Unit 3 Notes

 UNIT 3

2/12/16

·      Aggregate Demand Curve

·      AD is the demand by consumers, businesses, government, and foreign countries

·      What definitely doesn’t shift the curve?

·      Changes in price level cause a move along the curve

·      AD= C + I + G + Xn

·      AD Graph!

·      Why is AD downward sloping?

1.     Real- Balance Effect-

·      Higher price levels reduce the purchasing power of money.

·      This decreases the quantity of expenditures.

·      Lower price levels increase purchasing power and increase expenditures.

2.     Interest- Rate Effect

·      When the price level increases, lenders need to charge higher interest rates to get a REAL return to their loans.

·      Higher interest rates discourage consumer spending and business investment. WHY?

3.     Foreign Trade Effect

·      When U.S. price levels rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods

·      Exports fall and imports rise causing real GDP demand to fall. (Xn Decreases)

Shifters of aggregate demand

·      GDP= C + I + G + Xn

·      There are two parts to shift AD:

-       A change in C, Ig, G and/or Xn

-       A multiplier effect that produces a greater change than the original change in the 4 components.

Increases in AD = AD à

Decreases in AD = AD ß

Consumption:

-       Houshold spending is affected by-

-       Consumer wealth:

-       More wealth= more spending (AD shift à)

-       Less wealth= Less spending (AD shifts ß)

-       Consumer expectations:

-       Positive expectations = More spending (AD shifts à)

-       Negative expectations= Less spending (AD shifts ß)

-       Household indeptedness

-       Less dept= More spending (AD à)

-       Taxes

-       Less taxes = more spendings (AD à)

-       More Taxes= Less spending (AD ß)

Gross private investment: INVESTMENT DEMAND

-       Investment spending is sensitive to:

-       Real interest rate:

-       Lower real interest rate = more investment (ADà)

-       Higher real interest rate = Less investment (ADß)

-       Expected returns:

-       Higher expected returns = more investment (ADà)

-       Lower expected returns = less investment (ADß)

Expectations of future profitability

Technology

Degree of excess capacity

Business Taxes

Government Spending

-       More government spending (ADà)

-       Less government spending  (ADß)

Net Exports

-       Sensitive to:

-       Exchange rates (international value of $)

-       Strong $= more imports and fewer exports= (AD)

-       Weak $= Fewer imports and more exports= (AD)

-       Relative Income:

-       Strong foreign

2/18/16

·      Aggregate Supply- the level of Real GDP (GDP4) that firms will produce at each price level (PL)

·      Long Run v. Short Run

Long Run	Short Run
Period of time where input prices are completely flexible and adjust to changes in the price level	Period of time where input prices are so sticky and do not adjust to the changes in price level
The level of real GDP supplied is independent of the price level	The level of Real GDP supplied is directly related to the price level

·      Long-Run Aggregate Supply (LRAS)- marks the level of full employment in the economy (analogous to PPC)

·      Because input prices are completely flexible in the long-run, changes in price-level do not change firms’ real profits and therefore do not change firms’ level of output. This means that the LRAS is vertical at the economy’s level of full employment

·      Changes in SRAS

-an increase in SRAS shift to the Right

- A decrease in SRAS is seen as a shift to the left

- The key to understanding shifts in SRAS is per unit cost of production

Per-unit production cost= total input cost/ total output

Input X Price= Cost

OR input price/Level of productivity   

·      Determinants of SRAS:

·      Input prices

-Domestic Resource Prices:

  -wages (75% of all business costs)

  -Cost of capital

  -Raw materials (commodity prices)

-Foreign Resource Prices

-Market Power

-Increase in Resource Prices= SRAS 

-Decrease in Resource Prices= SRAS

·      Productivity:

= total output/ total inputs

More productivity= lower unit production cost=SRAS 

Lower productivity= higher unit production cost= SRAS 

·      Legal-institutional environment:

Taxes and Subsidies

-Taxes ($ to gov’t) on business increase per unit production cost= SRAS 

-Subsidies ($ from gov’t) to business reduce per unit production cost= SRAS

·      Government Regulation

-Government regulation creates a cost of compliance= SRAS 

-Deregulation reduces compliance costs= SRAS 

2/19/16

·      Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point. 

·      Recessionary Gap exists when equilibrium occurs below full employment output. 

·      Inflationary Gap exists when equilibrium occurs beyond full employment output 

2/22/16

(SRAS GRAPH RANGES)

·      Nominal wages- the amount of money received by a worker per unit of time (clock in by the hour/day)

·      Real wages- The amount of goods and services a worker can purchase with their nominal wage. (PURCHASING POWER OF NOMINAL WAGE)

·      Sticky wages- it is the nominal wage level that is set according to an initial price level and it does not vary due to labor contracts or other restrictions.

