Unit 3 Economics

Unit 3

2/12/16

Aggregate Demand Curve

o   AD is demand by consumers, businesses, government & foreign countries.

o   Changes in price level cause movement along the curve.

Why is AD downward sloping?

1.    Real-Balance Effect:

v  Higher price levels reduce the purchasing power of money

v  This decreases the quantity of expenditures

v  Lower price levels increase purchasing power & increase expenditures

2.    Interest-Rate Effect:

v  When the price level increases, lenders need to change higher interest rates to get a REAL return on their loans

v  Higher interest rates discourage spending and business investment

3.    Foreign-Trade Effect:

v  When U.S. price level rises, foreign buyers purchase fewer U.S. goods
& Americans buy more foreign goods

v  Exports fall and imports rise causing real GDP demanded to fall (XN decreases)

Shifters of Aggregate Demand

              GDP= C+Ig+G+Xn

§  There are two parts to a shift in AD:

1)    A change in C, Ig, G and/or Xn

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

§  Increases in AD= AD shift to the right

§  Decreases in AD= AD shift to the left

Determinants of AD:

§  Consumption:

Household spending is affected by:

►   Consumer Wealth

·         More wealth = more spending (AD à)

·         Less wealth = less spending (AD ß)

►   Consumer Expectations

·         Positive expectations = more spending (AD à)

·         Negative Expectations = less spending (AD ß)

►   Household Indebtedness

·         Less debt = more spending (AD à)

·         More debt = less spending (AD ß)

►   Taxes

·         Less taxes = more spending (AD à)

·         More taxes = less spending (AD ß)

§  Gross Private Investment

Investment spending is sensitive to:

►   The Real Interest Rate

·         Lower interest rate = more investment (AD à)

·         Higher interest rate = less investment (AD ß)

►   Expected Returns

·         Higher expected returns = more investment (AD à)

·         Lower expected returns = less investment (AD ß)

·         Expected returns are influenced by:

1)    Expectations of future profitability

2)    Technology

3)    Degree of Excess Capacity (existing stock of capital)

4)    Business taxes

§  Government Spending

►   More government spending (AD à)

►   Less government spending (AD ß)

§  Net Exports

Sensitive to:

►   Exchange Rates (International value of $)

·         Strong $ = more imports & fewer exports (AD ß)

·         Weak $ = fewer imports & more exports (AD à)

►   Relative Income

·         Strong foreign economies = more exports (AD à)

·         Weak foreign economies = less exports (AD ß)

2/18/16

Aggregate Supply

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

Long Run	Short Run
v  Period of time when input prices are completely flexible & adjust to change in the price-level v  The level of Real GDP supplied is independent of the price level	v  Period of time where input prices are sticky and do NOT adjust to changes in the price level v  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

►   Full Employment (FE, Y*)

Changes in SRAS

►   An increase in SRAS is seen as a shift to the right (SRAS à)

►   A decrease in SARAs is seen as a shift to the left (SRAS ß)

►   The key to understanding shifts in SRAS is per unit cost of production (= [total input × price]/total output)

Determinants of SRAS

►   Input Prices

                              I.        Domestic Resource Prices

a)    Wages (75% of all business costs)

b)    Cost of Capital

c)    Raw materials (commodity prices)

                            II.        Foreign Resource Prices

                           III.        Market Power

                          IV.        Increases in Resource Prices = SRAS ß

                           V.        Decreases in Resource Prices = SRAS à

►   Productivity

=total output/ total input

                                      I.        More productivity = lower unit production cost= SRAS à

                                    II.        Lowe productivity = higher unit production cost = SRAS ß

►   Legal-Institutional Environment

                                      I.        Taxes & Subsidies

a)    Taxes ($ to the government) on business increase per unit production cost = SRAS ß

b)    Subsidies ($ from the government) to business reduce per unit production cost= SRAS à

                                    II.        Government Regulation

a)    Government regulation creates a cost of compliance = SRAS ß

b)    Deregulation reduces compliance costs = SRAS à

2/19/16

Full Employment

o   Full employment equilibrium exists where AD intersects SRAS & LRAS at the same point

Recessionary Gap

o   Exists when equilibrium occurs below full employment output

Inflationary Gap

o   Exists when equilibrium occurs beyond full employment output

2/22/16

Nominal Wages

o   The amount received by a worker per unit of time

Real Wages

o   the amount of goods & services a worker can purchase with their nominal wages

Sticky Wages

o   it is the nominal wage level that is set according to an initial price level & DOES NOT vary do to labor, contracts or other restrictions

Interest Rates & Investment Demand

v Investment

·         Money spent or expenditures on:

a)    New Plants (factories)

b)    Capital Equipment (machinery)

c)    Technology (hardware & software)

d)    New Homes

e)    Inventories (goods sold by producers)

v  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 cost

·         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, then do NOT invest

