4: AGGREGATE D/S & FISCAL POLICY

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1 4: AGGREGATE D/S & FISCAL POLICY VOCABULARY (with some additional terms) Aggregate Demand curve that shows the amounts of real output that buyers collectively desire to purchase at each possible price level (inverse relationship) Real-Balances Effect increases in price level lower the real value (purchasing power) of financial assets with fixed money value which reduces total spending and output Interest-Rate Effect increases in price level increases demand for money and therefore reduces spending and output Foreign Purchases Effect inverse effect of domestic prices compared to foreign prices. If goods of foreign countries decrease in regard to domestic prices, net exports will decrease Aggregate Supply curve that shows the level of real domestic output that firms will produce at each price level (direct relationship) Horizontal Range real output levels less than full-employment level. This range is horizontal and shows that the economy can grow without experiencing inflation Intermediate Range an expansion of real output is accompanied by a rising price level (inflation). Full employment is just before the furthest extent of this section Vertical Range a section beyond the full employment point in which no further output occurs as price levels increase limitlessly Demand-Pull Inflation excess of demand over output which causes increased price levels Natural Rate of Unemployment Full unemployment rate ; unemployment rate occurring there is no cyclical Productivity measure of the relationship between a nation s level of real output and the amount of resources used to produce it Equilibrium Price Level price level at which AD curve and AS curve intersect Equilibrium Real Output GDPr level at which AD curve and AS curve intersect Efficiency Wages wages that elicit maximum work effort and thus minimize labor cost per unit of output Menu Costs charges surrounding the cost of communicating price changes

2 Fiscal Policy changes in government spending and taxes collection designed to achieve fullemployment and noninflationary domestic output (discretionary fiscal policy) Council of Economic Advisors cabinet of advisors organized to help president meet his economic goals Discretionary deliberate changes in tax rates and government spending by Congress Non-discretionary built-in mechanism of the economy that increases budget deficit or budget surplus without any action by policymakers Expansionary Fiscal Policy increase in government purchases of goods and services or a decrease in taxes to increase aggregate demand and expand real output Budget Deficit amount by which expenditures of government exceed revenues Contractionary Fiscal Policy decrease of government purchases or increase in taxes to decrease aggregate demand and contract real output Budget Surplus amount by which revenues of government exceed expenditures Built-in Stabilizers (see non-discretionary) intrinsic mechanism that affects government s budget in times of recession and inflation Progressive Tax System tax whose average tax rate increases as taxpayer s income increases and decreases as the income decreases Proportional Tax System tax whose average tax rate remains constant as taxpayer s income increases or decreases Regressive Tax System tax whose average tax rate decreases as income increases and increases as income decreases Full-Employment Budget comparison of tax collection and government spending that would occur if economy was at full-employment level Cyclical Deficit federal budget deficit that is caused by a recession and the consequent decline in tax revenues Political Business Cycle tendency of Congress to destabilize economy by reducing taxes and increasing government expenditures before elections to raise takes and lower expenditures after elections Crowding Out Effect rise in interest rates and resulting in decrease of planned investment caused by government s increased borrowing of money Crowding In Effect decrease in interest rates resulting in increase of planned investment caused by government s decreased borrowing of money

3 CHAPTER 11 AGGREGATE DEMAND curve that shows amount of goods and services that will be demanded at various price levels by householders, businesses, government and foreigners ADAS Model allows us to look at changes in GDPr and price levels equilibrium price/equilibrium GDPr for AD2 and AS1 Recession leads to GDP lowering but PL did not change due to ratchet effect RATCHET EFFECT prices are flexible upward but can never lower or return to initial lower prices. AD increases, PL increases and the PL will remain there until a further change in GDP During a period of full employment (FE), demand-pull inflation will cause PL to rise. PL will never return to previous levels due to CHUMP, reasons for ratchet effect: C Contracts a large part of the labor force works under wage contracts prohibiting wage reductions H Hiring Wages businesses cannon legally pay below the minimum wage of labor U Unproductiveness lower wages decrease morale and effort, lowered productivity and increases per-unit cost as result M Menu Cost changes in prices creates unwanted cost of communicating new prices P Price Wars price cuts may lead to retaliation from rival businesses

