NATIONAL INCOME & PRICE DETERMINATION UNIT 3

Transcription

1 NATIONAL INCOME & PRICE DETERMINATION UNIT 3

2 DAYS 1 AND 2 Income and Expenditures LGs: The nature of the multiplier, which shows how initial changes in spending lead to further changes. The meaning of the aggregate consumption function, which shows how current disposable income affects consumer spending. How expected future income and aggregate wealth affect consumer spending. The determinants of investment spending. Why investment spending is considered a leading indicator of the future state of the economy.

3 DISPOSABLE INCOME Your disposable income is anything you have left over after you pay taxes. It is your discretionary spending meaning you are done with your legal obligations on what you MUST pay and you can now choose what else you want to do with your cash. Another Term: Aggregate The whole, combining all the elements

4 WHAT HAPPENS WHEN YOU SPEND YOUR DISPOSABLE INCOME? You give your money to someone else a portion of that then becomes their disposable income. They may choose to buy something, in which case they give someone else some or all of that money That money goes to the third person, who will spend some of it. And so on, and so on This is called the Marginal Propensity to Consume (MPC) = Consumption Disposable Income

5 MPC Marginal Propensity to Consume is the amount by which consumer spending rises if current disposable income rises by $1 and is the slope of the consumption function The largest part of the US GDP is Consumption (personal) spending. Part of this is true because $1 may be spent over, and over, and over. Typically, consumption is over 2/3 of the GDP GDP Break down the name: Marginal (additional) Propensity (inclination) Consume (GDP/Consumption)

6 MARGINAL PROPENSITY TO SAVE Do people spend ALL of their disposable income? Some do, some do not. The Marginal Propensity to save is the increase in household savings when disposable income increases by $1. Note: this money does not get spent, therefore may not be counted in the GDP (it might depending on how it got to the owner) Marginal Propensity to Save (MPS) = Saving Disposable Income

7 MPC + MPS = 1 The MPC and MPS will be given as decimals (percentages) showing how much of their $1 people will save and/or consume. For example: If you got $1,000 and MPC =.7 and MPS =.3 How much would you spend and how much would you save? Because you must do one of these two things with money, their sum will always equal 1 (or 100%). This is often represented as Y d = C + S Y d = Income: as people s income goes up, they will increase both C and S

8 Notice, you spent even when you didn t have any income. How? You either borrowed money (like a credit card) or you spend some of what you may have already had in savings. That original spending when income was zero is known as autonomous spending. IN APPLICATION: LET S SAY THIS IS YOUR AUTONOMOUS CONSUMPTION Yd Consumption (C) Savings (S) MPC = C/ DI MPS = S/ DI

9 CONSUMPTION FUNCTION Is an equation showing how an individual household s consumer spending varies with the household s current disposable income. The simplest version of a consumption function linear equation is: c = a + MPC x Y d For our last example, graphed it would be:

10 LOOKING BACK AT PAGE 4 OF ACTIVITY PACKET Marginal (additional) Propensities to Consume and Save Marginal Propensity to Consume (MPC) = Consumption Disposable Income Disposable Income Consumption Saving MPC MPS $12,000 $12,100 -$ $13,000 $13,000 $ $14,000 $13,800 $200 $15,000 $14,500 $500 $16,000 $15,100 $900 $17,000 $15,600 $1,400 For the 13,000 line: Remember, it is the CHANGE in income/ CHANGE in savings.so C = 900 DI = 1000 C = 100 DI = 1000

11 LOOKING BACK AT PAGE 4 OF ACTIVITY PACKET Marginal (additional) Propensities to Consume and Save Marginal Propensity to Consume (MPC) = Consumption Disposable Income Disposable Income Consumption Saving MPC MPS $12,000 $12,100 -$ $13,000 $13,000 $ $14,000 $13,800 $ $15,000 $14,500 $500 $16,000 $15,100 $900 $17,000 $15,600 $1,400 For the 13,000 line: Remember, it is the CHANGE in income/ CHANGE in savings.so C = 800 DI = 1000 C = 200 DI = 1000

12 LOOKING BACK AT PAGE 4 OF ACTIVITY PACKET Marginal (additional) Propensities to Consume and Save Marginal Propensity to Consume (MPC) = Consumption Disposable Income Disposable Income Consumption Saving MPC MPS $12,000 $12,100 -$ $13,000 $13,000 $ $14,000 $13,800 $ $15,000 $14,500 $ $16,000 $15,100 $ $17,000 $15,600 $1,