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

•      What's the difference?
•      Nominal is observable rate of interest. Real subtracts out inflation (pi %) and is only know ex post facto.
•      How do you compute the real interest rate (r%)? r% = i% - pi%
•      What then, determines the 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

Shifts in ID

v Cost of Production

§  Lower costs shift ID →

§  Higher costs shift ID ←

v  Business Taxes

§  Lower business taxes shifts ID→

§  Higher business taxes shift ID ←

v  Technological Change

§  New technology shifts ID →

§  Lack of technology shifts ID ←

v  Stock of Capital

§  If economy is low on capital, then ID →

§  If economy has much capital, then ID  ←

v  Expectations

§  Positive expectations shift ID →

§  Negative expectations shift ID ←

2/25/16

Consumption & Saving 

·         Disposable Income (ID)

o    Income after taxes or net income

o    DI= Gross Income - Taxes

o    2 Choices: with disposable income, households can either

§  Consume (spend money on goods & services)

§  Save (to not spend money on goods & services)

·         Consumption

o    Household spending

o    The ability to consume is constrained by

§  The amount of disposable income

§  The propensity to save

o    Do households consume if DI=0?

§  Autonomous consumption

§  Dissaving

o    APC = C/ DI =% DI that is spent

·         Saving

o    Household not spending

o    The ability to save is constrained by

§  the amount of disposable income

§  The propensity to consume

o    Do household save if DI=0?

§  No

Average Propensity to Consume & Average Propensity to Save

·         APC & APS

o    APC + APS =1

o    1 - APC =APS

o    1 - APS =APC

o    APC > 1: Dissaving

o    –APS: Dissaving

·         MPC & MPS

o   Marginal Propensity to Consume

§  ΔC/ΔDI

§  % of every extra dollar earned that is spent

o   Marginal Propensity to Save

§  Δg/ΔDI

§  % of every extra dollar earned that is saved

o   MPC = MPS =1

o   1 –MPC= MPS

o   1 –MPS= MPC

Determinants of C & S

•         Wealth

–        Increased wealth .: Inc. C & Dec. S

–        Decreased wealth .: Dec. C & Inc. S

•         Expectations

–        Positive .: Inc C & Dec S

–        Negative .: Dec C & Inc S

•         Household Debt

–        High Debt .: Dec C & Inc S

–        Low Debt .: Inc C & Dec S

•         Taxes

–        Taxes Inc .: Dec C & Dec S

–        Taxes Dec .: Inc C & Inc S

Marginal Propensity to Consume (MPC):

·         The fraction of any change in disposable income that is consumed.

·         Formula:  MPC = Change in Consumption/ Change in Disposable Income

·         MPC =  ΔC / ΔDI

Marginal Propensity to Save (MPS):

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

·         Formula:  MPS= Change in Savings / Change in Disposable Income

·         MPS =  ΔS / ΔDI 

Marginal Propensities:

·         MPC + MPS = 1

·         MPC = 1 - MPS

·         MPS = 1 - MPC

·         Remember, people do two things with their disposable income. They consume it or save it. 

The Spending Multiplier Effect:

·         An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD). 

·         Formula:  Multiplier = Change in AD / Change in Spending

·         Formula:  Multiplier = ΔAD / Δ C, Ig, G, or Xn

Calculating the Spending Multiplier:

·         The spending multiplier can be calculated  by the MPC or the MPS.

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

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

Classical: 

·         Competition is good.

·         The invisible hand (means market will fix itself no government needed.)

·         In the long run, the economy will balance at full employment. 

·         Trickle down effect (help the rich first and everybody else second.)

·         The economy is always close to or at full employment. 

Keynesian: 

·         Competition is fraud.

·         AD is the key not AS.

·         Lits & Savings cause recessions.

·         Ratchets effects & sticky wages blocked Say's Law.

·         In the Long Run, we are all dead. 

2/29/16

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 entitles or 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 v. Automatic Fiscal policies:
- Discretionary:

·         Increasing or decreasing Government Spending and/or Taxes in order 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 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")

·         Combat a recession 

·         Increase government spending, Decrease taxes 

Contractionary Fiscal Policy:

·         ("Tight")

·         Combat inflation

·         Decrease government spending, Increase taxes 

Automatic or Built-In Stabilizers: 

- Anything that increase the governments budget deficit during a recession and increases it budget surplus during inflation without requiring explicit action by policymakers.

- Economic Importance:

·                     Taxes reduce spending & Aggregate Demand 

·                     Reductions in spending are desirable when the economy is moving toward inflation. 

·                     Increases in spending are desirable when the economy is heading toward recession.

For further explanation, visit any of these links:

AD & AS

Fiscal Policy

Classical v. Keynesian Economics