Table of Contents
REAL GDP & PRICE LEVEL
I. Output Growth and the Long-Run Aggregate Supply Curve: The total of all planned production for the entire economy is referred to as the aggregate supply of real output.
II. Spending and Total Expenditures: The spending decisions of individuals, firms, governments, and foreigners determine the total value of nominal GDP. There are two issues that need to be addressed. The first issue is, what determines the total amount that individuals, governments, businesses, and foreigners want to spend? Second, what determines the equilibrium price level and the rate of inflation? The total of all planned expenditures in the entire economy is called aggregate demand.
III. Aggregate Demand: The aggregate demand curve, AD, shows planned purchase rates for all goods and services in the economy at various price levels, ceteris paribus.
A) Aggregate Demand Curve: The aggregate demand curve shows planned purchase rates for all final goods and services in the economy at various price levels, other things constant. What Happens When the Price Level Rises?
1. The Real-Balance Effect: The change in expenditures resulting from the real value of money balances when the price level changes. A rise in the price level decreases the real value of a given amount of money balances and planned spending will decrease.
2. Interest Rate Effect: Higher prices result in a rising interest rate. Households spend less on consumer durables businesses spend less on capital investments, and the aggregate quantity of goods and services demanded decreases.
3. The Open Economy Effect: Substitution of Foreign Produced Goods: An increase in the price level in the United States makes US goods relatively more expensive compared with foreign produced goods. Planned purchases of domestically produced goods will fall and planned purchases of foreign produced goods (imports) will rise. Foreigners will no longer want to purchase as much US production as before and US exports will fall. The aggregate quantity of US produced goods and services demanded falls.
B) What Happens When the Price Level Falls: There are the same three effects when the price level falls as when it rises, they just have the reverse effect on the aggregate quantity of goods and services demanded.
C) Demand for All Goods and Services Versus Demand for a Single Good or Service: When the aggregate demand curve is derived, the entire economic system is viewed. The aggregate demand curve differs from an individual demand curve because it shows the circular flow of income and product constructed as AD.
IV. Shifts in the Aggregate Demand Curve: When non-price level determinants of aggregate demand change, a shift in the aggregate demand curve occurs. Any non-price-level change that increases aggregate spending on domestic goods shifts AD to the right. Any non-price-level change that decreases aggregate spending on domestic goods shifts AD to the left.
V. Long-Run Equilibrium and the Price Level: Long-run equilibrium occurs at the intersection of the aggregate demand and the long-run aggregate supply curve. At this point planned real expenditures for the entire economy equal actual GDP produced by firms.
VI. The Effects of Economic Growth on the Price Level: If LRAS increased over time and aggregate demand stayed constant, the price level would fall and there would be secular deflation. If aggregate demand increased at the same rate as LRAS, the price level would remain constant.
VII. Causes of Inflation: Inflation rates in the last 45 years have been positive but variable. Secular inflation rather than secular deflation has been the problem.
A) Supply-Side Inflation?: Inflation could be caused by a decrease in aggregate supply with a given aggregate demand curve. This cannot be the explanation of inflation for the persistent or secular inflation, because of the long-run increase in population, productivity, and real GDP, i.e. the aggregate supply curve has shifted to the right.
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CLASSICAL & KEYNESIAN ANALYSIS
I. The Classical Model: This model, which traces its origins to the 1770s, was the first systematic attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving and investment.
II. Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve: A horizontal short-run aggregate supply curve is called the Keynesian short-run aggregate supply curve. According to Keynes, the existence of unions and long-term contracts between workers and employers in and outside unionized environments can explain downward inflexibility of nominal wage rates. Such “stickiness” of wages makes involuntary unemployment of labor a possibility. Even in situations of excess capacity and large amounts of unemployment, the price level may not fall. There may be continuing unemployment and a reduction in the equilibrium level of real GDP per year.
III. Output Determination Using Aggregate Demand-Aggregate Supply: Fixed Versus Changing Price Levels in the Short-Run: An increase in aggregate demand using the Keynesian SRAS curve results in real GDP increasing by the amount of the increase in aggregate demand. When the price level can vary, i.e. the SRAS curve is upward sloping, then real GDP increases by less than the increase in aggregate demand because part of the increase in nominal GDP is a result of an increase in the price level.
IV. Shifts in the Aggregate Supply Curve: There is a core class of events that causes a shift in both the short-run and long run aggregate supply curves.
V. Consequences of Changes in Short-Run Aggregate Demand: Aggregate demand shocks are any unanticipated shocks that cause the aggregate demand curve to shift inward or outward. Aggregate supply shock are any unanticipated shocks that cause the aggregate supply curve to shift inward or outward.
