Econ 103 Chapter 8, 9, 10 Notes PDF

Chapter 8: Aggregate Expenditures Status Done Type Book Extra Credit Tutorial Aggregate Expenditures Income and Spending Macroeconomic Equilibrium Multipl...

Chapter 8: Aggregate Expenditures Status Done Type Book Extra Credit Tutorial Aggregate Expenditures Income and Spending Macroeconomic Equilibrium Multiplier Effect Spending affected by many variables Marginal Propensity to Consume Aggregate expenditures model to analyze the relationship between what a country spends relative to what it earns marginal propensity to consume marginal propensity to save Marginal propensity to consume = Spending/Earnings Marginal propensity to Save = Savings/Earnings Macroeconomic Equilibrium lower levels of income, consumption exceeds income, as income rises, debt is paid off, and savings are accrued intersection of two lines is known as Keynesian Cross Chapter 8: Aggregate Expenditures 1  Multiplier Effect Increase in spending generates new spending determined by marginal propensity to consume 1/(1-marginal propensity of consumption) it magnifies any increase or decrease in spending in an economy upward shift of aggregate expenditures line when more spending is made Other Types of Spending Spending by everyone, consumption, investment, government spending, and net exports both increases and decreases are magnified by the multiplier Aggregate Expenditures Math Formulas: Aggregate Expenditures (AE) GDP = AE = C + I + G + (X-M) Sum of Consumption and Savings C + S = Yd Average Propensity to Consume (C/Y); Y = income Average Propensity to Save Chapter 8: Aggregate Expenditures 2  (S/Y) ; Y = income Marginal propensity to consume (MPC) MPC = ∆C/∆Y Marginal propensity to save (MPS) ∆S/∆Y Spending Multiplier (k) k = 1/1-MPC AND k = 1/MPS Consumption and Saving Personal consumption expenditures (C) represent about 68% of GDP Consumption is a major component in AE model Yd = income households have available to spend after paying taxes disposable income that is not used for consumption is called saving Consumption spending grows as income grows, but not as fast as income grows, savings will grow as a percentage of income Keynes emphasizes income as main determinant of consumption and saving Chapter 8: Aggregate Expenditures 3  Average Propensities to Consume and Save Percentage of income that is consumed is known as the average propensity to consume (APC) The average propensity to save is the percentage of income that is saved Marginal Propensities to Consume and Save Chapter 8: Aggregate Expenditures 4  Average propensities to consume and save represent portion of income that is consumed or saved Marginal propensities measure what part of additional income will be either consumed or saved more people earn, greater percentage of income they will save MPC - slope of consumption function MPS - slope of saving function Other Determinants of Consumption and Saving Income is principal determinant but other factors affect the schedules Wealth Increases consumption at at levels of income occur with fluctuations in the stock market recessions typically reduce wealth Expectations future prices and incomes help determine how much a person will spend today Household Debt The more debt a household has, less it is able to spend in current period as it makes payments toward the debt Taxes reduce disposable income, reducing consumption by reduction in spendable income times the MPC Saving also falls by reduction in disposable income times the MPS Tax reductions have opposite effect Investment Investment is spending by businesses that adds to the productive capacity of the economy Chapter 8: Aggregate Expenditures 5  can come from foreign sources and domestic sources volatile from year to year constitutes about 17% of GDP Investment Demand Investment levels depend mainly on rate of return on capital earning a high rate of return are investments undertaken first as interest rates falls, investment rises, and vice versa rate of return on investments is main determinant of investment spending, but other factors can affect investments Expectations Projecting the rate of return on investment is difficult Technological Change periodically spur investment Operating Costs when costs to operate rise, rate of return on capital equipment declines Capital Goods on Hand More capital goods a firm has on hand, fewer new investments the firm will make Aggregate Investment Schedule Investment depends on rates of return that determine its potential profitability Chapter 8: Aggregate Expenditures 6  Checkpoint Aggregate Expenditures Aggregate expenditures are equal to the sum of all spending in an economy, with consumption being the largest component of aggregate spending. Keynes argued that saving and consumption spending are related to income. As income grows, consumption will grow, but not as fast. The marginal propensities to consume (MPC) and save (MPS) are equal to specific values ∆C/∆Y and ∆S/∆Y respectively. They represent the change in consumption and saving associated with a change in income. Other factors affecting consumption and saving include: Wealth Expectations about future income and prices The level of household debt Taxes Chapter 8: Aggregate Expenditures 7  Investment levels depend primarily on the rate of return on capital and are independent of income levels. Other determinants of investment demand include: Business expectations Technological change Operating costs The amount of capital goods on hand While consumption is relatively stable, investment is more volatile. Simple Aggregate Expenditures Model AE = C + I Chapter 8: Aggregate Expenditures 8  Macroeconomic Equilibrium in the Simple Model Keynesian Macroeconomic Equilibrium - the income at which there are no net pressures pushing the economy to move to a higher or lower level of output At equilibrium, saving and investment will always be equal Chapter 8: Aggregate Expenditures 9  AE = Y = C + I Y=C+S C+I=C+S I=S With desired investment exceeding desired saving, businesses want to borrow more funds than are available, outcome cannot be an equilibrium When intended saving and investment differ, the economy will have to grow or shrink to achieve equilibrium When desired saving exceeds desired investment, income will decline When intended saving is below intended investment, income will rise At equilibrium, all injections of spending into the economy must equal all withdrawals The Multiplier Injections and withdrawals in an economy produce an effect that is greater than