MACROECONOMIC EQUILIBRIUM AND FISCAL POLICY

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MACROECONOMIC EQUILIBRIUM AND FISCAL POLICY
Upon completing this lecture, students should
understand the AD and AS model, Short-run and
long-run equilibrium within the macroeconomy, and
fiscal policy. Both the classical and Keynesian's
point of view will be presented. OBJECTIVES 1.
Understand the AD and AS model. 2. Compare and
contrast short-run and long-run equilibrium. 3.
Illustrate and define business cycles. 3. Define
multiplier and its applications. 4. Evaluate the
effectiveness of changes in fiscal
policy.   TOPICS Please read all the following
topics. AGGREGATE DEMAND AGGREGATE SUPPLY SHORT
RUN AND LONG RUN EQUILIBRIUM BUSINESS
CYCLES CLASSICAL AND KEYNESIAN ECONOMICS SELF-REGU
LATING ECONOMY AGGREGATE EXPENDITURE MODEL AN
EXAMPLE FISCAL POLICY
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Aggregate Demand
The aggregate demand (AD) curve shows the real
output (real GDP) that people are willing and
able to buy at different price levels, ceteris
paribus. The AD curve shows an inverse
relationship between price level and domestic
output (real GDP in billions). The explanation of
the inverse relationship is not the same as for
demand of a single product, which centered on
substitution and income effect. The explanations
are
1. Wealth and real balances effect when price
level falls, purchasing power of existing
financial assets rises, which can increase
spending. People fell wealthier when price level
falls and will be encouraged to buy more goods
and services. 2. Interest-rate effect when
price level increases, businesses and households
may have to borrow additional funds to complete
their planned purchases. As borrowing demand
increases, the interest rate rises, reducing
actual borrowing amount and curtail planned
consumption and investment. A decline in price
level means lower interest rates which can
increase certain spending. 3. Foreign purchases
effect when price level falls, other things
being equal, US prices will fall relative to
foreign prices, which will tend to increase
spending on US exports and also decrease import
spending in favor of US products that compete
with imports.  A change in the quantity
demanded of Real GDP occurs because of a change
in the price level. This causes a movement along
the AD curve, but not a shift of the AD curve. A
change in an economic variable other than price
would be required to shift the AD curve. The
economy consists of four sectors Household,
Business, Government, and foreign sector. Every
sector buys a portion of GDP. The sum of their
demand is called total expenditure (TE) or
aggregate expenditure (AE). AE C I G Xn
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Aggregate Demand
Factors that change C, I, G, and Xn will change
AE and AD.  These factors are listed below 1.
Consumption Wealth, interest rate, income taxes,
and expectations about future prices and incomes
will change C and shift AD curve. 2. Investment
Interest rate, business taxes, and expectation
about future sales will change I and shift AD
curve. 3. Foreign Sector Foreign real national
income and exchange rate will change export and
import, causing AD curve to shift. 4. Money
Supply The money supply affects interest rates.
An increase in money supply will lower interest
rate, causing the AD curve to shift to the right.
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Aggregate Supply
Aggregate Supply (AS) curve below shows level of
real domestic output (real GDP in billions)
available at each possible price level, ceteris
paribus. The upward slope of the curve indicates
that producers are willing and able to sell more
units of their goods as prices increase, and that
their willingness to sell decreases as prices
falls. The reasons listed below explaining the
AS's upward sloping shape in the short run
1. Rigid Wages Economists believe that wages
tend to be fixed by contracts or other
agreements. When prices rise, but higher wages do
not accompany them , producers' profits will rise
temporarily, and the firm will produce more. 2.
Sticky Prices Prices are costly to change in
some industries (menu costs). Where this is true,
decreases in the general price level will
negatively affect sales, profits, and output,
causing  producers to produce less. These two
reasons given for the upward sloping AS are
likely to be true only for short periods of time,
and thus the AS curve described above is often
called short run AS (SRAS) curve.
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Aggregate Supply
A change in the general price level will change
the quantity supplied of the domestic output,
this is a change along the AS curve. Other
economic variables will change the SRAS curve and
shift the curve to a new position. Some of these
factors are listed below 1. The Wage Rate
Higher wage rates means higher labor cost. Given
constant prices, higher production costs reduce
the profit per unit and lowering the number of
goods produced. Therefore, higher wage rate
shifts the SRAS curve to the left. 2. Prices of
Non-labor inputs Energy, land, capital and other
non-labor inputs also have a significant impact
on SRAS. An increase in the price of these inputs
shifts the SRAS curve to the left. 3.