4 Please note that these are NOT reasons for the downward-sloping or inverse relationship. They explain why there is a horizontal range in the AS curve. For demand of a single product, the inverse relationship was due to income and substitution effects. The AD inverse relationship occurs due to: Real Balances Effect higher price levels reduce purchasing power of the public, resulting in less consumption Interest Rate Effect (assuming supply of money is fixed) as demand for money increases then there is a consequent increase in interest rates. Consumption and investment decrease due to high price levels Foreign Purchases Effect when U.S. price levels rise relative to foreign price levels, net exports fall and imports rise These factors cause QAD to decrease, GDP output to decrease as a result, and then movement ALONG the AD fixed curve. However, CIG-X represents the determinants of Aggregate Demand, shifting the curve left or right. Any change in CIG-X (consumption/expenditures, investment, government spending, or net exports) will shift the AD curve left or right This means that the AE model and AD model are closely related as changes in GDPr affect movement of the graphs. An increase in consumption on the AE model (x) causes a massive change in GDPr due to the expenditures multiplier (x Me). Because of this horizontal change of x Me in the horizontal axis of the AE model, the same horizontal change occurs in the AD model horizontal movement of AD curve = ΔCIG-X Me

5 AGGREGATE SUPPLY curve that shows the amount of goods and services that all businesses will produce at every possible level (direct relationship) 1) Horizontal Range Keynesian Range, shows economic inefficiency, any increase in AD within the range will result in increased GDPr without inflation 2) Intermediate Range shows economic efficiency. Increase in AD within this range results in increased GDPr and some demand-pull inflation. Resources are becoming scarcer so price levels increase. FE (full employment, 96% economic capacity) is found within this region just before the vertical range 3) Vertical Range Classic Range, shows extreme economic inefficiency, no more output as price levels drastically increase. This occurs when the economy is working at 100% capacity. Massive demand-pull inflation The AS curve can only shift left or right due to RAP: R Resource Cost increased cost of land, labor, capital goods, or entrepreneurial ability (shift left) A Actions by Government subsidies (payments from government, shift right) and taxes (shift left) P Productivity measure of average real output per unit of input (greater productivity = shift right)

6 Productivity = total output / total inputs Per-unit production cost = total input cost / total number of units produced AD increases (shifts right) due to: Demand-pull inflation, the multiplier effect (Me) AD decreases (shifts left) due to: Recession, cyclical unemployment AS increases (shifts right) due to: Full employment and price-level stability AS decreases (shifts left) due to: Cost-push inflation CHAPTER 12 FISCAL POLICY deliberate change in government spending and taxing to achieve full employment, control inflation and encourage economic growth. This is part of Keynesian economics that emerged in the 1930 s Congress (with help from the president) is responsible for fiscal policy COUNCIL OF ECONOMIC ADVISORS (CEA) cabinet of advisors organized to help president meet economic goals Massive decreases in AD indicate recessions while massive increases in AD indicate expansions

7 When a recessionary gap occurs in the economy, the goal of government should be to expand GDP output by pushing aggregate demand to the right. This is called Expansionary fiscal policy. PL AD 1 AD 2 SRAS FE PL 2 P L1 E1 E2 GDP 1 GDP2 GDPr G AD GDP/Emp/PL T DI C AD GDP/Emp/PL An expansionary fiscal policy will cause the government to run a budget deficit (spending more than it has or collecting less than it needs), to pay this deficit the government has to borrow funds from the loanable funds market (commercial banks). Since government is a more secure borrower than private businesses, banks will loan their funds to the government first. This will cause the supply of LF to decrease. Making loans more expensive (interest rates to increase), and decreasing the amount of LF in the market (decreasing QLF.) It is interest rates (IR) that determine the quantity of gross domestic investment spending (Ig). As IR increases the quantity of Ig will decrease. This will cause AD to shift to the left, causing a counter-cyclical effect on the expansionary fiscal policy. Loanable Funds Market RIR D S2 S1 IR=10% E2 IR=8% E1 Q 2 Q 1 QLF

8 When an inflationary gag occurs in the economy, and demand-pull inflation Is out of control, the goal of the government should be to contract GDP output by pushing AD to the left. This is called contractionary fiscal policy. PL P L1 PL 2 AS AD 1 AD 2 E1 E2 GDP I GDP 2 GDPr G AD GDP/Emp./PL T DI C AD GDP/Emp/PL A contractionary fiscal policy will cause the government to run a budget surplus (spending less than it has or collecting more than it needs). These surpluses will be put into the LF market, thus increasing the supply of LF. The increase supply of LF causes interest rates (IR) to decrease, leading to an increase in gross domestic investment spending (Ig), and an increase in AD. RIR Loanable Funds Market D S1 S2 IR=8% IR=6% E1 E2 Q 1 Q 2 QLf