ECON Midterm 3

Aggregate demand - Aggregate supply model (AD - AS model) is the model used to study

business cycle.

* The model is used to explain the fluctuation of the economy around the potential GDP.

* The model is also used to explain the effects of macro policies responses.

*

The

AD-AD

model

has

three

components:

aggregate

demand;

aggregate

supply;

and

macroeconomic equilibrium.

In which, aggregate demand is the total demand for final goods and services in an economy.

GDP = C + I + G + NX

(C: household consumption; I: Investment; G: Government spending; NX: Net exports)

* Why does the AD curve slope downward?

The AD curve is downward sloping - show the negative relationship between the quantity of

GDP demanded and the price level.

* There are three reasons for the negative relationship between the quantity of aggregate demand

and the price level: wealth effect; interest rate effect; international trade effect

.

+ Wealth effect: The wealth effect is the change in the quantity of aggregate demand that results

from wealth changes due to price-level changes. Given a constant wealth level, when price goes

up, people feel poorer and can buy fewer goods/ services. (C reduces => AD reduces)

+ Interest rate effect: The interest rate effect occurs when a change in the price level leads to a

change in interest rates and, therefore in the quantity of aggregate demand.

When the price goes up, people consume less and save less. Savings are reduced in the financial

market, and interest rates increase. Firm feels relatively more expensive to borrow money =>

Firm has less incentive to invest. (I reduces => AD reduces)

+ International trade effect: The international trade effect occurs when a change in the price level

leads to a change in the quantity of next exports demanded. When price level increases, U.S.

products are relatively expensive than the other countries’ products in the foreign market => X

reduces => NX reduces => AD reduces).

Shifting and movement of AD:

*Change in the price causes movement along the aggregate demand curve.

* Changes in other factors different from the price cause the shifting aggregate demand.

+ Factors shift in consumption: individual wealth; expected future income; taxes

+ Factors shift in investment: business firm confidence; interest rates; quantity of money

ange rate

*Aggregate supply: the total supply of final goods and services in an economy.

Differentiate between long-run aggregate supply and short-run aggregate supply.

* In long-run, aggregate supply is the vertical line. LRAS depends on resources, technology, and

institutions. The economy moves towards full-employment output and a natural unemployment

rate. Price level does not affect the long-run output.

* In short-run, there is negative relationship between price level and aggregate supply. Other

things remain the same, the higher price level, the greater is the quantity of real GDP supplied,

and vice versa.

* There are three reasons why the short-run AS curve slope upward:

+ Inflexible input prices: In the short-run, input prices are sticky, often set by the written

contracts, such as interest rates, workers’ wage. In the short run, some input costs are the same.

When the price of products increases, the firms increase output. Then, GDP increases.

Menu costs: In the short-run, when the price increases, but because of menu costs, the firms

decide not to adjust their prices. The customers buy more, and the output increases in response to

price increases.

+ Money illusion: Suppose output prices are falling, but workers are reluctant to accept nominal

pay decreases; they reinforce the stickiness of input prices. If input prices don’t fall with output

prices, firms reduce output in response to general price level changes.

* Two main factors shift in short-run aggregate supply: costs of production and supply shock.

* Adjustments in aggregate demand, short-run aggregate supply, and long-run aggregate supply

influence the output level, unemployment rate, and price level.

(Please goes detail in the lecture)

Exercises:

Apply AD-AS to explain the change in AD, short-run AS, long-run AS to the output,

unemployment rate, and price level.

Ch.16: Fiscal Policy

* Fiscal policy involves the use of the government’s budget tools - government spending and

taxes to influence the macroeconomy.

The majority of the budget (i.e., 60% of all federal spending) goes for healthcare, social security,

interest payments, and national defense. The remaining 40% of the budget covers all other

categories, such as education, transportation, national resources and agriculture, science and

medical research, and law enforcement.

The government’s taxation are from individual income tax, social insurance (payroll) tax,

corporate income tax, excise tax, and others.

* Expansionary fiscal policy occurs when the government increases spending or decreases taxes

to stimulate the economy toward expansion.

* Contractionary fiscal policy occurs when the government decreases spending or increases taxes

to slow economic expansion.

*Countercyclical fiscal policy is fiscal policy that seeks to counteract business cycle fluctuations.

In particular, using expansionary policy during economic downturns and using contractionary

policy during economic expansion.

Marginal

propensity

to

consume

(MPC)

is

the

portion

of

additional

income

spent

on

consumption.

0 ≤

𝑀𝑃𝐶

≤

1

* Spending multiplier indicates the total impact on spending from an initial change of a given

amount

𝑚

𝑠

=

1

(1− 𝑀𝑃𝐶)

* Three shortcomings of fiscal policy are time lag, crowding-out, and saving shifts.

+ Time lag could be from recognition lag, implementation lag, impact lag.

+ Crowding-out: occurs when private spending falls in response to increase in government

spending.

+ Saving shift happens when increases in government spending and decreases in taxes are largely

offset by increases in savings.

*

Supply-side

fiscal

policy

involves

using

government

spending

and

taxes to affect the

economy’s production (supply) side.