AP MACRO-Section 4

NATIONAL INCOME AND PRICE DETERMINATION

MODULES 16-21

• http://bcs.worthpublishers.com/Krugman_AP_Econ2e/default.asp#944422__946152__

Warm UpIf I were to give you

$1,000,000 dollars, what would you do with it?

World Record!?

• The Domino Effect?

• http://www.youtube.com/watch?v=vDjcJlDg_ig

What we will cover in this Module:What we will cover in this Module:

• The multiplier, which shows how initial changes in spending lead to further changes that literally multiply thru the economy.

• 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

In 2009, US government spent $787 billion in a “stimulus package” through the American Recovery and Reinvestment Act of 2009.

Why did the US Government want to do this? Did it work?

Gross Pay: Income before taxesNet Pay: After deductionsDisposable Income: Income after all fixed expenses are paid.

Marginal Tax Rate[18]

Single Taxable Income

Married Filing Jointly or Qualified Widow(er) Taxable Income

Married Filing Separately Taxable Income

Head of Household Taxable Income

10% $0 – $9,225 $0 – $18,450 $0 – $9,225 $0 – $13,150

15% $9,226 – $37,450

$18,451 – $74,900

$9,226 – $37,450

$13,151 – $50,200

25% $37,451 – $90,750

$74,901 – $151,200

$37,451 – $75,600

$50,201 – $129,600

28% $90,751 – $189,300

$151,201 – $230,450

$75,601 – $115,225

$129,601 – $209,850

33% $189,301 – $411,500

$230,451 – $411,500

$115,226 – $205,750

$209,851 – $411,500

35% $411,501 – $413,200

$411,501 – $464,850

$205,751 – $232,425

$411,501 – $439,000

39.6% $413,201+ $464,851+ $232,426+ $439,001

Marginal Propensity (tendency) to Consume (MPC)

•How much people consume rather than save when there is an change in income. •It is always expressed as a fraction (decimal).

MPC= Change in Consumer Spending Change in Disposable IncomeExamples: 1. If you received $100 and spent $50.2. If you received $100 and spent $80.3. If you received $100 and spent $100.

10

Marginal Propensity to Save (MPS)

MPS= Change in Saving Change in Disposable Income

•How much people save rather than consume when there is an change in income.

•It is always expressed as a fraction (decimal)

Examples: 1. If you received $100 and save $50.2. If you received $100 your MPC is .7 what is

your MPS? 11

Why is this true?Because people can either save or consume

12

MPS = 1 - MPC

Autonomous Change in Aggregate Spending

• This is the initial change in aggregate spending before real GDP rises. It is the cause, not the result, of the chain reaction.

• The multiplier is the ratio of the total change in real GDP caused by AAS. Multiplier = change in real GDP

change in AASYd= 0 and people consume=autonomous consumption

The size of the multiplier will depend on the MPC. The higher the MPC the higher the multiplier.

{In other words, the more money spent the greater the impact the multiplier will have}

How is Spending “Multiplied”?

Change inGDP = Multiplier x Initial Change

in Spending

Assume the MPC is .5 for everyone •Assume that when the Super Bowl comes to town there is an increase of $100 in Ashley’s restaurant.•Ashley now has $100 more income. •She saves $50 and spends $50 at Carl’s Salon•Carl now has $50 more income•He saves $25 and spends $25 at Dan’s fruit stand•Dan now has $25 more income.

This continues until every penny is spent or saved

15

If the MPC is .5 how much is the multiplier?

Change inGDP = Multiplier x initial change

in spending

SimpleMultiplier

= or 1

MPS

1

1 - MPC

•If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? •How much will a decrease of $3 in spending decrease GDP?

16

The Multiplier EffectPractice calculating the spending multiplier

SimpleMultiplier

= or 1

MPS

1

1 - MPC

1. If MPC is .9, what is multiplier?2. If MPC is .8, what is multiplier?3. If MPC is .5, and consumption increased $2M.

How much will GDP increase?4. If MPC is 0 and investment increases $2M.