13 TRY ONE MORE DI C S MPC MPS Marginal Propensity to Consume (MPC) = Consumption Disposable Income

14 THE SPENDING MULTIPLIER Let s assume everyone in the economy spends 80% of every additional dollar of new disposable income. What would happen if there was an injection of new spending into the economy? Ted is a chicken farmer in a local community. Suppose he decides to spend $1,000 on a chicken coup from Anthony s farm supply shop. This money now starts to be circulated around the country. Anthony now has $1,000 and spends 80% of it ($800) at Marcia s boutique. Marcia now has $800 and decides to spend 80% of it ($640) to fix her car at Pat s garage. Pat now has $640 from the sale and spends 80% of it ($512) at Dianna s grocery store. Diana now has $512 and spends 80% of it (409.60) with Catherine s catering company. In this case, Ted s $1,000 was the Autonomous change in aggregate spending what got this whole thing started. After 5 rounds of spending, we ve created $2,361.60, more than DOUBLE the original injection of spending. If we had continued until someone was trying to spend 80% of nothing, Ted s initial purchase would have multiplied into $5,000 of income/spending in the community. See page 4 of packet. Complete top table and answer the 3 questions below.

15 ANSWERS TO PAGE 4 SPENDING MULTIPLIER QUESTION: Round Income C S 1 $1, of $1000 = $ of $1000 = $250 2 $ of $750 = of $750 = $ $ of $ = $ of $562 = $ $ of $ = $ of $ = $ All rounds These rounds would continue until someone tried to spend/save until the amount reached $0 (Pause for just a second)

16 MULTIPLIER FORMULA Math people: the example on the last slide that of an infinite series If you re not a math person, just remember the formula The spending multiplier shows the relationship between changes in spending and the maximum resulting changes in real GDP. The simple spending multiplier is: Spending multiplier = 1 = 1 1-MPC MPS Finish questions on page 4

17 ANSWERS TO PAGE 4 SPENDING MULTIPLIER QUESTION: Round Income C S 1 $1, of $1000 = $ of $1000 = $250 2 $ of $750 = of $750 = $ $ of $ = $ of $562 = $ $ of $ = $ of $ = $ All rounds These rounds would continue until someone tried to spend/save until the amount reached $0 We need to figure out how much money would be created if we went until we reached $0 remaining so use the multiplier formula. Spending multiplier = 1 = 1 1-MPC MPS To find how much TOTAL money is created, multiply the INITIAL Autonomous Spending amount by the multiplier formula 1 = 1 = 4 x $1000 = $ To know how much was saved and then spent, apply the MPC and MPS from the problem.

18 CONSUMPTION FUNCTION The Bureau of Labor Statistics collects annual data on family income and spending. Families are grouped by levels of income. Families are grouped by levels of before tax income; after tax income for each group is also reported. Since the income figures include transfers from the government, what the BLS calls a household s after tax income is equivalent to its current disposable income. Generally speaking, the more money you have (the higher your disposable income) the more money you will spend Consumption function: c = a + MPC x Y d And in this case: MPC = c/ y d See Practice FRQ 1

19 SHIFTERS OF THE CONSUMPTION FUNCTION Just like supply and demand can shift, so can the Consumption Function! Finish page 5 C = a + MPC x Yd Consumption = autonomous aggregate spending + MPC x income 1. Changes in Expected Future Disposable income 1956 book, Milton Freedman Theory of Consumption Function, he talked about how future income expectations explains otherwise sometimes confusing aspects of consumer behavior. For example: people with a higher income tend to save a higher percentage Look at spending in recessions, maybe people borrow more because they are confident things will get better. When the economy grows, both high and low earners will do better. Higher current income leads to more savings, but higher future income leads to less savings According to freedman, spending/saving is more based on how much money people expect to have over what they currently have. 2. Changes in Aggregate Wealth Just because two people may have the same income, their wealth may be different one may have been working consistently and own their home the other maybe not. Wealth affects the Life-Cycle hypothesis: consumers plan their spending over their lifetime, not just in response to their current disposable income. As a result, people try to smooth their consumption over their lifetimes. They save at some times and they spend in others. Because wealth affects household consumer spending, changes in wealth across the economy can shift the aggregate consumption function. A rise in aggregate wealth (a booming stock market) increase the vertical intercept a and this shifts the whole function.

