Unit 3 Notes

Aggregate Demand (2/11/15)

AD: Shows amount of real GDP that the private, public, and foreign decor collectively desire to purchase at each possible price level. 

• Relationships between the price level and the level of real GDP is inverse

3 Reasons AD is Downward Slopping:

• Real Balances Effect: 

-When the price level is high; households and businesses can not afford to purchase as much output
-When price level low, households and businesses can afford to purchase more output

• Interest Rate Effect: 

-Higher price level increases interest rate which tends to discourage investment
-Lower price level decreases the interest rate which tends to encourage investment

• Foreign Purchases Effect:

-Higher price level increases the demand for relatively cheaper imports
-Lower price level increases foreign demand for relatively cheaper exports

Shifts in AD:
*There are 2 parts to shifts in AD

• A change in C, Ig, G, and/or Xn
• Multiplier effect that produces a greater change than original change in 4 components 

Increases in AD = Shifts right
Decreases in AD = Shifts left 

Increases in AD

Decreases in AD 

Consumption:
-Consumer wealth
More wealth = more spending (AD shifts right)
Less wealth = less spending (AD shifts left) 

-Consumer Expectations 
Positive expectations = more spending (AD shifts right)
Negative expectations = less spending (AD shifts left) 

-Household indebtedness 
Less debt = more spending (AD shifts right)
More debt = less spending (AD shifts left)

-Taxes
Less taxes = more spending (AD shifts right)
More taxes = less spending (AD shifts left) 

Gross Private Investment:

• Investment spending is sensitive to:

The Real Interest Rate:
Lower interest rate = more investment (AD shifts right) 
Higher interest rate = less investment (AD shifts left) 

-Expected Returns 
Higher expected returns = more investment (AD shifts right) 
Lower expected returns = less investment (AD shifts left) 

-Expected Returns are influenced by:

• Expectations for future profitability 
• Technology 
• Degree of excess capacity (existing stock of capital) 

Government Spending:
More government spending (AD shifts right)
Less government spending (AD shifts left) 

Net Exports:

• Net exports are sensitive to:

-Exchange Rates (international value of $)
Strong $ = more imports and fewer exports (AD shifts left)
Weak $ = fewer imports and more exports (AD shifts right)

Relative Income:
Strong foreign economies = more exports (AD shifts right)
Weak foreign economies = less exports (AD shits left)

Aggregate Supply (2/12/15)

Long Run: Period of time where input prices are flexible and adjustable to changes in price level.

• Level of RGDP supplied is independent of price level 

Short Run: Period of time where input prices are sticky and do not adjust to change in price level

• Level of RGDP supplied directly related to price level 

RGDP = output 

Long- Run AS (LRAS):
-LRAS makes level of full employment in economy (analogues to PPC)
-Because input prices completely flexible in long-run, changes in price level do not change firms real profits and do not change firms level of output. This means LRAS is vertical at economy's level of full employment.

LRAS Graph

Short-Run AS (SRAS)
-Because input prices are sticky in short run, the SRAS is upward sloping

SRAS Graph

Changes in SRAS

• increase in SRAS = shifts right 
• decrease in SRAS = shifts left 
• key to understanding shifts in SRAS is per unit cost of production 

Per-Unit Production Cost: Total input cost / total output

Increase in AS 

Decrease in AS 

Determinants of SRAS (all affect unit production cost)

Input Prices:

• Domestic Resource Prices 
• Wages (75% all business costs)
• Cost of capital 
• Raw material (commodity prices)

Foreign Resource Prices:
Strong $ = lower foreign resource prices 
Weak $ = higher foreign resource prices 

Market Power:

• Monopolies and cartels (Ex. OPEC dollars for oil) control resources, control prices of resources 

Increase in resource prices = SRAS shifts left 
Decrease in resource prices = SRAS shifts right 

Productivity:

• P = total output / total inputs 
• More production = lower unit production costs (SRAS shifts right) 
• Lower production - high unit production cost (SRAS shifts left) 

Legal Institution Environment
Taxes & Subsidies 

• Taxes ($ to gov.) to business increase per unit production cost = SRAS shifts left 
• Subsidies ($ from gov.) to business reduce per unit production cost = SRAS shifts right 

Government Regulation:

• Governemnt regulation creates cost of compliance = SRAS shifts left 
• Deregulation reduces cost of compliance = SRAS shifts right 

Notes (2/17/15)

Full Employment: Full employment equilibrium exists where AD intersects SRAS & LRAS at same point 

Recessionary Gap: Exists when equilibrium occurs below FE output 

Inflationary Gap: Exists hone equilibrium occurs beyond FE output 

• u = unemployment 
• (pie sign) = inflation (Cheat sheet) 

Investment: Money spent or expenditures on:

• New plants (factories) 
• Technology (hardware and software)
• Inventories (goods sold by producers) 
• Capital equipment (machinery)
• New homes 

Expected Rates of Return:

How business make investment decisions? 

• Cost/ benefit analysis

How does business determine 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 
• if expected return > interest cost, then invest
• if expected return < interest cost, then do not invest 

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

Difference?

• Nominal is observable rate of interest, real subtracts out inflation and only know export factor 

How to compute relate interest rate (r%) ?

• r% = i% - (pie symbol)%

What determines cost of investment decision?