Productivity This is the output produced per
unit of input used over a period of time. Higher
productivity of labor or any other inputs will
shift the SRAS to the right. 4. Supply Shock
Major natural or institutional changes will
affect AS. Shocks like the Iraq War and 9/11 both
impacted the AS. As mentioned earlier, factors
created the upward sloping SRAS are not present
in the long run. In the long run, the economy
will always produce the full employment real GDP
called potential GDP (GDPp) or natural real GDP (
Qn). The long run AS (LRAS) curve will be
vertical at this real GDP level. Change in
potential GDP will shift the LRAS curve to the
right.
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Equilibrium
Short Run Equilibrium Putting AD and SRAS
together, two curves will intercept at a point.
This point is the short run equilibrium. This
price level is the equilibrium price level, Pe
this quantity is the equilibrium quantity, Qe. At
any other price level, the economy is either in
surplus or in shortage.
Long Run Equilibrium The interception point of AD
and SRAS may be on the LRAS, creating a long run
equilibrium where real GDP is equal to potential
real GDP. If the potential GDP is at 600, then
the following graph shows that the SR equilibrium
is on the LRAS curve, creating a LR equilibrium.
However, short-run equilibrium (real GDP) may
occur on a level above or below the potential
GDP, creating a disequilibrium in the economy.
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GDP Gaps
Recessionary gap If real GDP lt Potential real GDP
(full employment GDP), then a recessionary gap
exist. At the same time Unemployment rate gt
natural rate of unemployment. Since more job
seekers are in the market, they tend to settle
with a lower wage. Lower wage will increase the
AS curve, causing the price to decrease. Lower
price will increase consumption. This process
will continue until the economy reaches the long
run equilibrium (potential real GDP). If the
potential GDP is at 700, graph on the right
presented a recessionary gap between SR
equilibrium and the LRAS curve.
Inflationary gap If real GDP gt Potential real GDP
(full employment GDP), then an inflationary gap
exist. At the same time Unemployment rate lt
natural rate of unemployment. Since job seekers
are less than job openings in the market,
employers are forced to raise the wage to attract
new workers. High wage will decrease the AS, and
raise the price. Higher price will lower
consumption. This process will repeat until the
long run equilibrium is reached. If the
potential GDP is at 500, left graph presented an
inflationary gap between SR equilibrium and the
LRAS curve.
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Classical and Keynesian Economics
CLASSICAL ECONOMICS According to Says law,
supply creates its own demand. Excess income
(savings) should be matched by an equal amount of
investment by business. Interest rates, wages and
prices should be flexible. The classical
economists believe that the market is always
clear because price would adjust through the
interactions of supply and demand. Since the
market is self-regulating, there is no need to
intervene. Economists who advocate this approach
to macroeconomic policy are said to advocate a
laissez-faire approach. The market will reach
full employment by itself.   KEYNESIAN
ECONOMICS The great depression is 1930s seemed to
refute the classical idea that markets were
self-correcting and should provide full
employment. Keynes provided some explanations 1)
savings and investments are not always equal 2)
producers may lower output instead of prices to
reduce inventories 3) Lower production may
increase unemployment rate and decrease incomes
4) monopoly power on the part of producers and
labor unions would prevent prices and wages to
adjust downward freely. According to Keynes
theory, wages and prices are not flexible. Rigid
price will give a horizontal AS curve in the
short run.
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Self-Regulating Economy
Classical economists believe in self-regulating
economy. Wage rate and prices are flexible.
Through the market mechanism, economy will move
towards long run equilibrium.     Recessionary
gap   If real GDP lt Natural real GDP (full
employment GDP), then a recessionary gap exist.
At the same time Unemployment rate gt natural
rate of unemployment. Since more job seekers are
in the market, they tend to settle with a lower
wage. Lower wage will raise the short run AS
curve and causing the price to decrease. Lower
price will increase consumption. This process
will continue until the economy reaches the long
run equilibrium (natural real GDP).  
Inflationary gap If real GDP gt Natural real GDP
(full employment GDP), then an inflationary gap
exist. At the same time Unemployment rate lt
natural rate of unemployment. Since job seekers
are less than job openings in the market,
employers are forced to raise the wage to attract
new workers. High wage will decrease the short
run AS, and raise the price. Higher price will
lower consumption. This process will repeat until
the long run equilibrium is reached.
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Aggregate Expenditure Model
Aggregate expenditure (AE) is the sum of
consumption, investment, government purchases,
and net export. Of these four sectors, the
consumption represents the largest share. The
consumption function  C Co MPC (Yd) C
total consumption Co autonomous consumption
whose amount is independent of disposable
income MPC marginal propensity to consume. This
is a fraction between 0 and 1 and MPC is equal
to change in consumption brought about by a
change in disposable income. (MPC change in C
/ change in Yd ) Yd disposable income. A
similar concept as MPC is MPS marginal
propensity to save. It is equal to change in
savings (S) brought about by a change in
disposable income. (MPS change in S / change
in Yd) Since all income must be either consumed
or saved, then any change in income must also be
consumed or saved. Therefore MPC MPS 1 The
average propensity to consume (APC) is the
portion of income spent on consumption. (APC C
/ Yd) The average propensity to save (APS) is the
portion of income saved.  (APS S / Yd) Again,
APC APS 1  
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Equilibrium GDP
EQUILIBRIUM GDP Equilibrium GDP is the level of
output whose production will create total
spending just sufficient to purchase that output.
