Unit 3 AD/AS & Fiscal Policy (Macro)

Unit 3 Overview: Top 10 things you must know for the aggregate demand and aggregate supply model, fiscal policy, spending and tax multipliers, and self-correction in the long run. This is geared toward college-level principles of macro and micro courses and students enrolled in AP Economics. 

Top 10 concepts covered in this video: 

#1. AD/AS – Long-Run Equilibrium

#2. AD/AS – Recession in Short Run

#3. AD/AS – Recession in Long Run

#4. AD/AS – Inflation in Short Run

#5. AD/AS – Inflation in Long Run

#6. Fiscal Policy and Budget Deficits

#7. Expansionary Fiscal Policy in Short Run

#8. Contractionary Fiscal Policy in Short Run

#9. Spending Multiplier

#10. Tax Multiplier

How do you graph an economy at full employment using the AD/AS model?

To graph an economy that is fully employed, use the aggregate demand and aggregate supply model. The short-run aggregate supply curve, long-run aggregate supply curve, and aggregate demand curve should all intersect at the same spot. This is known as the long run equilibrium. Price Level should be labeled on the y-axis and Real GDP should be labeled on the x-axis.

How do you graph an economy in recession?

To graph an economy experiencing a recession in the short run, the short-run aggregate supply curve and aggregate demand curve should intersect to the left of the long-run aggregate supply curve (full-employment level of output).

How do you graph an economy experiencing an inflationary gap?

To graph an economy experiencing inflation in the short run, the short-run aggregate supply curve and aggregate demand curve should intersect to the right of the long-run aggregate supply curve (full-employment level of output).

NB3. Expansionary Fiscal Policy (Macro)

What is fiscal policy in the Keynesian model?

Fiscal policy consists of government action which seeks to shift aggregate demand (and sometimes aggregate supply) to bring about full employment. The government does this primarily through changing its levels of spending and taxes.

What is an expansionary fiscal policy?

From the Keynesian perspective, an expansionary fiscal policy is appropriate if the economy is experiencing a recession in the short run. The government can increase spending and/or decrease income taxes to shift aggregate demand to the right. This will increase real GDP, increase the price level, and decrease the unemployment rate.

What is a budget deficit?

A budget deficit occurs when the government spends more than it receives in tax revenue. The government must borrow (by issuing new bonds) to finance its spending. This will often lead to the crowding out effect (see Unit 5).

Budget deficits increase the national debt, which consists of the amount of outstanding dollars owed by the United States in the form of marketable and non-marketable securities (bonds).

How does the Keynesian spending multiplier work?

To calculate the spending multiplier, simply divide 1 by the marginal propensity to save (1/MPS or 1/1-MPC). Once you have the spending multiplier, multiply the change in spending by the spending multiplier. This is used within the Keynesian model.

How does the tax multiplier work?

In the Keynesian model, the tax multiplier is -MPC/MPS. The tax multiplier is less than the spending multiplier because this formula accounts for savings, which is a leakage. Leakages are not directly used for spending in the short run. 

If there is an increase in taxes, multiply the negative tax multiplier by the change in taxes to see the potential change in real GDP. If there is a decrease in taxes, do the same thing as before, but ignore the negative sign to see the potential increase in real GDP.

Learning objectives:

1. Students will be able to list and explain the tools of an expansionary fiscal policy.

2. Students will be able to illustrate an expansionary fiscal policy using the AD/AS model.

3. Students will be able to identify the outcomes of an expansionary fiscal policy.

NB3. Contractionary Fiscal Policy (Macro)

What is a contractionary fiscal policy?

From the Keynesian economic perspective, a contractionary fiscal policy is appropriate if the economy is experiencing inflation in the short run. The government can decrease spending and/or increase income taxes to shift aggregate demand to the left. This will decrease real GDP, decrease the price level, and increase the unemployment rate.

Learning objectives:

1. Students will be able to list and explain the tools of a contractionary fiscal policy.

2. Students will be able to illustrate a contractionary fiscal policy using the AD/AS model.

3. Students will be able to identify the outcomes of a contractionary fiscal policy.

NB3. Macroeconomic Fun in the Long Run (Macro)

How does the economy self-correct from a recessionary gap?

If an economy is experiencing a recession in the short run, classical economists would say that the government should do nothing and the economy will correct itself in the long run. This is because prices and wages are flexible to according to classical economic thinkers.

In the long run, inflation expectations will fall so workers will take nominal wage cuts, thus lowering the costs of production. The short-run aggregate supply curve will shift to the right toward the long-run aggregate supply curve until full employment is restored. The price level decreases, real GDP increases, and unemployment decreases.

How does the economy self-correct from an inflationary gap?

If an economy is experiencing inflation in the short run, classical economists would say that the government should do nothing and the economy will correct itself in the long run. 

In the long run, inflation expectations will increase causing workers to demand higher nominal wages, thus raising the costs of production. The short-run aggregate supply curve will shift to the left toward the long-run aggregate supply curve until the long-run equilibrium is achieved. The price level increases, real GDP decreases, and unemployment increases.