1. society
2. work
3. unemployment

4: AGGREGATE D/S & FISCAL POLICY
VOCABULARY (with some additional terms)
Aggregate Demand – curve that shows the amounts of real output that buyers collectively desire to
purchase at each possible price level (inverse relationship)
Real-Balances Effect – increases in price level lower the real value (purchasing power) of financial assets
with fixed money value which reduces total spending and output
Interest-Rate Effect – increases in price level increases demand for money and therefore reduces
spending and output
Foreign Purchases Effect – inverse effect of domestic prices compared to foreign prices. If goods of
foreign countries decrease in regard to domestic prices, net exports will decrease
Aggregate Supply – curve that shows the level of real domestic output that firms will produce at each
price level (direct relationship)
Horizontal Range – real output levels less than full-employment level. This range is horizontal and shows
that the economy can grow without experiencing inflation
Intermediate Range – an expansion of real output is accompanied by a rising price level (inflation). Full
employment is just before the furthest extent of this section
Vertical Range – a section beyond the full employment point in which no further output occurs as price
levels increase limitlessly
Demand-Pull Inflation – excess of demand over output which causes increased price levels
Natural Rate of Unemployment – “Full unemployment rate”; unemployment rate occurring there is no
cyclical
Productivity – measure of the relationship between a nation’s level of real output and the amount of
resources used to produce it
Equilibrium Price Level – price level at which AD curve and AS curve intersect
Equilibrium Real Output – GDPr level at which AD curve and AS curve intersect
Efficiency Wages – wages that elicit maximum work effort and thus minimize labor cost per unit of
output
Menu Costs – charges surrounding the cost of communicating price changes
Fiscal Policy – changes in government spending and taxes collection designed to achieve fullemployment and noninflationary domestic output (discretionary fiscal policy)
Council of Economic Advisors – cabinet of advisors organized to help president meet his economic goals
Discretionary – deliberate changes in tax rates and government spending by Congress
Non-discretionary – built-in mechanism of the economy that increases budget deficit or budget surplus
without any action by policymakers
Expansionary Fiscal Policy – increase in government purchases of goods and services or a decrease in
taxes to increase aggregate demand and expand real output
Budget Deficit – amount by which expenditures of government exceed revenues
Contractionary Fiscal Policy – decrease of government purchases or increase in taxes to decrease
aggregate demand and contract real output
Budget Surplus – amount by which revenues of government exceed expenditures
Built-in Stabilizers – (see non-discretionary) intrinsic mechanism that affects government’s budget in
times of recession and inflation
Progressive Tax System – tax whose average tax rate increases as taxpayer’s income increases and
decreases as the income decreases
Proportional Tax System – tax whose average tax rate remains constant as taxpayer’s income increases
or decreases
Regressive Tax System – tax whose average tax rate decreases as income increases and increases as
income decreases
Full-Employment Budget – comparison of tax collection and government spending that would occur if
economy was at full-employment level
Cyclical Deficit – federal budget deficit that is caused by a recession and the consequent decline in tax
revenues
Political Business Cycle – tendency of Congress to destabilize economy by reducing taxes and increasing
government expenditures before elections to raise takes and lower expenditures after elections
Crowding Out Effect – rise in interest rates and resulting in decrease of planned investment caused by
government’s increased borrowing of money
Crowding In Effect – decrease in interest rates resulting in increase of planned investment caused by
government’s decreased borrowing of money
CHAPTER 11
AGGREGATE DEMAND – curve that shows amount of goods and services that will be demanded at
various price levels by householders, businesses, government and foreigners
ADAS Model – allows us to look at changes in GDPr and price levels
equilibrium price/equilibrium GDPr for AD2 and AS1
Recession leads to GDP lowering but PL did not change due to “ratchet effect”
RATCHET EFFECT – prices are flexible upward but can never lower or return to initial lower prices.
AD increases, PL increases and the PL will remain there until a further change in GDP
During a period of full employment (FE), demand-pull inflation will cause PL to rise. PL will never
return to previous levels due to CHUMP, reasons for ratchet effect:
C – Contracts – a large part of the labor force works under wage contracts prohibiting wage reductions
H – Hiring Wages – businesses cannon legally pay below the minimum wage of labor
U – Unproductiveness – lower wages decrease morale and effort, lowered productivity and increases
per-unit cost as result
M – Menu Cost – changes in prices creates unwanted cost of communicating new prices
P – Price Wars – price cuts may lead to retaliation from rival businesses
Please note that these are NOT reasons for the downward-sloping or inverse relationship. They
explain why there is a horizontal range in the AS curve. For demand of a single product, the inverse
relationship was due to income and substitution effects. The AD inverse relationship occurs due to:
Real Balances Effect – higher price levels reduce purchasing power of the public, resulting in less
consumption
Interest Rate Effect – (assuming supply of money is fixed) as demand for money increases then
there is a consequent increase in interest rates. Consumption and investment decrease due to high
price levels
Foreign Purchases Effect – when U.S. price levels rise relative to foreign price levels, net exports fall
and imports rise
These factors cause QAD to decrease, GDP output to decrease as a result, and then movement
ALONG the AD fixed curve. However, CIG-X represents the determinants of Aggregate Demand,
shifting the curve left or right. Any change in CIG-X (consumption/expenditures, investment,
government spending, or net exports) will shift the AD curve left or right
This means that the AE model and AD model are closely related as changes in GDP r
affect movement of the graphs. An increase in consumption on the AE model (x)
causes a massive change in GDPr due to the expenditures multiplier (x ● Me).