How much will GDP increase?Conclusion: As the Marginal Propensity to

Consume falls, the Multiplier Effect is less 17

Warm Up: Why do you think the MPC is higher in poorer

countries compared to richer countries?

Current Events: Housing Market Bubble

What determines how much consumers

spend?

Consumption Function: equation showing how

household’s consumer spending varies with the household’s current disposable income.

c= a + MPC x yd

c= individual household consumer spending

a= individual autonomous consumer spending (how much individual household would spend if no disposable income)

y = disposable incomed

Aggregate Consumption Function:

C = A + MPC x YD

Two factors can change Aggregate Consumption Function

• 1. Changes in expected future disposable income – (higher expected future income tends to lead to

lower savings today…this is known as the permanent income hypothesis)

• 2. Changes in aggregate wealth – (wealth has an effect on consumer spending

and consumers generally plan their spending over their lifetime and not just based on current disposable income…the life-cycle hypothesis).

Answer these questions in your notebook as we listen to the

broadcast:• Why do we want people to spend versus

save?• What are some problems that she cites?• Why are they nervous about investment?• As an economist, what would you advise

the Federal Reserve?

http://www.cnn.com/videos/business/2015/09/17/fed-under-the-hood-lake-pkg.cnn

• Do you understand Monetary Policy?

• Now might be a good time to start reading articles on what monetary policy does.

• Take a listen to video at the top of the page. Summarize what you learn.

• Planned Investment is what firms intend to undertake in a given period but it will depend on three (3) factors:

• 1- interest rates• 2-expected future GDP• 3- current level of

production capacity

Investment SpendingInvestment Spending

Interest Rates

• If a firm predicts high interest rates, then they will invest less and vice versa

= a negative relationship between interest rates and investment

Investment Spending

Expected return on the investment=expected economic profit from the factory= (total revenue minus

total cost)/investment cost.

Expected future REAL GDP

• If firms predict a rise in GDP, they are more likely to invest and vice versa

• ….only if production capacity is taken into account: the maximum they can produce and how close to it are they?

Perfect Storm

Production is near capacity and expectations of strong real GDP in the future

Inventories• Firms that increase inventories are engaging in

a form of investment spending. Higher than anticipated inventories due to a unplanned decrease in sales is known as unplanned inventory investment.

• Rising inventories typically indicates a slowing economy and falling inventories usually indicates a growing economy since sales are better than what was forecast.

Actual Investment Spending

= the sum of planned investment and unplanned inventory investment

Investment (I) = I unplanned + I planned

The Tax Multiplier• Recipients of a tax decrease treat it as an increase in disposable income. • A typical household increases consumption by a factor of the MPC and increases

savings by a factor of the MPS. • Keep in mind that less than a 100% of this increase in disposable income circulates

through the economy- WHY? Because most households save a proportion of it.• Example: If the MPC is equal to .90 and the govt. transfers back tax revenue to

consumers by sending each taxpayer a $200 check. With an MPC =.90, (.9 x 200) = $180 is consumed and $20 is saved. The multiplier kicks in, but not on the entire $200.

• Only on the consumed portion of the $180. The multiplier is 1/.10 = 10, GDP increases by $1800.

• Summary: A $200 change in tax policy ( tax rebate in this example) caused an $1800 change in real GDP. This tax multiplier of 9 measures the magnitude of the multiplier process when there is a change in taxes.

• The tax multiplier is found by : Tm= is (∆GDP)/(∆ taxes)• Tm= MPC*M= MPC/MPS

Be prepared to respond to a free-response question that asks you to explain why the tax multiplier is

smaller than the spending multiplier• With an MPC =.90 the spending multiplier is 10, so why is the

tax multiplier Tm smaller?• The Spending multiplier begins to work as soon as there is a

change in autonomous spending (C,I, G, Xn) but the tax multiplier but first go through a person’s consumption function as disposable income.

• In our $200 example some of the injected dollars are leakages in the form of savings.

• Therefore the final multiplier effect is smaller.• Tm= MPC*(Spending multiplier)= .90 * (1/.10)= 9 in our

example.

