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

1. 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

2. 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

3. Aggregate supply and demand

4. 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

5. 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)‏

6. Expanding Aggregate Demand

7. 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

8. 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)‏

9. 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

10. More and less money ... • With an increase in the money supply (without a change in the money demand) the interest rate falls --> it increases the aggregate demand at a given price level • With a decrease in the money supply the interest rate increases --> it decreases the aggregate demand at a given price level

11. 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

12. 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

13. 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

14. 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)‏