		Price	Wages	Employment	Implications
Keynesian range	Recession	Fixed	Fixed	Flexible	output depends upon changes in the employment level
	Intermediate	Flexible	fixed	Flexible	Output depends upon changes in price and the employment level
Classical range	Inflation	Flexible	Flexible	Fixed	Output is independent of changes in the price level

                     

Interest Rates and Investment Demand:

·      What is investment?

·      Money spent or expenditures on

-New Plants (factories)

-Capital equipment (machinery)

-technology (hardware & software)

-New homes

-Inventories (goods sold by producers)

·      Expected Rates of Return

·      How does business determine the benefits?

Expected rate of return

·      How does business make investment decisions?

             Cost / benefit analysis

·      Business count the cost?

Interest costs

·      How does business determine the amount of investment they undertake?

Compare expected rate of return to interest cost

-       If expected return > interest cost, then invest

-       If expected return < interest cost, do not invest.

·      Real (r%) v. Nominal (i%)

·      What is the difference?

·      Nominal is the observation rate of interest. Real subtracts out inflation (Pi%) and is only known ex past facto.

·      How do you compute the real interest rate (r%)

·      (r%) = i%- pi%

·      What then, determines the cost of an investment decision?

·      Real interest rate (r%)

Investment Demand Curve (ID)

·      Shape of investment demand curve?

Downward sloping

·      Why?

When interest rates are high, fewer investments are profitable; when interest rate are low, more investments are profitable 

Shifts in investment Demand (ID)

·      Cost of production

-lower costs shift ID 

-Higher costs shift ID

·      Business taxes

-Lower business 

-Higher business 

·      Technological Change

-New tech ID 

-Lack of tech change 

·      Stock of capital

-if an economy is low

2/25/16

·      AP MACRO- Consumption and saving

·      Disposible income (DI)- income after taxes or net income

DI = Gross income – Taxes

·      2 choices:

·      with disposable income, households can either

-consume

-save

·      Consumption- household spending

the ability to consume is constrained by

-the amount of disposable income

-the propensity to save

·      Do households consume if DI = 0?

Yes

-Autonomous consumption

-dissaving

·      Saving- Household NOT spending

The ability to save is constrained by

-the amount of disposable income

-the propensity to consume

·      Do households save if DI = 0?

NO

·      APC (average propensity to consume) & APS (average propensity to save)

·      APC + APS = 1

·      1 – APC = APS

·      1 – APS = APC

·      APC > 1 : dissaving

·      - APS : dissaving

·      Marginal propensity to consume (MPC)- the fraction of any change in disposable income that is consumed

·      MPC = change in consumption/ change in disposable income

·      Marginal propensity to save (MPS)

·      The fraction of any change in disposable income that is saved

·      MPS= change in savings/ change in disposable income

·      MPC + MPS = 1

·      MPC = 1 - MPS

·      MPS = 1 – MPC

·      Remember people consume or save

·      The spending multiplier effect- an initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or AD

·      Multiplier= change in AD/ Change in spending

·      Calculator the spending multiplier- can be calculated from the MPC or MPS

·      Multiplier = 1/ 1- MPC or 1/ MPS

·      Multipler are (+) when there is an increase in spending and (-) when there is a decrease

·      Calculating the tax multiplier

-when the gov’t taxes, the multiplier works in reverse

why?

-money leaves circular flow

·      Tax multiplier (negative)

·      = -MPC / 1- MPC OR –MPC/ MPS

if there is a tax cut, then the multiplier is +

2/29/16

·      Fiscal Policy-in the expenditures or tax revenues of the federal govt

-two tools of fiscal policy:

taxes- govt can increase or decrease taxes

spending- govt can increase or decrease spending

·      Deficits, surplus, debt:

·      Balanced budget- revenues equals to expenditure

·      Budget deficit- revenue < Expenditures

·      Budget surplus- revenues > Expenditures

·      Government debt- sum of all deficits – sum of all surplus

·      Government must borrow money when it runs a budget deficit

·      Govt borrows from-

-individuals

-corporations

-financial institutions

-Foreign entities or foreign governments

·      Fiscal policy two options:

·      Discretionary fiscal policy (action)

-expansionary fiscal policy- think deficit

-contractionary Fiscal Policy- surplus

·      Non- discretionary fiscal policy (no action)

·      Discretionary- increasing or decreasing govt spending and/or taxes in order to return the economy to full employment. Economic problem.

·      Automatic- unemployment compensation & marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

Expansionary fiscal policy (easy)	Contractionary fiscal policy (tight)
Combat recession	Combat inflation
Inc govt spending	Dec govt spending
Dec taxes	Inc taxes

Automatic or built in stabilizers

·      Anything that increases govts budget deficit during recession and increases its budget surplus during inflation without requiring explicit action by policymakers.

Ex. Transfer payments- SSN, medicade, medicare, unemployment, veterans benefits

·      Progressive tax system- average tax rate (tax revenue/GDP) rises with GDP

·      Proportional tax system-average tax rate remains constant as GDP changes

·      Regressive tax system- Average tax rate fall with GDP