Example #2

• The MPC =.80 and the government decides to impose a $50 increase in taxes.

• Tm=.80*Multiplier =.80 *(1/.20 = 4• B/cause the tax multiplier is equal to 4 we determine that

GDP falls by $200. 50 x 4= 200.• Taxes were increases-disposable income falls, consumption

falls, causing GDP to fall, in this case by a factor of 4.

Balanced Budget Multiplier• The government collects and spends tax revenue• IF the dollars spent equals the dollars collected the budget is balanced.• The spending and tax multipliers are different• Here’s an example of the balanced-budget multiplier• The govt wants to spend $100 on a federal program and pay for it by

collecting $100 in additional taxes.• The MPC = .9 in this case.• Spending multiplier= 10 implies that $100 of new spending (G) creates a

$1000 increase in real GDP.• Taxation effect: The Tm=.9 implies that a $100 increase in taxes decreases

real GDP by $900.• Balanced budget effect: Change in real GDP= $1000 -$900 = +100• So, a $100 increase in spending, financed by a $100 increase in taxes,

created only $100 in new GDP. The balanced-budget multiplier is always equal to one, regardless of the MPC.

• Balanced-Budget Multiplier =1

Warm Up

Do you like to be judged on one action or your overall actions? Why?

Current EventsEyes Turn To The Fed As Unemployment Rate Falls

To 5-Year LowDecember 06, 2013 8:40 AM

The nation's unemployment rate dropped to 7 percent — the lowest mark in five years — and employers added 203,000 jobs to payrolls last month, the Bureau of Labor Statistics Friday.

The latest data could build anticipation that the Federal Reserve might taper its stimulus program.

Current Events

• Unemployment Article• http://blogs.wsj.com/briefly/2015/11/06/

october-jobs-report-the-numbers-2/

You are an economic advisor to CongressAfter reading the article, create a proposal for what

the government should do in regards to unemployment benefits.

include the positives and negatives for extending/cutting the benefits. include what you think will happen to the MPC and MPS for people who are unemployed and people who are afraid they may be unemployed in the near future.Predict what you think will happen to aggregate supply and demand as well (this is what we are learning about today)

When we use aggregates

we combine all prices and all quantities.

Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at

different price levels.

There is an inverse relationship betweenprice level and Real GDP.

If the price level:•Increases (Inflation), then real GDP demanded falls.•Decreases (deflation), the real GDP demanded increases.

Aggregate Demand: Module 17

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This is Simple Demand

This is Aggregate Demand

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Demand and Supply Review

1. Define the Law of Demand.2. Explain why demand is downward

sloping.3. Identify the difference between a

change in demand and a change in quantity demanded.

4. Define the Law of Supply.5. Why is supply upward sloping?

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Answers to Review

Define the Law of Demand. Higher price equals less demandExplain why demand is downward sloping.

Lower price equals greater quantity demandedIdentify the difference between change in

demand and change in quantity demanded. Shift in curve vs. movement along the curve

Define the Law of Supply.P and Q are positively related

Why is supply upward sloping?higher price equals greater quantity supplied

48

Aggregate Demand Curve

Price Level

Real domestic output (GDPR)

AD

49

AD is the demand by consumers, businesses, government, and

foreign countries

Changes in price level cause a move along the curve not a

shift of the curve

= C + I + G + Xn

Aggregate Demand

• The aggregate demand curve shows the output of goods and services (real GDP) demanded at different price levels. The aggregate demand curve slopes down due to:

–The wealth effect –The interest rate effect

2 Reasons Why is AD downward sloping

1. Wealth Effect• Higher prices reduce purchasing power of $• This decreases the quantity of expenditures• Lower price levels increase purchasing power

and increase expendituresExample: • If the balance in your bank was $50,000, but inflation

erodes your purchasing power, you will likely reduce your spending.

• So…Price Level goes up, GDP demanded goes down.

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2. Interest-Rate Effect• As price level increases, lenders need to

charge higher interest rates to get a REAL return on their loans.

• Higher interest rates discourage consumer spending and business investment.

