AP Macro Unit 3

Aggregate Demand

Aggregate Demand

all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels

Aggregate Demand Curve

→ the demand by consumers, businesses, government, and foreign countries → downward slope → x-axis: real domestic output, y-axis: price level

Wealth Effect

→ higher price levels reduce the purchasing power of money; this decreases the quantity of expenditures → lower price levels increase the purchasing power and increase expenditures → Real Balance Effect

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

Foreign Trade Effect

→ when U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods → exports fall and imports rise causing real GDP demanded to fall

Shifters of Aggregate Demand

( 1 ) Change in Consumer Spending ( 2 ) Change in Investment Spending ( 3 ) Change in Government Spending ( 4 ) Change in Net Exports (X - M)

Change in Consumer Spending

→ increase in disposable income → consumer expectations → household indebtedness → taxes

Change in Investment Spending

→ real interest rates (price of borrowing money) → future business expectations → business taxes

Change in Government Spending

→ government expenditures

Change in Net Exports

→ exchange rates → national income compared to abroad

Marginal Propensity to Consume (MPC)

how much people consume rather than save when there is a change in disposable income (always expressed as a decimal)

MPC = Change in Consumption / Change in Disposable Income

Marginal Propensity to Save (MPS)

how much people save rather than consume when there is a change in disposable income (always expressed as a decimal)

MPS = Change in Save / Change in Disposable Income

Calculating the MPS

1 / MPS or 1 / 1 -- MPC

Total Change in GDP

Total Change in GDP = Multiplier * Initial Change in Spending

Calculating the Tax Multiplier

MPC / MPS The Tax Multiplier is always one less than the Spending Multiplier

MPS = 1 -- MPC

people can either save or consume

Total Change in GDP (w/Tax Multiplier)

Total Change in GDP = Tax Multiplier * Initial Change in Taxes

Aggregate Supply

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

Short-run Aggregate Supply (SRAS)

wages and resource prices are sticky and WILL NOT change as price levels change

Long-run Aggregate Supply (LRAS)

wages and resource prices are flexible and WILL change as price levels change

Shifters of Short-run Aggregate Supply

( 1 ) Change in Resource Prices ( 2 ) Change in Actions of the Government (NOT Government Spending) ( 3 ) Change in Productivity

Shifter of SRAS: Change in Resource Prices

→ price of domestic and imported resources → supply shocks → inflationary expectations

Supply Shock

an unexpected event that suddenly changes the supply of a commodity resulting in an unforeseen change in price → negative supply shock: low supply, high price → positive supply shock: increased supply, low price

Shifter of SRAS: Change in Actions of the Government

→ taxes on producers → subsidies for domestic producers → government regulations

Shifter of SRAS: Change in Productivity

→ technology

Shifters of Long-run Aggregate Supply

( 1 ) Change in Resource Quantity or Quality ( 2 ) Change in Technology ( 3 ) Change in Population (SAME SHIFTERS AS THE PPC!!!!)

Difference Between SRAS and LRAS

SRAS → in the short run, wages and resource prices are sticky and WILL NOT change when price level changes

LRAS → in the long run, wages and resource prices are flexible and WILL change when price level changes

AD/AS Equilibrium: Full Employment

Long Run Equilibrium the economy is at potential output

AD/AS Equilibrium: Inflationary Gap

ABOVE or BEYOND full employment, positive output gap

AD/AS Equilibrium: Recessionary Gap

BELOW or LESS THAN full employment, negative output gap

Stagflation

stagnant economy + inflation SRAS decreases, causing high unemployment and high inflation

Disposable Income

the amount of money households have to save or spend after taxes

(Supply) Cost-Push Inflation

(SRAS decrease) → tighter production costs increase prices → a negative supply shock increases the costs of production and forces producers to increase prices

(Demand) Demand-Pull Inflation

(AD increase) → demand pulls up prices: consumers want goods and services so bad they pull up prices → "too many dollars chasing too few goods"

Role of Consumers in the Economy

→ consumers will spend a certain amount no matter what, regardless of their income (this is usually called autonomous consumption) → consumer spending is made up of autonomous spending and disposable income → if incomes are less than autonomous spending, then there is dissaving (or negative savings)

How Does the Government Stabilize the Economy?

( 1 ) Fiscal Policy → actions by Congress to stabilize the economy ( 2 ) Monetary Policy → actions by the Federal Reserve Bank to stabilize the economy

Discretionary Fiscal Policy

Congress creates a new bill that is designed to change AD through government spending or taxation → one problem is lag times due to bureaucracy → it takes time for Congress to act → EX.) in a recession, Congress increases spending

Non-Discretionary Fiscal Policy

(AKA: Automatic Stabilizers) 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 → EX.) Welfare, Unemployment, Income Tax

Contraction Fiscal Policy (The BRAKE)

Laws that reduce inflation, decrease GDP (close an Inflationary Gap) → decrease government spending → increase taxes (decrease disposable income) → combinations of the two

Expansionary Fiscal Policy (The GAS)

Laws that reduce unemployment and increase GDP (close recessionary gap) → increase government spending → decrease taxes (increasing disposable income) → combinations of the two

Timing and Fiscal Policy

Fiscal Policy has three time lags: ( 1 ) Recognition Lag → Congress must react to economic indicators before it's too late ( 2 ) Administrative Lag → Congress takes time to pass legislation ( 3 ) Operational Lag → spending/planning takes time to organize and execute (changing taxing is quicker)

The Multiplier Effect

the idea that an initial change in spending will set off a spending chain that is magnified in the economy; the strength of the multiplier depends on the amount that consumers spend of new income

Autonomous Consumption

the minimum amount of consumer spending when people have no income

LRAS Self-Adjustment: Positive Output Gap

SRAS will shift left due to an increase in expected inflation, which causes wages to increase

LRAS Self-Adjustment: Negative Output Gap

SRAS will shift to the right due to a decrease in wages and resource prices, which causes production costs to fall

Automatic Stabilizers

policies that are already in place in an economy due to previously passed legislation