the initial value of the injection or withdrawal Chapter 8: Aggregate Expenditures 10 Chapter 8: Aggregate Expenditures 11  The Multiplier Works in Both Directions If spending increases raise equilibrium income by the increase times the multiplier, a decrease in spending will reduce income in corresponding fashion Chapter 8: Aggregate Expenditures 12  Paradox of Thrift Paradox of thrift - When investment is positively related to income and households intend to save more, they reduce consumption. Consequently, income and output decrease, reducing investment such that saving actually ends up decreasing. if households save more, they will reduce consumption, thereby reducing income and output, resulting in job losses and further reductions in income - lower actual aggregate saving Checkpoint The Simple Aggregate Expenditures Model In a simple aggregate expenditures model that ignores both the government and the foreign sector, macroeconomic equilibrium occurs when aggregate Chapter 8: Aggregate Expenditures 13  expenditures are exactly equal to what is being produced. At this equilibrium, aggregate saving equals aggregate investment. The multiplier process amplifies any change in new spending: some of the new spending is saved, and some becomes additional spending. This cycle continues as some of each round of spending is saved, and some is spent. The multiplier is calculated as: 1/1 - MPC = 1/MPS This multiplier works in both directions. Changes in spending, whether positive or negative, lead to amplified changes in income, resulting in an income change larger than the initial spending shift. The paradox of thrift occurs when households attempt to save more, but at equilibrium, they end up saving less than intended due to reduced aggregate income. The Full Aggregate Expenditures Model Adding Government Spending and Taxes Chapter 8: Aggregate Expenditures 14  Equilibrium income occurs when injections equals withdrawals Changes in spending modify income by an amount equal to the change in spending times the multiplier Tax Changes and Equilibrium When taxes are increased, money is withdrawn from the economy’s spending stream When taxes are decreased, money is injected into the economy’s spending stream Taxes are the difference between income and that part of income that can be spent or disposable income Yd = Y - T Chapter 8: Aggregate Expenditures 15  Equilibrium requires that injections equal withdrawals G+I=S+T consumers pay for tax, reducing their saving Chapter 8: Aggregate Expenditures 16  A tax increase (decrease) will have a smaller impact on income, employment, and output than will an equivalent change in government spending Tax multiplier: MPC/(1-MPC) is smaller than the spending multiplier by a value of 1 Balanced Budget Multiplier When an increase in government spending is paid for by an equal increase in taxes (and vice versa), the multiplier has a value of 1 regardless of the values of MPC and MPS. if spending and taxes are increased by same amount, income grows by this amount, hence a balanced budget multiplier equal to 1 Adding Net Exports Chapter 8: Aggregate Expenditures 17  Net exports (X - M) Exports are injections of spending into domestic economy imports are withdrawals With foreign sector included, all injections into the economy must equal all withdrawals; I+G+X=S+T+M if we import more and all other spending remains the same, equilibrium income will fall Investment, government spending, and exports all increase income, whereas saving, taxes, and imports reduce it Chapter 8: Aggregate Expenditures 18  GDP Gaps Without sufficient spending, an economy can be stuck at a point below full employment for an extended period government should spend if consumers, businesses, and foreigners are unwilling to spend When macroeconomy is in equilibrium, its producing the maximum amount of goods and services using its limited resources as efficiently as possible, it has achieved its potential income Differences between actual income and potential income (GDP at full employment) are called GDP gaps Positive GDP gap occurs when actual output exceeds the potential output A negative GDP gap occurs when actual output falls below the potential output GDP gap is related to but not the same as a recessionary gap or inflationary gap Recessionary gap - increase in spending needed to eliminate a negative GDP gap and bring an economy back to equilibrium Inflationary gap - decrease in spending needed to eliminate a positive GDP gap and bring the economy back to equilibrium Checkpoint The Full Aggregate Expenditures Model 1. Government Spending Government spending affects the economy in the same way as other types of spending. 2. Tax Increases and Decreases Tax Increases: Tax hikes withdraw money from the spending stream but don’t impact the economy as heavily as direct spending reductions. Chapter 8: Aggregate Expenditures 19  This is because some of the tax increase is offset by reduced savings. Tax Decreases: Lower taxes inject money into the economy but have a smaller effect than equivalent spending increases. This is because tax reductions are partly offset by increases in saving. 3. Balanced Budget Multiplier Equal changes in government spending and taxes (a balanced budget) lead to an equal change in income. This is known as the balanced budget multiplier, which is equal to 1. 4. Recessionary and Inflationary Gaps Recessionary Gap: The additional spending required to bring the economy to full employment, after being multiplied through the economy. Inflationary Gap: The necessary spending reduction (amplified by the multiplier) to return the economy to full employment. Increasing government spending: GDP is 200 billion below equilibrium, how much government spending needed to bring economy back to equilibrium if MPS is 0.25 1/0.25 = 4. 