20 CONSUMPTION FUNCTION C = a + MPC x Yd Consumption (AAS) initial amount MPC(decimal) disposable income Try Practice FRQ1 on page 15 For a general Macroeconomics course such as this, the most AP will do is as you to draw a very rough version or to name a component (essentially just say what the variable represents)

21 FRQ 1 PRACTICE C = $15, x Yd a. Value of mpc? =.08 b. If disposable income is $40,000? = consumption is $47,000 c. Draw a consumption function graph d. Slope of CS =.8 e. Future income decreases = function shifts downward Consumer Spending $15,000 Disposable income

22 MPC/MPS/MULTIPLIER CLOSING - National Income when we look at spending, we can see how spending and saving are injected back into our economy and our GDP. We see that they multiply exponentially and have a large effect on GDP.

23 INVESTMENT SPENDING The next largest component of GDP is the investment spending. Investment spending often shows us a precursor to a recession. Investment typically leads to long term business production or growth. So if/when investment spending is down, it often implies that future growth will be down as a result. Planned Investment Spending is dependent up on 3 things. Depending on these three factors, businesses may or may not actually spend what they had planned.

24 FACTORS OF INVESTMENT SPENDING 1. Interest Rate Builders only build homes they anticipate they can sell, and houses are more affordable when interest rates are low. They allow the builder to borrow the cost of supplies at lower rates and the buyer to buy at lower rates. Other businesses invest in big spending projects only when they thing the return will be more than what it cost them to do/build. It is easier to make more money on the return when your initial loan was less money. If retained profit is used instead of a loan, a firm still needs to determine if it is better for them to invest their money or loan it to someone else. When rates are lower, they tend to spend it themselves. When interest rates are low, planned investment spending is up 2. Expected future level of GDP If a firm doesn t expect sales to go up in the future, they will only replace existing equipment. But, if they believe the GDP will rise in the future, they will purchase more on investment spending in order to meet the demand of the market. 3. Current level of production capacity Most firms keep inventories stocks of goods to meet future sales (13% of GDP in 2009) A firm that increases inventories is actually engaging in investment spending. (consider Amazon) This is called inventory investment the value of the change in total inventories held in the economy during a given period. This number could actually be negative if the company reduces its inventory over that period of time. Unplanned inventory investment actual sales are less than firm expected, leading to excess inventory Actual investment spending, equals planned investment spending + actual investment spending.

25 INVESTMENT SPENDING When interest rates are down, investment tends to be higher because firms can borrow money at a cheaper rate and/or make less off of lending it. See page 8 of packet

26 DAY 3 Aggregate Demand The purpose of the next two weeks lessons are to get you to understand AD and AS. They are tested thoroughly on the AP exam (and therefore in this class). If you master these, you are likely to do well on the exams. LG: How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy How the wealth effect and the interest rate effect explain the aggregate demand curve s negative slope What factors can shift the aggregate demand curve

27 WHAT IS AGGREGATE DEMAND? Most economists believe the Great Depression was caused by a dramatic negative demand shock. This means that overall, across the whole country, consumers were demanding less. This is called AGGREGATE DEMAND. Aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demand by households business, the government, and the rest of the world.

28 HOW DO WE KNOW WHAT THE OVERALL PRICE AND OUTPUT LEVELS ARE? GDP!!!! Aggregate Demand is made up of all the components of GDP. The teams are often interchangeable. Be careful to really interpret this graph. The AD curve is downward sloping for a different reason than the regular demand curve. Here, as prices go down, real GDP goes up. But this shows prices of ALL goods (no substitutes, etc). So why is there a negative slope?