• Ex: Increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.

• Result…Price Level goes up, GDP demanded goes down (and Vice Versa).

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53

Higher Inflation brings higher interest rates

Agenda

• Warm up• Current Events• Brief Notes• Shifting Graphs• Practice• Aggregate Supply-Long and short run notesHomework: Module 18 in SG

How does this cartoon relate to Aggregate Demand?

55

Shifts of the Aggregate Demand Shifts of the Aggregate Demand CurveCurve

• ∆C, ∆I, ∆G, ∆X - ∆M

•∆Expectations

•∆Wealth

•∆Existing Stock of Capital

•∆Fiscal Policy

•∆Monetary Policy

GDP= C+ I+ G+(X-M)

• GDP = private consumption + gross investment + government spending + (exports − imports),

How the Government Stabilizes the EconomyThe Government has two different tool boxes it can

use:

1. Fiscal Policy-Actions by Congress &

the PresidentOR

2. Monetary Policy-Actions by the

Federal Reserve Bank (aka Central

Bank actions) 58

Fiscal Policy Changes to AD Curve

• Direct: The Government’s purchases of final goods and services.

• Indirect: A change in either tax rates or transfers to households.

Monetary Policy Changes to AD Curve• Federal Reserve Bank’s change in the quantity

of money or interest rates will shift the curve.

• Increasing the quantity of money shifts the AD curve to the right

• Reducing the quantity of money supply will shift the AD curve to the left.

• If one of these components of aggregate spending changes, the aggregate demand curve will shift.–A rightward shift of the curve is an

increase in aggregate demand.–A leftward shift of the curve is a

decrease in aggregate demand.

From Khan: https://www.khanacademy.org/economics-finance-domain/macroeconomics/aggregate-supply-demand-topic/aggregate-supply-demand-tut/v/shifts-in-aggregate-demand

Acronym?-turn and talk to your partner to create an acronym for our shifters:

Wealth, expectations, existing physical capital, fiscal and monetary.

Write down your suggestion on the flashcard

Shifts in Aggregate DemandA

ggre

gate

Pric

e Le

vel

(P)

Output (Q)

AD0AD2

AD1

P0

Q0Q2 Q1

A shift of aggregate demand to the right means that more real output will be demanded at each price level. If AD shifts left, less real output is demanded at each price level.

Price Level

Real domestic output (GDPR)65

An increase in spending shifts AD right, a decrease in spending shifts AD left

AD1

AD2

How does this cartoon relate to Aggregate Demand?

66

67

How does this cartoon relate to Aggregate Demand?

Review:

Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward). Then, in a correctly labeled graph, show

how each of the following will affect the AD curve.a. Business owners are less optimistic about the health of the economy.b. The government decreases welfare and veteran’s benefits.c. The Federal Reserve increases interest rates.d. A rising price level decreases the value of money held for purchases.e. The government lowers personal income taxes.f. Consumers expect the job market to be much stronger in the next few months.g. The stock market has reached new records high levels of value.h. The stock of physical capital has been falling for nearly a year.

a. Leftward shift in AD (a decrease in AD). Weak business optimism will decrease business spending and capital investment. b. Leftward shift in AD. Less government spending on these transfer payments means less income received by those who qualify for them, thus less consumer spending. c. Leftward shift in AD. Higher interest rates decrease borrowing for both capital investment and large consumer spending. d. Upward movement along the AD curve. The rising price level will reduce spending because each dollar held by households and firms is worth less than it used to be. e. Rightward shift in AD. Lower taxes put more income in the hands of consumers so consumer spending rises. f. Rightward shift in AD. Stronger consumer optimism will increase consumer spending. g. Rightward shift in AD. Higher value of household wealth causes consumer spending to rise h. Leftward shift in AD. A. lower level of physical capital is an indicator that investment spending has fallen.

