National Income and Price Determination Aggregate Supply and

National Income and Price Determination: Aggregate Supply and Aggregate Demand By: Darshana Balasubramaniam, Kristina Bogardy, Spencer Cappelli, Ryan Lawler

Aggregate Demand • Aggregate Demand is the relationship between all spending on domestic output (real GDP) and the average price level of that output. • Real GDP and price level are inversely proportional. • AD= C + I + G + Xn

Why is AD Downward Sloping? • Real-Balance Effect: Higher price levels reduce the purchasing power of money and decrease the quantity of expenditures. (also known as the Wealth Effect) • Interest Rate Effect: When the price level increases lenders need to charge higher interest rates to get a real return on loans. • Higher interest rates discourage spending. • Foreign Trade Effect: When U. S. price level increases, exports fall and imports rise causing GDP to fall, and vice versa.

Shifters of Aggregate Demand • An increase in spending shift AD to the right. • 1. Change in Consumer Spending (ex. Taxes, Consumer Expectations) • 2. Change in Investment Spending (ex. Interest rates) • 3. Change in Government Spending (ex. War) • 4. Change in Net Exports (ex. Exchange Rates)

Multiplier Effect: Discretionary Fiscal Policy • Describes how a change in any component of aggregate expenditures creates a larger change in GDP. • MPS = Marginal Propensity to Save: How much people save rather than consume when there is a change in income. It is described as a fraction • MPS = Change in Savings/Change in Income

Marginal Propensity to Consume • MPC: How much people consume rather than save when there is a change in income. Also expressed as a fraction: • MPC = change in consumer spending/change in income • MPS + MPC = 1

Spending Multiplier • Spending is “multiplied” until every dollar is consumed or saved. • Spending Multiplier=1/MPS= 1/(1 -MPC) • Total Change in GDP= Spending Multiplier x Initial Change in Spending • As the MPC decreases, the multiplier effect becomes less.

Tax Multiplier • The multiplier effect also applies when the government cuts or increases taxes. (effect is less than that of the spending multiplier) • Tax Multiplier: -(MPC/MPS) • If the government increases taxes spending will decrease and the TM will be negative and vice versa if taxes are cut. • Total change in spending = Initial Tax Change x Tax Multiplier

Balanced Budget Multiplier • When a change in government spending is offset by a change in lump sum taxes, real GDP changes by the amount of the change in government spending. • Balanced Budget Multiplier: 1/MPS + (MPC/MPS) = 1

Crowding Out Effect • http: //www. youtube. com/watch? v=hucf. T z 4 s. Pf. U • The deficit spending of the government causes the real interest rate to increase which leads to the “crowding out” of investment spending.

Aggregate Supply • The amount of goods and services (real GDP) that firms produce in an economy at different price levels. • Short Run AS: Wages and resource prices will not increase as price levels increase. • Long Run AS: Wages and resource prices will increase as price levels increase.

Sticky vs. Flexible Wages/Prices • Sticky: The case when price levels do not change. (Keynesian Theory) • Flexible: The case when price levels do change.

Shifters of Aggregate Supply • 1. Change in inflationary expectations. (ex. If increase in AD leads people to expect greater prices, labor and resource costs increase which decreases AS). • 2. Change in Resource Prices: Prices of Domestic and Imported Resources. – Supply Shock: negative-shift AS to left/positive-shifts AS to the right.

Shifters of AS cont. • 3. Change in Action of the Government. (ex. Taxes on producers, subsidies, government regulations). • 4. Changes in Productivity (ex. Technology)