see assignment document attached. 5 question parts for assistance.
Question 5 is based on the smartwatch industry.
ECO 2302, Principles of Macroeconomics 1
Upon completion of this unit, students should be able to:
5. Differentiate the aggregate expenditure and demand model of the macro economy from the supply
and demand model at the micro level.
5.1 Describe how consumption and investment relate to the aggregate demand curve.
5.2 Explain factors that affect the consumption function.
5.3 Explain market forces that push the economy toward its potential output in the long run.
Course/Unit
Learning Outcomes
Learning Activity
5.1
Chapter 9
Article: “What Is Aggregate Demand?”
Unit V Assessment
5.2
Unit Lesson
Chapter 9
Article: “The U.S. Economy to 2024”
Unit V Assessment
5.3
Unit Lesson
Chapter 10
Article: “GDP and the Digital Economy: Keeping Up With the Changes”
Unit V Assessment
Chapter 9: Aggregate Demand
Chapter 10: Aggregate Supply
In order to access the following resources, click the links below.
Board of Governors of the Federal Reserve System. (2017, July 31). What is aggregate demand?
https://www.federalreserve.gov/faqs/what-is-aggregate-demand.htm
Byun, K. J., & Nicholson, B. (2015, December). The U.S. economy to 2024. U.S. Bureau of
Statistics.
https://www.bls.gov/opub/mlr/2015/article/the-us-economy-to-2024.htm
Moulton, B. R. (n.d.). GDP and the digital economy: Keeping up with the changes. Bureau of Economic
Analysis. https://www.bea.gov/sites/default/files/2018-05/gdp-and-the-digital-economy
Unit Lesson
Before beginning Unit V, reflect back on how far you have come as an economics student. You are now half-
way through this course. Your economics vocabulary has, most likely, dramatically increased. You may be
finding yourself applying economic concepts in your daily life. This means that you are starting to become an
economist. Don’t worry—you do not have to start wearing polyester clothes and a bow-tie. Joking aside, you
should be proud of the knowledge you have gained so far in this course.
UNIT V STUDY GUIDE
Aggregate Demand and Supply
https://www.federalreserve.gov/faqs/what-is-aggregate-demand.htm
https://www.bls.gov/opub/mlr/2015/article/the-us-economy-to-2024.htm
https://www.bea.gov/sites/default/files/2018-05/gdp-and-the-digital-economy
ECO 2302, Principles of Macroeconomics 2
UNIT x STUDY GUIDE
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In Unit V, you are going to be studying the components of aggregate spending and how it relates to the
aggregate demand curve along with examining potential output. These concepts are addressed in Chapters 9
and 10 of the textbook and are discussed below.
The aggregate demand curve is influenced by consumption, investment, government spending, and net
exports. This means that a thorough understanding of the aggregate demand curve requires that each of
these elements be examined.
Each and every one of us consumes goods and services. From food and computers to cab rides and doctor
visits, we are consuming goods and services. It is well understood that consuming goods requires money,
and this money is acquired by income.
Economic theory presented in Unit II of this class showed us that changes in income can result in the demand
curve shifting one way or another. Specifically, we saw that an increase in income results in the demand
curve shifting to the right, as illustrated below.
In the figure above, increases in income have caused the demand curve to shift from D1 to D2. Additional
increases in income cause the demand curve to shift from D2 to D3.
ECO 2302, Principles of Macroeconomics 3
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Drawing even more on the information provided in Unit II, we learned that as the demand curve shifts to the
right, holding price constant, quantity demanded will increase. In the figure below, price is held constant at
“P.”
The price line (red line) intersects the initial demand curve (D1) at a quantity of Q1. When an increase in
income shifted the demand curve to D2, the red price line intersected D2 at a quantity of Q2. Further increases
in income caused the demand to shift to D3. The quantity level here is Q3.
Notice that the price level is not changing at all. The only factor that has been changed is income. What the
above graphic is suggesting is that there is a positive relationship between the amount consumed and income
levels. This concept is not earth-shattering as you have probably witnessed this behavior in yourself and
others. If you receive a bonus at work, your demand curve shifts to the right. You might be willing—and now
able—to go eat a meal at a restaurant that might not normally be in your budget. You might be willing to
purchase that new laptop computer. The list goes on and on regarding how the demand curve can shift to the
right as income increases.
