Unit 12. Aggregate supply and aggregate demand. Fiscal policies.

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Unit 12. Aggregate supply and aggregate demand.
Fiscal policies.

• IES Lluís de Requesens (Molins de Rei)?
• Batxillerat Social
• Economics (CLIL) Innovació en Llengües
  Estrangeres
• Jordi Franch Parella

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• The model of aggregate supply and demand is used
  to explain short-run fluctuations in economic
  activity
• The aggregate demand shows the quantity of goods
  and services that households, firms and
  government want to buy at each price level
• The aggregate supply shows the quantity of goods
  and services that firms want to produce and sell
  at each price level

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Aggregate supply and demand
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Aggregate demand

• The aggregate demand has a negative slope,
  because of
• Price level and consumption (the wealth effect)
  consumers feel wealthier and spend more
• Price level and investment (the interest rate
  effect) a lower interest rate encourages greater
  spending
• Price level and net exports (the exchange-rate
  effect) the real exchange rate depreciates,
  which stimulates net exports

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Aggregate supply

• In the short term, the aggregate supply is upward
  sloping (a lower price level makes production
  less profitable because nominal wages are fix)?
• In the long run, the aggregate supply is vertical
  at the potential output or full-employment output
  (it depends on natural resources, labour,
  capital, entrepreneurship and technology)?

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Expanding Aggregate Demand
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Fiscal Policy

• Fiscal policy refers to the choices of government
  spending and taxes by the state
• Fiscal policy, in the short run, affects the
  aggregate demand
• Fiscal policy, in the long run, affects saving,
  investment and growth

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More government spending

• When the government increases government
  spending, it expands public consumption and
  investment, it tries to expand aggregate demand,
  as well as production, employment and inflation
• BUT it causes the crowding-out effect (it raises
  the interest rate, decreases the private
  investment and that offsets the initial increase
  in aggregate demand)?

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Less taxes

• When the government cuts income taxes, it
  increases households' disposable income
• Households spend some of this additional income
  on consumer goods
• Households save some of this additional income

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More and less money ...

• With an increase in the money supply (without a
  change in the money demand) the interest rate
  falls --gt it increases the aggregate demand at a
  given price level
• With a decrease in the money supply the interest
  rate increases --gt it decreases the aggregate
  demand at a given price level

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Active Fiscal Policy

• Active stabilization. It involves the use of
  fiscal and monetary policies to pursue certain
  goals (to achieve full employment by means of
  fiscal deficits and creation of money out of thin
  air).
• BUT it can destabilize the economy
• Time lags and information problems
• Crowding out of the private sector
• Consumption not sensitive to tax changes
• Government intervention increases aggregate
  demand too much or too little

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Automatic Stabilizers

• Automatic stabilizers are changes in fiscal
  policy that stimulate aggregate demand when the
  economy goes into a recession or dampen aggregate
  demand when the economy goes into a boom (without
  taking any deliberate action)?
• Examples some forms of government spending
  (unemployment subsidies) and the tax system

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Expansion and Contraction

• Reflationary fiscal policies (more government
  spending and less taxes) and monetary policies
  (creation of money and lower interest rates) try
  to increase aggregate demand
• Deflationary fiscal policies (less government
  spending and more taxes) and monetary policies
  (reduction of money and higher interest rates)
  try to decrease aggregate demand

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Inflation and Unemployment

• When the government expands aggregate demand, it
  can lower unemployment at the cost of higher
  inflation
• When the government contracts aggregate demand,
  it can lower inflation at the cost of higher
  unemployment
• This trade-off between inflation and unemployment
  (Phillips curve) is only supportable in the short
  run, but not in the long run (Phillips curve is
  vertical at the natural rate of unemployment)?