29 SHAPE OF AD CURVE: WEALTH EFFECT An increase in prices often means a decrease in purchasing power your dollars can buy less stuff Similarly, a fall in aggregate price level increases purchasing power of consumer s assets and leads to more consumer demand. The wealth effect of a change in the aggregate price level is the change in consumer spending caused by the altered purchasing power of consumer s assets. Because of the wealth effect, consumer spending falls when aggregate price level rises, leading to a downward slope of the AD curve. Its not that prices are falling which makes people buy more, its that lower price levels increase buyer s purchasing power driving up demand and/or that when consumer spending falls, price levels rise

30 SHAPE OF AD CURVE: INTEREST RATE EFFECT Why do people carry money and/or deposit it into a bank? Because it makes it easier to engage in a transaction. When aggregate price levels go up, your purchasing power diminishes. To purchase the same things, you need to have access to more money, meaning you (and businesses) invest less. This lowers amount of money available for banks to loan, driving interest rates up. A rise in the interest rate reduces investment spending and makes borrowing costs higher. Increasing Aggregate price levels slows investment and also consumer spending. This is known as the interest rate effect of a change in Aggregate Price Level.

31 SHIFTERS OF AD

32 AD SHIFT: CHANGES IN EXPECTATIONS Both households and firms planned investment spending depends on people s expectations about the future. If consumers and firms become more optimistic about the future, aggregate spending rises. If they become more pessimistic about the future, aggregate spending falls. There are even Consumer Confidence Indices to measure how people feel about the overall health of the economy as it relates to future spending.

33 AD SHIFT: CHANGES IN WEALTH Consumer spending depends on household s purchasing power. If there is an overall market shock that impacts purchasing power, AD will shift (again, if it is just PL that changes, movement along Demand Curve happens) Ex: 1990s there was a huge rise in the stock market that increased AD. Or, if there is suddenly a huge increase in home prices, this means a family can now sell their house for much more, this is an overall increase in everyone s wealth, allowing them to buy more.

34 AD SHIFT: SIZE OF EXISTING STOCK OF PHYSICAL CAPITAL What is available today determines much of current and futue behavior. If business have lots of stock (not stock market stock, inventory stock) and physical capital, they won t feel the need to increase their stock or capital as much. For example, if there are a ton of homes for sale on the market right now, builders will be less inclined to continue to increase their inventory of new homes. They will let the existing ones sell before the build more.

35 GOVERNMENT POLICIES AND AD Macroeconomic KEY IDEA: the government can have A HUGE influence on aggregate demand. They can use their influence to improve economic performance this is through both Fiscal and Monetary policies

36 AD SHIFT: FISCAL POLICY Fiscal policy is the use of either government spending (gov. purchases of final goods and services) or tax policy to stabilize the economy. In practice, governments respond by either increasing spending or decreasing taxes if we are in a recession.

37 CHANGES IN AD: MONETARY POLICY More on monetary policy in the following chapters but for now: Monetary Policy are the actions of the Federal Reserve Bank. The FED actually controls how much money is in the economy. (They actually have 2 ways they can do this, but one that you will understand at this point is the interest rates) By raising or lowering the interest rate, they control their own version of the money multiplier. By controlling the money in the economy, they have a say in both consumer spending and investment spending.

38 SHIFTERS OF DEMAND (PGS 6-10 OF PACKET SHOULD BE COMPLETED) Changes in Expectations People become more optimistic People become more pessimistic AD increases AD decreases Changes in Wealth If the real value of household assets rises AD increases If the real value of household values falls AD decreases Size of existing physical capital If the existing stock of physical capital is relatively small If they existing stock of physical capital is relatively large AD increases AD decreases Fiscal Policy If the gov. increases spending or cuts taxes AD increases If the gov. lowers spending or raises taxes AD decreases Monetary Policy If the FED increases quantity of money AD increases If the FED decreases quantity of money AD decreases

39 DAY 4 Aggregate Supply LGs: How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied by the economy. What factors can shift the aggregate supply curve Why the aggregate supply curve is different in the short and long run.

40 WHAT IS AGGREGATE SUPPLY? Because so many people cut spending in the Great Depression, businesses shut down (and the dust bowl, etc.) and there was a general decline in the overall output of goods and services. GDP fell by 27% between 1929 and The Aggregate Supply curve shows the relationship between the economy s aggregate price level (the overall price level of all final goods and services in the economy) and the total output quantity of final goods and services, or aggregate output, producers are willing to supply. (still GDP is how we get this but now we re exploring from the supply side)

41 SHORT RUN AGGREGATE SUPPLY Economists believe in the short run there is a positive relationship between the aggregate price level and quantity of aggregate output supplied, all things equal. The aggregate supply curve is upward sloping for the SAME REASONS the supply curve is upward sloping, at higher prices, companies are more motivated to make a profit. profit per unit of output = price of unit of output production cost per unit of output If the price of a unit of output is rising faster than the cost of producing that output, that unit of output will be produced. This gives us the SRAS curve.