Now that you know the basis behind the positive relationship between income and consumption, it is time to
introduce a new curve to the learning—the consumption function. The consumption function shows the
relationship between consumption and income (McEachern, 2019). More specifically, the consumption
function shows the relationship between consumer spending and disposable income at the aggregate level.
ECO 2302, Principles of Macroeconomics 4
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The above graphic utilizes data concerning consumer spending and disposable income for the United States
from the first quarter of 2017 through the third quarter of 2019 (Bureau of Economic Analysis [BEA], 2019).
This data is also presented in the table below.
Year Quarter
Personal
Income
(Billions of $)
Consumer Spending
(Billions of $)
2017
Q1 16,604.1 13,104.4
Q2 16,749.6 13,212.5
Q3 16,930.4 13,345.1
Q4 17,231.2 13,586.3
2018
Q1 17,540.3 13,728.4
Q2 17,725.0 13,939.8
Q3 17,928.5 14,114.6
Q4 18,082.8 14,211.9
2019
Q1 18,355.4 14,266.3
Q2 18,555.9 14,511.2
Q3 18,676.9 14,678.2
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain.
Marginal analysis was introduced in Chapter 1. As a refresher, anytime you see the term marginal in
economics, think change. Here, marginal analysis is used to determine how much consumption changes if
income changes. This type of marginal analysis is referred to as the marginal propensity to consume (MPC).
The MPC is determined by dividing the change in consumption by the change in income (McEachern, 2019).
An example of how the MPC is calculated is shown below using disposable income and consumer spending
information from the table above.
ECO 2302, Principles of Macroeconomics 5
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Title
Step 1: Calculate the difference in consumption. In the example below, the difference in consumer spending
between the first quarter of 2017 and the first quarter of 2019 is calculated.
Year Quarter
Consumer
Spending
(Billions of $)
Difference in Consumer Spending
(Billions of $)
2019 Q1 14,266.3
14,266.3 – 13,104.4 = 1,161.9
2017 Q1 13,104.4
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain.
Step 2: Calculate the difference in disposable income using the same two time periods used in Step 1. For
example, the table below uses the difference in personal income between the first quarter of 2017 and the
first quarter of 2019.
Year Quarter
Disposable
Income
(Billions of $)
Difference in Disposable Income
(Billions of $)
2019 Q1 18,355.4
18,355.4 – 16,604.1 = 1,751.3
2017 Q1 16,604.1
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain
Step 3: Dividing the answer in Step 1 by the answer in Step 2 will yield the marginal propensity to consume
(MPC).
Step 1 Answer Step 2 Answer Step 1 ÷ Step 2
Difference in Consumer Spending
(Billions of $)
Difference in Personal
Income
(Billions of $)
MPC
1,161.9 1,751.3 0.66
The result of 0.66 in the table above suggests that a $1 billion increase in income will cause consumption to
increase by $0.66 billion.
When you sit back and think about MPC, it is a very powerful calculation. For instance, policy makers may be
trying to determine if a reduction in income taxes would help increase spending in the economy. By using the
MPC, these policy makers can get an estimate of just how much consumption will change as income
changes. As you might have already noticed as well, the MPC is also the slope of the consumption function
illustrated earlier in this lesson.
Notice that disposable income is greater than the consumer spending in the first table above for every
quarter. For instance, in Quarter 1 of 2017, personal income equals $16,604.1 billion, and consumer spending
totals $13,104.4 billion. One would wonder why consumer spending does not equal income. The answer is
savings.
If income is not spent, it is assumed that income is saved. Regardless of whether income above expenses is
deposited into a savings account at a bank or extra cash is lost between the cushions of a sofa, any income
over and above expenses is considered to be saved. That means an additional column can be added to the
table above. This additional column would be savings and is determined by subtracting consumer spending
from disposable income.
