Unit 5 Review AP Macroeconomics 1. 1. The modern tools of macroeconomic policy are: Monetary and Fiscal Policy Aggregate Demand Curve AD is downward sloping: Price Level Negative relationship between PL and Output Changes in price level cause a move along the curve AD = C + I + G + Xn Real domestic output (GDPR) 3 Aggregate Demand Curve Price Level AD shows the relationship between aggregate PL and Aggregate demand by households, businesses, government, and the rest of the world AD = C + I + G + Xn Real domestic output (GDPR) 4 Why is AD downward sloping? 1. Wealth Effect • Higher price levels reduce the purchasing power of money • This decreases the quantity of expenditures • Lower price levels increase purchasing power and increase expenditures Example: • 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. 5 Why is AD downward sloping? 2. Interest-Rate Effect • When the 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. WHY? • Example: An 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). 6 What is Aggregate Supply? Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms. 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. 7 Aggregate Supply Curve Price Level AS AS is the production of all the firms in the economy Real domestic output (GDPR) 8 Shifters of Aggregate Supply 1. Change in Inflationary Expectations If an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS. (If people expect lower prices…) 2. Change in Resource Prices Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) 9 Shifters of Aggregate Supply 3. Change in Actions of the Government (NOT Government Spending) Taxes on Producers (Lower corporate taxes…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) 4. Change in Productivity Technology (Computer virus that destroy half the computers…) (The advent of a teleportation machine…) 10 Shifts in Aggregate Demand An increase in spending shift AD right, and decrease in spending shifts it left Price Level AD1 AD2 AD = C + I + G + Xn Real domestic output (GDPR) 11 Inflationary and Recessionary Gaps 12 Example: Assume the government increases spending. What happens to PL and Output? Price Level LRAS AS PL and Q will Increase PL1 PLe AD QY Q1 AD1 GDPR 13 Inflationary Gap Output is high and unemployment is less than NRU LRAS Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 14 Example: Assume the price of oil increases drastically. What happens to PL and Output? Price Level LRAS AS1 AS PL1 Stagflation PLe Stagnate Economy + Inflation AD Q1 QY GDPR 15 Recessionary Gap Output low and unemployment is more than NRU LRAS AS1 Price Level Actual GDP below potential GDP PL1 AD Q1 QY GDPR 16 Marginal Propensity to Consume (MPC) • The fraction of any change in disposable income that is consumed. • MPC= Change in Consumption Change in Disposable Income • MPC = ΔC/ΔDI Marginal Propensity to Save (MPS) • The fraction of any change in disposable income that is saved. • MPS= Change in Savings Change in Disposable Income • MPS = ΔS/ΔDI Practice • The limiting factor is savings. • For every additional dollar spent a portion of it will be saved (the MPS). • The multiplier is the reciprocal of the MPS or 1/MPS. • The larger the MPC (the smaller the MPS) the larger the multiplier will be. • Tax Multiplier (note: it’s negative because tax increases reduce spending) -MPC/ or MPC/ 1-MPC MPS • If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow Government Spending during a recession or depression and can improve an economy by injecting money into households. Recessions are inevitable. Many government programs like Social Security, Medicare, Unemployment, and Welfare were begun as Keynesian economic stimulus. Aggregate Demand must be stimulated in order to recover from a recession. Free Markets will lead to full employment Keynesian Economics causes price bubbles, (inflation.) When the bubbles break, a recession (hangover) incurs. The booms and busts of the business cycle are natural and are self-correcting. Competition is the invisible hand Government should be limited to preventing monopolies or unions A non-political agency can regulate banks, the money supply, and interest rates. It will be especially effective when painful and unpopular decisions need to be made and will make them in a timely manner. This can be the central banking system. During recessions, impact the overall investment demand through tools that increase the incentive to borrow. This will be lower interest rates. During inflation, impact the overall investment demand through tools that decrease the incentive to borrow. This will be higher interest rates.