42 STICKY PRICES Some input prices are sticky This just means that they don t rise or fall very quickly in response to a change in demand for them. As an example of this is labor wages are determined in the labor markets. Let s consider what happens in both good and bad economic times. When are labor wages determined?

43 WHY ARE PRICES (WAGES) STICKY? A GOOD ECONOMY Demand for producers is strong, produces are selling more output lets say hotcakes. With rising output prices, their profit per unit is skyrocketing Eventually they need to hire more workers Employers are reluctant to immediately raise wages because some workers have already agreed to be paid lower wages and those are fixed for the time being Eventually competition for good workers get so fierce that wages rise So prices went up before wages went up A WEAK ECONOMY Demand for hotcakes is weak, the economy is in a recession and are selling fewer units of output with falling output prices, and profit per unit is crashing! Eventually they need to reduce their # of workers Employers are somewhat reluctant to immediately lower wages because they will lose employees. Some employers have already signed contracts at a higher wage so those wages are fixed for the time being. Eventually, the labor market gets so weak, and unemployment is so high, nominal wages begin to fall. Price of output fell quicker than wages fell

44 SHIFTERS OF SHORT RUN AGGREGATE SUPPLY The reasons for a positive slope/relation of the aggregate supply curve is the SAME reasons it is positive of the regular supply curve: at higher prices, producers are willing to produce more.

45 SHIFTERS OF AS: CHANGES IN COMMODITY PRICES If the overall level of INPUT prices go up, then the price of actual goods will go up shifting the entire curve to the right. If the overall level of INPUT prices go down, then the price of actual goods will go down shifting the entire curve to the left. Examples: a major decline in oil prices. What would it do to the curve?

46 SHIFTERS OF AS: CHANGES IN NOMINAL WAGES This would be an example of a specific factor of production, labor, saw an increase in nominal wages. For example: minimum wage laws what would it do to the curve

47 SHIFTERS OF AS: CHANGE IN PRODUCTIVITY If workers are given better tools so they can increase output with the same amount of effort then aggregate supply would increase.

48 LONG RUN AGGREGATE SUPPLY What if wages were NOT sticky? What if wages could just exactly as prices do? So if prices went up by 5%, then wages would immediately go up by 5%. LRAS hits the horizontal axis at the economy s potential output. This is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Many economists believe that, given enough time, the economy will adjust back to this level of output.

49 LONG RUN AGGREGATE SUPPLY For almost all of our purposes, the LRAS will stay where it is, at the optimal level of output. However, if the economy truly GROWS, then the entire LRAS would shift to the right.

50 FROM THE SHORT TO THE LONG RUN The economy from year to year fluctuates around the level of potential output. Some years the economy is weak and real GDP lies below potential output. Other years, the economy is extremely strong and real GDP lies above potential output. In the AD/AS model, the economy is always operating along the SRAS curve, but only sometimes does the spot on that curve also intersect with the LRAS. This model predicts however, in the long run, the economy will adjust to where SRAS intersects with LRAS.

51 IS THIS ECONOMY STRONG OR WEAK? In this economy, lots of people are unemployed, and wages are dropping. As this continues to happen, overtime, employers will realize workers will accept less wages and the SRAS shifts out and at some point may potentially intersect with LRAS Price Level LRAS Y d SRAS SRAS 1 Output/ Real GDP

52 IS THIS ECONOMY STRONG OR WEAK? In this economy, a strong labor market has rising demand for labor. There are very few workers that are unemployed. Employers are scrambling to find scarce employees. Eventually nominal wages rise and SRAS shifts to the left until current output is equal to the potential output. Price Level LRAS Y d SRAS 1 SRAS Output/ Real GDP

53 UNIT 3 FORMATIVE ASSESSMENT Q A 1 B 2 B 3 C 4 C 5 E 6 A 7 B 8 A 9 A 10 D 11 A 12 C 13 B Multiplier = 1 XXXX B.2

54 DAY 5 AD/AS EQUILIBRIUM AND STABILIZATION POLICIES LGS The difference between short and long run equilibrium Causes of demand shocks and supply shocks Determining recessionary vs. inflationary gap and calculate Rationale for stabilization policy what leads to expansionary policies vs contractionary policies Why fiscal policy has a multiplier effect How multiplier effect is influenced by automatic stabilizers.