ECO 2302, Principles of Macroeconomics 6
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Year Quarter
Personal
Income
(Billions of $)
Consumer
Spending
(Billions of $)
Savings
(Billions of $)
2017
Q1 16,604.1 13,104.4 3,499.7
Q2 16,749.6 13,212.5 3,537.1
Q3 16,930.4 13,345.1 3,585.3
Q4 17,231.2 13,586.3 3,644.9
2018
Q1 17,540.3 13,728.4 3,811.9
Q2 17,725.0 13,939.8 3,785.2
Q3 17,928.5 14,114.6 3,813.9
Q4 18,082.8 14,211.9 3,870.9
2019
Q1 18,355.4 14,266.3 4,089.1
Q2 18,555.9 14,511.2 4,044.7
Q3 18,676.9 14,678.2 3,998.7
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain.
Marginal analysis can also be used to determine how much a change in income will impact savings. To
perform this marginal analysis, the change in savings would need to be divided by the change in income. The
result of this calculation is called the marginal propensity to save (MPS).
An example of how the MPS is calculated is shown below using the disposable income and saving
information in the table above.
Step 1: Calculate the difference in saving. In the example below, the difference in saving between the first
quarter of 2017 and the first quarter of 2019 is calculated.
Year Quarter
Saving
(Billions of $)
Difference in Saving
(Q12019 – Q12017)
(Billions of $)
2019 Q1 4,089.1
4,089.1 – 3,499.7 = 589.4
2017 Q1 3,499.7
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain.
Step 2: Calculate the difference in disposable income using the same two time periods as in Step 1. For
example, the table below uses the difference in disposable income between the first quarter of 2017 and the
first quarter of 2019 is calculated.
Year Quarter
Personal
Income
(Billions of $)
Difference in Disposable Income
(Q12019 – Q12017)
(Billions of $)
2019 Q1 18,355.4
18,355.4 – 16,604.1 = 1,751.3
2017 Q1 16,604.1
Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d.
(https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ
ories=survey). In the public domain.
ECO 2302, Principles of Macroeconomics 7
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Step 3: Dividing the answer in Step 1 by the answer in Step 2 will yield the MPS.
Step 1 Answer Step 2 Answer Step 1 ÷ Step 2
Difference in Saving
(Billions of $)
Difference in
Disposable Income
(Billions of $)
MPS
589.4 1,751.3 0.34
The result of 0.34 in the table above suggests that a $1 billion increase in income will cause savings to
increase by $0.34 billion.
The MPS is also equal to the slope of the marginal propensity to save function. Also, adding up the marginal
propensity to consume and the marginal propensity to save will equal 1.0 (remember, income is either spent
or it is saved).
Remember the demand curve back in Unit II? The demand curve showed the relationship between price and
quantity. If any other factor changed, the demand curve would shift.
Here in Unit V, the consumption function shows a relationship between spending and disposable income,
holding a host of other variables constant. Just like the demand curve, the consumption function can shift if
one of the other factors changes. These factors are net wealth, price level, interest rates, and consumer
expectations. These factors are discussed in detail below.
Net wealth is explained as the value of assets that are owned by households less liabilities or debts
(McEachern, 2019). To put it in another way, net wealth is the difference between what you own and what you
owe. The clothes you have on right now are part of your owned assets. The pen you use to take notes is as
well. The same goes for your car, bank account, etc. What you owe would represent any debts you have. To
calculate your own net wealth, add up the value of every asset you have and subtract the total debts you
have.
Changes to net wealth would cause the consumption function to shift to a new location. For instance, home
values in California fell 6.6% between the last quarter of 2006 and the last quarter of 2007 (Kolko, 2008). With
the net wealth of home owners being lower, home owners were less willing to spend money. That means the
consumption function shifted to the left (decrease). On the other hand, stock prices increasing dramatically
results in an increase in net wealth for many individuals. Increases in net wealth will cause the consumption
function to shift to the right (increase).
As the price level in the economy changes, the purchasing power of consumers changes as well (McEachern,
2019). For instance, let’s say $100 in a checking account today can purchase 100 packs of gum (each pack
of gum costs $1). If the price of a pack of gum increased by 10% (each pack now costs $1.10), that same
$100 could now only purchase 90 packs (with $1 left over). In this case, your own personal consumption
function has shifted to the left (decreased).
