2 Changes in the real interest rate The interest rate is inversely related to how much households consume ECO2013 Study Guide Chapter 10 Working with Our Basic Aggregate Demand and Aggregate Supply Model Anticipated changes changes foreseen by individuals giving them time to adjust before the changes occur Unanticipated changes changes that are not foreseen Shifters of Aggregate Demand 1 Changes in Real Wealth Increase in real wealth shifts AD curve right a b Decrease in real wealth shifts AD curve left and businesses invest a b Interest rate falls shifts AD curve right Interest rate rises shifts AD curve left a Optimism Shift AD curve right b Pessimism Shift AD curve left c Measured by the Consumer Sentiment Index 4 Changes in the expected rate of inflation 3 Changes in the expectations of businesses and households about the future a expect inflation to increase spend more now AD curve shifts right b expect inflation to decrease spend less now AD curve shifts left 5 Changes in income abroad a Foreign income increases aggregate demand shifts right b Foreign income decreases aggregate demand shifts left 6 Changes in exchange rates a Dollar depreciates AD curve shifts right b Dollar appreciates AD curve shifts left Shifts in Aggregate Supply Permanent changes will shift both LRAS and SRAS curves temporary changes shift only SRAS curve 3 things that will shift both LRAS and SRAS 1 Change in resource base 2 Change in level of technology 3 Change in institutional arrangements that affect productivity Temporary Changes 3 things that will shift SRAS only 1 Changes in resource prices 2 Changes in the expected rate of inflation 3 Supply shocks Productivity average output produced per worker during a specific time period Supply shock an unexpected event that temporarily affects aggregate supply Chapter 11 Fiscal Policy The Keynesian View and Historical Perspective Classical Economics believes that market and resource prices are flexible and allow the economy to self correct fairly quickly Keynesian Economics believe that market and resource prices are inflexible and therefore the market will not be able to quickly correct itself o Reason for sticky wages and prices 1 Trade unions and large corporations enter into long term contracts 2 Menu costs The costs of changing prices o Planned Aggregate Expenditure PAE PAE CP IP GP NXP o Output Y Y C I G NX o Keynesian equilibrium Y PAE firms correctly anticipate actual sales Example Actual vs Planned Investment o Investment fixed inv inventory inv o The difference between actual and planned investment occurs in inventory investment 1 Actual Investment I Fixed Inv production actual sales 2 Planned Investment Ip Fixed Inv production planned sales Keynesian Cross graph o Equilibrium occurs where PAE line crosses the 45 degree line does not indicate full employment o Reason why the economy does not self correct This is why there is government intervention Marginal Propensity to Consume MPC the amount of additional income that is consumed o additional consumption additional income The Expenditure Multiplier M A change in expenditures will have a greater impact than the initial change o M 1 1 MPC o T G Balanced budget government revenues taxes is equal to government expenditures Budget deficit government spending is greater than government revenues Budget surplus government revenue is greater than government spending o T G o T G Changes in the size of the deficit or surplus can have two main sources 1 A reflection of the state of the economy 2 Discretionary Fiscal Policy Fiscal Policy Deliberate changes in tax policy and or government expenditures designed to affect the budget deficit or surplus o Keynesian View of Fiscal Policy 1 Expansionary Fiscal Policy Increasing government expenditures and or 1 2 Reducing tax rates Designed to bring the economy out of a recession by increasing aggregate demand Expansionary policy will increase the size of the budget deficit 2 Restrictive Fiscal Policy 1 Decreasing government expenditures and or 2 Raising tax rates Designed to bring the economy down from an expansion by decreasing aggregate demand Restrictive policy will reduce the size of the budget deficit Fiscal policy Expansionary policy Restrictive policy Government spending Increase government spending Decrease government spending Taxes Lower taxes Raise taxes Effect on AD Shifts AD right Shifts AD left Counter cyclical policy a policy that moves the economy in the opposite direction from the forces of the business cycle recession expansionary policy expansion restrictive policy Problems of Fiscal Policy o Effectiveness of fiscal policy is reduced by the following timing problems 1 Our ability to forecast is extremely limited 2 Change in fiscal policy requires legislative action which takes a long time 3 A change in fiscal policy will not have an immediate impact on the economy o If timed incorrectly fiscal policy will increase rather than reduce economic instability Automatic Stabilizers Built in features that automatically promotes a budget deficit during a recession and a budget surplus during an expansion even without a change in policy 1 Unemployment compensation recession G T 2 The corporate profit tax recession T 3 The progressive income tax recession T Chapter 12 Fiscal Policy Incentives and Secondary Effects Keynesian Economist expansionary fiscal policy during a recession will stimulate Aggregate Demand AD and pull us out of a recession Classical Economist possibly but maybe not Crowding out a reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing The crowding out process 1 Government conducts expansionary fiscal policy to bring economy out of a recession 2 This increases the budget deficit which must be financed through borrowing 3 Government borrowing increases the demand for loanable funds and thus the interest rate 4 Increase in interest rate causes consumption and investment to decrease It also causes capital inflow to increase 5 This causes the dollar to appreciate which causes net exports to decline fiscal policy fails to bring economy out of a recession New Classical Economists do not believe that budget deficits will stimulate additional consumption and aggregate demand because people will save for the expected future tax increase o Ricardian equivalence belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people
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