Chapter 10 WORKING WITH THE BASIC AGGREGATE SUPPLY AGGREGATE DEMAND MODELS Anticipated Changes occur Shifters of Aggregate Demand Unanticipated Changes changes that are not foreseen changes foreseen by individuals giving them time to adjust before the changes Increase in real wealth shifts AD to the right Decrease in real wealth shifts AD to the left Changes in real wealth income stocks bonds etc Changes in the real interest rate the interest rate is inversely related to how much households consume and how much businesses invest r C I AD Interest rate falls and shifts AD curve right Interest rate rises and shifts AD curve left r C I AD Changes in the expectations of businesses and households about the future Optimism shift AD curve right Pessimism shift AD curve left Measured by the consumer sentiment index Expected Inflation AD Expected Inflation AD Changes in the expected rate of inflation Changes in income abroad Foreign income AD Foreign income AD Changes in exchange rates Dollar depreciates AD Dollar appreciates AD Permanent Changes 3 Shifters of LRAS SRAS Change in resource base Change in the level of technology Resource base LRAS Resource base LRAS If foreigners have more money they have more money to spend on American goods and services If the dollar can buy less euros then the euro can buy more dollars so foreigners will want more American goods because they re cheaper American goods are now more expensive relative to foreign goods shift both the LRAS and SRAS curves Technology LRAS Technology LRAS Changes in rules laws Positive changes LRAS Negative changes LRAS Temporary Changes 3 Shifter of SRAS only shift only the SRAS curve Resource prices SRAS Resource prices SRAS Change in resource prices Change in the expected rate of inflation Supply shocks all the other stuff an unexpected event that temporarily affects aggregate supply Expected inflation SRAS Expected inflation SRAS Producers want to sell their goods when they ll receive the most money Positive SRAS Negative SRAS Unanticipated fall in AD Unanticipated fall in SRAS average output produced per worker during a specific time period Productivity 2 Causes for Recession 2 Causes for Expansion 3 Facts that Imply that the Economy Can Correct Itself Without Government Intervention Unanticipated rise in AD Unanticipated rise in SRAS Consumption demand is relatively stable Permanent Income Hypothesis permanent income rather than their current income People will Save during expansion with spending increasing only slightly Spend their savings during recession with spending decreasing only slightly peoples consumption depends on their long run expected Changes in real interest rates stabilize aggregate demand and redirect economic fluctuations Recession less investment low interest rates higher consumption and investment offsets recession Expansion more investment high interest rates lower consumption and investment offsets expansion Changes in real resource prices will help redirect economic fluctuations Recession low demand resource prices SRAS to w SRAS Expansion high demand resource prices SRAS to w SRAS How quickly the economy corrects itself however is up for debate Chapter 11 FISCAL POLICY KEYNESIAN VIEW AND HISTORICAL PERSPECTIVE believe that market and resource prices are inflexible and therefore the believes that market and resource prices are flexible and allow the economy to supply creates demand production is what matters Say s Law People respond to economic calculation AKA incentives matter F A Hayek kind of anti government due to his experiences in WWI The debate on how quickly the economy corrects itself really started with the Great Depression Classical Economics self correct fairly quickly Keynesian Economics market will not be able to quickly correct itself Demand creates supply it s all about spending People respond to animal spirits John Maynard Keynes well liked extremely smart would openly insult politicians to their face Bloomsberry group that had orgy parties openly homosexual married a Russian ballerina woman Reason for sticky wages and prices Menu costs the costs of changing prices Trade unions and large corporations enter into long term contracts stabilizing wages As a result of sticky prices businesses produce the amount demanded MPC the amount of additional income that is consumed Marginal Propensity to Consume MPC additional consumption additional income The Expenditure Multiplier the initial change M EM a change in the expenditures will have a greater impact than EM 1 1 MPC For the multiplier to be effective it must come from resources that otherwise would have been unemployed Budget Deficits and Surpluses government revenues taxes is equal to government expenditures government revenue is greater than government revenues government spending is greater than government revenues T G T G G T Balanced Budget Budget Deficit Budget Surplus Changes in the size of the deficit or surplus can have 2 main sources Recession T G Budget Deficit Expansion T G Budget Surplus A reflection of the state of the economy Discretionary Fiscal Policy expenditures designed to affect the budget deficit or surplus deliberate changes in tax policy and or government Keynesian View of Fiscal Policy increasing government expenditures and or 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 Expansionary Fiscal Policy Restrictive Fiscal Policy Designed to bring the economy down from an expansion by decreasing aggregate demand Restrictive policy will reduce the size of the budget deficit by running a budget surplus Keynesians believed in the use of counter cyclical policy rather than balancing the budget decreasing government expenditures and or raising tax rates a policy that moves the economy in the opposite direction from the Counter cyclical Policy forces of the business cycle Recession Expansionary policy Expansion Restrictive policy Timing Problems of Fiscal Policy According to Keynesian view if policy makers thought that the economy was about to fall into a recession a planned increase in the budget deficit would be appropriate Effectiveness of the fiscal policy is reduced by the following timing problems Recognition Lag our ability to forecast is extremely limited Administrative Lag change in fiscal policy requires legislative action which takes a long time Impact Lag a change in fiscal policy will not
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