ECO 2302, Principles of Macroeconomics 8
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The same holds true for a nation’s consumption function. If the average price level in an economy increases,
the entire nation’s consumption function will shift left, and vice versa if the average price level in an economy
decreases.
When money is deposited into a savings account, that money will earn interest (McEachern, 2019). Likewise,
credit card companies charge interest on spending that is not paid off at the end of the month. These interest
rates can cause the consumption function to shift.
For instance, if the interest rate that would be paid for depositing money into a savings account is 0.25%, a
$10,000 investment today would be worth $10,025 in 1 year. In this case, there is little incentive to invest the
$10,000 in a savings account, and consumers are more willing to spend their additional money. However, if
the interest rate were at 14%, that $10,000 investment would be worth $11,400 in 1 year. There would be
much more incentive to save money when the interest rate is at 14% versus 0.25%.
Since we already know that money is either saved or it is spent, higher interest rates would mean the
consumption function would shift to the left (decrease due to reduced spending). Lower interest rates would
cause the consumption function to shift to the right (increase due to increased spending).
Interest rates on credit cards work similarly. Higher interest rates on credit cards discourage spending, while
lower interest rates on credit cards encourage spending.
Consumer expectations regarding future income, net wealth, price level, or interest rates can cause the
current consumption function to shift (McEachern, 2019). Expectations for a big raise after completing your
degree can result in the purchase of a new car, home, and so on, during the last semester of school.
Expectations of higher price levels in the economy next year can result in increased consumption this year for
larger items as well.
The same goes for interest rates. Expectations that interest rates are going to increase next quarter may be
the deciding factor for purchasing a new car now that will be financed. We can even find that the expectation
regarding the need to save will impact the consumption function. Investing money monthly into a 401k is an
example of expectations concerning the need for money in the future. The investments made today represent
a decision to delay consumption today (the consumption function has shifted to the left).
Investment represents the second component of the aggregate demand curve. McEachern (2019) points out
that investment does not refer to buying stocks and bonds; instead, he suggests that investment refers to
purchasing new factories, buildings, and equipment; developing new intellectual property; purchasing new
housing; and increasing the net worth of inventories. When investments are made, people expect a future
return. A firm deciding whether to purchase a new machine that incorporates the latest technology will only do
so if the expectation is that the additional income generated from the new machine is going to be higher than
what would be generated by using that money elsewhere (maybe investing in a savings account).
ECO 2302, Principles of Macroeconomics 9
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McEachern (2019) points out that the opportunity cost of investing in capital is the market interest rate. This
means that the demand for investment is dependent on interest rates. As with consumption above, higher
interest rates reduce investment as the opportunity cost of investing increases as interest rates increase. On
the flip side, lower interest rates encourage investment as it will be much easier to get a higher rate of return
on the investment than depositing that money in to a savings account.
Aggregate demand is also influenced by government purchases. Government purchases represent federal,
state, and local governments spending money on items ranging from military vehicles to street lights;
however, not all government spending is included in government purchases. Governments also make transfer
payments, such as Social Security disbursements, welfare benefits, and unemployment insurance payments
that are not counted towards aggregate demand (McEachern, 2019). These transfer payments are given
outright to households. The households then use these transfer payments for consumption and saving. This
means that counting transfer payments as part of aggregate demand would end up double-counting this
spending—it would be counted once for the government purchase and again for consumption.
The demand for goods and services produced domestically does not stop at the borders of the nation. Goods
and services are exported to other nations, and imports are purchased from other nations. As you might have
guessed, exports add to aggregate demand and imports subtract from aggregate demand.
McEachern (2019) points out that increased domestic incomes result in increased imports being purchased,
while decreased consumer incomes result in fewer imports being purchased.
The aggregate supply curve is the relationship between the amount firms supply and the economy’s price
level (McEachern, 2019). As with aggregate demand, this definition also assumes that all other factors are
held constant. These factors include resource prices, technology, and property rights, patent laws, and taxes,
known as the rules of the game in our textbook.
Labor
McEachern (2019) suggests that labor is the most important resource and accounts for about 70% of
production costs. The amount of labor in an economy is known as the supply of labor and depends on the
size of the adult population as well as their abilities and preferences for work versus leisure.
