Unit 4 Quiz 2

Review

Price Level

Measure of

Inflation

G.D.P real

employment

Aggregate Supply (AS)

Aggregate Demand (AD)

Q e

P e

Aggregate- all together (total)

The Aggregate Market- The Basics

Long Run Aggregate Supply (LRAS)

Qy

Qy= Quantity at full employment

The purpose of this graph is to look at countries. Total supply and demand at full employment

You may find it amazing how a graph can be interpreted in so many different ways.

Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.

The law of demand is the same.

There is an inverse relationship- PL up, AD down, PL down AD up

The law of supply is the same

There is a direct relationship- PL up, AS up, PL down AS down

AD= Aggregate Demand

AD= GDP= C + I + G + NX

Conflicting Views

Classical Views- Bottom Up (we cannot know everything!!) Keynesian Views- Top Down (government has a larger view)

1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem

2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output 3. Savings-investment equality-any decrease in output

because of savings is offset an increase in the demand for investment

This creates a different market – the money marketInvestment is demandSavings is SupplyInterest rates create equilibrium- Monetarist

1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.- savings hurt The paradox of thrift

3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run

4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending 5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle

Less Government

Equilibrium of market

Increase consumer or InvestmentsSAVINGS!!!!!

F.A. HayekNeo-ClassicalAustrianSupply-sidersReal Production= real wealth

John M. Keynes More GovernmentMacro not Micro

Keynesians Multiplier Neo-Keynesians Increase Gov’tDemand-siders spending!!!!!!!!

Fiscal Policy

4. Individualism

5. Savings leads to investments, which lead to stronger business, which leads to investments in capital and to more supply and more employment. Stronger econ. in the Long Run 6. The Animal Spirits- believed growth and contraction had

much to do with confidence and trust

Summary

To Hayek:

Only real savings should lower interest rates, not the Fed. Interest rates drop as private savings increase.

During recession: We will stay at full employment if prices and wages are allowed to be flexible.

Runaway inflation is a wealth destroyer that lowers the standard of living, this must be feared during the boom. Inflation hurts those who have money.

To Keynes:--Spending!!!!!!!

During a recession: Only prices and wages will stay (prices and wages are sticky) and employment drops. Government spending during a recession will increase employment, GDP, and AD and will not have an impact on price level until full employment is reached.

Cyclical unemployment and underproduction is the biggest concern. Free Markets can not be trusted to provide full employment.

Economies can suffer from insufficient aggregate demand because people want to acquire liquid assets (stocks, bonds, etc.) rather than real goods.

P.L.

G.D.P real

LRAS

Q yfull

P e

Aggregate Supply – So what Model is correct?

They Both have some valid points

Keynesian Phase

AD

When in the Keynesian Phase

Output can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.

Intermediate Phase

AD

When in the Intermediate Phase

As AD approaches the curve

An increase in AD and decrease in unemployment

Result in a gradual increase of price and some inflationary pressure

ClassicalPhase

AD

When in the Classical Phase

The economy is operating at full employment

Any and all increase in AD will result in an increase in price and in increase in inflation

Inflationary and Recessionary Gaps- Steering the Market

Economic Activity

Time (years)

Potential GDP

Inflationary Gap

Recessionary Gap

The Government can steer the economy in different ways1. Laws and Regulations- stabilizers2. Fiscal Policy- changes in government spending or taxation to influence the economy3. Monetary policy- changes in monetary supply to influence the interest rates that influence economy

(Full Employment)

Fiscal Policy:

Monetary Policy:

Actual GDP < Potential GDP Output is below full employment

High unemployment

Government wants to limit unemployment by increasing demand

Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NECongress

Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE

Summary

Recessionary Gap and what Keynesians think the government should do.

Fiscal Policy:

Monetary Policy:

Actual GDP > Potential GDP Output is beyond full employment

Unemployment very low

Prices very high

Government wants to limit inflation by reducing demand

Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NECongress

Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE

Summary

Inflationary Gap and what Keynesians think the government should do.

