Unit 3 notes

Aggregate demand (AD)

• Shows the amount of real GDP that the privat, public and foreign sector collectively desire to purchase at each possible price level.
• The relationship between price level and level of real GDP is inverse
• Price level increases, output increases

Real balances effect

• Based on purchasing power
• High price, households and businesses cut on output purchase
• Low, more affordable

Interest rate effect

• High price level increases interest rate which tends to discourage investment
• Low price level decreases interest rate which tends to encourage investment

Foreign purchases effect

• High price level increases demand for relatively cheap imports 
• Low price levels increase foreign demand for cheaper US exports

What causes shifts in AD?

• Two parts to a shift in AD
• Change in C, Ig, G, Xn
• multiplier effect that produces a greater change than the original change in the 4 components
• An increase in AD would shift to the right, and the opposite if it were to decrease.

Consumption:

• Household spending affected by:

1. Consumer wealth
• More wealth, more spending (AD shifts to the right)
• Less wealth, less spending (AD shift to the left)
2. Consumer expectations
• Positive expectations = more spending (AD shift to the right)
• Negative expectations = less spending (AD shift to the left)
3. Household indebtedness
• Less debt = more spending (AD shift to the right)
• More debt = less spending (AD shift to the left)
4. Taxes
• Less taxes = more spending (AD shift to the right)
• More taxes = less spending (AD shift to the left)

Gross Private Consumption

• Investment spending sensitive to:

1. The real interest rate
• Low real interest rte= more investment (AD shift to the right)
• High real interest rate = less investment (AD shift to the left)
2. Expected returns
• Higher expected returns = more investment (AD shifts to the right)
• Lower expected returns = less investment (AD shifts to the left)
• Expected returns are influenced by:
• expectations of future probability
• technology
• degree of excess capacity (existing stock of capital)
• business taxes

Government spending

• More government spending (AD shift to the right)
• Less government spending (AD shift to the left)

Net exports

1. Exchange rate
• Strong $ = more imports, fewer exports (AD shift to the left)
• Weak $ = less imports. more exports (AD shift to the right)
2. Relative income
• Strong foreign economies = more exports (AD shift to the right)
• Weak foreign economies = less exports (AD shifts to the left)

Aggregate Supply

The level of Real GDP (GDPR) that firms will produce at each price level (PL)

Long Run v. Short Run

• Long run: time where input prices are flexible and adjust to change in price level
• level GDP supplied is independent of the price level
• Short run: time where input prices are sticky and don't adjust to change in price level
• level of GDP supplied is directly related to price level

Long run AS

• LRAS marks level of full employment in the economy (analogous to PPC)
• because input is completely flexible in the long run, changes in price level do not change firms real profits and so don't change firms level of output
• Meaning LRAS is vertical at the economies level of full employment
• SRAS is upward sloping because input prices are sticky

Remember

1. No matter whether its a decrease in supply or demand, it will always shift left
2. If it increases it will shift right

Per-unit production cost

• To get per-unit production cost = total input cost/total output
• The per-unit production cost is the key in understanding shifts

Determinants of SRAS:

• Input price
• Productivity
• Legal institutional environment

1. Input prices
• Domestic Resource prices
• wages (75% of all business prices)
• cost of capital
• raw materials (commodity prices)
• Foreign resource power
• Strong money = low foreign resource prices
• Weak money = high foreign resource prices
• Market power
• monopolies and cartel that control resources and control prices of those resources
• an increase in resource price shifts SRAS to the left
• a decrease would shift it to the right
2. Productivity
• Productivity = total output/total inputs
• More productivity = low unit production cost (AS shift to the right)
• Less productivity = high unit production cost (AS shift to the left)
3. Legal institutional enviroment
• Taxes and subsidies
• Taxes ($ to the govt.) on business increase per-unit production cost (AS shift to the left)
• Subsidies ($ from the govt.) to business reduce per-unit production cost (AS shift to the right)
• Government regulation
• Government regulation creates a cost of compliance (AS shift to the left)
• Deregulation reduce compliance cost (AS shift to the right)

Interest

• Full employment equilibrium exist where AD intersects with SRAS and LRAS at the same point
• Recessionary gap: exist when equilibrium occurs below full employment output
• AD shift to left with recessionary gap
• Inflationary gap: when equilibrium occur beyond full employment output
• AD shift to right with inflationary gap
• Unemployment increase, deflation decreases

Interest rate and investment demand

Investment: your expidentures

• New plants
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories

Expected rates of return

• How business makes investment decisions
• cost benefit analysis
• How businesses determine benefits
• Expected rate of return
• How businesses count cost
• interest cost
• How to determine the amount of interest
• compare expected rate of return to interest cost
• if expected cost > iterest then invest, if not, then don't invest

Real (r%) v. Nominal (i%)

• What is the difference?
• Nominal is the observable rate of interest
• Real subtracts out inflation only known to ex post facto
• How to compute real interest rate?
• r% = i% - π%
• What then determines cost of investment  decision?
• real interest rate (r%)

Investment demand curve (ID)

• is downward sloping because when interest rate is high people don't want to pay, few investments profitable

