Aggregate Demand, Fiscal Policy, and Economic Impact

Downward Sloping Aggregate Demand Curve

• The aggregate demand curve slopes downwards due to two primary effects:
  • Wealth Effect: When prices decrease, consumers feel wealthier and are likely to spend more due to lower prices.
  • Interest Rate Effect: Lower price levels lead to lower interest rates, making borrowing cheaper for firms and individuals, thus encouraging investment and spending.

Importance of Effects

• Interest Rate Effect vs Wealth Effect:
  • Interest rate effect is more significant particularly during a focus on investments, which constitutes 17-18% of GDP.
  • Lower interest rates facilitate borrowing for capital investments, thus boosting aggregate demand.

Government and Federal Reserve (Fed) Influence

• Government policies, such as changes in taxes, can shift the aggregate demand curve:
  • Reducing taxes increases consumers' disposable income, shifting aggregate demand rightward.
  • Moreover, changes in trade policies can also affect aggregate demand.
• The Fed influences aggregate demand by adjusting interest rates:
  • Lowering interest rates allows consumers and firms to borrow more, further increasing aggregate demand.

Long-Run vs Short-Run Aggregate Supply

• Potential GDP vs Real GDP:
  • Actual GDP deviations from potential GDP indicate economic conditions such as recession, leading to changes in aggregate demand.
• Governments or the Fed may intervene to counteract drops in output or employment.

Fiscal Policy

• Fiscal policy involves government spending and taxation decisions made by policymakers:
  • Example: Biden administration's infrastructure investments increase aggregate demand.
  • When firms, like Boeing, receive government contracts, they may need to hire more workers, thus impacting other sectors and the overall economy.

Multiplier Effect

• Refers to the amplification of economic activity due to increased government spending:
  • Initial government expenditures lead to higher income for workers, which results in further consumption (e.g., a new airplane requires materials, resulting in additional jobs).
  • Income generated stimulates further spending, leading to a chain reaction of economic activity.

Crowding Out Effect

• This occurs when government spending raises demand for resources, leading to higher prices or interest rates, which can dampen private investment.
• A notable balance exists between the multiplier effect and crowding out, where conclusions depend on the phase of the economic cycle (expansion vs recession).

Propensity to Consume

• The Marginal Propensity to Consume (MPC) affects the strength of the multiplier effect:
  • Higher MPC means that households will spend more of their additional income, leading to greater shifts in aggregate demand.
• Formula for calculating the total change in output includes determining the multiplier effect:
  • Multiplier = \frac{1}{1 - MPC}

Examples of Government Spending Impact

• A practical example showing how government spending multiplies:
  • If the government spends 20,000,000 and the MPC is 75%, it leads to initial additional consumption of 15,000,000. This triggers further consumption effects.
  • Cumulative effects can result in total economic activity much greater than the original spending (e.g., 80,000,000,000 total impact from initial spending).

Economic Policies During Recession vs Expansion

• During recessions, increasing government spending is recommended for boosting the economy (Keynesian view).
• Policymakers must balance inflation concerns when stimulating growth, particularly evident when evaluating trade-offs related to the Phillips curve, linking inflation and unemployment—high inflation corresponds with low unemployment and vice versa.

Challenges in Economic Predictions

• Historical economic data interpretation often faces issues of accuracy due to methodological limits of the time.
• Example: Miscalculations in nutrient content (like iron in spinach) demonstrate risks of drawing conclusions from flawed early data.

Future Implications

• Ongoing discussions on government intervention can lead to inflation increases, challenging policymakers who must decide between prioritizing employment or controlling inflation.

Conclusion

• Understanding the dynamics of fiscal and monetary policies is crucial to addressing the economy's challenges during shifting economic cycles (i.e., recession, expansion). Understanding concepts like the multiplier effect and crowding out can guide better policy decisions for sustained economic growth.