If the economy produces an amount of goods that
differs to the amount that the four sectors of
the economy buy (AE), AE and aggregate production
( AP) are not equal then the economy is in
disequilibrium. When AE lt AP, firms will
involuntarily accumulate inventory. This will
signal firms that they have overproduced. As a
result, firms will cut back on production and/or
prices. This will decrease the total value of
output, moving the economy towards the
equilibrium GDP. When AE gt AP, inventories will
be depleted unexpectedly. This will signal firms
that they have not produced enough. As a result,
firms will increase productions and/or prices.
This will increase the total value of output,
moving the economy towards the equilibrium GDP.
  MULTIPLIER Keynes observed that changes in
autonomous expenditures (those expenditures
independent of income) could create even larger
changes in national income. For example, a
technological break through has increased the
autonomous investment by 50million, this 50M
will become the income of the resources market.
Workers who may have higher income are willing to
spend more in the market. Their spending becomes
the income of producers who will again spend in
the market, and create extra income. This process
repeats itself, creating a multiplier effect. If
the Multiplier (M) 2.5, then the aggregate
expenditure will increase by 50M X 2.5
125M. M  1 / MPS is commonly used to calculate
the expenditure multiplier. An individual may
increase the aggregate expenditure if he took
100 from his shoebox and spent on goods and
services. His initial expenditure could be
multiplied if the retailers who received the 100
spent part of the 100 to buy more supplies from
the wholesalers, and the wholesalers might buy
more from the manufacturers. This process
continues to create a multiplier effect in the
economy. The aggregate expenditure would be
increased by a multiple amount. Obviously, if an
individual took 100 and put into his shoebox, he
would decrease the aggregate expenditure by a
multiple of that amount.
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An Example
In this example, the equilibrium between AE and
AP is illustrated. Data in this table is used to
construct the graph below.
GDP CONSUMPTION CONSUMPTION GDPCI   SAVING INVESTMENT INVESTMENT
240 244   264   -4 20  
260 260   280   0 20  
280 276   296   4 20  
300 292   312   8 20  
320 308   328   12 20  
340 324   344   16 20  
360 340   360   20 20  
380 356   376   24 20  
400 372   392   28 20  
As you can see from the graph in the next page,
investment has increased the equilibrium GDP,
(from the intersection of red and blue curves to
the new intersection of red and yellow
curves). The same equilibrium GDP can be
obtained by observing the Investment and Saving
schedule. In both graphs, we can see that
equilibrium GDP is at 360. Another approach to
get the equilibrium GDP is by using the
multiplier. The equilibrium GDP, GDPe, before the
investment is 260. MPC for this data set is
0.8. Multiplier 1 / 1-MPC 1 / (1-0.8) 5 The
investment amount of 20, will increase GDPe by 5
times, this will give us an increase of 20 X 5
100. Therefore, the new equilibrium GDP will be
260 100 360.  
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Fiscal Policy
Government may change its expenditures and
taxation to achieve particular macroeconomic
goals. Fiscal policy is one of the most important
economic tools available to the federal
government. a. Expansionary fiscal policy
policy adopted during recession, aiming to
increase AD through increases in government
spending or decreases in taxes. b. Contractionary
fiscal policy policy adopted during inflation,
aiming to decrease AD through decreases in
government spending or increases in taxes. After
the second quarter of 2001, the U.S. economy has
entered into a recession phrase. In order to
counter the recession, the Bush administration
has started to impose the expansionary fiscal
policy. Households got tax refunds. Government
has increased expenditure in various sectors such
as national defense (especially after September
11s attack). The effect of expansionary or
contractionary fiscal policy will be multiplied
by the multiplier. For example, government has
decided to provide a 40B aid for the airline
industry after September 11, 2001. This 40B
increase in government spending will increase the
aggregate expenditure by 100B (for M 2.5).
However, the effect of fiscal policy is limited
by certain factors such as the crowding out
effect, foreign loanable funds effect and time
lag problems.   Crowding out effect Crowding out
effect is quite important because it can
completely erase fiscal policy's intention to
correct the market. As the government tried to
spend more to correct the recessionary gap in our
economy, they compete with private sector for
resources and goods and services. As government
expenditure increases, consumption and investment
decreases, causing the ineffectiveness of the
fiscal policy. On the other hand, in the
expansionary fiscal policy, government increases
spending and reduces taxation, most likely result
in a deficit which must be funded through
borrowing. This increased borrowing will push the
interest rate higher, reducing the consumption
and investment in the private sector.