 7. Jacob Clifford is very attractive. Very True ! SRPC1 SRPC NRU U1 Unemployment Showing Economic Growth with AD and AS Draw an economy at full employment. Show what happens in the long run if investment increases