MACROECONOMIC EQUILIBRIUM AND

FISCAL POLICY

Upon completing this lecture, students should understand the AD and AS model, Shortrun 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-REGULATING ECONOMY
AGGREGATE EXPENDITURE MODEL
AN EXAMPLE
FISCAL POLICY

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
1.
and and
realincome
balances
effect:
onWealth
substitution
effect.
The when price level falls, purchasing power of existing
financial
assets
rises, which can increase spending. People fell wealthier when price level falls and
explanations
are:
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

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.

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
1. Rigid Wages: Economists believe that wages tend to be fixed by
explaining the AS's upward
contracts or other agreements. When prices rise, but higher wages do not
sloping shape in the short run:
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.

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 nonlabor 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

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 ashort-run
LR equilibrium.
However,
equilibrium (real
GDP) may occur on a level above or
below the potential GDP, creating a
disequilibrium in the economy.

Recessionary gap

GDP Gaps

If real GDP < Potential real GDP (full

employment GDP), then a recessionary gap
exist. At the same time: Unemployment rate >
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 rightInflationary gap
presented a recessionary gap between SR
If real GDP > Potential real GDP (full employment
equilibrium and the LRAS curve.
GDP), then an inflationary gap exist. At the same
time: Unemployment rate < 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

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.

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 < Natural real GDP (full employment GDP), then a recessionary
gap exist. At the same time: Unemployment rate > 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 > Natural real GDP (full employment GDP), then an inflationary
gap exist. At the same time: Unemployment rate < 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.

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

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 < 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 > 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

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

GDP=C+I

SAVING

INVESTMENT

240

244

264

-4

20

260

260

280

20

280

276

296

20

300

292

312

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

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