To purchase labor, firms pay wages. The higher the wage rate is, the more labor will be supplied. The lower
the wage rate is, the less labor will be supplied.
ECO 2302, Principles of Macroeconomics 10
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The wage rate that is paid by firms to workers is based on the expected price level in the economy in the
future. If firms and workers expect prices to increase by 4% over the next year, an agreement on a 5%
increase in wages may be reached. If the price level in the economy ends up as expected by the end of the
year, there are no surprises. This results in the economy operating at its potential output. As McEachern
(2019) states, think of the potential output as the economy’s maximum sustainable output, given that the
amount of resources on hand, the level of technology, and the current rules of the game are as expected.
Problems can arise when there are surprises in the economy. For instance, if the price level in the economy is
lower than expected, firms will lose money. These firms negotiated a wage rate based on the expectation of
higher prices. Lower prices would mean lower revenues while labor costs would continue to be high.
The opposite would be true if prices were higher than expected. The firm would experience higher profits than
expected because wage rates would remain the same, but the selling price for output would be higher. In this
case, firms have the incentive to increase production beyond potential output. Firms could pay higher wages
for overtime or hire more unemployed labor to capture these unexpected profits.
When the economy’s actual output exceeds the economy’s potential output, an expansionary gap is created
(McEachern, 2019). In this instance, workers are putting in longer hours, factories may add additional shifts,
and machinery is being pushed to its limits to take advantage of the higher-than-expected prices. When actual
output exceeds the economy’s potential output, inflation is created (prices move even higher). When an
expansionary gap occurs, workers will renegotiate contracts for higher wages. The new higher wages cause
firms to begin producing at the potential output level again.
A recessionary gap occurs when the actual average price level is below the expected level in the economy. In
this instance, firms will be losing money and attempt to renegotiate wages to lower them. Firms also do not
need as many laborers, and work hours may be reduced. With unemployment rates higher, more workers are
competing for available jobs. This puts downward pressure on wages as well. With wages now being lower,
the cost of production for firms is also lower. A lower cost of production shifts the supply curve to the right
(increase) and will begin producing at the potential output level again.
References
Bureau of Economic Analysis. (n.d.). Table 2.1. Personal income and its disposition. Retrieved January 15,
2020, from
https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categories=sur
vey
Kolko, J. (2008, March). The California economy: Crisis in the housing market. Public Policy Institute of
California. https://www.ppic.org/content/pubs/jtf/JTF_HousingMarketJTF
McEachern, W. A. (2019). Macro ECON6: Principles of macroeconomics (6th ed.). 4LTR Press.
-
Course Learning Outcomes for Unit V
Required Unit Resources
Unit Lesson
The Aggregate Demand Curve
Consumption
Calculating Marginal Propensity to Consume
Saving
Calculating Marginal Propensity to Save
Other Factors Affecting Consumption
Net Wealth
Price Level
Interest Rate
Consumer Expectations
Investment
Government Purchases
Net Exports
The Aggregate Supply Curve
Labor
Potential Output
Expansionary/Recessionary Gap
ECO 2302, Principles of Macroeconomics 1
Upon completion of this unit, students should be able to:
6. Discuss the interaction of the federal government and the Federal Reserve Bank in controlling the
U.S. economy.
6.1 Describe expansionary and contractionary fiscal policy.
6.2 Describe fiscal policies used to close a recessionary gap and an expansionary gap.
6.3 Explain the rationale for budget deficits.
Course/Unit
Learning Outcomes
Learning Activity
6.1
Chapter 11
Article: “Introduction to U.S. Economy:
”
Unit VI Assignment
6.2
Unit Lesson
Chapter 11
Unit VI Assignment
6.3
Unit Lesson
Chapter 12
Article: “Budget of the U.S. Government”
Unit VI Assignment
Chapter 11: Fiscal Policy
Chapter 12:
s and Public Policy
In order to access the following resources, click the links below.
Labonte, M. (2019, June 18). Introduction to U.S. economy: Fiscal policy. In Focus.
https://crsreports.congress.gov/product/pdf/IF/IF11253
USAGov. (n.d.). Budget of the U.S. government. https://www.usa.gov/budget
Unit Lesson
In Unit VI, you are going to be studying fiscal policy and the federal budget. The information for these subjects
can be found in Chapters 11 and 12 of the textbook and is discussed below.
