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Aim: What can the government do to bring
stability to the economy?
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Two Views of Government Policy
Classical – “government is best that governs least”
Keynesian – government role is to safeguard the economy – “in the long-run we are all dead”
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Classical Economic Theory
• Adam Smith – laissez-faire– competitive markets, flexible prices
– limited role of govt– demand is more influential than price
–supply in the short-run is fixed
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Great Depression
- foundation for an activist government
Pre 1945 → booms and busts for “natural” economic reasons
Post 1945 → managed government
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John Maynard Keynes
The General Theory of Employment, Interest and Money
Keynesians look to demand to manage the economy
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Safeguarding the economy
Fiscal Policy
- govt uses taxes and spending to achieve macroeconomic goals
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Expansionary Fiscal Policy
• used in recessionary economy
• decrease taxes
• increase spending
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Contractionary Fiscal Policy
• used in demand side inflation
• increase taxes
• decrease spending
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Role of govt is to provide for the public good – protect quality of life- persuasion- regulation- subsidies- taxation- services- transfer payments
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Key TermsConsumption – refers to the
willingness of people to purchase goods and services
Disposable income – is the income available to consumers, after taxes to spend
Savings – is money not used for consumption
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Planned investment – which equals savings in equilibrium, is the amount firms intend to spend on investment in capital goods for future production
Actual investment – is the money spent, in reality, on investment goods
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Inventories – represent the difference between planned investment and actual investment
National Income – in equilibrium, represents Real GDP
Transfer payments – are monies spent by the government without corresponding provisions of goods and services
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Consumption function – the relationship between expenditure and income
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Determinants of Consumer Spending
• the past/the lag
• wealth
• price level
• inflation rate
• expectations about the future
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Aim: How is equilibrium in the
market for goods and services analyzed graphically?
What is the role of savings, consumption and investment?
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Do Now
(1) If the economy is expanding too quickly and prices are rising, how should government officials adjust taxes?
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(2) If there is growing unemployment and business inventories, how should government officials adjust taxes?
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Income-Expenditure Diagram
• 45° line marks all the points at which output and spending are equal – all the points at which the economy can possibly be in equilibrium
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Reaction to price levels
• higher prices lead to lower consumer spending
• a rise in price level leads to a reduction in the consumption function
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The effect of the price level on the expenditure schedule
• a rise in price level leads to a lower equilibrium level of real aggregate quantity demanded
• a fall in prices leads to a higher equilibrium aggregate quantity demanded
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• When equilibrium GDP falls above full employment, the economy will probably be plagued by inflation.
• When equilibrium falls below full employment, there will be unemployment and recession
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Recessionary Gap – amount at which the equilibirum level of GDP fall short of potential GDP
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Inflationary Gap – the amount by which equilibrium level of GDP exceeds the full employment level of GDP
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Aim: How will consumers respond to a tax cut – a $1 increase in disposable income?
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The primary tool that the govt can use to stabilize the economy is the personal income tax – personal consumption makes up 65% - 75% of GDP
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Marginal Propensity to Consume
• Basis for Keynesian Expenditure Analysis
• MPC states that consumers will spend a fraction of each additional dollar of income on goods and services and save the rest
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GDP = Y
Aggregate output = real GDP
Y = savings + consumption
Y = S + C
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MPC = Change in Consumption
Change in disposable income
MPC = ∆C
∆Y
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MPS = Change in Savings Change in disposable
income
MPS = ∆S ∆Y
MPC + MPS = 1
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Expenditure Multiplier
1/MPS = 1/1-MPC
the greater the MPC the greater the multiplier
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Aim:How has the Keynesian model been modified to include aggregate price levels?
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• Keynesian model could not accurately forecast GDP, employment & price levels in an inflationary environment.
• AD/AS Model
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Aggregate Demand
• accounts for the purchases of all consumers, businesses, governments and foreign trade in the entire domestic economy
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Reasons for negative slope of the Aggregate Demand Curve
• Interest rate effect – increased prices lead to an increasing demand for money – this increased demand for money leads to higher interest rates which leads to a decrease in output
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• Real Wealth Effect - as prices increase, the value of consumer wealth falls – this fall leads to a decrease in consumption, which leads to a decrease in output
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• Foreign sector substitution – as prices for domestic goods rise, consumers begin to substitute with foreign sector goods which are less expensive – this results in less consumption of domestic goods which leads to a decrease in production
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Aggregate Supply
• Relationship between the quantity of output supplied by all firms in an economy and the overall price level
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Along the AS Curve
• Horizontal range – unused capacity, supply can increase without increasing the price – this can occur when there is excess capacity in terms of raw materials or labor
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• Mid-range – illustrates tightening of resource availability and therefore impacts price level as more products are demanded – occurs when demand for the product increases and the resources needed to produce more products are scarce and thus more costly
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• Vertical range – situation where all resources are being used and no more products can be produced – the only thing that can happen is that suppliers raise their prices – it is the Long Run AS Curve
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Graphs
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