Unit 3

Aggregate Demand (AD)

·         Price level in Real GDP

·         Shows the amount in Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level

·         Relationship between price level and the level of Real GDP is inverse

 

3 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 output

- 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 (AD)

·         There are 2 parts to a shift in AD

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

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

·         Increases in AD = AD goes Right

·         Decreases in AD = AD goes Left

 

 

 

 

 

Aggregate Supply (AS)

·         Level of Real GDP that firms will produce at each price-level (PL)

Long Run Vs. 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)

·         ALWAYS VERTICLE

 

 

- What Causes LRAS to Shift

·         Increase in capital

·         Technology

·         Economic growth

·         Entrepreneurship

·         Resources available

Short Run Aggregate Supply (SRAS)

·         SRAS is upward sloping

 

 

- Changes in SRAS

·         Increase in SRAS is seen as a shift to the right. SRAS -->

·         Decrease in SRAS is seen as a shift to the left. SRAS <--

·         The 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

o    Increase in resource prices = SRAS <--

o    Decrease in resource prices = SRAS -->

·         Productivity

o    = total output / total inputs

o    more productivity = lower unit production cost = SRAS -->

o    lower productivity = higher unit production cost = SRAS <--

·         Legal - institutional environment

 

 

 

 

What is Investment?

·         Money spent or expenditures on:

o    New plants (factories)

o    Capital equipment (machinery)

o    Technology (hardware & software)

o    New homes

o    Inventories (goods sold by producers)

Expected Rates of Return

- How does business make investment decisions?

·         Cost/benefit analysis

- How does business determine the benefits?

·         Expected rate of return

- How does business count the cost?

·         Interest costs

- How does business determine the amount of investment they undertake

·         Compare expected rate of return to interest cost

o    If expected return > interest cost, then invest

o    If expected return < interest cost, then do not invest

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

- What's the difference?

·         Nominal is the observance rate of interest. Real subtracts out inflation (pi%) and is only known ex post facto.

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

·         r% = i% - pi%

- What determines cost of an investment decision?

·         The real interest rate (r%)

Investment Demand Curve (ID)

- What is the shape of the investment demand curve?

·         Downward sloping

- Why?

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

·         Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Shifts in Investment Demand (ID)

·         Cost of production

·         Business taxes

·         Technological demand

·         Stock of capital

·         Expectations

Consumption and Savings

Disposable Income

·         Income after taxes or net income

2 Choices:

·         With disposable income, households can either

o    Consume (spend money on goods and services)

o    Save (not spend money on goods and services)

Consumption

·         Household spending

·         The ability to consume is constrained by

o    Amount to disposable income

o    Propensity to save

- Do households consume in (decreasing)DI = 0?

·         Autonomous consumption

·         Dissaving

Savings

·         Household not spending

·         Ability to save is constrained by

o    The amounts of disposable income

o    Propensity to consume

- Do households save if DI = 0?

·         NO

APC/APS

·         APC - average propensity to consume

·         APS - average propensity to save

- Formulas

·         APC + APS = 1

·         1 - APC = APS

·         1 - APS = APC

·         APC>1 = Dissavings

·         - APS = Dissavings

MPC/MPS

·         MPC = marginal propensity to consume

o    ΔC / ΔDI

o    Percent of every extra dollar earned that is spent

·         MPS = marginal propensity to save

o    ΔS / ΔDI

o    Percent of every extra dollar earned that is saved

- Formulas

·         MPC + MPS = 1

·         1 - MPC = MPS

·         1 - MPS = MPC

Determinants of C & S

·         wealth

·         expectations

·         household debt

·         taxes

The Spending Multiplier Effect

·         An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or aggregate demand (AD)

Multiplier = change in AD / change in spending
Multiplier = ΔAD / Δ C,I,G, or X

- 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 / 1 - MPC [or] 1 / 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 / 1 - MPC [or] -MPC / MPS

·         If there is a tax- CUT, then the multiplier is (+), because there is now more money in the circular flow

MPS, MPC and Multiplier Examples

1. Assume the U.S. citizens spend 90cents for every extra $1 they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in Ig on U.S. Aggregate Demand (AD).

1.       Calculate the MPC & MPS

o    MPC = ΔC / ΔDI = .9/1 = .9

o    MPS = 1 - MPC = .10

2.       Determine which multiplier to use, whether its (+) or (-)

o    The problem mentions an increase in ^IG .: use a (+) spending multiplier

3.       Calculate the spending and/or tax multiplier

o    1 / MPS = 1 / .10 = 10

4.       Calculate the change in AD

o    (ΔC, Ig, G, or Xn) * spending multiplier

o    ($50 billion ^Ig) * (10) = $500 billion ^AD

2. Assume Germany raise taxes on its citizens by 200 billion. Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the 200 billion change in taxes on the German economy

1.       Calculate the MPC & MPS

o    MPS 25% = .25

o    MPS = 1 - MPS = 1 - .25 = .75

2.       Determine which multiplier to use, whether its (+) or (-)

o    Tax multiplier because it said change in taxes

3.       Calculate the spending and/or tax multiplier

o    -MPC / MPS = -.75 / .25 = -3

4.       Calculate the change in AD

o    (ΔTax) * tax multiplier

o    (200 billion ΔT) * (-3) = -600 billionΔAD

 

 

 

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

o    Revenues = Expenditures

·         Budget Deficit

o    Revenues < Expenditures

·         Budget Surplus

o    Revenues > Expenditures

·         Government Debt

o    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 entities or foreign government

Fiscal Policy Two Options

1.       Discretionary Fiscal Policy (action)

o    Expansionary fiscal policy - think deficit

o    Contractionary fiscal policy - think surplus

2.       Non - Discretionary Fiscal Policy (no action)

Discretionary VS. Automatic Fiscal Policy

- Discretionary

·         Increasing or decreasing government spending and/or taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem

- Automatic

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

Contractionary VS Expansionary Fiscal Policy

- Contractionary Fiscal Policy

·         Policy designed to decrease aggregate demand

·         Strategy for controlling inflation

- Expansionary Fiscal Policy

·         Policy designed to increase aggregate demand

·         Stategy for increasing GDP, combating a recession, and reducing unemployment

Expansionary Fiscal Policy

·         Recession is countered with expansionary policy

o    Increase government spending

o    Decrease taxes

Contractionary Fiscal Policy

·         Inflation is countered with contractionary policy

o    Decrease government spending

o    Increase taxes

·         Progressive Tax Rate

o    Average tax rate (tax revenue/GDP) rises with GDP

·         Proportional Tax System

o    Average tax rate remains constant as GDP changes

·         Regressive Tax system

o    Average tax rate falls with GDP

·         The more progressive the tax system, the greater the economies built in stability