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Aggregate Demand, Aggregate Supply, Keynesian Theory, Philips Curve

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AP Macro Unit 3 Notes

Study note

Diya Shriyan

United States of America

AP Macroeconomics

National income and price determination

Long-run aggregate supply

What is Aggregate Demand?
• Aggregate: added all together
● 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
•
The demand for everything by everyone in the U.S.
If the price level:
•
Increases (inflation), then the real GDP demanded falls
Decreases (deflation), then the real GDP demanded increases
AD is the demand by consumers, businesses, government and foreign countries.
What definitely doesn't shift the curve?
Changes in price level cause a move along the curve
Screencast-O-Matic.com
Setting up the AD Graph
Price Level (PL)
Why is the AD downward sloping?
1. The Wealth Effect-
AD
Real GDP
a. Higher price levels reduce the purchasing power of money. This decreases
the quantity of expenditures
b. Lower price levels increase purchasing power and increase expenditures c. AKA Real Balance Effect
• If the price levels doubles, people are going to buy less stuff because they
have less purchasing power
• So price level goes up, GDP demanded goes down
2. Interest Rate Effect -
a. When the price level increases, lender need to charge higher interest rates to
get a REAL return on their loans
b. Higher interest rates discourage consumer spending and business
investment
c. Example: An increase in prices leads to an increase in the interest rate from
5 to 25 percent, You are less likely to take out loans to improve your
business.
3. Foreign Trade Effect-
a. When U.S. price level rises, foreign buyers purchase fewer U.S. goods and
Americans buy more foreign goods
b. If prices triple in U.S, Canada will buy less goods from us so the quantity
demanded of U.S> falls
c. If price level goes up, GDP demanded goes down
Shifters of Aggregate Demand
1. Change in Consumer Spending
a. Increase in Disposable income
b. Consumer expectations (people feat recession)
c. Household indebtedness (more consumer debt)
d. Taxes (decrease in income taxes)
e. AN INCREASE IN SPENDING SHIFTS AD TO THE RIGHT
f. A DECREASE IN SPENDING SHIFTS AD TO THE LEFT
2. Changes in Investment Spending
a. Real Interest Rates (price of borrowing)
i. If interest rates increase/decrease
b. Future business expectations (high expectations...)
c. Productivity and technology (new robots...)
d. Business Taxes (Higher corporate taxes means...)
3. Changes in Government Spending
a. Government expenditures
b. Decrease in defense spending c. Increase in public works programs
5
4. Change in Net Exports
a. Exchange rates
b. If the U.S. dollar depreciates relative to the euro
c. National Income Compared to Abroad
d. (If a major importer has a recession)
e. (If the U.S. has a recession)
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.
o Short Run aggregate supply: wages and resource prices WILL NOT
increase as price levels increase
O As the price level increases, the GDP is going to increase
PRESSIVIT
Short-Run Aggregate Supply
P₁ Price
Level
05:45
AS
AS is the
production of all
the firms in the
economy.
YFE
AP Macro PPT 3.2 Recorded Lecture.mp4 47 MB | VIEW
GDPR
21:39) >>
o Long Run aggregate supply: wages and resource prices WILL increase as
price levels increase. In the Long RUN workers demand higher wages to match price
levels. So labor costs could double.
■
If REAL profit doesn't change the firm has no incentive to increase
output
■
If profit was 20 and price level doubles, so now profit becomes 40. It
really only acts like what 20 dollars was
Long-Run Aggregate Supply
In long run, price level increases but GDP doesn't.
LRAS
Price level
Copyright
ACDC Lip 2018
Long-run
Aggregate
Supply
Shifters of Aggregate Supply
1. Change in Resource Prices
a. Prices of Domestic and Imported Resources
i.
GDPR
Increase in price of canadian lumber, decreases in AS
ii. Decrease in price of chinese steel, Increase in AS
b. Supply Shocks
i.
ii.
Negative, decrease in AS
Positive, increase in AS
c. Inflationary Expectations
If producers expect higher prices in the future, workers will demand higher wages and
costs will increase. This will decrease Aggregate Supply.
2. Changes in Actions of the Government (not Government Spending)
a. Taxes on producers i. Lower corporate taxes, Aggregate supply increase
Price
level
b. Subsidies for domestic producers
i. Lower subsidies for domestic farmers, Aggregate supply decrease
c. Government regulations
i. EPA inspections required to operate a farm
1. If less regulations, AS increase
3. Change in Productivity
a. Technology
i.
ii.
Computer virus that destroys half the computers, decrease in AS
The advent of a teleportation machine, increase in AS
Long run
aggregate
supply
Output or
Income
Short run
aggregate
supply
Aggregate
demand
Long-Run Aggregate Supply
• In the Long Run, wages and resources prices WILL increase as price levels
increase
• We assume that in the long-run the economy will be producing at full employment The Long-Run Aggregate Supply (LRAS)
PL
O
P1
Y1
LRAS
AD
What would most likely occur as a result of an increase in labor productivity in an
