Lesson 12--ad-as-equilibrium[1]

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Lesson 12--ad-as-equilibrium[1]

  1. 1. Aggregate Demand, Aggregate Supply, and Equilibrium Academic Decathlon Lesson 12 Berryhill
  2. 2. Aggregate Demand• Aggregate demand is a schedule or curve that shows the amounts of real output that buyers collectively desire to purchase at each possible price level• The relationship between the price level and the amount of real GDP demanded is inverse or negative
  3. 3. Aggregate Demand Curve• Why downward sloping? • Real-balances effect--A higher price level reduces the real value or purchasing power of the public, because of this, the public is poorer and will reduce its spending • Interest-rate effect--As the price level rises, there is an increase in money demand and the price paid for its use (interest rate); higher interest rates curtail investment spending and the amount of real output demanded
  4. 4. Aggregate Demand Curve• Why downward sloping? • Foreign purchases effect--when the U.S. price level rises relative to foreign price levels, foreigners buy fewer U.S. goods and Americans buy more foreign goods thereby reducing the quantity of U.S. goods demanded as net exports
  5. 5. Determinants of Aggregate Demand• Change in consumer spending • Consumer wealth • Consumer expectations • Household indebtedness • Taxes
  6. 6. Determinants of Aggregate Demand• Change in investment spending • Interest rates • Expected returns • Expected future business conditions • Technology • Degree of excess supply • Business taxes
  7. 7. Determinants of Aggregate Demand• Change in government spending• Change in net export spending • National income abroad • Exchange rates
  8. 8. Aggregate Supply• Aggregate supply is a schedule or curve showing the level of real domestic output that firms will produce at each price level• This is a direct or positive relationship between the price level and the amount of real output that firms offer for sale
  9. 9. Aggregate Supply Curve• Three distinct ranges • The horizontal or Keynesian range • The intermediate (upsloping) range • The vertical or Classical range
  10. 10. Horizontal/Keynesian Range• Includes only levels of real output that are substantially less than the full- employment output• Firms can put idle workers/machinery on hold and rehire without upward pressure on price level• Because input costs remain the same here (no increase in wages--sticky wages), there is no reason to raise prices
  11. 11. Intermediate (Upsloping) Range• Expansion of real output is accompanied by a rising of price level• As we reach full employment, input costs increase and firms will raise the price level to compensate
  12. 12. Vertical or Classical Range• Economy is overstressed• Economy is already operating at full capacity (full employment)• Companies may try to out bid other companies for employees, the gain of output for the firm will be offset by the loss of another• Bidding raises input costs and that will increase price level
  13. 13. Determinants of Aggregate Supply• Change in input prices • Domestic resource availability • Land • Labor • Capital • Entrepreneurial ability
  14. 14. Determinants of Aggregate Supply• Changes in input prices • Prices of imported resources • Market Power
  15. 15. Determinants of Aggregate Supply• Change in productivity• Change in legal-institutional environment • Business taxes and subsidies • Government regulations
  16. 16. Equilibrium• Equilibrium occurs where the AD curve crosses the AS curve on the graph• This point determines the economy’s equilibrium price level and equilibrium real output
  17. 17. Changes in Equilibrium: Changes in AD• Increases in AD: Demand-Pull Inflation • Say households and businesses decide to increase their consumption and investment spending and the AD curve shifts to the right (ceteris paribus) • The inflationary effects of this shift depend on the stage we are in • Horizontal range-- in AD leads to an in output with no inflationary effects • Intermediate range-- in AD leads to an in both real output and price level • Vertical range-- in AD leads to an in price level only because output can’t increase
  18. 18. Changes in AD• Demand-pull inflation • Rising price levels in the intermediate and vertical ranges of the AS curve constitute demand-pull inflation, which results because shifts in AD pull up the price level
  19. 19. Decreases in AD• Most economists believe that decreases in AD occur mostly in the horizontal range of AS• A decrease in AD at this range will have no effect on price level but will decrease real output• Real output would take the brunt of the decline due to “sticky” prices or wages
  20. 20. “Sticky” Prices and Wages• Numerous reasons for the downward inflexibility of prices and wages • Wage contracts • Morale, effort and productivity • Minimum wage • Menu costs • Fear of price wars
  21. 21. Decreases in AS• If there is a decrease in AS (ceteris paribus), real output declines and price level rises• This is called cost-push inflation--a disruption in production forces costs of production up and this will push up prices
  22. 22. Increases in AS• Alone increases in AS would decreases prices (deflation--very bad) and increase real output• Usually (in the U.S.) we see an increase in AS only after there is an increase in AD, which keeps price levels low but increases output
