Macroecon

Aggregate Demand and Aggregate Supply

Depression

  • A prolonged economic downturn marked by high unemployment and low economic output.

Boom

  • A period of rapid economic growth and high employment.

Recession

  • A temporary decline in economic activity, typically defined as two consecutive quarters of negative GDP growth.

Inflation

  • A sustained increase in the overall price level of goods and services in an economy.

Deflation

  • A sustained decrease in the overall price level of goods and services in an economy.

Stagflation

  • A period characterized by stagnant economic growth, high unemployment, and high inflation simultaneously.

Why the Aggregate Demand Curve Slopes Downward

  • The curve slopes downward because of:

    • Wealth effect: Lower price levels increase the purchasing power of money, boosting consumption.

    • Interest rate effect: Lower prices reduce interest rates, encouraging investment.

    • Net export effect: Lower domestic prices make exports more competitive globally, increasing net exports.

Why the Aggregate Supply Curve is Vertical in the Long Run

  • In the long run, output depends on the economy's productive capacity, not price levels.

Why the Aggregate Supply Curve is Upward Sloping in the Short Run

  • In the short run, wages and some prices are sticky, meaning they do not adjust immediately to changes in economic conditions.

Factors that Shift Aggregate Demand (AD)

  • Consumption: Changes in consumer spending due to wealth, taxes, or expectations.

  • Investment: Business spending on capital influenced by interest rates and expectations.

  • Government Spending: Fiscal policies like infrastructure investments or defense spending.

  • Net Exports: Changes in export and import levels based on global economic conditions or exchange rates.

Factors that Shift Short-Run Aggregate Supply (SRAS) and Long-Run Aggregate Supply (LRAS)

  • Physical capital: Availability of machinery and infrastructure.

  • Human capital: Education, skills, and productivity of the labor force.

  • Labor force: Changes in the size or composition of the workforce.

  • Natural resources: Availability of resources like oil, minerals, or land.

  • Technology: Innovations that enhance production efficiency.

Another Factor that Shifts SRAS

  • Expectations of future prices: Higher expected prices reduce supply in the short run as firms withhold production for better returns.

Effects of Shifts in AD and AS

  • Short Run:

    • Increase in AD causes higher output and prices (boom).

    • Decrease in AD causes lower output and prices (recession).

    • Decrease in SRAS causes higher prices and lower output (stagflation).

  • Long Run:

    • Adjustments return the economy to its potential GDP as wages and prices stabilize.

1. Write down the formula for:

  • a. Government spending multiplier:

    Government spending multiplier=11−MPC\text{Government spending multiplier} = \frac{1}{1 - \text{MPC}}Government spending multiplier=1−MPC1​

  • b. Tax multiplier:

    Tax multiplier=Government spending multiplier−1\text{Tax multiplier} = \text{Government spending multiplier} - 1Tax multiplier=Government spending multiplier−1

  • c. Net change in aggregate demand:

    Net change in AD=Total multiplier effect−Total crowding-out effect\text{Net change in AD} = \text{Total multiplier effect} - \text{Total crowding-out effect}Net change in AD=Total multiplier effect−Total crowding-out effect

2. Suppose the marginal propensity to consume for US consumers is 0.8. Suppose government cuts taxes by $10 billion and the crowding-out effect is half as strong as the multiplier effect. By how much will aggregate demand change? By how much will GDP change?

  • Government spending multiplier: Multiplier=11−0.8=5\text{Multiplier} = \frac{1}{1 - 0.8} = 5Multiplier=1−0.81​=5

  • Tax multiplier: Tax multiplier=5−1=4\text{Tax multiplier} = 5 - 1 = 4Tax multiplier=5−1=4

  • Tax cut: Tax cut effect on AD=10 billion×4=40 billion\text{Tax cut effect on AD} = 10 \, \text{billion} \times 4 = 40 \, \text{billion}Tax cut effect on AD=10billion×4=40billion

  • Crowding-out effect:
    If the crowding-out effect is half as strong, it will reduce AD by 20 billion.
    So the net change in AD = $40 billion (multiplier effect) - $20 billion (crowding-out effect) = $20 billion increase.

3. Suppose the economy experiences a mild recession that decreases aggregate demand by $50 billion from full employment GDP. Let the crowding-out effect be $5 billion (for both tax cuts and government spending) and the marginal propensity to consume for US consumers be 0.9.

