Eco 6351 Economics for Managers Chapter 11b. Aggregate Supply and Demand

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Eco 6351Economics for ManagersChapter 11b.
Aggregate Supply and Demand

• Prof. Vera Adamchik

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Competing Theories of Short-Run Instability

• Economists are not in complete agreement about
  how to achieve desired macro outcomes.
• Macro controversies focus on the shape of
  aggregate supply and demand curves and the
  potential to shift them.

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Demand-Side Theories

• Keynesian Theory
• Monetary Theories

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Keynesian Theory

• Keynes argues that if people demand a product,
  producers will supply it.

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Measuring GDP Expenditure approach

• GDP C I G NX
• Spendings not included in GDP
• on intermediate goods and services
• on used goods
• on financial securities (firms often sell
  financial assets to finance purchases of new
  capital goods. GDP includes the amount spent on
  new capital, not the amount spent on pieces of
  paper.)

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GDP C I G NX

• Personal Consumption Expenditures (C) are the
  expenditures by households on goods and services
  produced in the U.S. and the rest of the world.
  They do not include the purchase of new homes,
  which is counted as part of investment.

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GDP C I G NX

• Gross Private Domestic Investment (I) is
  expenditure by firms on buildings and capital
  equipment produced in the U.S. and the rest of
  the world PLUS expenditure on new homes by
  households. It also includes the change in
  business inventories.

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GDP C I G NX

• Government purchases of goods and services (G)
  are the purchases of goods and services (produced
  in the U.S. and the rest of the world) by all
  levels of government. But it does not include
  transfer payments. These payments, such as
  medical aid and social security benefits, are not
  purchases of goods and services. They are
  transfers of funds from government to households.

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GDP C I G NX

• Net Exports (NX) are the value of exports (X)
  minus the value of imports (M).

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Keynesian Theory

• Keynes theory was that depression and high
  unemployment result from insufficient private
  spending and that to cure these problems, the
  government must increase its spending (in order
  to increase aggregate demand).

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Monetary Theories

• Monetary theories focus on the control of the
  quantity of money in circulation and interest
  rates as mechanisms for shifting the aggregate
  demand curve.

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Monetary Theories

• Low interest rates increase aggregate demand,
  which speeds real GDP growth and inflation.
• High interest rates decrease aggregate demand,
  which slows real GDP growth and inflation.

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Supply-Side Theories

• Supply-side theories focus on incentives that
  will increase AS. Supply-side policies include
  cutting tax rates, deregulation, and other
  production enhancing mechanisms.

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Eclectic Explanations

• Shifts in both supply and demand curves may occur.

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Policy Options

• Fiscal policy is the governments attempt to
  influence the economy by setting and changing
  taxes, government purchases of goods and
  services, and transfer payments.
• Monetary policy is conducted by the Federal
  Reserve and includes adjusting the quantity of
  money in circulation and interest rates.

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Supply-Side Policy

• Supply-side policies seek to increase the ability
  and willingness to produce goods and services.
• Supply-side policies include cutting tax rates,
  deregulation, and other production enhancing
  mechanisms.

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• Government policies that increase AD and GDP are
  called expansionary policies.
• Government policies that decrease AD and GDP are
  called contractionary policies.

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The Changing Choice of Policy Levers

• Before the 1930s
• A do nothing approach prevailed until the Great
  Depression.
• The Great Depression spurred a desire for a more
  active government role.

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The Changing Choice of Policy Levers

• The 1930s
• The Keynesian economics was born in 1936.
  However, during the 1930s, politician did not
  believe in it, largely because they feared the
  consequences of government budget deficits.

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The Changing Choice of Policy Levers

• The 1940s
• Although Keynesian fiscal policy was not
  deliberately used during the 1930s, the growth in
  military spending at the onset of World War II
  increased total demand and helped to pull the
  economy out of its long decade of poor
  performance.

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The Changing Choice of Policy Levers

• The 1960s
• Fiscal policy dominated the economic debate in
  the 1960s. The top individual tax rate was 91
  (40 today), corporate tax rate was 52 (35
  today). Pres. Kennedy and Johnson. Tax cut in
  1964.Rapid growth of real GDP and consumption
  over 4.

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The Changing Choice of Policy Levers

• The 1960s
• The promise of fiscal policy was tarnished by its
  failure to control inflation in the late 1960s.
  In 1968, a temporary one-year tax surcharge of
  10 was enacted. Moderate impact on consumption.

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The Changing Choice of Policy Levers

• The 1970s
• During the 1970s, there were many changes in
  taxes and spending but no major changes in
  overall fiscal policy. There was a tax rebate and
  other tax incentives in 1975 following the
  recession in 1973. However, these tax changes
  were mild.
• Monetary policy dominated macro policy in the
  1970s. The heavy reliance on monetary policy
  ended with a recession in the late 1970s.

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The Changing Choice of Policy Levers

• The 1980s
• Supply-side policies prevailed in 1980s with
  Ronald Reagan. The 1981 tax cuts was designed to
  increase the supply of output. Nonetheless, the
  tax cuts did appear to increase consumer demand
  and helped the economy recover from the
  back-to-back recessions in the early 1980s.

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The Changing Choice of Policy Levers

• The 1990s
• By the mid-1980s, large government budget
  deficits began to emerge. As deficits grew, there
  was no longer interest in using Keynesian fiscal
  policy to manage the economy. The George H. Bush
  administration pursued a less activist approach
  in the early 1990s.

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The Changing Choice of Policy Levers

• The 1990s
• Bill Clinton pursued a contractionary fiscal
  policy in the mid-1990s. The fiscal restraint of
  the late 1990's helped the federal budget move
  from deficits to surpluses.
• One of the biggest points of debate during the
  2000 presidential campaign was whether to use the
  surplus to cut taxes, increase government
  spending, or pay down the debt.

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The Changing Choice of Policy Levers

• The 1990s
• This fiscal policy retreat cleared the way for a
  reemergence of monetary policy. The job of
  fighting inflation in the 1990s was left to the
  Fed's monetary policy.