Fiscal Policy
Prior to the Great Depression that began in 1929 governments took a passive view in terms of fiscal policy.
However, the game changed with the Great Depression as governments began to view their roles differently.
Governments began to use fiscal policy in an attempt to stimulate economic growth or slow down the
economy when needed. Government purchases, transfer payments, taxes, and borrowing are all used as a
means of driving the economic ship in the preferred direction (McEachern, 2019). Some of the means by
which the government directs the economy happen automatically, while others require deliberate action by
UNIT VI STUDY GUIDE
Fiscal Policy and the Federal Budget
https://crsreports.congress.gov/product/pdf/IF/IF11253
https://www.usa.gov/budget
ECO 2302, Principles of Macroeconomics 2
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Title
the federal government. These are addressed below. To learn more on this topic, watch the video Fiscal
Policy. A transcript and closed captioning are available once you access the video.
Think about federal income taxes. The federal government passed legislation that designates the percentage
that citizens will have to pay in income taxes. As incomes change, the amount (not the percentage) collected
for income taxes changes as well. There is no need for the federal government to debate and pass income
tax levels on a yearly basis. That means income tax rates automatically adjust to the ups and downs of the
economy. McEachern (2019) goes on to explain that federal income taxes are automatic stabilizers because
they allow citizens to keep more disposable income during recessions and avoid paying more during
expansions.
Some fiscal policies do require the government to make new policy on a regular basis. These are called
discretionary fiscal policies. McEachern (2019) identifies the tax cut package and spending increases that
occurred when the American Recovery and Reinvestment Act (ARRA) was passed in 2009 as an example of
a discretionary fiscal policy. These tax cuts and additional government spending could not have taken effect if
the new law had not been passed.
An economy producing less than its potential creates a recessionary gap. A recessionary gap is shown below
where the aggregate demand curve (AD1) intersects the short-run aggregate supply (SRAS) to the left of the
long-run potential output (which is also considered to be the long-run aggregate supply, or LRAS). This
recessionary gap also results in a price level in the economy (P) that is lower than the potential price level
(P’).
Now, the federal government could sit back and wait for the market to adjust and close this recessionary gap
naturally. Natural market forces would push the supply curve to the right in the long run (shown as point A
below).
https://c24.page/8vp7ffu6rpet7kknzxsbh39f3d
https://c24.page/8vp7ffu6rpet7kknzxsbh39f3d
ECO 2302, Principles of Macroeconomics 3
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However, there are problems with waiting for the economy to naturally correct itself. McEachern (2019)
suggests that wages and other resource prices may be slow in responding to the recessionary gap signals,
and it can take a long time to close this gap. The federal government can step in and use expansionary fiscal
policy (increase government purchases, decrease net taxes, or a combination of both) to close this gap.
When the federal government increases purchases and/or decreases taxes, the aggregate demand curve will
shift to the right (AD2). When the federal government implements fiscal policy perfectly, the price level will be
at P’, output will be equal to the LRAS, and the recessionary gap will be closed.
ECO 2302, Principles of Macroeconomics 4
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If the economy were facing an expansionary gap (e.g., the economy was producing more than its potential,
and the aggregate demand curve was intersecting the short-run aggregate supply curve to the right of the
long-run potential output), the federal government could engage in contractionary fiscal policy (reduce
government spending, increase taxes, or a combination of both). The contractionary fiscal policy would cause
the aggregate demand curve to shift to the left (decrease). Hopefully, the appropriate measures have been
taken, and the aggregate demand curve intersects the short-run aggregate supply curve at the economy’s
potential output level.
As you might expect, enacting fiscal policy that perfectly adjusts the aggregate demand curve to exactly
intersect the short-run aggregate supply curve at exactly the point where it also intersects the long-run
potential output can be difficult. However, you might ask why it would be so bad. The answer is that a fiscal
policy that is not perfectly adjusted can have very negative consequences. Let’s look again at expansionary
fiscal policy that is used to close an expansionary gap. Expansionary policy is used to shift the aggregate
demand curve from AD1 to AD2, as illustrated below.