VI. Explaining Variations in Inflation—Demand-Pull or Cost-Push?
VII. Aggregate Demand and Supply in an Open Economy: The effect of exchange rates and trade with the rest of the world has an impact on both the aggregate supply and the aggregate demand curves.
VIII. Some Simplifying Assumptions in a Keynesian Model: (1) Businesses pay no indirect taxes, such as sales taxes. (2) Businesses distribute all of their profits to shareholders. (3) There is no depreciation, or capital consumption allowances, so gross private domestic investment equals net investment. (4) The economy is closed. Given all these simplifying assumptions, real disposable income will be equal to real national income minus taxes.
IX. Determinants of Planned Consumption and Planned Saving: The consumption function shows the relationship between planned consumption and various levels of disposable income. Real saving and consumption decisions depend primarily on an individual’s current real disposable income.
X. Determinants of Investment: Investment is defined as expenditures on new plant, capital equipment, and changes in business inventories. Real gross private domestic investment in the United States has been volatile compared to real consumption, because investment decisions of business people are based on highly variable, subjective expectations of the economic future.
XI. Savings and Investment: Planned Versus Actual: Equilibrium occurs at the intersection of the planned saving and planned investment schedules. There is no tendency for businesses to alter the rate of production or the level of employment because they are neither increasing nor decreasing their inventories in an unplanned way. When the saving rate planned by households differs from the investment rate planned by businesses, there will be an increase or decrease in real GDP in the form of unplanned inventory changes. Real GDP and employment will change until unplanned inventory changes are again zero.
XII. Keynesian Equilibrium with Government and the Foreign Sector Added
XIII. The Multiplier: The multiplier is the number by which a permanent change in autonomous spending such as autonomous investment or autonomous consumption is multiplied to get the change in the equilibrium level of real GDP. Any permanent increase in autonomous spending will cause a more than proportional increase in real national income.
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I. Discretionary Fiscal Policy: The discretionary changing of government expenditures and/or taxes in order to achieve national economic goals, such as high employment with price stability. It is a deliberate attempt to cause the economy to move to full employment and price stability more quickly than it otherwise might.
A) Changes in Government Spending:
1. When There is a Recessionary Gap: An expansionary fiscal policy, which would cause the AD curve to shift to the right, is required. By increasing government expenditures policy makers can shift the aggregate demand curve to the right, and the price level and real GDP will go up.
2. When There is an Inflationary Gap: A contractionary fiscal policy, which would cause the AD curve to shift to the left, is required. By decreasing government expenditures policy makers can shift the aggregate demand curve to the left, the price level and real GDP will go down.
B) Changes in Taxes: Holding all other things constant, a rise in taxes creates a reduction in AD for 1 of 3 reasons: it reduces (1) consumption, (2) investment or (3) net exports.
1. When the Current Short-Run Equilibrium is Greater than LRAS: An increase in taxes will cause AD to shift inward, real GDP and the price level index falls.
2. When the Current Short-Run Equilibrium is Less than LRAS: A decrease in taxes will cause AD to shift outward, real GDP and the price level will rise.
II. Offsets to Fiscal Policy: Fiscal policy does not operate in a vacuum so offsets can occur.
A) Indirect Crowding Out: An increase in government spending without raising taxes creates additional government borrowing from the private sector or from foreigners.
1. Induced Interest Rate Changes: Deficit spending tends to crowd out private spending reducing the positive effect of increased government spending on AD. Planned investment and consumption in the private sector decrease because of the rise in interest rates.
2. The Firm’s Investment Decision: The rise in interest rates causes monthly loan payments to go up and discourages some firms from making investments.
B) Planning for the Future: The Ricardian Equivalence Theorem: The proposition that an increase in the government budget deficit has no effect on aggregate demand. The idea is that people’s horizons extend beyond this year, and they take into account the effects of today’s government policies on the future. The Ricardian equivalence theorem is the proposition that an increase in the budget deficit has no effect on aggregate demand. If government spending increases without increasing taxes (increased budget deficit), taxes will have to be higher in the future and individual saving has to take place now to be able to pay this future tax liability. In the extreme case there is long-run no effect on AD.
C) Direct Expenditure Offsets: Actions on the part of the private sector in spending income that offset fiscal policy actions. Any increase in government spending that competes with the private sector will have some offset effect.
1. The Extreme Case: In this case the offset is dollar for dollar, so we merely end up with a relabeling of spending from private to public. Aggregate demand and GDP are unchanged.
2. The Less Extreme Case: To the extent that there are some offsets to fiscal policy, predicted changes in aggregate demand will be lessened and real output and the price level will be less affected.
D) The Supply-Side Effects of Changes in Taxes: Supply-side economics is the notion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward. Thus the government will not necessarily lose tax revenues by lowering marginal tax rates. The lower marginal rates will be applied to a growing tax base because of economic growth.
