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Aggregate Demand
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the total demand for goods and services in the economy:
AD = C + I + G + NX
AD = C + I + G + NX
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Why the AD curve slopes downward
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1. wealth effect
2. interest rate effect
3. international trade effect
2. interest rate effect
3. international trade effect
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Wealth Effect
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Increase in price reducing the quantity of GDP Demanded:
- when P rises, consumers are poorer in real terms, Decreases the demand for consumption goods.
Decrease in Price raises quantity of GDP demanded
- When P falls, consumers are wealthier in real terms. Increases the demand for consumption goods.
- when P rises, consumers are poorer in real terms, Decreases the demand for consumption goods.
Decrease in Price raises quantity of GDP demanded
- When P falls, consumers are wealthier in real terms. Increases the demand for consumption goods.
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Interest Rate Effect
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When Increase in price reducing the quantity of GDP Demanded:
- When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods.
Decrease in Price raises quantity of GDP demanded:
- when P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods.
- When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods.
Decrease in Price raises quantity of GDP demanded:
- when P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods.
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International Trade Effect
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When Increase in price reducing the quantity of GDP Demanded:
- When P rises, goods and services produced elsewhere are less expensive. Imports rise and exports fall so the NX fall.
Decrease in Price raises quantity of GDP demanded:
- When P falls, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports rise.
- When P rises, goods and services produced elsewhere are less expensive. Imports rise and exports fall so the NX fall.
Decrease in Price raises quantity of GDP demanded:
- When P falls, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports rise.
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Domestic factors that can shift AD
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Anything that changes major spending habits of individual firms will shift AD:
- stock market rise/fall
- widespread change in real estate values
- general expectations about the future
- change in consumer confidence.
- stock market rise/fall
- widespread change in real estate values
- general expectations about the future
- change in consumer confidence.
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International Factors that can shift AD
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Foreign Income and Wealth:
- foreign income decreases or increases NX
Exchange rate (value of dollar):
- If value of the $ increases, U.s.s can buy more imports, but other countries can buy less U.S. goods, so NX falls.
- foreign income decreases or increases NX
Exchange rate (value of dollar):
- If value of the $ increases, U.s.s can buy more imports, but other countries can buy less U.S. goods, so NX falls.
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Aggregate Supply
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the total supply of all goods and services in the economy
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Aggregate Supply Curve (AS)
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graph that shows the relationship between aggregate quantity of output supplied by all firms in an economy and the overall price level.
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Why nominal price level affects real GDP in the short run, leading to an upward-sloping SRAS curve.
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1. sticky input prices
2. menu costs
3. money illusion
2. menu costs
3. money illusion
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Sticky Input Prices
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input prices (e.g. wages of workers) tend to be sticky and adjust more slowly.
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Factors that shift only the Short-Run AS curve
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- temporary supply shocks
- changes in expected future prices
- adjustments to errors in past price expectations.
- changes in expected future prices
- adjustments to errors in past price expectations.
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Demand-pull inflation
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inflation initiated by an increase in aggregate demand.
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Cost-push/Supply-side inflation
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inflation caused by an increase in costs.
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Stagflation
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occurs when output is falling at the same time that prices are rising.
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Federal budget
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annual statement of the federal government's revenues and expenditures.
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Fiscal Policy
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the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained economic growth, and price level stability.
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Proportional Tax (flat tax)
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the burden is the is the same percentage of income for all households
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Progressive Tax
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the burden, expressed as a percentage of income, increases as income increases.
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Regressive Tax
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the burden, expressed as a percentage of income, falls as income increases. (ex. excise taxes such as gasoline)
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marginal tax rate
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the tax rate you pay on any additional income you earn.
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average tax rate
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the total amount of tax you pay divided by your taxable income.
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Countercyclical Fiscal Policy
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used to describe changes in spending or taxation designed to smooth fluctuations in output and employment.
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Marginal Propensity to Consume (MPC)
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The fraction of a given change in income that is consumed. aggregate consumption (C) , aggregate income/output (Y).
MPC = change in C / Change in Y
MPC = change in C / Change in Y
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Aggregate saving (S)
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S = Y - C
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Marginal Propensity to save (MPS)
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the fraction of a given change in income that is saved.
MPS = change in S / change in Y
MPS = change in S / change in Y
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The Multiplier
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describes the overall impact of an initial increase in some variable (gov. spending) on the overall economy given a change in some other variable.
Mgov. spending = change in Y / change in G
= 1 / 1-MPC
= 1 / MPS
Mgov. spending = change in Y / change in G
= 1 / 1-MPC
= 1 / MPS
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Time Lags
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the effects of fiscal policy may be delayed by lags in recognition, implementation, and impact
Result: Magnifies business cycles
Result: Magnifies business cycles
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Crowding-Out
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Gov. spending can serve as a substitute for private spending.
result. reduces the impact of fiscal stimulus
result. reduces the impact of fiscal stimulus
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Savings Shifts
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in response to increases in government spending or lower taxes, people may increase their current savings to help pay for inevitably higher future taxes
result: if current savings increases by the entire amount of the federal stimulus, the effects of the stimulus are negated.
result: if current savings increases by the entire amount of the federal stimulus, the effects of the stimulus are negated.
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recognition lag
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the time it takes for policymakers to realize that a downturn has begun..
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implementation lag
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the time it takes to decide what the fiscal policy response should be.
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impact lag
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the time it takes for increased spending to affect the behavior for households and firms and for the multiplier effects to play out.
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Ricardian equivalence
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theoretical prediction that households will respond to increased government spending by increasing their saving. (MPS increase).
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