  • a. How much does government spending have to rise to get the economy out of the recession?

    Multiplier=11−0.9=10\text{Multiplier} = \frac{1}{1 - 0.9} = 10Multiplier=1−0.91​=10

    Required increase in spending to offset $50 billion AD decrease:

    Required increase in spending=50 billion10=5 billion\text{Required increase in spending} = \frac{50 \, \text{billion}}{10} = 5 \, \text{billion}Required increase in spending=1050billion​=5billion

    After the crowding-out effect of $5 billion, the total increase will be enough to close the gap.

  • b. If the government were to reduce personal income taxes instead of increasing spending, how much does taxes have to decrease to get the economy out of the recession?

    Tax multiplier=10−1=9\text{Tax multiplier} = 10 - 1 = 9Tax multiplier=10−1=9

    Required tax cut to offset $50 billion AD decrease:

    Required tax cut=50 billion9=5.56 billion\text{Required tax cut} = \frac{50 \, \text{billion}}{9} = 5.56 \, \text{billion}Required tax cut=950billion​=5.56billion

    After the crowding-out effect of $5 billion, the total tax cut would also close the gap.

  • c. Why are the answers in (a) and (b) different? Taxes have a different multiplier than government spending because the marginal propensity to consume (MPC) reduces the impact of tax cuts compared to direct government spending. Spending directly increases aggregate demand, while tax cuts rely on consumer response, which is less immediate.

4. Using aggregate demand and aggregate supply curves, show and explain why stagflation (i.e. high unemployment and high inflation) may happen.

  • Stagflation can happen when the short-run aggregate supply (SRAS) curve shifts to the left due to factors like rising oil prices or a decrease in productivity. This increases prices (inflation) and decreases output (higher unemployment). The AD curve might not shift, but the SRAS curve will result in an economy experiencing both inflation and higher unemployment.

5. In the 1990s, the U.S. experienced two major phenomena: (1) the internet, (2) a sustained decrease in the cost of commodities used to manufacture goods in the U.S. Use an AD/AS graph to show what happened in the 1990s to prices and GDP in both the short run and the long run. Briefly explain your reasoning.

  • Short-run: The introduction of the internet and lower commodity prices would increase aggregate supply (SRAS), lowering prices and increasing GDP.

  • Long-run: Over time, the economy would adjust, and the long-run aggregate supply (LRAS) would also shift right as technology and lower production costs increase potential GDP.

  • Phillips curve: In the short run, a rightward shift of the SRAS curve would reduce inflation and increase GDP. In the long run, the economy would return to its natural rate of unemployment, with stable prices.

6. Multiple Choice Questions:

  1. When consumer confidence in the economy increases, consumption increases, as shown by:
    Answer: b. shifting aggregate demand to the right.

  2. Aggregate demand would shift to the right if:
    Answer: c. government spending increased.

  3. The long-run aggregate supply curve shifts to the right if:
    Answer: c. there is a new technology.

  4. When we run out of oil at some point in the future, it can primarily shift:
    Answer: b. short run and long run aggregate supply left.

  5. Which of the following would cause “stagflation”?
    Answer: d. short run aggregate supply shifts left.

  6. Suppose the US economy is initially in long-run equilibrium. The European Union, which is a major buyer of American products, starts to experience strong economic growth. As a result, in the long run, US prices:
    Answer: c. are higher and US real GDP is at the long run equilibrium.

  7. Suppose the economy is in long-run equilibrium. A new study from Indiana University found that although some immigrants take up jobs from local workers, the net effect of immigration on employment is “positive”, i.e. more immigrants create new jobs or perform jobs that local workers do not want to do. This finding suggests that as a result of immigration, in the long run:
    Answer: a. prices will decrease and real GDP will increase.

  8. When the interest rate increases:
    Answer: b. the quantity of money demanded decreases and investment decreases.

  9. Which of the following options includes only “expansionary” fiscal and monetary policies?
    Answer: b. decrease in interest rate and increase in government spending.

  10. If the “Marginal Propensity to Consume” (MPC) is 0.80 and the crowding-out effect is $10 billion, an initial increase in government spending of $10 billion will eventually shift the AD curve to the right by:
    Answer: b. $40 billion.