200 / 4 = 50 billion if MPS is 0.33 1/0.33 = 3 200 / 3 = 66.7 billion if government increases = amount of increased spending, balanced budget multiplier would be equal to 1 : 200 billion would be needed Chapter Summary GDP = AE = C + I + G + (X-M) Chapter 8: Aggregate Expenditures 20  Marginal propensity to consume (MPC) = ∆C/∆Y Marginal propensity to save (MPS) = ∆S/∆Y MPC + MPS = 1 Disposable Income Yd = C + S Aggregate Expenditures AE = C + I AE = total income C+I=C+S Multiplier Effect 1/1-MPC or 1/MPS Injections Equal Withdrawals: I+G+X=S+T+M Section 1: Aggregate Expenditures 8.1 Gross Domestic Product (GDP) GDP can be measured by either spending or income. Using the spending approach, GDP is equal to aggregate expenditures (AE): Chapter 8: Aggregate Expenditures 21  GDP = AE = C + I + G + (X-M) The 45° line represents where total spending (AE) equals income, indicating no borrowing or saving along this line. Consumption Line (C) The consumption line starts above the origin on the vertical axis, showing that consumption occurs even without income (due to borrowing). As income increases, consumption rises but at a slower rate (the slope of C depends on the marginal propensity to consume, or MPC, and is less than 1). When C intersects AE, spending equals income along the 45° line. When C is below AE, saving is positive. Disposable Income Disposable income is income after taxes have been paid. It can either be spent (C) or saved (S): Disposable Income = C + S The portion of disposable income that is consumed or saved is a critical aspect of the aggregate expenditures model. 8.3 Marginal Propensities Marginal Propensity to Consume (MPC): The fraction of additional income spent on consumption. Marginal Propensity to Save (MPS): The fraction of additional income saved. Since all income is either spent or saved, MPC + MPS = 1. Determinants of Consumption and Saving Income is the primary determinant of consumption and saving, but other factors can shift the consumption schedule, including: Wealth Expectations about the future Household debt Chapter 8: Aggregate Expenditures 22  Taxes Determinants of Investment Demand Investment demand is typically independent of income, but it can shift due to factors such as: Expectations Technological change Operating costs Amount of capital goods on hand Section 2: The Simple Aggregate Expenditures Model Ignoring government spending and net exports, aggregate expenditures (AE) consist of consumer spending (C) and investment spending (I): AE = C + I In equilibrium, AE equals total income, meaning C + I = C + S, so saving must equal investment. Example of the Multiplier Without investment, income = $12 million. Adding $1 million in investment increases income to $15 million, an increase of $3 million. Thus, the multiplier is 3. 8.6 The Multiplier Effect The multiplier effect occurs when each dollar of spending generates additional spending throughout the economy. The multiplier is calculated as: 1/1-MPC or 1/MPS Section 3: The Full Aggregate Expenditures Model 8.7 Government Spending and Net Exports Government spending and spending on exports affect the economy just like any other spending. In the full aggregate expenditures model, all spending forms (C, I, G, and \( X - M \)) are included. Chapter 8: Aggregate Expenditures 23  If the multiplier is 5, a $1 million increase in investment raises income by $5 million. The same effect applies to increases in government spending or net exports. 8.8 Injections and Withdrawals Injections increase spending and include investment (I), government spending (G), and exports (X). Withdrawals decrease spending and include savings (S), taxes (T), and imports (M). In equilibrium, total injections must equal total withdrawals. Economic Gaps When the economy deviates from full employment equilibrium, it creates one of two gaps: Recessionary Gap: The increase in spending needed (multiplied through the economy) to bring it back to full employment. Inflationary Gap: The decrease in spending required (multiplied through the economy) to reduce overheating and return to full employment. Learning Curve MPC x Disposable Income = Change in Consumption Chapter 8: Aggregate Expenditures 24  Chapter 9: Aggregate Demand and Supply Status Done Type Book Extra Credit Tutorial Aggregate Demand and Aggregate Supply Aggregate demand curve shows the relationship between the aggregate price level in an economy and the overall demand for goods and services has downward slope three main effects: 1. wealth effect (higher price causes the purchasing power of its citizens to fall) 2. export effect (when a higher price level causes the prices of exports to be more expensive, reducing exports and aggregate demand) 3. Interest rate effect (higher prices make it harder for citizens to make money, reducing aggregate demand) Changes in Aggregate Demand increase in consumption activity shifts the aggregate demand curve to the right Shifts is the result of changes in any of the components of GDP: Consumption, Investment, Government Spending, Net Exports When it decreases at every price level, AD shifts to the left Aggregate Supply Curve Chapter 9: Aggregate Demand and Supply 1  price level and economy’s total output relationship long-run, aggregate supply is not affected by the price level similar rise in wages to inevitably occur depends on existing resources and technology short-run aggregate supply curve is affected by the price level output rises, business owners and citizens benefit until wages and input prices increase to match the new price level, aggregate output can increase in the short-run Changes in Aggregate Supply improvements in production capacity shifts the long-run curve to the right technology short-run, aggregate supply shifts cause of input, prices, technology, taxes, businesses taxes reduce incentive for businesses to produce, shifting AS to the left expectations fall Macroeconomic Equilibrium Aggregate output at equilibrium price level if Long-run and aggregate supply curve all cross at same point, represents the long-run macroeconomic equilibrium SRAS =! LRAS If AD curve shifts to the left, it is a recession If AD curve shifts to the right, it is an inflation Aggregate Demand The aggregate demand (AD) curve shows the total output of goods and services (real GDP) purchased at different price levels Chapter 9: Aggregate Demand and Supply 2  output rises as prices fall, and vice versa Why is the Aggregate Demand Curve Negatively Sloped? due to income and substitution effects income effect - price of a given product falls, allowing consumers to afford more of all goods substitution effect - price of a product falls, causing consumers to purchase more of the product because they substitute it for relatively higher-price goods Chapter 9: Aggregate Demand and Supply 3  Aggregate demand measures the demand for ALL products, not just one product 1. The Wealth Effect A rising aggregate price level means that the purchasing power of this monetary wealth decreases 2. Export Price Effect When aggregate price level rises, American goods become more expensive in global marketplace Higher prices mean that our goods are less competitive with goods made in other countries foreigners