economy?
→ An increase in output and a decrease in inflation
Stagflation is most likely to be caused by a decrease in aggregate supply
Real GDP (Y)
• If investment increases, what happens in the short run and long run?
It shifts to the right in short run
O The aggregate supply shifts to the right in the long run because of more
productivity and less wages/resource prices
● Increase in investment, increase in AD
o If productivity increases, then AS increases
o If in a new equilibrium, then the LRAS shifts to the right
o ONLY INVESTMENT CAUSES GROWTH SINCE FIRMS INCREASE
THEIR CAPITAL STOCK Classical Theory
1. A change in AD will not change output, even in the short run, because prices of
resources are very flexible.
2. AS is vertical so AD can't increase without causing inflation
3. Price level will fall and economy will fix itself
4. Recessions caused by a fall in AD are temporary
Keynesian Theory
• Keynes said that in times of need, economists should do more than just say that the
economy will fix itself. They should suggest policies that can help the economy.
Like deficit spending.
● A decrease in AD will lead to a persistent recession because prices of resources
are not flexible
• Increase in AD during a recession doesn't cause inflation
• "Sticky Wages" prevents wages from falling. The government should deficit spend
to close the gap
•
When there is high unemployment, an increase in AD doesn't lead to higher prices
until you get close to full employment
Three Ranges of Aggregate Supply
Copyright
ACDC Leden 2018
Price
level
P
Keynesian
Range
AS
Classical
Range
Intermediate SRAS
Range
Q₁
Real domestic output, GDP
13 The Phillips Curve
• Inverse relationship between unemployment and inflation
Short Run Phillips Curve (SRPC)
→ When the economy is overheating, there is low unemployment but high inflation
→ An increase in aggregate demand will cause movement along the short run phillips
curve
12
10-
8
Inflation rate
6.
2
Phillips Curve
6
8
10
12
Unemployment rate
14
Long Run phillips curve
• No tradeoff between inflation and unemployment
• LRPC is vertical at the natural rate of unemployment Inflation
Rate
↑
B
NAIRU or
Long-Run
Phillips Curve
New Short-Run
Phillips Curve
Initial Short-Run
Phillips Curve
Unemployment Rate
The short-run Phillips curve states that when unemployment is low, inflation tends to be
high, and when unemployment is high, inflation tends to be low.
This is because when unemployment is low, employers are in competition for a limited
number of workers, and they will have to offer higher wages to attract and retain
employees.
As wages rise, the cost of goods and services also increases, leading to higher inflation.
Conversely, when unemployment is high, employers have a surplus of workers to choose
from, and they do not have to offer as high wages to attract employees. As wages remain
low, the cost of goods and services also remains low, leading to lower inflation.
It is important to note that the short-run Phillips curve is based on the assumption that
prices and wages are "sticky" in the short run, meaning they do not adjust immediately to
changes in the economy.
This means that changes in unemployment will only affect inflation with a lag.
In the long-run, the Phillips curve is considered to be vertical, meaning that inflation does
not have any impact on unemployment. This is because in the long-run, prices and wages
are able to adjust to changes in the economy, and the relationship between inflation and
unemployment is not as strong. Movements along the SRPC correspond to shifts in aggregate demand,
while shifts of the entire SRPC correspond to shifts of the SRAS
(short-run aggregate supply) curve.
Shifts of the long-run Phillips curve occur if there is a change in the
natural rate of unemployment.
Anything that would shift the SRAS curve to the right, will
shift the SRPC to the left. Anything that would shift the
SRAS curve to the left, will shift the SRPC to the right.
. An increase in AD will cause movement on the left side of the
SRPC
• A decrease in AD will case movement on the right side of the
SRPC
The Role of Consumers in the Economy
• Consumption is the most important part of the economy
• Consumers will spend a certain amount no matter what, regardless of income. This
is called autonomous consumption
o Usually to pay for necessities
• Consumer spending is made up of autonomous spending and disposable income o If incomes are less than autonomous spending, there is dissaving (or
negative savings)
■ Spending more than what is earned
What if the income falls and people stop buying things? Who often steps in?
o Recession, government stabilizes economy
How does the Government Stabilize the Economy?
• Fiscal Policy
a. Actions by Congress to stabilize economy
• Monetary Policy
a. actions by the Federal Reserve Bank to stabilize the economy
Discretionary vs Non-Discretionary
1. Discretionary Fiscal Policy/Spending
a. Congress creates a new bill that is designed to change AD through
government spending or taxation
b. One problem is lag times due to bureaucracy
c. It takes time for Congress to act
i. Ex. In a recession, Congress increases spending
2. Non-Discretionary Fiscal Policy