III. Discretionary Fiscal Policy in Practice: Coping with Time Lags: The political process of fiscal policy and the various time lags involved in conducting fiscal policy create problems of achieving the policy makers’ goals. A recognition time lag is the time required to gather information about the current state of the economy. An action time lag is the time required between recognizing an economic problem and putting policy into effect. The action time lag is short for monetary policy but quite long for fiscal policy, which requires congressional approval. The effect time lag is the time that elapses between the onset of policy and the results of that policy. By the time a proposed change in fiscal policy works its way through the system, it may no longer be applicable and may even be harmful.
IV. Automatic Stabilizers: Types of automatic (or nondiscretionary) fiscal policies which do not require new legislation on the part of Congress which are provisions of the tax laws and certain entitlement programs that cause changes in desired aggregate demand.
A) The Tax System as an Automatic Stabilizer: As taxable income rises, marginal tax rates rise. The progressive nature of the personal and corporate income tax systems means that when the economy expands, tax collections increase faster than income, while during contractions, tax collections fall faster than income.
B) Unemployment Compensation and Welfare Payments: As the economy contracts, unemployment compensation and welfare payments rise. As the economy expands, unemployment compensation and welfare payments fall. Disposable income does not fluctuate by as much as does total income.
C) The Stabilizing Impact: The automatic stabilizers mitigate undesirable changes in disposable income, consumption, and the equilibrium level of national income. If disposable income is not allowed to fall as far as it would during a recession, the downturn will be moderated. If disposable income is not allowed to rise as rapidly as it would during an expansion, the boom will not get out of hand.
V. What Do We Really Know About Fiscal Policy?
A) Fiscal Policy During Normal Times: Discretionary fiscal policy probably is not very effective at these times. Automatic stabilizers are probably the most useful.
B) Fiscal Policy During Abnormal Times: Fiscal policy can be important during these times. Consider some classic examples: the Great Depression and war periods.
1. The Great Depression: When there is a substantial drop in GDP, such as in the Great Depression, fiscal policy can probably stimulate aggregate demand. However, there was in fact very little stimulation by government in the form of aggressive expansionary fiscal policy during this period.
2. Wartime: War expenditures have little or no direct expenditure offsets. So, war spending as part of expansionary fiscal policy usually has significant effects.
C) The “Soothing” Effect of Keynesian Fiscal Policy: The knowledge by consumers and investors that the federal government can use fiscal policy to prevent another great depression may induce more buoyant and stable expectations, thereby smoothing investment decisions.
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I. Public Deficits and Debts: Flows Versus Stocks: The deficit is the excess of government spending over government revenues during a given period of time. The deficit is financed by the US Treasury borrowing by selling bonds to US and foreign households, businesses, and governments.
A) Distinguishing Between Deficits and Debts: The deficit is a flow and is the negative difference between tax receipts and total federal spending during a given time period. The federal government has a balanced budget when revenues equal spending during a given period of time.
B) The Public Debt: The total accumulated public debt is a stock measured at a given point in time. It increases when there is a deficit.
II. Government Finance: Spending More Than Tax Collections:
A) Historical Record of Federal Budget Deficits: Surpluses have occurred in only 13 years since 1940. In all of the other years the federal government has run deficits. In recent years the size of the real annual budget deficit as a percentage of GDP peaked during the Reagan Administration and began rising during the first George W. Bush administration and fell in fiscal 2005.
B) The Resurgence of Federal Budget Deficits: Between 2002 and 2004 federal spending increased faster than at any time since World War II. In 2001 tax rates were reduced near the end of a recession that reduced federal revenue for a time. When the economy began to grow rapidly in 2003 revenues began to grow rapidly as well.
III. Evaluating the Rising Public Debt: All federal government debt is the gross public debt. The net public debt is the gross public debt minus the debt held by government agencies.
A) Accumulation of the Net Public Debt: The US net public debt, as a percentage of GDP, fell steadily from the end of World War II until the early 1970s when it leveled off until the 1980s. It has risen since, except for declining slightly in the period of budget surpluses from 1998–2001.
B) Annual Interest Payments on the National Debt: Around 1975 interest payments on the public debt as a percentage of GDP started rising dramatically and have declined since. Today they are about 16 percent higher than they were about a half a century ago. Foreigners currently own around 40 percent of the US public debt.
C) Burdens of the Public Debt
1. How Today’s Budget Deficits Might Burden Future Generations: Future generations will have to be taxed to retire the higher public debt resulting from the present generation’s increased consumption of public goods.
2. The Crowding-Out Effect: In a full employment economy the increased level of consumption by the present generation crowds out investment and reduces the growth of capital goods leaving them with a smaller capital stock and thereby reducing their wealth. In this case future taxpayers will have higher taxes.