purchase fewer American products, resulting in exports decline 3. Interest Rate Effect If quantity of money is fixed, then as aggregate prices rise, people will need more money to carry out their economic transactions as people demand more money, cost of borrowing money - interest rates - will increase Rising interest rates mean reduced business investment Determinants of Aggregate Demand The determinants of aggregate demand are those factors that shift the entire aggregate demand curve as they change “everything else held constant.” components of GDP: consumption, investment, government spending, and net exports if any of these components of aggregate spending change, aggregate demand curve will shift Chapter 9: Aggregate Demand and Supply 4  Consumer Spending affected by several factors wealth consumer confidence household debt interest rates Chapter 9: Aggregate Demand and Supply 5  taxes due to its large part of economy, small changes can have a significant impact on the economy increases in wealth as a result of increase in home prices/stock prices may lead to increased consumption at all price levels COVID-19 caused consumption to decrease at all price levels high confidence in the economy shifts the aggregate demand curve to the right higher taxes reduce disposable income, reducing consumer spending and shifting aggregate demand curve to the left Investment determined mainly by interest rates and expected rate of return on capital projects When interest rates rise, investment will fall and aggregate demand curve will shift to the left, and vice versa when business expectations become more favorable, investment will increase, shifts the aggregate demand curve to the right if businesses see higher taxes, aggregate demand curve will shift to the left relative instability can result in a significant effect on aggregate economy Government Spending and Net Exports When government spending or net exports rise, aggregate demand increases, and vice versa foreign exchange rates also affect aggregate demand, appreciation of euro will result in Europeans buying more American goods Appreciation of US dollar would decrease U.S. exports and aggregate demand Foreign tourism Chapter 9: Aggregate Demand and Supply 6  aggregate demand curve has a negative slope because of wealth effect, the export price effect, and interest rate effect changes in one of determinants of aggregate demand shift the entire aggregate demand curve Chapter 9: Aggregate Demand and Supply 7  Policies are often enacted to change one/more of the determinants of aggregate demand Checkpoint Aggregate Demand The aggregate demand curve shows the relationship between real GDP and the price level. The aggregate demand curve has a negative slope because of the impact of the price level on financial wealth, export prices, and interest rates. The determinants of aggregate demand are consumer spending, investment spending, government expenditures, and net exports. Changes in any of these determinants will shift the entire aggregate demand curve. Aggregate Supply Aggregate supply curve shows the total output of goods and services that firms will produce at varying price levels production side long-run and short-run short-run: aggregate supply increases as the price level rises (vice versa) and is represented by a positively sloped curve long-run: aggregate supply measures the economy at its potential output with full employment and is represented by a vertical curve Growth occurs in economy shifting this vertical aggregate supply curve to the right Long Run Long-run aggregate supply curve (LRAS) Chapter 9: Aggregate Demand and Supply 8  all variables are adjustable in the long run, product prices, wages, and interest rates are flexible full employment is referred to by economists as natural rate of output or natural rate of unemployment Chapter 9: Aggregate Demand and Supply 9  LRAS curve represents the full employment capacity of the economy economy’s productive capacity is determined by capital available, size and quality of labor force, technology employed Determinants of Long-Run Aggregate Supply Productivity increases and leads to economic growth increased trade and globalization have allowed resources to flow more freely each of shifts in LRAS curve takes time Short Run short-run aggregate supply curve (SRAS), upward sloping to indicate a positive relationship between the aggregate price level and aggregate output slope is relative flat at lower levels of aggregate output and relatively steep at higher levels of aggregate output Chapter 9: Aggregate Demand and Supply 10  when an economy is experiencing a downturn resulting in lower levels of aggregate output, factors of production are not being fully utilized input prices are sticky/slow to change when an economy recovers towards full employment, prices of inputs will rise as output increases slope of SRAS curve increases as economy approaches full employment and input prices become less sticky Keynesian analysis of sticky prices is most evident at lower levels of output, while classical analysis of flexible prices is most evident at higher levels of output Chapter 9: Aggregate Demand and Supply 11  Determinants of Short-Run Aggregate Supply change in aggregate output, other things held constant, will result in a change in the aggregate price level determinants are input prices, productivity, taxes, regulation, market power of firms, and business and inflationary expectations when any of these determinants changes, entire SRAS curve shifts Chapter 9: Aggregate Demand and Supply 12  Input Prices Changes in the cost of land, labor, or capital will affect the output that firms are willing to provide to the market higher input prices are quickly passed along to consumers Chapter 9: Aggregate Demand and Supply 13  new discoveries of raw materials result in falling input prices, causing prices for products incorporating these inputs to drop Productivity Changes in productivity are another determinate of SRAS rising productivity will shift SRAS curve to the right, and vice versa willingness of firms to invest in new capital equipment will enhance productive capacity of an economy, can increase LRAS Taxes and Regulation Rising taxes can shift the SRAS curve to the left new costs exceed the benefits, decrease in SRAS tax reductions reduce the costs of production, resulting in increase in SRAS Market Power of Firms Change in market power of firms can increase prices for specific products, reducing SRAS Inflationary