55 AD AS EQUILIBRIUM If price levels are above equilibrium, there will be a surplus If price levels are below equilibrium there will be a shortage ALWAYS LABEL PRICE LEVELS ON GRAPHS!!

56 SHIFTERS AKA SHOCKS Anything that shifts aggregate supply and/or aggregate demand is known as a supply shock or a demand shock When you see/are asked to draw one of these, you will always need to determine what happened to overall price levels and output. Example: What would happen if suddenly households and businesses become more optimistic about the future of the economy? What would happen to Price Quantity

57 STAGFLATION Stagflation is when the supply curve shifts back causing increased prices and decreased output. It is considered the most detrimental of the shocks Example: Suppose commodity prices (oil) rapidly increase. This could cause aggregate supply to shift to the left.

58 UNEMPLOYMENT Unemployment is closely linked with the Aggregate Supply, Aggregate Demand equilibrium. If Supply or demand INCREASE (shift to the right) unemployment falls because people/businesses are producing more overall goods and services. Complete pages

59 SO WHERE DOES LRAS COME IN?? AD/AS model predicts that in the LONG RUN, when prices are flexible, that the economy will correct itself and return to Long Run equilibrium. Let s say for whatever reason, AD shifts to the left: Here, we are in a RECESSIONARY GAP we are producing below our potential (long run equilibrium)

60 THE SELF CORRECTING MARKET When we are in a recession: poor economy, unemployment on the rise, eventually workers take pay cuts, and as those wages fall, short run aggregate supply will shift out. To this Remember, we talked about only one shift moving at a time, so if you are given a shock question, you would only show something like this if the question asks you what will EVENTUALLY happen in the long run. Theory says that we will achieve LR equilibrium eventually no matter what, but governments try to get us there as fast as possible.

61 RECESSIONARY GAP Whenever the economy is out of long run equilibrium (so when the AD/SRAS intersects anywhere but the LRAS, we are facing one of two gaps: recessionary or inflationary. In a recessionary gap, AD and SRAS intersect below the LRAS or below our potential output. Where would this be on the business cycle?

62 INFLATIONARY GAP In an inflationary gap, SRAS and AD intersect beyond or above our potential output. Here, we are probably experiencing inflation and minimal unemployment. Where would this be on the business cycle?

63 SAME CONCEPTS, DIFFERENT ECONOMIC MODELS

64 STABILIZATION POLICIES The financial goals of governments is to mitigate financial peaks (and therefore limit inflation) and financial troughs (and therefore limit unemployment). Remember, the tools at their disposal are FISCAL and/or MONETARY Policies. These tools are different and can be done by two separate groups in the US. The rest of this unit (today) will focus on FISCAL policy.

65 STABILIZATION POLICY The long run adjustment back to potential output may take a long time, so most economists believe that the government can and should help expedite the return to full employment and stable prices. A stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

66 POLICY IN THE FACE ON DEMAND SHOCKS Demand shocks are the easiest to deal with. The government can heavily influence AD spending. Demand pull inflation

67 POLICY IN THE FACE OF SUPPLY SHOCKS Supply shocks are much more difficult for the government to influence. The worst situation is stagflation (negative shift in supply curve) What happens if the government tries to deal with unemployment? What happens if they try to deal with inflation? No good answer. Cost push inflation Complete pages in packet

68 BACKGROUND OF FISCAL POLICY Fiscal policy is ALL about taxing and spending. Every year the President of the US proposes a budget to Congress. Congress will amend and eventually approve the budget and it becomes law. The federal government should pay for 2 years of college for every student in America

69 HOW CAN THE GOVERNMENT IMPACT SPENDING? 1. Government spending (impacts GDP: gov. spending) 2. Transfer payments (controls incomes for some people) 3. Tax collection (takes money out of the economy)

70 EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY EXPANSIONARY (NEED MORE GROWTH) Fiscal policy should try and shift AD to the right. Typically one of three forms: 1. An increase in gov. purchases of goods and services. 2. A cut in taxes 3. An increase in gov. transfer payments CONTRACTIONARY (NEED TO SLOW GROWTH) Fiscal policy should try and shift AD to the left. Typically takes one of three forms: 1. A decrease in gov. purchases of goods and services 2. An increase in taxes 3. A decrease in gov. transfer payments While this is a great/easy theory it is important to remember there are time lags Recognition lag, decision lag, or implementation lag. Often times it takes quite a while before big spending or cutting begins. During this time, the economy may have been already self-correcting.