  23. 23. Aggregate Supply• Aggregate supply is a schedule or curve showing the level of real domestic output that firms will produce at each price level• This is a direct or positive relationship between the price level and the amount of real output that firms offer for sale
  24. 24. Aggregate Supply Curve• Three distinct ranges • The horizontal or Keynesian range • The intermediate (upsloping) range • The vertical or Classical range
  25. 25. Horizontal/Keynesian Range• Includes only levels of real output that are substantially less than the full- employment output• Firms can put idle workers/machinery on hold and rehire without upward pressure on price level• Because input costs remain the same here (no increase in wages--sticky wages), there is no reason to raise prices
  26. 26. Intermediate (Upsloping) Range• Expansion of real output is accompanied by a rising of price level• As we reach full employment, input costs increase and firms will raise the price level to compensate
  27. 27. Vertical or Classical Range• Economy is overstressed• Economy is already operating at full capacity (full employment)• Companies may try to out bid other companies for employees, the gain of output for the firm will be offset by the loss of another• Bidding raises input costs and that will increase price level
  28. 28. Determinants of Aggregate Supply• Change in input prices • Domestic resource availability • Land • Labor • Capital • Entrepreneurial ability
  29. 29. Determinants of Aggregate Supply• Changes in input prices • Prices of imported resources • Market Power
  30. 30. Determinants of Aggregate Supply• Change in productivity• Change in legal-institutional environment • Business taxes and subsidies • Government regulations
  31. 31. Fiscal Policy• Fiscal Policy—deliberate changed in government spending and tax collections to achieve full employment, control inflation, and encourage economic growth
  32. 32. Historical Fiscal Policy• Early 1960s—cut taxes to increase sluggish economic growth• 1970—it placed a 10% surcharge (a tax on top of existing taxes) on both corporate and personal income taxes to reduce aggregate demand and curb inflation• Early 1980s—cut personal income taxes by 25% over 3 years to increase work incentives and encourage economic growth
  33. 33. Historical Fiscal Policy• Early 1990s—it increased taxes to reduce large Federal budget deficits, which were thought to be causing high interest rates, low levels of investment, and slow economic growth• Each of these had varying degrees of success
  34. 34. Other Countries Historical Fiscal Policy• In recent years Japan launched a series of government spending programs designed to increase aggregate demand and extract its economy from a major recession
  35. 35. Legislative Mandates• In the US, the idea of fiscal policy to stabilize the economy emerged during the Depression (1930s) with the ascension of Keynesian economics• Since then, Keynesian economics has played a major role in the design of fiscal policy• We have also learned of its limitations
  36. 36. Employment Act of 1946• Commits the Federal government to use all practical means, consistent with a market system, “to create economic conditions under which there will be…employment opportunities, including self-employment, for those able, willing, and seeking work, and to promote maximum employment, production, and purchasing power.”
  37. 37. Employment Act of 1946• Commits the Federal government to take action through monetary and fiscal policy in order to maintain economic stability
  38. 38. CEA and JEC• Executive branch is responsible for fulfilling the purposes of the act• The act also established the Council of Economic Advisors (CEA) to assist and advise the president on economic matters• Also established the Joint Economics Committee (JEC) of Congress to investigate a wide range of economic problems of national interest
  39. 39. Fiscal Policy and the AD-AS model• The fiscal policy we have described is discretionary (or “active”)• The changes in government spending and taxes are at the option of the Federal government• They do not occur automatically
  40. 40. Fiscal Policy and the AD-AS Model• Some fiscal policy is nondiscretionary (or “passive” or “automatic”)• We’ll look at those later
  41. 41. Fiscal Policy and the AD-AS• When a recession occurs, an Model expansionary fiscal policy may be in order• Say there is a sharp decline in Ig spending and the AD curve has shifted left• As a result GDP declines and there is an increase in unemployment• The economy is experiencing both recession and cyclical unemployment
  42. 42. Fiscal Policy and the AD-ASPrice LRAS SRAS ModelLevel AD’ AD FE GDPr
  43. 43. Expansionary Fiscal Policy• What fiscal policy should the Federal government adopt in order to stimulate the economy?1. Increase government spending2. Reduce taxes3. Use a combination of the two
  44. 44. Expansionary Fiscal Policy• Expansionary fiscal policy is government action to increase GDP and decrease unemployment by shifting the AD curve to the right to correct a recession
  45. 45. Expansionary Fiscal Policy• If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit— government spending in excess of tax revenues