Expectations Change in inflationary expectations by businesses/workers can shift SRAS curve Chapter 9: Aggregate Demand and Supply 14  Checkpoint Aggregate Supply The aggregate supply curve shows the real GDP that firms will produce at various price levels. The vertical long-run aggregate supply (LRAS) curve represents the full- employment productive capacity of the economy. Increasing resources or improving technology shift the LRAS curve, which represents economic growth. The short-run aggregate supply (SRAS) curve is upward-sloping, reflecting rigidities in the economy because input and output prices are slow to change (sticky). The determinants of short-run aggregate supply include input prices, productivity, taxes, regulations, the market power of firms, and inflationary expectations. Macroeconomic Equilibrium Chapter 9: Aggregate Demand and Supply 15  short-run macroeconomic equilibrium occurs at intersection of short-run aggregate supply and aggregate demand curves intersection can coincide with full employment output at long-run macroeconomic equilibrium can be above or below full employment output if economy is facing inflationary pressures or a recession long-run macroeconomic equilibrium where intersection of AD and SRAS curves coincide with LRAS curve at full employment output Chapter 9: Aggregate Demand and Supply 16  The Spending Multiplier new spending creates more spending, income, and output multiplier works as long as aggregate price level is stable flat portion of SRAS curve once SRAS curve increases, actual multiplier will be smaller Chapter 9: Aggregate Demand and Supply 17  increase in aggregate output rises by less than the multiplier as the price level rises once economy reaches full employment, any further increases in aggregate demand will have little to no effect on output because real output does not change in the long run short-run macroeconomic equilibrium occurs at intersection of AD and SRAS curves can occur at less than (or greater than) full employment increases in spending are enhanced by the multiplier, allowing GDP gap to be closed with a smaller change in spending The Great Depression economy can reach short-run equilibrium at output levels substantially below full employment Chapter 9: Aggregate Demand and Supply 18  Demand-Pull Inflation occurs when aggregate demand expands so much that equilibrium output exceeds full employment output Chapter 9: Aggregate Demand and Supply 19  on temporary basis, economy can expand beyond full employment as workers work overtime activities increase costs and prices in long run, economy will gravitate to points e and c policymakers could return economy back to original point e by instituting policies that reduce aggregate demand back to AD0 Chapter 9: Aggregate Demand and Supply 20  Cost-Push Inflation occurs when a supply shock hits the economy, shifting the SRAS curve to the left Chapter 9: Aggregate Demand and Supply 21 Chapter 9: Aggregate Demand and Supply 22  After 1930’s, federal government’s role to 1) expand spending and taxation, 2) extensive new regulation of business, 3) expanded regulation of banking sector Checkpoint: Macroeconomic Equilibrium Macroeconomic Equilibrium Macroeconomic equilibrium occurs where the short-run aggregate supply and aggregate demand curves intersect. The Spending Multiplier The spending multiplier exists because new spending generates additional, round-by-round spending based on the marginal propensities to consume (MPC) and save (MPS). This cycle creates additional income. Chapter 9: Aggregate Demand and Supply 23  Spending Multiplier Formula Spending Multiplier = 1/1-MPC = 1/MPS The effect of the multiplier on aggregate output is larger during a deep recession or depression. Policy Implications Policymakers can increase output by: Expanding government spending, consumption, investment, or net exports. Reducing taxes. Types of Inflation Demand-Pull Inflation: Occurs when aggregate demand exceeds the level needed for full employment. Cost-Push Inflation: Occurs when a supply shock causes the short-run aggregate supply curve to shift left, leading to higher prices and increased unemployment. Chapter Summary Section 1: Aggregate Demand 9.1 The aggregate demand curve shows the quantity of goods and services (real GDP) demanded at different price levels. 9.2 The aggregate demand curve has a negative slope due to three primary effects: Wealth Effect: Rising price levels reduce the purchasing power of savings. Export Price Effect: Higher price levels make domestic goods more expensive globally, reducing foreign demand. Interest Rate Effect: Higher price levels increase money demand, driving up interest rates and decreasing investment spending. 9.3 Determinants of aggregate demand include the components of aggregate spending: Consumption Spending Chapter 9: Aggregate Demand and Supply 24  Investment Spending Government Spending Net Exports Changing any of these components shifts the aggregate demand curve. For example, increased home construction due to high housing demand boosts aggregate demand. Section 2: Aggregate Supply 9.4 The aggregate supply curve illustrates the quantity of goods and services (real GDP) that firms will produce at different price levels: Long-Run Aggregate Supply (LRAS): The LRAS curve is vertical because, in the long run, prices and wages adjust fully, so output is unaffected by price levels. Short-Run Aggregate Supply (SRAS): The SRAS curve slopes positively. With sticky prices and wages, firms increase output in response to rising prices. 9.5 Factors shifting the LRAS curve include: Technological advancements Increased human capital Trade Innovation and R&D Factors shifting the SRAS curve include: Input prices Productivity Taxes and regulations Firms’ market power Inflationary expectations Chapter 9: Aggregate Demand and Supply 25  For instance, electronic toll booths lower transportation costs, which can increase both SRAS and potentially LRAS. Section 3: Macroeconomic Equilibrium 9.6 Macroeconomic equilibrium: Long-Run Equilibrium: Occurs at the intersection of the LRAS and AD curves, where the economy is at full employment. Short-Run Equilibrium: Occurs where the SRAS and AD curves intersect. It can happen above full employment (causing inflationary pressure) or below it (leading to recession). 