71 FISCAL POLICY IN PRACTICE There are 3 ways the government can influence AD: Changes in government purchases This is magnified through the Multiplier Effect Changes in government transfers and/or taxes These is also magnified through a Multiplier Effect, but to a smaller extent (and a different formula)

72 SPENDING MULTIPLIER AT WORK FOR THE GOVERNMENT We already discussed the multiplier given a MPC Your spending multiplier = 1 1 MMM X your initial injection Just like this was true of Consumption and Investment spending, it is also true of Government spending. So, suppose the government is experiencing a recessionary gap. Let s say in this economy the MPC =.9 Current output is $500 billion below potential GDP and unemployment is beginning to rise. Does the government need to inject $500 billion of new Government spending in the economy to return the economy to full employment? NN!! MMM = 1 Gap is $500 billion/10 means you need an 1.9 = 10 initial injection of only $50 billion to close the gap

73 TRY ONE MORE Suppose the government is experiencing an inflationary gap. Suppose MPC =.75 Current output is $800 billion above potential GDP and inflation is starting to hurt the economy Multiplier = = 4 $800 billion/4 means you need to cut government spending by $200 billion

74 SPENDING MULTIPLIER FOR TAXES IS SLIGHTLY DIFFERENT (SEE NOTE ON PAGE 5 OF ACTIVITY PACKET) The government can also indirectly affect AD through taxes and transfers. But the impact of taxes/transfers is secondary/indirect because it first impacts consumer s disposable incomes, and therefore attempts to change their CONSUMPTION habits (versus directly controlling its own GOVERNMENT spending habits) If the government gives people a tax refund, they won t spend ALL of it, they will only spend the current rate of MPC. Similarly, if the government increases a transfer payment, the individual typically won t spend ALL if it, only the current rate of MPC.

75 TAX MULTIPLIER Taxes are the trickiest part, its no different than the MPC, it just requires one extra step to consider Instead of putting the entire amount into the MPC formula (like we would for spending) we need to start with a reduced sum as people will save a bit of their taxes at first. Let s say the government decides to lower income taxes by $1,000 and the MPC is.90 Can we multiply that initial $1,000 by.9? NO! Because people would save $100 of it from their taxes so we can only multiply $900 by x.9; x 900 = a $9000 difference in GDP

76 IN REALITY.WE HAVE PROGRESSIVE TAXES Lump-sum taxes would be taxes that do not depend on a taxpayer s income, all households would be taxed the same, but we don t have there in the US, so it makes things a bit more difficult Tax brackets married filing jointly The good news is we are working in theories, and so we aren t going to try and determine all the different mathematic scenarios of how this works, but you need to understand that in the US, this oversimplified system is more difficult, and you may see something on an FRQ etc where the question will say given a flat tax, etc.

77 AUTOMATIC STABILIZERS Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the when the economy expands, without requiring any deliberate action by policy makers. Some examples: when people make more money, they pay more in taxes, which allows the government to lessen the effects of inflation (if they don t spend the money) and vice versa We give out unemployment insurance, this lessens recessionary periods, Medicaid, food stamps (SNAP) all of these payments tend to rise when the economy is doing poorly, which help to get us back on track. Just like taxes, these have a smaller multiplier because people will save some of the new money when possible. Discretionary Fiscal policy is action on top of these automatic stabilizers that is a deliberate action to try and combat the state of the economy.

78 PRACTICE: Real GDP is currently $600 Billion above potential GDP and price inflation is beginning to dominate the headlines. How could the government adjust taxes or transfers to return the economy to full employment? How large would this lumpsum adjustment need to be? Assume the MPC =.75

79 PRACTICE: Current real GDP is $6 trillion and potential GDP is $7.5 trillion. The government is prepared to pass a spending package to return the economy to full employment. What kind of spending package should be passed and how big does it need to be? Assume MPC =.90.

80 TEST: THURSDAY Review for about 30 minutes (go over any questions, practice FRQs, etc.) Test starting around 1:45-ish giving you an hour to complete about 35 MC and 2 FRQs. (you should be getting familiar with a MC pace of about a question per minute)