3. Paying Off the Public Debt in the Future: If the debt had to be paid off by raising taxes, what would mostly happen is that taxpayers would incur higher tax liabilities while bondholders, who are also mostly US taxpayers would get the money. As a generation US citizens would both pay higher taxes and receive (most of) the money back.
4. Our Debt to Foreign Residents: The percentage of the US public debt owned by foreigners is about 40 percent. If foreigners buy US government bonds, we do not owe that debt to ourselves, and a potential burden on future generations may result. If government expenditures financed by foreigners are made on wasteful projects rather than on goods and services that increase productivity and output, then a burden may be placed on future generations.
5. The Effect of Unemployment: If the economy is operating at a level substantially below full-employment real GDP, crowding out need not take place. In such a situation an expansionary fiscal policy via deficit spending can increase current consumption (of governmentally provided goods) without crowding out investment.
6. Not All Borrowing is Bad: Increased public debt is not necessarily bad if it creates a net investment for the future. Much of the analysis so far has assumed that deficit spending increases the demand for credit, while the supply of credit remains constant so interest rates rise and investment is crowded out.
IV. Federal Budget Deficits in an Open Economy: There is a link between US trade deficits and government budget deficits. By virtue of trade deficits, foreigners have accumulated US dollars and purchased US assets.
A) Trade Deficits and Government Budget Deficits: Larger trade deficits tend to accompany larger fiscal deficits.
B) Why the Two Deficits are Related: Part of the money to finance the federal government deficit must come from abroad. When the US runs large deficits, foreign dollar holders spend more on US government securities, bonds, and less on US produced goods and services, our exports. The effect is to further increase the trade deficit.
V. Growing US Government Deficits: Implications for US Economic Performance
A) Which Government deficit is the “True Deficit?: There is disagreement about how the deficit is measured. The problem has to do with the use of measurements that minimize the reported deficit. The other is that the government does not track its expenditures and receipts in a business-like manner.
1. Capital Budgeting Theory: Businesses, as well as state and local governments, have an operating budget, which includes expenditures for current operations and a capital budget, which includes expenditures on investment items. The federal government has only one budget. It has been recommended that Congress set up a capital budget, removing investment outlays from its operating budget. Opponents say this would allow the government to grow even faster since the operating budget, and its deficit would be reduced and the pressure would be reduced on Congress to curtail federal spending.
2. Pick a Deficit, Any Deficit: The government figures can be used to report several different deficits. The problem is that no one number gives a complete picture of how much the government is spending over and above what it is receiving.
B) The Macroeconomic Consequences of Budget Deficits: The effects of deficits should be compared to the effects higher taxes to finance government spending. In addition the effects of a deficit when the economy is at full employment and when there is substantial unemployment.
1. Short-Run Macroeconomic Effects of Higher Budget Deficits: If there is a recessionary gap, then deficits due to higher government spending or lower taxes can increase aggregate demand and eliminate the recessionary gap. If the economy is at full employment, the increase in aggregate demand causes an inflationary gap with increased real GDP and inflation.
2. Long-Run Macroeconomic Effects of Higher Budget Deficits: Increases in aggregate demand have no effect on real GDP. They only cause inflation. An increase in government spending redistributes a larger share of real GDP to government provided goods and services.
C) How Could the Government Reduce All Its Red Ink?
1. Increasing Taxes for Everyone: The office of Budget and Management estimated the 2004 budget deficit at about $521 billion. To have eliminated the deficit by raising taxes, every worker in the US would have had to pay $3,750 more in taxes.
2. Taxing the Rich: Currently 84 percent of federal income taxes is paid by the top 25 percent of families. The bottom 50 percent of families (below $60,000 per year) pay about 4 percent of federal income taxes. The top 5 percent pay about 57 percent of income taxes and the richest 1 percent pay about 37 percent of all income taxes paid. An increase in the top marginal tax rate from 35 percent to 45 percent will raise about $30 billion in additional taxes. The data do not support the notion that tax increases result in reduced deficits. Since World War II, for every dollar increase in taxes legislated, federal spending has increased $1.60.
3. Reducing Expenditures: Reduced spending will reduce the deficit. Entitlements are legislated payments that anybody who qualifies is entitled to receive. They are the most important component of the federal budget today. Entitlements, such as welfare, Social Security, Medicare, and Medicaid, change automatically without direct action by the congress.
4. Is It Time to Start Whittling Away at Entitlements?: In 1960 entitlements represented 10 percent of the federal budget. Today they make up more than half. In the last two decades, real spending on entitlements grew between 7 and 8 percent per year, while the economy grew by less than 3 percent per year. Entitlement programs are believed to be necessary, and it is difficult to cut government benefits once they are established.
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