Unit 3 Notes

Aggregate Demand

• Shows the amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level
• Relationship between price level and Real GDP is inverse

Reasons Why AD is Downward Sloping:

• Real Balances Effect
• When the price level is high, households and businesses cannot afford to purchase as much output
• When the price level is low, households and businesses can afford to purchase more outputs
• Interest Rate Effect
• A higher price level increases the interest rate which tends to discourage investment
• A lower price level decreases the interest rate which tends to encourage investment
• Foreign Purchases Effect
• A higher price level increases the demand for relatively cheaper imports
• A lower price level increases the foreign demand for relatively cheaper U.S exports

Shifts in Aggregate Demand

• Change in C, Ig, G, and Xn
• Multiplier Effect
• Produces a greater change than the original change in the 4 components
• Increase in AD = AD →
• Decrease in AD = AD ←

Determinants of AD

• Consumption
• House spending is affected by:
• Consumer Wealth
• More Wealth = More Spending AD →
• Less Wealth = Less Spending AD ←
• Consumer Expectations
• Positive Expectations = More Spending AD →
• Negative Expectations= Less Spending AD ←
• Household Indebtedness
• Less Debt = More Spending AD →
• More Debt = Less Spending AD ←
• Taxes
• Less Taxes = More Spending AD →
• More Taxes = Less Spending AD ←
• Gross Private Investment
• Investment spending is sensitive to:
• Real Interest Rate
• Lower Interest Rate = More Investment AD →
• Higher Interest Rate = Less Investment AD ←
• Expected Returns
• Higher Expected Returns = More Investment AD →
• Lower Expected Returns = Less Investment AD ←
• Expected Returns are influenced by:
• Expectation of future profitability
• Technology
• Degree of excess capacity (existing stock of capital)
• Business taxes
• Government Spending
• More government spending AD →
• Less government spending AD ←
• Net Exports
• Net exports are sensitive to:
• Exchange Rate (International Value of Dollar)
• Strong Dollar = More Imports and Less Exports AD ←
• Weak Dollar = Less Imports and More Exports AD →
• Relative Income
• Stronger Foreign Economies = More Exports AD →
• Weak Foreign Economies = Less Exports AD ←

Aggregate Supply

• Level of Real GDP (GDPr) that firms will produce at each price level

Long-Run v. Short-Run

• Long-Run
• Period of time where input prices are completely flexible and adjust to changes in the price-level
• In the long-run, the level of Real GDP supplied is independent of the price-level
• Short-Run
• Period of time where input prices are sticky and do not adjust to changes in the price-level
• In the short-run, the level of Real GDP supplied is directly related to the price level

Long-Run Aggregate Supply (LRAS)

• 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
• Always vertical to full employment
• Represents a point on an economy’s production possibilities curve
• Does not change as price level chenges
• Things that change LRAS same thing that change PPC curve outward (Resources, Technology, Economic Growth)

Short-Run Aggregate Supply (SRAS)

• Because input prices are sticky in the short run, SRAS is upward sloping

Changes in SRAS

• Increase in SRAS seen as shift to the right
• Decrease in SRAS seen as shift to the left
• Key to understanding shifts in SRAS is per unit cost of production
• Per-unit production cost = total input cost/total output

Determinants of SRAS (all of the following affect unit production cost)

• Input Prices
• Domestic Resource Prices
• Wages (75% of all business cost)
• Cost of capital
• Raw Materials (commodity prices)
• Foreign Resource Prices
• Strong $ = lower foreign resource prices
• Weak $ = higher foreign resource prices
• Market Power
• Monopolies and cartels that control resources control the price of those resources
• Increases in Resource Prices = SRAS ←
• Decreases in Resource Prices = SRAS →
• Productivity
• 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 on business increase per unit production cost = SRAS  ←
• Subsidies to business reduce per unit production cost = SRAS →
• Government Regulation
• Government regulation creates a cost of compliance = SRAS  ←
• Deregulation reduces compliance costs = SRAS →

AS/AD Model

• Full Employment
• Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point.
• Recessionary Gap
• Exists when equilibrium occurs below full employment output
• Anytime you have recessionary gap, AD goes to the left (Decreases)
• Inflationary Gap
• Exists when equilibrium occurs beyond full employment output

Interest Rates and Investment Demand

Investment

• Money spent on expenditures
• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• New homes
• Inventories (goods sold by producers)

Expected Rates of Return

• Business makes investment decisions

• Cost/Benefit Analysis
• Business determines benefits
• Expected rate of return
• Business count the cost
• Based upon interest cost
• Business determine amount of investment they undertake
• Compare expected rate of return to interest cost
• Expected Return > Interest Cost (Invest)
• Expected Return < Interest Cost (Do Not Invest)
• Real (r%) v. Nominal (i%)
• Difference
• Nominal is observable rate of interest. Real subtracts out inflation (丌%) and is only known ex post facto
• How to compute
• r% = i% - 丌%
• Determines cost of investment decision
• Real interest (r%)

Investment Demand Curve

• Shape of demand curve
• Downward sloping
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
• Shifts in Investment Demand
• Cost of production
• Lower costs shift ID →
• Higher costs shift ID ←
• Business Taxes
• Lower business taxes shift ID →
• Higher business taxes shift ID ←
• Technological Change
• New technology shifts ID →
• Lack of technological change shifts ID ←
• Stock of Capital
• If an economy is low on capital, then ID shifts →
• If an economy has much capital then ID shifts ←
• Expectations
• Positive expectations shift ID →
• Negative expectations shift ID ←