  46. 46. Expansionary Fiscal PolicyPrice LRAS SRASLevel AD’ AD AD” FE GDPr
  47. 47. Increased Government Spending• Other things equal, an increase in government spending will shift an economy’s aggregate demand to the right (AD’ to AD”)• The initial increase in AD is not the end of the story• Through the multiplier effect, the AD curve will increase more than just the initial amount
  48. 48. Increased Government Spending• Say the Government spends $5 billion to increase AD• The MPC is .75• The multiplier is 4 (1/1- .75)• 4 x $5 billion is $20 billiond
  49. 49. Tax reductions• Say the government reduces taxes to increase Consumption and raise AD’ to AD”• Let’s say government reduces personal income tax by $6.7 billion• DI increases by $6.7 billion, but consumption only increases by $5 billion ($6.7 billion x .75) and savings increases by $1.67 billion (%6.7 billion x .25)
  50. 50. Tax Reductions• This is just initial consumption because again, we have to use the multiplier to understand the true affect on GDP• You may notice that a tax cut must be somewhat larger than the proposed increase in government spending if it is to achieve the same amount of increase on GDP
  51. 51. Tax Reductions• This is because part of a tax cut goes to saving, rather than consumption
  52. 52. Combined Gov’t Spending Increases and Tax Reductions• Government sometimes uses a combination of the two• In our example, they may increase spending by $1.25 billion while reducing taxes by $5 billion to get the same result
  53. 53. Contractionary Fiscal Policy• When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it
  54. 54. Contractionary Fiscal Policy AD’Price LRAS SRASLevel AD FE GDPr
  55. 55. Contractionary Fiscal Policy• This graph takes advantage of the vertical area of the SRAS graph to show the inflationary effects of the shift in AD• To correct this inflation the government could1. Decrease government spending2. Raise taxes3. Use some combination of the two
  56. 56. Contractionary Fiscal Policy• By doing any of these, the government is creating a budget surplus—tax revenues in excess of government speding
  57. 57. Decreased Government Spending• Reduced government spending shifts the AD curve leftward to AD’ control demand-pull inflation LRAS SRAS Price Level AD AD” FE GDPr
  58. 58. Decreased Government Spending• Real world prices tend to be inflexible downward• Stopping inflation is more of a matter of halting the rise in price level, not trying to lower it to some previous level• Demand-pull inflation usually is experienced as a continual shifting of the AD curve to the right
  59. 59. Decreased Government Spending• Fiscal policy is designed to stop a shift, not to restore a lower price level• Nevertheless, the graph displays the basic principle: Reductions in government expenditures can halt demand-pull inflation
  60. 60. Increased Taxes• Just as government can use tax cuts to increase consumption spending, it can use tax increases to reduce consumption spending
  61. 61. Combination of the two• The government can use any combination of the two to slow down the economy and halt inflation
  62. 62. Financing of Deficits and Disposing of Surpluses• The expansionary effect of deficit spending on the economy depends on the method used to finance the deficit• Similarly, the anti-inflationary effect of a budget surplus depends on what is done with the surplus
  63. 63. Borrowing vs. New Money• Two ways for the government to finance a deficit: borrowing from the public (by selling interest-bearing bonds) and issuing new money to its creditors
  64. 64. Borrowing from the Public• This is will cause the government to compete for funds with private business borrowers• The added demand for funds might drive up the interest rate and crowd out some private investment spending and interest-sensitive consumer spending• Any decline in private spending will weaken the expansionary effect of the deficit spending
  65. 65. Money Creation• If new money is created, the central government can avoid the crowding out of private spending• Federal spending can increase without adversely affecting investment or consumption• The creation of new money is more expansionary (but potentially more inflationary) than borrowing
  66. 66. Debt Retirement vs. Idle Surplus• Contractionary fiscal spending results in a budget surplus• The anti-inflationary effect of the surplus depends on what the government does with it
  67. 67. Debt reduction• If the surplus is used to pay off debt, the anti-inflationary impact of the surplus could be reduced• To retire the debt, the government buys back some of its bonds; thereby transferring its surplus tax revenues back into the money market, causing interest rates to fall and investment to rise
  68. 68. Debt reduction• An increase in investment or consumption will offset the contractionary fiscal policy by increasing AD
  69. 69. Impounding• The government can realize a greater anti-inflationary effect from its creation of a budget surplus by impounding the surplus funds—by letting them stand idle• This causes the government to extract and withhold purchasing power from the economy
  70. 70. Impounding• If surplus tax revenues are not put back into the economy, no portion of that surplus can be spent• Consequently, there is no chance that the surplus funds will create inflationary pressure to offset the anti-inflationary impact of the contractionary fiscal policy