Fiscal Policy (Demand side)

Keynesians and Democrats

Keynesian economics

President sets the budget, Congress develops programs- they can tax and borrowCommerce clause – etc.

Raising Revenue- Tax or Borrow

Spending- increase of Decrease (discretionary and nondiscretionary)

Deficit Spending- annually – When the government spends more that it brings in as tax revenue.

Deficits make good politics, why?

Surplus- when revenue exceeds spending (annually)

It is popular to cut taxes and to increase spending.

How do we pay for the deficit? Borrowing

Debt- Accumulation of Deficits over the years

What is the Fiscal Cliff?

To balance the budget many Republicans proposed cutting programs and not raising taxes.

To balance the budget many Democrats proposed raising taxes and not cutting programs.

This was a game of chicken.http://money.msn.com/investment-advice/fiscal-cliff-worst-case-scenarios

Monetary Policy (Demand side)

Who- the Federal ReserveWhat- increasing or decreasing the amount of money in circulationGoal- full employment, stability, and growth

Easy Money Supply- increasing money supply and decreasing interest rates

Open Market Operations- buy securitiesDiscount Rates- lower discount rateReserve Requirements- lessen requirements

Decrease interest rates

Tight Money Supply – decreasing the money supply and increasing interest rates

Open Market operations- sell securitiesDiscount Rates- increase discount ratesReserve Requirements- increase requirements

Monetary Policy (Demand side)Leading advocates- Monetarist

Milton Friedman showed that people’s annual consumption is a function of their “permanent income,” a term he introduced as a measure of the average income people expect over a few years.

Monetarist believe that price level depends on money supply

Friedman stated that in the long run, increased monetary growth increases prices but has little or no effect on output. In the short run, he argued, increases in money supply growth cause employment and output to increase, and decreases in money supply growth have the opposite effect.

Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to increase the money supply at the same rate as real GDP increased, he argued, inflation would disappear.

He argued that the Great Depression was caused by the Federal Reserves poor management of money. Most monetarist do not support the idea of using money supply to fix the economy- too much lag

To keep unemployment permanently lower, he said, would require not just a higher, but a permanently accelerating inflation rate – increase with rate of increase of real GDP

Milton Friedman’s money-supply rule

Growth of the Money Supply < rate of Growth of real GDP= Recession

There is not enough money to buy what has been produced this leads to inventory and layoffs

Growth of the Money Supply > rate of Growth of real GDP= Inflation

There is an abundance of money and not enough goods- prices will rise

Growth of Money Supply = rate of Growth of real GDP= equilibrium

Supply-side theory in AS/AD/LRAS

v v v

LRAS 1 LRAS 2 LRAS 3

Supply side economics

Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.

This increases potential output (Increase abundance, decreases price). Price drops= Increase in demandSupply creates its own demand

There are a number of methodsa. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefitsb. Invest in educationc. Advancements in technology – lowers production cost and creates new marketsd. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)e. Lower corporate tax ratesf. Invest in infrastructure g. reduce regulations and oversighth. Remove barriers of entry (licenses, certs. Etc.)

Eliminate safety nets and allow for profit and loss

AD

AS 1AS 2

P 1

P 2

Q1 Q2

How to fix the economy? According to . . .

Fiscal Policy Monetary Policy Supply Side Policy

During aRecession

With high unemployment

During Expansion

With high inflation

Increase Government Spending

Decrease Taxes

Buy Securities from banks or dealers

Decrease Discount Rate

Reduce Reserve requirements

All ideas intended to lower interest rate

Cut tax on Business

Reduce Regulation

Give business a chance to expand and hire

Decrease Government Spending

Increase Tax

Sell securities to banks

Increase Discount Rate

Increase Reserve Requirements

All ideas intended to increase interest rates

Do nothing the market will take care of itself.

No capital gains tax or marginal (progressive income tax)

Progressive Tax

Laffer Curve