Three Schools of Economics

Classical

• Adam Smith
• Invisible hand
• Don’t need government intervention in order to function
• Competition is good
• John B. Say
• Say’s Law
• Supply creates its own demand
• AS determines output
• David Ricardo
• Alfred Marshall
• In the long run, the economy will balance at full employment
• The economy is always close to or at full employment
• AS=AD at Full Employment Equilibrium
• Trickle Down Effect- Help rich first and everybody else later
• Savings (leakage) = Investment (injection)
• Savings increase with the interest rate
• The lower the interest rate, more consumers spend
• Prices and wages are flexible downwards
• Foster laissez-faire

Keynesian

• John Maynard Keynes
• Competition is flawed
• AD is key and not AS
• AD determines it’s own output, demand creates creates its own supply
• Leaks cause constant recession
• Savings cause recessions
• Savers and investors save and invest for different reasons
• Savings are inverse to the interest rate
• Ratchet effect and sticky wages block Say’s law
• Prices and wages are inflexible downwards
• Since there is no mechanism capable of guaranteeing full employment, in the long run we are all dead
• Economy is not always close to or at full employment
• There is government intervention
• Use fiscal policy
• Uses contractionary and expansionary policy

Monetary

• Alan Greenspan
• Ben Bernanke
• Fine tuning is needed
• Voters won’t allow contractionary options
• Congress can’t time policy options
• Institute Easy Money and Tight Money
• Change required reserves if needed
• Buy and sell bonds through open market
• Use interest rates to change discount rate and federal fund rate

Fiscal Policy

• Changes in the expenditures or tax revenues of the federal government
• 2 Tools of Fiscal Policy:
• Taxes - Government can increase or decrease taxes
• Spending - Government can increase or decrease spending

Deficits, Surpluses, and Debt

• Balanced Budget:
• Revenues = Expenditures
• Budget Deficit:
• Revenues < Expenditures
• Budget Surplus:
• Revenues > Expenditures
• Government Debt:
• Sum of all deficits - sum of all surpluses
• Government must borrow money when it runs a budget deficit
• Government borrows from:
• Individuals
• Corporations
• Financial institutions
• Foreign entitled of foreign government

Fiscal Policy Two Options

• Discretionary Fiscal Policy (Action):
• Expansionary Fiscal Policy - think deficit
• Contractionary Fiscal Policy - think surplus
• Non Discretionary Fiscal Policy (No Action)

Discretionary vs. Automatic Fiscal Policies

• Discretionary - Increasing or decreasing government and/or taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing policy in response to an economic problem
• Automatic - Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effect of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems
• Contractionary fiscal policy - policy designed to decrease aggregate demand. Strategy for controlling inflation.
• Expansionary fiscal policy - policy designed to increase aggregate demand. Strategy for increasing GDP, combatting a recession and reducing unemployment.
• Expansionary Fiscal Policy: increase government spending; decrease taxes. Cannot happen at the same time.

• Contractionary Fiscal Policy: decrease government spending, and increase taxes.

Automatic or Built-In Stabilizers

• Anything that increases the government's budget deficit during a recession and increased its budget surplus during inflation without requiring explicit action by policy makers

No Discretionary Fiscal Policy

• Transfer Payments
• Welfare checks
• Food stamps
• Unemployment checks
• Progressive income taxes
• Corporate dividends
• Social security
• Veteran's 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 falls with GDP

Consumption and Saving

• Disposable Income:
• Income after taxes or net income
• DI= Gross Income - Taxes
• Two choices: With disposable income, households can either
• Consume (spend money on goods & services)
• Save (not spend money on goods & services)
• 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?
• Autonomous consumption
• Dissaving
• -APC = C/DI = % DI that is spent
• 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.
• -APS = S/DI = % DI that is not spent
• APC= Average Propensity to Consume
• APS = Average Propensity to Save
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 .: Dissaving
• -APC
• MPC= Marginal Propensity to Consume
• Change in C divided by change in DI
• % of every extra dollar earned that is spent
• MPS= Marginal Propensity to Save
• Change in S divided by change in DI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1-MPC=MPS
• 1-MPS=MPC  
• The Spending Multiplier Effect
• An initial change in spending(C,Ig,G, Xn) causes a larger change in aggregate spending of Aggregate Demand
• Multiplier = Change in AD divided by the  Change in Spending
• = Change in AD divided by the change in C, Ig, G, or Xn
• Why does this happen?
• Expenditures and income flow continuously which sets off a spending increase in the economy
• Calculating the Spending Multiplier
• The Spending Multiplier can be calculated from the MPC or the MPS
• Multiplier = 1 divided by 1 - MPC or 1 divided by MPS
• Multipliers are(+) when there is an increase in spending and(-) when there is a decrease.
• Calculating the Tax Multiplier
• When the government taxes, the multiplier works in reverse.
• Why? Because now money is leaving the circular flow.
• Tax Multiplier = -MPC divided by 1 - MPC or -MPC divided by MPS
• If there is a tax-cut, then the multiplier is positive, because there is now more money in the circular flow