1. Change in Consumer Spending Consumer Wealth (Boom in the stock market…)Consumer Expectations (People fear a recession…)Household Indebtedness (More consumer debt…)Taxes (Decrease in income taxes…)

2. Change in Investment SpendingReal Interest Rates (Price of borrowing $)

(If interest rates increase…)

(If interest rates decrease…)

Future Business Expectations (High expectations…)Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

71

3. Change in Government Spending (War…)(Nationalized Heath Care…)(Decrease in defense spending…)

72

4. Change in Net Exports (X-M) Exchange Rates(If the us dollar depreciates relative to the euro…) National Income Compared to Abroad(If a major importer has a recession…)(If the US has a recession…)

“If the US get a cold, Canada gets Pneumonia”

AD = GDP = C + I + G + Xn

Current Events

•http://www.npr.org/2013/12/17/251796694/year-in-numbers-the-federal-reserves-85-billion-question

Warm Up: What do you think the Consumer Confidence Index measures? Why? How does this tie into aggregate demand?

Agenda:Warm UpGraphing ShiftersPractice Graphing

Current Events:

http://www.bbc.co.uk/news/business-25299683

http://www.bbc.co.uk/news/business-25440142

http://www.bbc.co.uk/news/business-25415501

Aggregate Supply: Module 18The amount of goods and services (real GDP) that

firms produce in an economy at different price levels.

Aggregate Supply differentiates between short run and long-run and has two different curves.

Short-run Aggregate Supply•Wages and Resource Prices will not increase as price levels increase.

Long-run Aggregate Supply•Wages and Resource Prices will increase as price levels increase.

77

This is SupplyThis is Supply

This is Aggregate SupplyThis is Aggregate Supply

79

Short-Run Aggregate SupplyIn the Short Run, wages and resource prices will NOT

increase as price levels increase.Example:

• If a firm currently makes 100 units that are sold for $1 each and the only cost is $80 of labor how much is profit?

• Profit = $100 - $80 = $20What happens in the SHORT-RUN if price level doubles?

• Now 100 units sell for $2 so total return=$200. How much is profit?• Profit = $120

With higher profits, the firm has the incentive to increase production.

80

The SRAS curve is upward sloping..But why?

If the price of a unit of output is rising faster than the cost of producing that unit, that unit

of output will be produced. (some input prices are “sticky” meaning they don’t rise of fall very quickly in response to a

change in demand for them.)

Aggregate Supply Curve

Price Level

Real domestic output (GDPR)

AS

82

AS is the production of all the firms in

the economy

The Shifters for Aggregate Supply can be remembered as

I. R. A. P.

Shifts in Aggregate Supply

Price Level

Real domestic output (GDPR)

AS

84

An increase or decrease in national production can shift the curve right or left

AS1

AS2

Graph Shifters:1.Commodity Prices: standardized input bought and sold in bulk quantities2. Nominal Wages3. Productivity: increasing/decreasing output

Long-Run Aggregate SupplyIn the Long Run, wages and resource prices

WILL increase as price levels increase.Same Example:

• The firm has TR of $100 an uses $80 of labor. • Profit = $20.

What happens in the LONG-RUN if price level doubles?• Now Total Revenue=$200•In the LONG RUN workers demand higher wages to

match prices. So labor costs double to $160• Profit = $40, but REAL profit is unchanged.

If REAL profit doesn’t changethe firm has no incentive to increase output.

87

Long run Aggregate Supply

Price level

GDPR

In Long Run, price level increases but GDP doesn’t

LRAS

Long-runAggregate

Supply

QY or Yp

Full-Employment(Trend Line)

Assume that in the long run the economy will be producing at full employment. 89

Potential Output: the level of Real GDP the economy would produce if all prices, including nominal wages, were fully flexible

Given this, which way do you think our long run aggregate supply curve has been shifting?

Practice-CPTS!

a. Leftward shift in SRAS. This disruption would act as a short-term decrease in a nation’s technology and hinder the nation’s ability to produce goods and services. b. Leftward shift in SRAS. When the price of a commodity such as grain rises, it will increase production costs for many goods and services; shifting SRAS to the left. c. Rightward shift in SRAS. A population with higher levels of education translates into a more productive workforce that is able to produce more goods and services. d. Downward movement along the SRAS curve. The SRAS curve is upward sloping so that, all else equal, a lower aggregate price level will reduce the level of GDP supplied. e. Leftward shift in SRAS. Labor is a key resource in the production of most goods and services so if labor is becoming more expensive, the SRAS will shift to the left.