9.7 The spending multiplier exists because initial spending generates income that leads to further spending, based on the marginal propensities to consume and save. Multiplier Example Round 1: $100 in new spending → $100 in new income Round 2: $80 is spent, $20 is saved ($80 in new income) Round 3: $64 is spent, $16 is saved ⋮ Total Effect: $100 in initial spending results in $500 total spending and $100 in total savings. 9.8 Types of Inflation: Demand-Pull Inflation: Occurs when aggregate demand expands beyond the output at full employment. This can temporarily push the economy beyond full employment, but wage increases eventually lead to a new long- run equilibrium at a higher price level. Cost-Push Inflation: Happens when a supply shock shifts the SRAS curve left, decreasing output and increasing the price level. Increasing aggregate demand can restore full employment but may add further inflationary pressure. Chapter 9: Aggregate Demand and Supply 26  Chapter 10: Fiscal Policy and Debt Status Done Type Book Extra Credit Tutorial Fiscal Policy and Taxation Spending Taxes and government spending - Fiscal Policy Individual Income Taxes - percentage of annual income Payroll taxes - taxes taken to fund government benefits Corporate Income Taxes - taxes paid by firms based on their profit Taxes used for Social Security, Military, Health Care for Seniors, Income Assistance, Interest on National Debt, Education, Research, Roads Discretionary vs. Mandatory Spending Spending enacted by law is mandatory spending (Social Security, Health Care for Seniors, Interest on National Debt) Rest of government spending is passed by Legislature and signed by the president - Discretionary Spending (National Defense, Education, Environmental Protection, Transportation, Science & Research, Unemployment Insurance) Using Fiscal Policy to Correct Macroeconomic Disequilibrium period of recession, AD falls below equilibrium expansionary fiscal policy increasing government spending or decreasing taxes Chapter 10: Fiscal Policy and Debt 1  will increase aggregate demand, shifting AD curve to the right period of inflation, AD exceeds equilibrium government can use contractionary fiscal policy decreasing government spending and increasing taxes will decrease aggregate demand, shifting AD curve to the left Criticisms of Fiscal Policy fiscal policy is difficult to time accurately takes time to implement fiscal policy to correct the problem can crowd out consumption and investment when a government spends money or offers tax cuts by running up government debt, causing interest rates to rise reducing aggregate demand if no political action is taken, economy will eventually correct itself classical theory potential benefits outweigh the potential costs How can government taxation and spending change without any approval? Automatic Stabilizers When a country is in recession, fiscal policy applies expansionary fiscal policy government assistance programs helps without any proactive action by the government Contractionary fiscal policy as incomes rise, amount of income being taxed increases demand for income assistance programs falls Chapter 10: Fiscal Policy and Debt 2  higher tax revenues and smaller government spending Fiscal Policy and Aggregate Demand Discretionary and Mandatory Spending Discretionary spending - part of the budget that works its way through appropriations process of Congress (national defense, transportation, science, environment, income security, education, veterans benefits and services) 25% of budget Mandatory spending - authorized by permanent laws and does not go through the same appropriations process as discretionary spending Congress must change the law Social Security, Medicare, interest on national debt, SNAP, TANF 75% of budget Discretionary Fiscal Policy influences aggregate demand Chapter 10: Fiscal Policy and Debt 3  adjusting government spending and/or tax policies to move economy toward full employing by stimulating economic output/mitigating inflation includes tax cuts, increasing aggregate demand more common form of discretionary fiscal policy involves changes in government spending Government Spending annual federal budget authorized by Congress includes spending for thousands of programs and agencies changes in government spending will cause income and output to rise or fall by change in spending times the multiplier Chapter 10: Fiscal Policy and Debt 4  once economy reaches full employment (a), further spending has little to no impact on aggregate output workers begin to demand higher wages, businesses increase prices Taxes Changes in government spending modify income by an amount equal to the change in spending times the multiplier GDP = C + I + G (X-M) Chapter 10: Fiscal Policy and Debt 5  when economy is at equilibrium, all spending injections into economy must equal ALL withdrawals of spending In equilibrium: I+G+X=S+T+M when taxes are increased, money is withdrawn from economy’s spending stream when taxes are reduced, consumers and businesses have more to spend Disposable income is equal to income minus taxes (Y - T) when new tax is imposed, equilibrium income falls since taxes represent a withdrawal of spending from the economy tax increase would reduce consumption by multiplier tax decrease would increase consumption by multiplier Tax Multiplier: MPC/(1-MPC) Transfers paid directly to individuals (social security, unemployment compensation) represent part of country’s social safety net smaller role in discretionary fiscal policy since required by law Expansionary and Contractionary Fiscal Policy Increases aggregate demand by increasing government spending and/or decreasing taxes highways and education, transfer payments, decreasing federal income taxes more money in hands of consumers and businesses, greater spending Chapter 10: Fiscal Policy and Debt 6  instead of allowing SRAS curve to shift when economy is above its full employment output, government can reduce inflationary pressures by using contractionary fiscal policy reducing government spending reducing transfer payments raising taxes Chapter 10: Fiscal Policy and Debt 7  tradeoffs between increasing output at expense of raising price levels, or else lowering price levels by accepting a lower output demand-side fiscal policy tools (government spending, transfer payments, taxes) may remain unused Checkpoint Fiscal Policy and Aggregate Demand Demand-side fiscal policy involves using government spending, transfer payments, and taxes to influence aggregate demand. The change in aggregate Chapter 10: Fiscal Policy and Debt 8  demand results in changes in equilibrium income, output, and the price level in the economy. In the short run, increasing government