a. AKA: Automatic Stabilizers
i.
ii.
Permanent spending or taxation laws enacted to work counter
cyclically to stabilize the economy
Ex: Welfare, unemployment, progressive income tax
1. When there is high unemployment, unemployment benefits to
citizens increase consumer spending
3. Contractionary Fiscal Policy (The BRAKE)
a. Laws that reduce inflation, decrease, GDP (close an inflationary Gap)
i.
Decrease consumer spending
ii.
Increase taxes (decrease disposable income)
iii.
Combinations of the two
4. Expansionary Fiscal Policy (The GAS)
a. Laws that reduce unemployment and increase GDP (close recessionary gap)
i.
Increase government spending
ii. Decrease taxes (increase disposable income)
iii.
Combination of the two Spending Multiplier
• 1/MPS
• If multiplier is 4, how much will an initial increase of 5 dollars in government
spending increase the gdp
o 20 dollars
• Total change in GDP = multiplier * change
● As the MPC falls, the multiplier effect reduces
What about Taxing?
• The multiplier effect also applies when the government cuts or increases taxes
• But, changing taxes has less of an impact than government spending. Why?
Expansionary Policy (cutting taxes)
• Assume the MPC is 0.75 so the multiplier is 4
• If the government cuts taxes by $4 million how much will consumer spending
increase?
Not 16 million!!!!!!
• When they get the tax cut, consumers will save 1 million and spend $3 million
. The $3 million is the amount magnified in the economy
•
THE TAX MULTIPLIER IS ALWAYS ONE LESS THAN THE SPENDING
MULTIPLIER
o SO IF SPENDING IS 4 THEN THE TAX IS 3
→ If the government increases expenditures on goods and services and increases
taxation by hte same amount
The aggregate demand increases
Why? Because of the money multiplier effect, the spending will multiply
but the tax will always be one less Non-Discretionary Fiscal Policy
When GDP is down...
o
●
The tax burden on consumers is low, promoting consumption and
increasing aggregate demand
o Unemployment is higher and more benefits will be paid out. This helps
increase aggregate demand
When GDP is up...
O more tax burden on consumers, discouraging consumption and decreasing
aggregate demand
o
• The more progressive the tax system, the greater the economy's stability
Unemployment is low and fewer benefits will be paid out. This decreases
aggregate demand
5 Problems with Fiscal Policy
• When there is a recessionary gap, what two options does Congress have to fix it?
• What is wrong with combining both?
1. Deficit Spending!!!!!
A Budget Deficit is when the government's expenditures exceeds its revenue
• The National Debt is the accumulation of all the budget deficits over time.
● If the government increases spending without increasing taxes they will increase
the annual deficit and the national debt
• MOST economists agree that budget deficits are a necessary evil because forcing a
balanced budget would not allow the Congress to stimulate the economy
2. Problems of Timing
a. Recognition Lag- congress must react to economic indicators before it is to
late
b. Administrative Lag - congress takes time to pass legislation
c. Operational Lag - spending/planning takes time to organize and execute
(changing taxing is quicker)
3. Politically Motivated Policies
a. Politicians may use economically inappropriate policies to get reelected
i.
A senator promises more welfare and public works programs when
there is already an inflationary gap 4. Crowding-Out effect
a. Government spending might cause unintended consequences that weaken
the impact of policy
i. Example: we have a recessionary gap
ii.
Government creates new public library (Aggregate demand
increases)
iii.
iv.
V.
vi.
vii.
viii.
New consumers spend less on books (aggregate demand decreases)
Example 2:
The government increases spending must borrow money (AD
Increases)
This increase price for money (the interest rate)
Interest rates rise so investment decreases
Government crowds out consumers/investors
5. Net Export Effect
a. International trade reduces effectiveness of fiscal policies
b. Example: we have a recessionary gap, so the government spends to increase
AD
c. The increase in aggregate demand increases price level and interest rates
d. U.S. goods are now more expensive and US dollar appreciates
e. Foreign countries buy less (exports fall)
f. Net exports falls, decreasing aggregate demand

AP Macro Unit 3 Notes

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AP Macro Unit 3 Notes

Can't find what you're looking for? Explore other subjects.

Knowunity is the # 1 ranked education app in five European countries

Knowunity was a featured story by Apple and has consistently topped the app store charts within the education category in Germany, Italy, Poland, Switzerland and United Kingdom. Join Knowunity today and help millions of students around the world.

4.9+

13 M

#1

950 K+

Still not sure? Look at what your fellow peers are saying...

I love this app so much [...] I recommend Knowunity to everyone!!! I went from a C to an A with it :D

The application is very simple and well designed. So far I have found what I was looking for :D

Love this App ❤️, I use it basically all the time whenever I'm studying