1. Cost of production
• Low cost shit ID to the right
• High cost shift ID to the left
2. Business taxes
• Low business taxes shift ID to the right
• High business taxes shift ID to the left 
3. Technological change
• New technology shift ID to the right
• Lack of technology shift ID to the left
4. Stock of capital
• Economy low on capital, ID shift to the right
• More capital, ID shifts to the left
5. Expectations
• Positive expectations shift ID to the right
• Negative expectations shift ID to the left
6. Long run
• Always vertical at full employment
• Represents point on an economy's production possibilities curve (PPC)
• Doesn't change as price level changes
• Only factors which would change it would be what  shifts the PPC outward
•  Δresources
•  Δtechnology
•  Δeconomic growth

Three Schools of Economics

Classical	Keynesian	Monetary
Savings(leakage) = investment injection	Savers ≠ investors	Allen Greenspon
Adam Smith	John Maynard	Ben Bernank
John B. Say
David Ricardo
Affard Marshall

• Classical
• Competition is good
• Adam Smith: invisible hand >> don't need government intervention, run without it
• Say's law
• supply creates own demand
• As determine output
• In the long run, economy will balance at FE
• The economy is always at or close to FE
• AS=AD at full employment equilibrium
• Trickle down effect
• Help rich first, everybody else later
• Savings increase with interest rate
• save more at high interest, low interest rate you spend
• Prices and wages flexible downward
• Foster Laissez faire >> don't need the government
• Keynesian
• Competition is flawed
• AD is key, not AS 
• AD determines own output, demand create own supply
• Leaks cause constant recessions
• savings cause recessions
• Savings and investors save and invest for different reasons
• savings inverse to interest rate
• Ratchet effect and sticky wages block Say's law
• Prices and wages inflexible downward
• Since there is no guarantee of FE, in the long run, we are all dead
• The economy is never close to or at FE
• Use fiscal policy, add stabilizers, use expansionary and contract policy
• Monetary
• Fine tuning needed
• Voters won't allow contract. actions
• Congress can't time policy actions
• Institute easy money and type money
• Change regulation reserves if needed
• Buy and sell bond via open market operations
• Use interest rate to change discount and federal fund rates

Consumption and Savings

• Two choices; with disposable income, households can either:
1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)
• Disposable income (DI)
• Income aft taxes or net income
• DI = gross income - taxes
• Consumption
• Household spending
• Ability to consume constrained by
• amt of disposable income
• propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• Dissaving
• APC = C / DI = % DI that is spent
• Saving
• Household not spending
• Savings constrained by
• amt of  disposable income
• the propensity to save
• Do households save if DI = 0?
• No
• APS = S/DI = % that is not spent
• Calculations
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = Dissaving
• -APS = Dissaving

MPC and MPS

• Change in consumption/change in DI
• Marginal propensity to save and marginal propensity to consume
• ΔS/ΔDI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC
• Spending multiplier effect
• initial change in spending (C, Ig, G, Xn) causes larger change in Aggregate spending or Aggregate demand
• Multiplier = Δ in AD/C, Ig, G, Xn
• Why does this happen?
• Expenditures and incomes flow continuously which sets off a spending increase in the economy
• Spending multiplier can be calculated from MPC or MPS
• Multiplier = 1/1-MPC or 1/MPS
• Multipliers are positive (+) when there is an increase in spending and negative (-) with a decrease
• Tax multiplier (note it is negative)
• When government taxes, multipliers work in reverse because money is leaving the circular flow
• -MPC/1-MPC or -MPC/MPS
• If there is a tax cut, then mulltiplier (+), because more money is in the circular flow

Fiscal Policy

• Change in expenditures or tax revenues of federal government
• 2 tools
• Taxes (increase or decrease)
• Spending (increase or decrease)
• Deficits, surpluses, & Debt
• Balanced budget
• Revenue=Expenditures
• Budget deficit: spending more than what is being brought in
•  Revenue<Expenditures
• Budget surplus: bringing in more than what spent out 
• Revenue>Expenditures
• Government debt
• sum of all deficits – summation of all surplus
• Government must borrow money when in budget deficit
• Borrow from:
• Individuals
• Corporation
• Financial institutions
• Foreign entitled foreign government

Fiscal policy

• Two options:

1. Discretionary (action)
• expansionary fiscal policy (think deficit)
• contractionary (think surplus)
2. Non-discretionary (no action)

Discretionary v. Automatic

• Discretionary
• Increase or decrease government spending/taxes in order to return the economy to full employment
• Involves policy makers in response to economic problems
• Automatic
•  Unemployment compensation and marginal tax rates are examples of automatic policies that mitigate recession and inflation effects
• Takes place without policy makers having to respond to current economic problems

• Contractionary fiscal policy
• policy designed to decrease AD
• strategy for combating inflation
• decrease govt. spending and increase taxes
• Expansionary fiscal policy 
• policy designed to increase AD
• strategy for increasing GDP
•  strategy for combating recession and reducing unemployment
• increase govt. spending and decrease taxes.  
• Automatic or built-in stabilizers: (non-discretionary)
• anything that increases the governments budget deficit during a recession and increases its budget surplus during inflation without requiring action from policy makers
• Transfer payments:
• Welfare checks
• Unemployment checks
• Social security
• Food stamps
• Corporate dividends 
• Veteran's benefit
• Progressive tax system:
• avg. tax rate (tax revenue/GDP) rises w/ GDP 
• Proportional tax system
• avg. tax rate remains constant as GDP changes 
• Regressive tax system
• avg. tax rate falls w/ GDP