spending raises income and output by the amount of spending times the multiplier. Tax reductions have a smaller impact on the economy than increased government spending because some of the reduction in taxes is added to saving and is therefore withdrawn from the economy. Expansionary fiscal policy involves increasing government spending, increasing transfer payments, and/or decreasing taxes. Contractionary fiscal policy involves decreasing government spending, decreasing transfer payments, and/or increasing taxes. When an economy is at full employment, expansionary fiscal policy may lead to greater output in the short term but will ultimately just lead to higher prices in the longer term. Politicians tend to favor expansionary fiscal policy because it can bring increases in employment even at the cost of higher inflation. Politicians tend to steer away from contractionary fiscal policy because it results in unemployment. Fiscal Policy and Aggregate Supply Supply-side fiscal policies require more time to work than do demand-side fiscal policies shift the LRAS curve to the right shift moves the economy’s full employment equilibrium from point a to point b, expanding full-employment output price level falls as output expands Chapter 10: Fiscal Policy and Debt 9  improvements in technology and communicating increase productivity to point that global LRAS shifts outward Fiscal policies aimed at increasing aggregate supply include increased spending on infrastructure, capital, and research and development along with reduction in tax rates Investment in Infrastructure, Capital, and Research and Development roads, bridges, communications networks can lead to more efficient production higher levels of human capital lead to greater productivity Chapter 10: Fiscal Policy and Debt 10  LRAS is enhanced through investment in higher education, etc. Reducing Tax Rates and Regulations Reducing tax rates has an impact on both aggregate demand and aggregate supply Lower individual tax rates increase aggregate demand because households keep more of what they earn more consumption spending lower business taxes encourage entrepreneurs to take risks supply-side fiscal policies - lower tax rates resulted in sharp rise in national debt reducing tax rates could increase tax revenues Laffer curve shows that if tax rate is 0%, tax revenue will be zero because no taxes are collected, if tax rate is 100%, tax revenue will also be zero because no incentive to earn income Chapter 10: Fiscal Policy and Debt 11  repeal regulations that hamper business activity some regulation is certainly needed Checkpoint Fiscal Policy and Aggregate Supply Chapter 10: Fiscal Policy and Debt 12  The goal of fiscal policies that influence aggregate supply is to shift the long- run aggregate supply curve to the right. Expanding long-run aggregate supply can occur through increased investments in infrastructure, research and development, and human capital. Other fiscal policies to increase long-run aggregate supply include providing tax incentives for business investment and reducing burdensome regulations. The Laffer curve suggests that reducing tax rates could lead to higher revenues if tax rates are so high that it disincentivizes work. The major limitation of fiscal policies to influence long-run aggregate supply is that they take a longer time to have an impact compared to polices aimed at influencing aggregate demand. Implementing Fiscal Policy Us Senate, House, and President must collectively agree on specific spending and tax policies Automatic Stabilizers Tax revenues and transfer payments are the two principal automatic stabilizers; without any overt action by Congress or other policymakers, these two components of federal budget expand or contract in ways that help counter movements of the business cycle when economy is steadily growing, tax receipts increase as individuals and firms experience higher taxable incomes transfer payments decline because fewer people require welfare Rising tax revenues and declining transfer payments have contractionary effects When economic expansion ends and economy enters a downturn: tax revenues decline, transfer payments rise Income tax is a powerful: Chapter 10: Fiscal Policy and Debt 13  incomes fall, tax revenues fall faster because people do not just pay taxes on smaller incomes, but also pay tax rates at lower rates disposable income falls more slowly than aggregate income when economy is booming, higher marginal income tax rate results in tax revenues rising faster than income Automatic stabilizers reduce severity of business cycle fluctuations Fiscal Policy Timing Lags most of macroeconomic data is not available until three months after the fact information lag creates a 1-6 month period before informed policymaking can even begin even if most recent data suggest it’s a recession, it may take several quarters to confirm this fact recognition lag is one reason why recessions are well under way before policymakers fully acknowledge a need for action policymakers require a long and often contentious legislative process decision lag - arduous legislative process requires months of planning implementation lag - 18 to 24 months lags can be reduced by expediting spending already approved for existing programs rather than implementing new programs The Government’s Bias Toward Borrowing and Away from Taxation left tend to favor more government spending and transfer payments in times of recessions those on the right tend to favor reductions in taxes Chapter 10: Fiscal Policy and Debt 14  fiscal policy is financed by deficits Public Choice theory - economic analysis of public and political decision- making, voting behavior, election incentives on politicians Checkpoint Implementing Fiscal Policy Automatic stabilizers reduce the intensity of business fluctuations. When the economy is booming, tax revenues automatically rise and unemployment compensation and welfare payments fall, dampening the expansion. When the economy enters a recession, tax revenues automatically fall and transfer payments rise, cushioning the decline. Fiscal policymakers face information lags (the time it takes to collect, process, and provide data on the economy), recognition lags (the time required to recognize trends in the data), decision lags (the time it takes for Congress and the president to decide on a policy), and implementation lags (the time required by Congress to pass a law and see it put in place). Timing lags can often result in government policy being