However, suppose that the federal government made a mistake and reduced taxes and/or increased
government spending more than needed. Instead of shifting the aggregate demand curve to AD2, the
aggregate demand curve would instead shift to AD3, as shown below.
ECO 2302, Principles of Macroeconomics 5
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In the short run, the price level will rise to P’’ and actual output will be above potential. Now, we know that the
economy cannot sustain output above its potential. That would mean that the short-run aggregate supply
curve would shift to the left (decrease) to SRAS’ (shown below).
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When the short-run aggregate supply curve shifts to the left to SRAS’ where it intersects both the aggregate
demand (AD3) and the LRAS, we are left with much higher prices. The federal government was attempting to
shift the aggregate demand curve to AD2, which would have resulted in a price of P’. However, because the
federal government enacted stronger expansionary fiscal policy than necessary, the long-run result was a
shift to AD3 and a price level of P’’’.
As you might have already guessed, the ever-changing economy can cause problems with implementing the
correct fiscal policy. Imagine being tasked with the chore of determining what the correct long-run potential
output of the economy will be (which is already a difficult task). Then add the responsibility of having to select
the appropriate expansionary or contractionary fiscal policy to use (decrease or increase taxes and/or
increase or decrease government spending). Added on top of these difficult decisions is the fact that the
chosen level of change had better be correct, or the choices made could result in the economy being worse
than before. Public outcry can be enormous if the appropriate fiscal policy is not enacted. This means that the
pressure is on for the federal government to get it right.
Even if the federal government gets it right when enacting fiscal policy, there can still be problems.
McEachern (2019) points out that it can take time (months or even years) to approve and implement fiscal
policy. By the time the appropriate fiscal policy has been approved and implemented, the economy may have
already adjusted. This market adjustment could make the new fiscal policy less effective. Take for instance
the recession that occurred between January 1980 and July 1980 (McLaughlin, 1982). This recession only
lasted 6 months. With a recession taking 6 months to identify after it begins, the recession of 1980 was over
before it was ever even identified (McEachern, 2019). That would mean steps could have been taken to enact
expansionary fiscal policy when no action was required at all.
Federal Budget
Just like individuals, the federal government develops a budget. The federal budget helps to plan for revenue
the government will be receiving and expenses it will have; however, when the federal government attempts
to develop a budget, it can run into problems that everyday citizens may not face. For one, McEachern (2019)
suggests that the continuing resolutions can create problems. Deadlines for developing the federal budget
can be missed. This causes the federal government to allow government agencies to continue to operate
without having a budget in place. These government agencies are allowed to spend at the rate of the previous
year. Continuing resolutions create a situation where successful programs are not provided with additional
money to grow. Also, government programs that are unsuccessful are allowed to continue to operate with no
modifications. To learn more, watch the brief video Federal Budget. A transcript and closed captioning are
available once you access the video.
Another issue pointed out by McEachern (2019) regarding the federal budget is that it can take a very long
time to be developed and approved. As mentioned above, the federal budget plans for all expenses the
federal government will have. This includes everything from social programs to military spending. With so
many areas of interest, one can imagine how difficult it is to plan. It does not take long to realize how easy it
could be to lose sight of the overall budget when elected officials are trying to determine how much to allocate
to each and every segment.
Listen to news stories about government spending, and you will likely hear about budget deficits. Listen to
political debates, and the subject of budget deficits will likely come up. Prior to the Great Depression, running
a budget deficit was not much of a consideration. Except for during wartime, fiscal policy focused on running a
balanced budget before the Great Depression (McEachern, 2019). Such a philosophy relies on markets
correcting themselves when they encounter problems. However, as we have learned, the Great Depression
resulted in an economy that could not correct itself. It was at this point that John Maynard Keynes introduced
a theory that the federal government could stimulate economic growth through spending (McEachern, 2019).
Keeping taxes at the same level (or even reducing them) can also lead to increased economic activity.
However, increasing government spending while keeping taxes at the current level (or even reducing them),
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creates a situation where the federal government is spending more than it is receiving. This is where a budget
deficit is created.