Module 19: Putting AD and AS together to get Equilibrium Price Level and Output

93

How does this cartoon relate to Aggregate Demand?

94

• Macroeconomic equilibrium occurs at the intersection of aggregate demand and short-run aggregate supply.

It can also happen that this

occurs at the long-run equilibrium point, but not necessarily.A

ggre

gate

Pric

e Le

vel

Aggregate Output

LRASSRAS

AD

• As we have learned a Demand Shock can effect equilibrium:– Great Depression– Housing Market crash of 2007-2008

Shocks cause a shift in the Aggregate Demand or Supply and can also lead Recessionary Gaps orInflationary Gaps or

Stagflation

Shifters of Aggregate Demand

Change in Consumer Spending

Change in Investment SpendingChange in Government Spending

Net EXport Spending

AD = C + I + G + X

Shifters of Aggregate SupplyAS = I + R + A + P

Change in Resource PricesChange in Actions of the GovernmentChange in Productivity (Investment) 97

Change in Inflationary Expectations

BA

D

A

D

B

A

A

C A major increase in productivity.A

Answer and identify shifter: C.I.G.X or R.A.P

98

Price Level

99

AS

Inflationary Gap

GDPR

LRAS

QY

AD1

PL1

Q1

Output is high and unemployment is less than NRU

Actual GDP above potential

GDP

Price Level

100

AD

GDPRQY

PL1

Q1

LRAS AS1

Recessionary Gap

Output low and unemployment is more than NRU

Actual GDP below potential

GDP

Price Level

101

AD

AS

GDPRQY

PLe

PL1

Q1

LRAS AS1

StagflationStagnate Economy

+ Inflation

Assume the price of oil increases drastically. What happens to PL and Output?

Price Level

102

AD

AS

Assume the government increases spending. What happens to PL and Output?

GDPR

LRAS

QY

AD1

PLe

PL1

Q1

PL and Q will Increase

Price Level

103

AD

AS

Assume consumers increase spending. What happens to PL and Output?

GDPR

LRAS

QY

AD1

PLe

PL1

Q1

Price Level

104

AD

AS

Now, what will happen in the LONG RUN?

GDPRQY

AD1

PLe

PL1

Q1

LRAS

Inflation means workers seek higher wages and production costs increase

AS1

PL2

Back to full employment with higher price level

Negative and Positive Aggregate Demand Shocks

Another Example

Negative and Positive Supply Shocks

Another Example

Long Term Equilibrium

• To summarize how an economy responds to recessions/inflation we focus on Output Gap which is the % difference between actual aggregate output and potential output. Actual Aggregate Output-Potential Output x 100

Potential Output

In the Long Run the economy is self-correcting but many times Governments are not willing to wait that long which brings about Macroeconomic Policy (Module 20)

Short-Run Versus Long-Run Effects of a Positive Demand Shock and a return to Equilibrium via self- correcting economy.

Adam Smith1723-1790

John Maynard Keynes1883-1946 109

MODULE 20Classical

vs. Keynesian

Economic Theory

110

Debates Over Aggregate SupplyClassical Theory1. A change in AD will not change output even in the short run

because prices of resources (wages) are very flexible. 2. AS is vertical so AD can’t increase without causing inflation.

Price level

Real domestic output, GDP

AS

Qf

AD

111

Recessions caused by a fall in AD are temporary.

Price level will fall and economy will fix itself.

No Government Involvement Required

AD1

Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because

prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices

Price level

Real domestic output, GDP

AS

Qf

AD

112

Q1

“Sticky Wages” prevents wages to fall.

The government should increase spending to close the gap

AD1

Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because

prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices

Price level

Real domestic output, GDP

AS

Qf

AD2

113

AD1

Q1

When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment

AD3

The Ratchet EffectA ratchet (socket wrench) A ratchet (socket wrench)

permits one to crank apermits one to crank a tool forward but not backward. tool forward but not backward.