Because of this horizontal change of x ● Me in the horizontal axis of the AE model,
the same horizontal change occurs in the AD model
horizontal movement of AD curve = ΔCIG-X ● Me
AGGREGATE SUPPLY – curve that shows the amount of goods and services that all
businesses will produce at every possible level (direct relationship)
1) Horizontal Range – “Keynesian Range”, shows economic inefficiency, any increase in AD within
the range will result in increased GDPr without inflation
2) Intermediate Range – shows economic efficiency. Increase in AD within this range results in
increased GDPr and some demand-pull inflation. Resources are becoming scarcer so price levels
increase. FE (full employment, 96% economic capacity) is found within this region just before the
vertical range
3) Vertical Range – “Classic Range”, shows extreme economic inefficiency, no more output as price
levels drastically increase. This occurs when the economy is working at 100% capacity. Massive
demand-pull inflation
The AS curve can only shift left or right due to RAP:
R – Resource Cost – increased cost of land, labor, capital goods, or entrepreneurial ability (shift left)
A – Actions by Government – subsidies (payments from government, shift right) and taxes (shift left)
P – Productivity – measure of average real output per unit of input (greater productivity = shift right)
Productivity = total output / total inputs
Per-unit production cost = total input cost / total number of units produced
AD increases (shifts right) due to:
Demand-pull inflation, the multiplier effect (Me)
AD decreases (shifts left) due to:
Recession, cyclical unemployment
---------------------------------------------AS increases (shifts right) due to:
Full employment and price-level stability
AS decreases (shifts left) due to:
Cost-push inflation
CHAPTER 12
FISCAL POLICY – deliberate change in government spending and taxing to achieve full employment,
control inflation and encourage economic growth. This is part of “Keynesian economics” that
emerged in the 1930’s
Congress (with help from the president) is responsible for fiscal policy
COUNCIL OF ECONOMIC ADVISORS (CEA) – cabinet of advisors organized to help president meet
economic goals
Massive decreases in AD indicate recessions while massive increases in AD indicate
expansions
When a recessionary gap occurs in the economy, the goal of government should
be to expand GDP output by pushing aggregate demand to the right. This is called
Expansionary fiscal policy.
PL
SRAS
AD2
AD1
PL2
PL1
FE
E1
E2
GDP1GDP2
G
T
AD
DI
GDPr
GDP/Emp/PL
C
AD
GDP/Emp/PL
An expansionary fiscal policy will cause the government to run a budget deficit
(spending more than it has or collecting less than it needs), to pay this deficit the
government has to borrow funds from the loanable funds market (commercial
banks).
Since government is a more secure borrower than private businesses, banks
will loan their funds to the government first. This will cause the supply of LF to
decrease. Making loans more expensive (interest rates to increase), and
decreasing the amount of LF in the market (decreasing QLF.)
It is interest rates (IR) that determine the quantity of gross domestic investment
spending (Ig). As IR increases the quantity of Ig will decrease. This will cause AD to
shift to the left, causing a counter-cyclical effect on the expansionary fiscal policy.
Loanable Funds Market
RIR
IR=10%
IR=8%
S2
D
S1
E2
E1
Q2 Q1
QLF
When an inflationary gag occurs in the economy, and demand-pull inflation Is out of
control, the goal of the government should be to contract GDP output by pushing AD
to the left. This is called contractionary fiscal policy.
PL
AD2
AS
AD1
PL1
PL2
E1
E2
GDP2 GDPI
G
T
GDP/Emp./PL
AD
DI
GDPr
C
GDP/Emp/PL
AD
A contractionary fiscal policy will cause the government to run a budget surplus
(spending less than it has or collecting more than it needs). These surpluses will be put
into the LF market, thus increasing the supply of LF.
The increase supply of LF causes interest rates (IR) to decrease, leading to an increase
in gross domestic investment spending (Ig), and an increase in AD.
Loanable Funds Market
S1
D
RIR
S2
IR=8%
IR=6%
E1
E2
Q1 Q2
QLf