  71. 71. Policy Options: G or T?• Which is a better method? Government spending or taxes?• This depends on an individual’s view as to whether the government is too large or too small
  72. 72. Government too small• Government spending goes up during recession• Tax increases during inflationary periods• Both actions increase or preserve the size of the government
  73. 73. Government too big• Advocate tax cuts during recessions• Cuts in government spending during inflationary periods• Both actions restrain the growth of or reduce its size
  74. 74. Built-In Stability• To some degree, government tax revenues change automatically over the course of the business cycle to stabilize the economy• These are nondiscretionary (or “passive” or “automatic”) budgetary policies
  75. 75. Built-In Stability• The actual US tax system is such that net tax revenues vary directly with GDP• Personal income taxes have progressive rates (higher rates for higher incomes)• As GDP rises and more goods and services are produced, revenues from corporate income taxes and excise taxes also increase
  76. 76. Automatic or Built-In Stabilizers• Built-in stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during inflation without requiring explicit action by policymakers
  77. 77. G and T relationship• Congress sets a particular level of spending, so Government expenditures (G) is fixed and independent of the level of GDP• Congress does not determine the magnitude of tax revenues (T), instead it establishes tax rates, and tax revenues then vary directly with the level of GDP
  78. 78. G and T Relationship T Surplus GDeficit
  79. 79. Problems, Criticisms, and Complications• Timing problems --Recognition lag (time between the beginning of the recession and the awareness that it is happening) --Administrative lag (takes time to implement fiscal policy) --Operational lag (takes time for policy’s affect to be seen in the economy)
  80. 80. Problems, Criticisms, and Complications• A political business cycle? --Re-election sometimes sways politicians’ fiscal policy --Fiscal policy can be manipulated to maximize voter support, even though the policy could destabilize the economy --Politicians like to cut taxes and increase government spending when elections approach
  81. 81. • After elections, continued expansion of the economy will be reflected in demand-pull inflation
  82. 82. Problems, Criticisms, and Complications• Offsetting state and local finance --state and local fiscal policies are often pro-cyclical (they worsen a recession or inflation) because they have balanced- budget restrictions in their constitutions --They can offset any federal fiscal policy (raise taxes after a federal tax decrease)
  83. 83. Problems, Criticisms, and Complications• Crowding-Out Effect --An expansionary fiscal policy (deficit spending) will increase the interest rate and reduce private spending, thereby weakening or canceling the stimulus of the expansionary policy --This could make fiscal policy largely or totally ineffective --Criticisms of crowding-out: some economists believe there will be little crowding out during a severe recession; policy can counteract crowding out by
  84. 84. Problems, Criticisms, and Complications• The AS curve can complicate the fiscal policy actions --The upward sloping portion of the AS curve may cause some inflation along with declines in unemployment and increases in real GDP
  85. 85. Problems, Criticisms, and Complications• Other nations and our interaction with them can affect fiscal policy actions --As our interest rates increase or decrease, nations want to invest more or less in our banks. To invest they need our currency, this will change the value of the dollar. As the value of the $ changes, net exports change because foreign or domestic goods relative prices change.
  86. 86. Supply-Side Fiscal Policy• Tax changes may alter AS and affect the results of a change in fiscal policy --”Supply-side economists” say tax reductions shift the AS curve to the right, negating the inflation and increasing economic growth that the tax cuts were passed to achieve.
  87. 87. Supply-Side Fiscal Policy• Supply siders give 3 reasons for this effect: 1. saving and investment—lower taxes will increase savings and investment, thereby increasing the nation’s stock of capital so our production capacity will grow (AS increase)
  88. 88. Supply Side Fiscal Policy2. Work incentives—lower income tax rates increase wages and encourage more people to work3. Risk taking—lower tax rates encourage risk takers so entrepreneurs and businesses will be more willing to risk their energies on new production methods and new products
  89. 89. Supply side AS1 Fiscal PolicyPL AS2P2P3P1 AD2 AD1 Q1 Q2 Q3 GDPr
  90. 90. Supply side Fiscal Policy• Most economists are skeptical of supply side tax cuts—they believe that the positive effects are not nearly as strong and that the rightward shifts of AS are slow and long-term so the AD impact would be more immediate and potentially more inflationary• However, most agree that AS effects of fiscal policy need to be considered when passing discretionary fiscal policy

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