AD-ASFiscal Policy

Analyzing the National Economy

Why model the economy?

To understand causes of business cycles and possible

resolutions or fixes.

On one graph put inflation, unemployment, GDP, and

economic growth

Aggregate DemandNegative Slope: As Price Level goes up:Real Balance Effect Feel PoorerInterest Rate Effect Need to borrow more consumption borrowing, i rates, Investment borrowingOpen Economy Effect Go to exports

Aggregate DemandShifters:Consumers: Expectations Income

Taxes or TransfersWages or Wealth

Businesses Investment

Interest RatesTaxes

Government SpendingNet Exports International Income/Expectations Tariffs Dollar strength

Aggregate SupplyPositive Slope: As Price Level goes up

Profit Illusion As prices go up, wages and input costs stay fixed.

Inventory Effect If below full capacity can sell from inventory with no cost pressures

Aggregate SupplyShifters:

Change in input prices

wages, oil, etc.TechnologyRegulationsChange in input quality

Together:

Unemployment will increase as Y decreases andUnemployment will decrease as Y increases.

AD ShockInventories increaseUnemployment increases

Prices fallWages fall

People feel richer buy moreBack to equilibrium ….or not.

Aggregate Supply DebateKeynsians ClassicalNever at full

employment even in good times

Prices and wages sticky

Adjustment will not happen

Always at full employment

Prices and wages slippery

Adjustment will happen

Another look at the differences

Demand Shift with Keynsian-Sticky Wages -Sticky Prices-Slow recovery-Stuck below Y*

Demand shifts with Classical-Wages and Prices Adjust

-Restoring the economy back to full output

Aggregate Supply DebateKeynsians ClassicalNever at full

employment even in good times

Prices and wages sticky

Need to push AD right with government

Always at full employment

Prices and wages slippery

Need to stay out of way and wait for wages/prices to fall

Compromise AS Curve

PracticeAggregate Demand Aggregate SupplyConsumer Income

or expectationsInvestment income

or expectationsGovernment

SpendingChange in exports

or imports

Costs of ProductionTechnology or

weatherGovernment Policy

Inflation Causes

Demand Pull Inflation Cost Push Inflation

Full Employment Long Run AS

Below Y* recessionary gap Above Y* inflationary gapPL down, Y down, Unemp up PL up, Y up, Unemp down

Y*

LRAS

LRAS relates to PPF

Growth

Increases LRAS and PPF

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

1. The personal income tax rate goes up by a significant amount

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

2. The stock market falls to record low levels following remarks by the Fed Chairman that “it is all just irrational exuberance”

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

3. A new computer program reads your mind and automatically prepares word documents dramatically increasing productivity.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

4. Nationwide the minimum wage goes to $20 with retirement contributions.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

5. The European union dissolves. The ensuing uncertainty throws the entire continent into a recession.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

6. A La Nina weather system causes massive droughts through out the US severely reducing crop production, livestock health and even the snow pack for ski resorts.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

7. Congress passes tax cuts for firms that expand jobs by 10%.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

8. With increased pressure to fight crime, states significantly tighten their sentencing laws and increase their prison budgets.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

9. A major earthquake and tsunami in China disrupts supply chains across the world.

Practice1.AD or AS

2.Shift Right or Left

3.Find new equilibrium

4.Outcomes:-Price Level?-Output?-Unemployment?

10. Following the building of a wall Canada and Mexico leave NATO and form their own trading bloc excluding the US.

Effects on AD of DeflationIf consumers expect prices to keep falling,

they may hold off on purchases today.

Value of debt rises, causing C & I confidence to fall

Cost of borrowing increases, as paying back $ that are worth more than those borrowed.

If input costs are locked up, profits fall

Costs of Recessionary GapUnemployment, Loss Production, Loss tax

revenue

Long-term:Loss of relevant skills for job seekers – Permanently unemployedBusiness failuresDecreased investmentLost government programs, higher deficits

Shifts LRAS to the left

Phillips CurveLimitations

Worker expectations

Only true for AD shifts, not supply shocks