One theory behind running a budget deficit is that excess money spent during recessions can be paid for by
surplus money collected during expansions (McEachern, 2019). This theory is called a cyclically balanced
budget. Basically, this theory revolves around the theory of saving money during the good times and using
those savings when needed to stimulate economic growth during difficult times. The budget is effectively
balanced over the long term.
Another theory—functional finance—focuses more on ensuring that the economy produces at its potential
output than on balancing the budget (McEachern, 2019). A drawback to this theory is that it can lead to
deficits that occur year after year and result in massive amounts of federal debt. Looking back through the
history of federal budgets in the United States, there have been only 14 years when the budget was in surplus
since the Great Depression.
When looking at the effects of budget deficits and surpluses, we need to first focus on interest rates. As we
know from previous units, the level of interest rates affects investment (one component of gross domestic
product). If the federal government increases spending without increasing taxes, we know the result will be a
budget deficit. The increased deficit reduces the supply of national saving, leading to higher interest rates
(McEachern, 2019). Higher interest rates result in less private investment. This is called crowding out private
investment and reduces the positive impact of the increased government spending on economic growth.
On the other hand, an economy that is operating well below its potential output could see a crowding in effect.
In this situation, the increased government deficit encourages firms to invest more, as businesses expect
growth to occur from the increased government spending (McEachern, 2019).
The crowding out effect can be applied to our own personal decisions. Think about a time when you might not
have wanted to stop at a shopping mall (maybe during the holiday season) because you did not want to fight
the large crowd. The thought of having to park a great distance from the entrance, fight the large number of
people, stand in long lines, and so on crowded you out from visiting the mall. On the other hand, you may
have walked by a store and noticed that no one was shopping there. Your thought may have been that the
merchandise in the store must not be worth the price if no one is shopping in the store. On the other hand, if
only a few people had been in the store, you would have entered and looked around. Effectively, you would
have been crowded in to the store.
When people do not have enough cash money or money available in their checking or savings accounts to
make purchases, they might use credit cards to make the purchases. This would be an example of running a
budget deficit and financing additional spending through borrowing money from the credit card companies.
The borrowed money is a debt that they will have to repay in the future. The federal government is no
different in terms of accumulating debt. When the federal government runs a budget deficit, the money to fund
additional spending comes from federal debt. That means running budget deficits adds to federal debt.
There are distinctions between who holds the debt owed by the federal government. If the federal government
chooses to borrow money by selling U.S. Treasury securities to itself, then, essentially, the federal
government owes this debt to itself. On the other hand, the federal government can also sell government
securities to households, firms, banks, and foreign entities (McEachern, 2019). The second way of financing
deficit spending is the one on which most economists focus their attention.
There are debates regarding national debt and its impact. One theory is that future generations bear the
burden of paying the debt (McEachern, 2019). This is true. However, the same generation that is paying the
debt gets to reap the benefits of the debt. For instance, if the federal government sells bonds to its citizens
today to finance spending today, those citizens are delaying purchases of goods and services to own those
bonds. When those bonds mature, those citizens will be paid their initial investment plus interest. This
argument does not apply when it comes to those government securities that are sold to foreign entities. It is
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the foreign entities that receive the future benefits. Future generations, in this instance, do bear the burden of
the debt.
References
McEachern, W. A. (2019). Macro ECON6: Principles of macroeconomics (6th ed.). 4LTR Press.
McLaughlin, R. L. (1982, January/March). A model of an average recession and recovery. Journal of
Forecasting, 1(1), 55–65. https://doi-
org.libraryresources.columbiasouthern.edu/10.1002/for.3980010107
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Course Learning Outcomes for Unit VI
Required Unit Resources
Unit Lesson
Fiscal Policy
Automatic Stabilizers
Discretionary Fiscal Policy
Recessionary Gap
When the Government Does Not Get It Just Right
Problems With Fiscal Policy
Federal Budget
The Dreaded Budget Deficit
Effects of Budget Deficits and Surpluses
National Debt
Unit V Question 1:
Unit V Question 2:
Unit V Question 3:
Describe in your own words, what happens when a firm and workers underestimate future prices in the economy. Focus your answer on what would happen to acutal output as opposed to the expected potential output. 500 word minimum.
Unit VI Question 4:
Unit VI Question 5:
Budget of the United States Government | GovInfo
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