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Aggregate Demand (AD)

• Aggregate is the sum of everything
• Aggregate demand is the total amount of goods and services (real GDP) that buyers are willing and able to purchase at different price levels
• If the price level increases, the real GDP demanded decreases
• If the price level decreases, the real GDP demanded increases

Why AD is Downward Sloping

• The wealth effect explains that higher price levels reduce the purchasing power of money, thus decreasing expenditures
• Lower price levels increase purchasing power and increase expenditures, also known as the real balance effect
• The interest rate effect occurs when an increase in the price level causes lenders to charge higher interest rates for a real return on their loans
• Higher interest rates discourage consumer spending and business investment
• The foreign trade effect is when a rise in the U.S. price level causes foreign buyers to purchase fewer U.S. goods while Americans buy more foreign goods
• Exports fall and imports rise, causing a fall in real GDP demanded

Shifters of Aggregate Demand

• An increase in spending shifts AD to the right, while a decrease in spending shifts it to the left
• Consumer spending changes with disposable income increases, consumer expectations, household indebtedness, and taxes decrease
• Investment spending changes with real interest rates, future business expectations, productivity and technology, and business taxes
• Government spending changes with government expenditures
• Net exports change with exchange rates when the U.S. dollar depreciates relative to the euro and national income compared abroad if a major importer has a recession

Multipliers

• The multiplier effect is when an initial change in spending sets off a spending chain that is magnified in the economy, showing how spending is magnified

Effects of Government Spending

• If the government spends $5,000,000, AD will increase by more than that because government spending becomes income for other consumers who then spend, increasing AD
• The increase in AD depends on how much of the new income consumers save
• High saving leads to less spending and AD increase
• Low saving leads to more spending and AD increase

Marginal Propensity to Consume (MPC)

• MPC measures how much people consume rather than save when there is a change in disposable income
• MPC is always expressed as a fraction (decimal)
• MPC = change in consumption / change in disposable income

Marginal Propensity to Save (MPS)

• MPS measures how much people save rather than consume when there is a change in disposable income
• MPS is always expressed as a fraction (decimal)
• MPS = change in savings / change in disposable income

Calculating the Spending Multiplier

• Spending multiplier is equal to 1/MPS or 1/(1-MPC)
• Total change in GDP = multiplier * initial spending

Tax Cuts

• The multiplier effect applies when the government cuts or increases taxes
• Changing taxes has less of an impact than government spending
• Tax multiplier = MPC / MPS
• Spending multiplier is stronger than the tax multiplier

Short-Run Aggregate Supply (SRAS)

• Aggregate supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels
• Short-run aggregate supply means wages and resource prices are sticky and will not change as price levels change
• Long run aggregate supply means wages and resource prices are flexible and will change as price levels change

SRAS Shifters

• Resource prices, including domestic and imported
  • For example, an increase in the price of Canadian lumber or a decrease in the price of Chinese steel
• Supply shocks can be negative or positive
• Inflationary expectations occur if people expect higher prices in the future
• Government actions such as taxes on producers or subsidies for domestic producers
  • Lower corporate taxes or lower subsidies for domestic farmers
• Government regulations like EPA inspections can affect supply
• Productivity, such as from a computer virus that destroys computers or the advent of a teleportation machine

Long-Run Aggregate Supply (LRAS)

• A permanent change in the production possibilities of the economy can shift LRAS
• If a firm makes 100 units sold for $1 each with $80 labor costs, profit = $100 - $80 = $20
• LRAS shifters are the same shifters of the PPC, inclduing change in resource quantity or quality and change in technology

Changes in the AD-AS Model in the Short Run

• Demand-Pull inflation occurs if the AD increases
• Cost-Push inflation occurs if the SRAS decreases
• An increase in GDP means an increase in employment

Long-Run Self Adjustment

• As prices go down, wages and costs decrease, so AS shifts right
• As prices go up, wages and costs increase, so AS shifts left
• When AD decreases/shifts left, AS increases/shifts right
• When AD increases/shifts right, AS decreases/shifts left
• An increase in consumption or government spending does not cause economic growth, only investment causes growth since firms increase their capital stock

Fiscal Policy

• Consumption is the most important part of the economy
• Consumers will spend a certain amount regardless of their income, called autonomous consumption
• This spending is usually for necessities
• Consumer spending is made up of autonomous spending and disposable income, which is income after taxes
• If incomes are less than autonomous spending, there is dissaving or negative supply shocks
• The government uses fiscal policy from Congress and monetary policy from the Federal Reserve Bank to stabilize the economy

Discretionary vs. Non-Discretionary Fiscal Policy

• Discretionary fiscal policy involves Congress creating a new bill to change AD through government spending or taxation
  • It has problems like lag times due to bureaucracy
  • It takes time for congress to act
• Non-discretionary fiscal policy are automatic stabilizers that include permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy
  • When GDP goes down, government spending automatically increases and taxes automatically fall

Contractionary Fiscal Policy

• Laws that reduce inflation and decrease GDP to close an inflationary gap
• It can include decreasing government spending, increasing taxes to decrease disposable income, or a combination of both

Expansionary Fiscal Policy

• Laws that reduce unemployment and increase GDP to close a recessionary gap
• It can include increasing government spending and decreasing taxes to increase disposable income

Timing and Fiscal Policy

• Because fiscal policy takes time to go into effect, it often has three time lags: Recognition lag for Congress, administrative lag, and operational lag

Automatic Stabilizers

• The U.S. progressive income tax system acts counter cyclically to stabilize the economy
• When DP is down, the tax burden on consumers is low, promoting consumption and increasing AD
• When GDP is up, the tax burden on consumers increases, discouraging consumption and decreasing AD
• Unemployment benefits and social service programs act counter cyclically to stabilize the economy
• When GDP is down, unemployment is higher and more benefits are paid out, increasing AD
• When GDP is up, unemployment is low and fewer benefits are paid out, decreasing AD