mistimed. For example, expansionary policy taking effect when the economy is well into a recovery or failing to take effect when a recession is under way can make stabilization more difficult. Public choice economists argue that deficit spending reduces the perceived cost of current government operations, and therefore politicians are generally more willing to enact expansionary policies that lead to deficits and a higher public debt. Financing the Federal Government Defining Deficits and the National Debt A deficit occurs when spending exceeds revenue or income Fiscal deficit - amount by which annual government expenditures exceed tax revenues Surplus - revenue or income exceeds spending Chapter 10: Fiscal Policy and Debt 15  Fiscal surplus - amount by which annual tax revenues exceed government spending National debt - total accumulation of past deficits less surpluses over 30 trillion in 2022 held by other agencies of government public debt - federal debt held by the public, portion of national debt held by individuals National debt and public debt are distinct measures of extent to which government spending has exceeded tax revenues over course of time Public debt is held in form of U.S. Treasury securities treasury bills are short-term instruments with a maturity period of a year or les and pay a specific sum at maturity most actively traded securities in US economy Treasury notes are financial instruments issued for periods from 1 to 10 years, treasury bonds have maturity periods exceeding 10 years Chapter 10: Fiscal Policy and Debt 16  interest rates on public debt - 1% and 4% Balanced Budget Amendments politician propose federal balanced budget amendments requiring federal government to balance its budget every year most balanced budget amendments require an annually balanced budget, government must equate its revenues and expenditures every year Alternative to balancing the budget annually would be to require a cyclically balanced budget, in which the budget is balanced over the course of the business cycle Or the functional finance approach to the budget, where governments provide public goods and services that citizens desire and focus on policies that keep the economy growing because growing economies tend not to have significant public debt or deficit issues Financing Debt and Deficits Government deals with debt in two ways: 1) borrow or 2) sell assets Government Budget Constraint: G - T = ∆M + ∆B + ∆A where G = government spending T = Tax revenues (G-T) is federal budget deficit ∆M = change in money supply ∆B = change in bonds held by public entities ∆A = sale of government assets Positive (G-T) value is budget deficit Negative (G-T) value is a budget surplus Chapter 10: Fiscal Policy and Debt 17  ∆M > 0: government can sell bonds to government agencies ∆B > 0: bonds can also be sold to the public ∆A > 0: Sales include auctions of telecommunications spectra and offshore oil leases Checkpoint Financing the Federal Government A deficit is the amount that government spending exceeds tax revenue in a particular year. The public (national) debt is the total accumulation of past deficits less surpluses. Approaches to financing the federal government include annually balancing the budget, balancing the budget over the business cycle, and ignoring the budget deficit and focusing on promoting full employment and stable prices. The federal government’s debt must be financed by selling bonds to the Federal Reserve (“printing money” or “monetizing the debt”), by selling bonds to the public, or by selling government assets. This is known as the government budget constraint. Why is the Public Debt So Important? Chapter 10: Fiscal Policy and Debt 18  US Public debt is over $68,000 per person Is the Size of the Public Debt a Problem? burden of interest rate payments on the debt if taxes were raised to pay down the debt, those who did not own any public debt would be in a worse position than those who did Servicing the debt requires taxing the general public to pay interest to bondholders Most people who own part of national debt tend to be richer than those who do not rising interest rates will raise the burden of this debt Does it Matter if Foreigners Hold a Significant Portion of the Public Debt? Internally held debt - as people, we essentially own this debt Externally held debt - Foreigners own a sizeable portion of the public debt countries are buying our debt to keep their currencies from rising relative to the dollar Chapter 10: Fiscal Policy and Debt 19  when their currencies rise, their exports to America are more costly, sales fall, hurting their economies Does Government Debt Crowd Out Consumption and Investment? government can sell bonds to the public drives up interest rates consumer spending then falls reduces private business investment crowding-out effect of deficit spending; government borrowing crowds out private borrowing can be mitigated if funds from deficit spending are used for public investment How Will the National Debt Affect Our Future? Economists have argued that economic growth depends on the fiscal sustainability of the federal budget to be sustainable, present value of all projected future revenues must be equal to or greater than the present value of projected future spending without some significant change in economic or demographic growth, taxes will have to be increased dramatically at some point, or benefits for Social Security and Medicare will have to be drastically cut Checkpoint Why Is the Public Debt So Important? Interest payments on the debt account for 5% of the federal budget. These funds could have been spent on other programs. About 66% of the public debt held by the public is held by domestic individuals and institutions, and 34% is held by foreigners. The domestic portion is internally held and represents transfers among individuals, but that part held by Chapter 10: Fiscal Policy and Debt 20  foreigners is a real claim on our resources. When the government pays for the deficit by selling bonds, interest rates rise, crowding out some consumption and private investment and reducing economic growth. To the extent that these funds are used for public investment, this effect is mitigated. The rising costs of Social Security and Medicare represent the biggest threat to the long-run federal budget. Either the costs of such programs eventually need to be reduced or additional taxes will be required to cover these rising expenses. Chapter Summary Chapter 10: Fiscal Policy and Debt 21