AP Economics Mod 16-21

Fiscal policy

Actions by Congress and by the President through taxation and government spending

Monetary Policy

Actions by the Federal Reserve Bank through decreasing interest rates and federal reserve rates

Expansionary Fiscal Policy

Laws that reduce unemployment and increase GDP by increasing government spending and/or decreasing taxes on consumers

contractionary fiscal policy

Laws that reduce inflation and decrease GDP by decreasing government spending and/or enacting tax increases

direct fiscal policy

changes in government spending of final goods

indirect fiscal policy

a change in taxes and transfers to households

Monetary Policy Changes to AD curve

1. Federal Reserve Bank's changes in the quantity of money or interest rates will shift the curve

2. Increasing the quantity of money shifts the AD curve to the right

3. Reducing the quantity of money supply will shift AD curve to the left.

Discretionary fiscal policy

Congress creates a law designed to change AD through govn't spending or taxation but time lags due to bureaucracy

Non-Discretionary Fiscal Policy

automatic stabilizers; permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy

Marginal Propensity to Consume (MPC)

the increase in consumer spending when disposable income rises by $1

= Change in consumer spending/Change in income

Marginal Propensity to Save (MPS)

the increase in household savings when disposable income rises by $1

=Change in savings/Change in income

The multiplier

the ratio of the total change in real GDP caused by an autonomous change in aggregate spending

The higher the MPC the higher the multiplier (the more money spent, the greater impact the multiplier will have).

autonomous change in aggregate spending

an initial rise or fall in aggregate spending that is the cause, not the result, of a series of income and spending changes

Change in GDP formula

multiplier x initial change in spending

Multiplier formula

1/MPS or 1/1-MPC

Consumption function

the relationship between consumption spending and disposable income

=a+MPCxYd a= autonomous spending Yd= disposable income

2 factors that change Aggregate Consumption Function

1. Changes in expected future disposable income: permanent income hypothesis (Milton Friedman, "Theory of the Consumption Function")

2. Changes in aggregate wealth: life-cycle hypothesis

Shifters of Aggregate Demand

1. Consumer Spending

2. Investment Spending

3. Government Spending

4. Net Exports (Exports - Imports)

AD=C+I+G+X

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.

2. Change in Resource Prices: Supply shocks

3. Change in Actions of the government (NOT spending): taxes, subsidies, regulations

4. Change in Productivity

AS= I+R+A+P

Supply shock

An unexpected event that causes the short-run aggregate supply curve to shift

Recessionary Gaps, Inflationary Gaps or Stagflation

Shocks cause a shift in the aggregate demand or supply and can lead to this

Recessionary Gap

when aggregate output is below potential output

Inflationary Gap

when aggregate output is above potential output

Accounts for 2/3 of our GDP

consumer spending

Investment spending

spending on new productive physical capital, such as machinery and structures, and on changes in inventories.

Not as large as a piece of the GDP as consumer spending

Rising inventories typically indicates a slowing economy and vice-versa

Planned investment spending

Depends on three factors:

1. interest rates

2. Expected future GDP

3. Current level of production capacity

Relationship between price level and Real GDP

inverse

If price level increases (inflation) then real GDP demanded falls

If price level decreases (deflation) then real GDP demanded increases

Law of Demand

Higher prices = less demand

Explain why demand is downward sloping

Lower prices = greater quantity demanded

Identity a difference between a change in demand and a change in the quantity demanded

Shift in curve= change in demand

movement along the curve (prices)= change in quantity demanded

Define the law of supply

price and quantity supply have a direct relationship

Why is supply upward sloping?

At higher prices, profit seeking firms have an incentive to produce more

higher prices=greater quantity supplied

What does it mean if there is a perfectly inelastic supply curve

Occurs when quantity is not affected by change in price

3 reasons why the aggregate demand curve slopes downward

1. Wealth effect

2. Interest-Rate Effect

3. Foreign Trade Effect

Wealth Effect

The tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls.

Higher prices decreases purchasing power of money and decreases quantity of expenditures and vice-versa

Interest Rate Effect

As price levels 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. foods and Americans buy more foreign goods.

Short Run Aggregate Supply

Wages and resources prices will NOT increase as price levels increase.

Long Run Aggregate Supply

wages and resource prices will increase as price levels increase

Output Gap

the % difference between actual aggregate output and potential output

(Actual Aggregate output-potential output)/potential output

The most important factor affecting a household's consumer spending is:

expected future disposable income

The modern tools of macroeconomic policy

Fiscal and discretionary policy