114

Like a ratchet, prices can easily move up but not down!

•If prices fall, the cost of resources must fall or firms would go out of business.

•The cost of resources (especially labor) rarely fall because:

•Labor Contracts (Unions)•Wage decrease results in poor worker morale.•Firms must pay to change prices (ex: re-pricing

items in inventory, advertising new prices to consumers, etc.)

Deflation (falling prices) does not often happen

115

Module 21: Fiscal Policy & The Multiplier

116

The Car AnalogyThe economy is like a car…• You can drive 120mph but not for long.

(Extremely Low unemployment)• Driving 20mph is too slow. The car can easily go faster.

(high unemployment)• 70mph is sustainable. (Full employment)• Some cars have the capacity to drive faster then others.

(industrial nations vs. 3rd world nations)• If the engine (technology) or the gas mileage

(productivity) increase then the car can drive at even higher speeds. (Increase LRAS)

The government’s job is to brake or speed up when needed as well as promote things that will improve the engine.

(Shift the PPC outward) 118

Two Types of Fiscal PolicyDiscretionary Fiscal Policy-

• Congress creates a law designed to change AD through government spending or taxation.•Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increases spending.

Non-Discretionary Fiscal Policy•AKA: Automatic Stabilizers•Permanent spending or tax laws enacted to counter

cyclical problem to stabilize the economy •Ex: Welfare, Unemployment, Min. Wage, etc.•When there is high unemployment, unemployment benefits to citizens increase consumer spending.

119

Laws that reduce inflation, decrease GDP Either Decrease Government Spending or Enact

Tax Increases• Combinations of the Two

Contractionary Fiscal Policy (The BRAKE)

Laws that reduce unemployment and increase GDP• Increase Government Spending or Decrease

Taxes on consumers• Combinations of the Two

Expansionary Fiscal Policy (The GAS)

How much should the Government Spend? 120

Example of Expansionary Fiscal PolicyExample of Expansionary Fiscal Policy

• increase G

• decrease T

• increase transfers

Expansionary Policy: The Stimulus Package

Example of Contractionary Fiscal PolicyExample of Contractionary Fiscal Policy

• decrease G

• increase T

• decrease transfers

The Multiplier Effect

As the Marginal Propensity to Consume falls, the Multiplier Effect becomes less effective

124

SpendingMultiplier OR

Effects of Government SpendingIf the government spends $5 Million, will AD increase by the same amount?

• No, AD will increase even more as spending becomes income for consumers.

• Consumers will take that money and spend, thus increasing AD.

How much will AD increase?• It depends on how much of the new income

consumers save.• If they save a lot, spending and AD will increase

less.• If they save a little, spending and AD will be

increase a lot. 125

Problems With Fiscal Policy

126

Explain this cartoon About Fiscal Policy

2003127

Who ultimately pays for excessive government spending?

128

Pri

ce le

vel

Real GDP (billions)

Practice Problem to Draw

AD1 AD

P2

$50FE $100

AS

1. What type of gap?2. Contractionary or

Expansionary needed?3. What are two options

to fix the gap?4. How much needed to

close gap?

LRAS

Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .9)

-$5 Billion

129

Pri

ce le

vel

Real GDP (billions)

Practice Problem to Draw

1. What type of gap?2. Contractionary or

Expansionary needed?3. What are two options

to fix the gap?4. How much initial

government spending is needed to close gap?

AD2 AD1 +$40 Billion

Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8)

P1

$800 $1000FE

AS

LRAS

130

Pri

ce le

vel

Real GDP (billions)

The government should increasing spending which would increase AD

They should NOT spend 100 billion!!!!!!!!!!

If they spend 100 billion, AD would look like this:

AD1

AD2

• What type of gap and what type of policy is best?• What should the government do to spending? Why?• How much should the government spend?

P1

$400 $500

AS

LRAS

FE

WHY?

131

Answers to Practice FRQ

132