ECO2013 Study Guide-Chapter 10: Working with Our Basic Aggregate Demand and Aggregate Supply ModelAnticipated changes: changes foreseen by individuals, giving them time to adjust before the changes occurUnanticipated changes: changes that are not foreseenShifters of Aggregate Demand:1. Changes in Real Wealtha. Increase in real wealth: shifts AD curve rightb. Decrease in real wealth: shifts AD curve left2. Changes in the real interest rate: The interest rate is inversely related to how much households consume and businesses investa. Interest rate falls: shifts AD curve rightb. Interest rate rises: shifts AD curve left3. Changes in the expectations of businesses and households about the futurea. Optimism: Shift AD curve rightb. Pessimism: Shift AD curve leftc. Measured by the Consumer Sentiment Index4. Changes in the expected rate of inflationa. 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 abroada. Foreign income increases: aggregate demand shifts rightb. Foreign income decreases: aggregate demand shifts left6. Changes in exchange ratesa. Dollar depreciates: AD curve shifts rightb. Dollar appreciates: AD curve shifts leftShifts in Aggregate Supply:-Permanent changes will shift both LRAS and SRAS curves, temporary changes shift only SRAS curve3 things that will shift both LRAS and SRAS:1. Change in resource base 2. Change in level of technology3. Change in institutional arrangements that affect productivityTemporary Changes:3 things that will shift SRAS only1. Changes in resource prices2. Changes in the expected rate of inflation3. Supply shocksProductivity: average output produced per worker during a specific time periodSupply shock: an unexpected event that temporarily affects aggregate supplyChapter 11: Fiscal Policy: The Keynesian View and Historical PerspectiveClassical Economics: believes that market and resource prices are flexible and allow the economy to self-correct fairly quicklyKeynesian 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 + NXPo Output (Y) Y = C + I + G + NXo Keynesian equilibrium: Y = PAE (firms correctly anticipate actual sales)Example: Actual vs. Planned Investmento Investment = fixed inv. + inventory inv.o The difference between actual and planned investment occurs in inventory investment1. 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 employmento Reason why the economy does not self-correct This is why there is government interventionMarginal Propensity to Consume (MPC): the amount of additional income that is consumedo additional consumption / additional incomeThe Expenditure Multiplier (M): A change in expenditures will have a greater impact than the initial changeo M = 1 / 1- MPCBalanced budget: government revenues (taxes) is equal to government expenditureso T = GBudget deficit: government spending is greater than government revenueso T < GBudget surplus: government revenue is greater than government spending o T > GChanges in the size of the deficit or surplus can have two main sources:1. A reflection of the state of the economy2. Discretionary Fiscal PolicyFiscal Policy: Deliberate changes in tax policy and/or government expenditures designed to affect the budget deficit or surpluso Keynesian View of Fiscal Policy:1. Expansionary Fiscal Policy:1. Increasing government expenditures and/or2. 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/or2. 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 policyGovernment spendingIncrease governmentspendingDecrease governmentspendingTaxes Lower taxes Raise taxesEffect on AD Shifts AD right Shifts AD leftCounter-cyclical policy: a policy that moves the economy in the opposite direction from the forces of the business cycle. recession: expansionary policy expansion: restrictive policyProblems of Fiscal Policy:o Effectiveness of fiscal policy is reduced by the following timing problems:1. Our ability to forecast is extremely limited2. Change in fiscal policy requires legislative action, which takes a long time3. A change in fiscal policy will not have an immediate impact on the economyo 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 budgetsurplus 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 EffectsKeynesian Economist: expansionary fiscal policy during a recession will stimulate Aggregate Demand (AD) and pull us out of a recessionClassical Economist: possibly, but maybe not….Crowding-out: a reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowingThe 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
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