• Real interest rate (r%)

Investment Demand Curve

What is the shape of Investment Demand Curve?

• Downward slopping 

Why?

• When interest rates are higher, fewer investments are profitable
• When interest rates are lower, more investments are profitable 

Shifts in Investment Demand (2/18/15) 

Cost of Production:

lower costs shift ID right 

higher costs shift ID left 

Business Taxes :

lower business taxes shifts ID right 

higher business taxes shifts ID left 

Technological Change: 

new tech. shifts ID right

lack tech. shifts ID left 

Stock of Capital: 

if economy low on capital = ID shifts right 

if economy high on capital = ID shifts left 

Expectations: 

Positive = ID shifts right 

Negative = ID shifts left 

• LRAS represents point on economy production possibility curve. The LRAS is a vertical line at an output level that represents quantity of goods and services a nation can produce over a sustained period using all of its productive resources. 
• LRAS is always at full employment. Does not change as price level changes, shifts outward if change in technology, resource, or economic growth 

The School of Economics (2/19/15)

Classical:

• Adam Smith
• John B. Say
• David Ricardo
• Alfred Marshal
• Says competition is good 
• Invisible Hand: means market runs itself 
• Concept laissez faire (no gov. intervention)
• Say's Law: Supply creates own demand (w/e output is produced, that is what's going to be demanded)
• Economy is always to/at FE
• Trickle Down Effect: Help rich first, then help everyone else 
• Savings (Leakage)
• Investment (Injection)
• Savings increase with interest rate (higher IR- save; low IR- spend)
• prices in wages are flexible downward (higher minimum wage could cut hours) 
• AS determines output 
• AS=AD at FE

Keynesian:

• John Maynard Keynes 
• Congress 
• Competition is flawed 
• AD is key, not AS 
• Demand creates its own supply, AD creates its own output 
• Savers/savings does not equal investment 
• Savings are inverse to interest rate 
• Leaks causes constant recession 
• Savings also causes recession (suppose to spend) 
• Ratchet Effects & Sticky Wages: Block Say's law
• Since no mechanism guarantee at FE, in long run we are dead 
• The economy is not always close/to at FE 
• Use fiscal policy 
• Add stabilizer 
• Use expansionary/contractionary polices 

Montary:

• Alan Greenspan
• Ben Barnanke 
• Congress can't time policy options 
• Voters won't allow contractionary options 
• Easy Money, Tight Money
• We can change the required reserves if needed 
• We can buy/sell bonds through open market operation 
• We can use interest rate to change the federal fund and discount rate 

Notes (2/20/15)

Disposable Income:

• income after faces or net income 
• DI = gross income x races 
• 2 choices 

1. Concome (spend money on goods and services)
2. Save (not spend on goods and services)

Consumption:

• Household spending 
• Ability to consume is constrained by: 

1. amount of disposable income 
2. propensity to save 
3. DI household consume if DI = O
4. autonomous consumption 
5. dissaving 
6. APC = C/DI = %DI that is spent 

Saving: 

• household NOT spending 
• ability to save is constrained by: 

1. amount of disposable income 
2. propensity to consume 
3. do household save if DI = O 
4. APS = S/DI = % that is not spent 

APC & APS:

• APC + APS = 1
• 1 - APC = APS 
• 1 - APS = APC 
• APC > 1: Dissaving 
• APS is dissaving 

MPC & MPS:

• marginal propensity to consume 
• Change C / Change DI 
• % of every extra dollar earned that is spent 
• marginal propensity to save 
• Changes S / Changes DI 
• % 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, G, XN) causes a larger change in AS or AD 
• Multiplier = change in AD / change in spending 
• why does this happen?
• Expenditure  & income flow continuously which sets off a spending increase in the economy 

Calculating Spending Multiplier: 

• Multiplier = 1 / 1 - MPC or 1 / MPS 
• multiplier are (+) when there is an increase in spending & (-) negative when there is a decrease 

Calculating the Tax Multiplier: 

• When fix taxes the multiplier works in reverse because now money os leaving the circular flow
• Tax Multiplier = -MPC / 1 - MPC or -MPC/MPS
• if there is a tax cut the multiplier (+) because now more money in circular flow 

Fiscal Policy (2/25/15)

Fiscal Policy: changes in the expenditures or taxes revenues of the federal government 

2 Tools:

• Tax:  Government can increase/ decrease taxes
• Spend: Government can increase/ decrease 
• controlled by CONGRESS not by president 

Balanced Budget: Revenues = expenditures 

Budget Deficit: Revenues < expenditures 

Budget Surplus: Revenues > expenditures 

Government Deficit:

• Sum of all deficits - sum of all surpluses 
• government must borrow money when if deficit

Government borrows money from: 

1. Individuals 
2. Corporations 
3. Financial Institutions 
4. Foreign entities or foreign governments (through process of land) 

Fiscal Policy (2 options)

• Discretionary: (Action)
• Expansionary Fiscal Policy: Think deficit
• Contractionary Fiscal Policy: Think surplus
• Non-Discresionary Fiscal Policy: (No action)

Discretionary v. Automatic Fiscal Policies: 

• Discretionary: increasing/ decreasing government spending or taxes in order to return the economy to FE. Policy involved policy makers doing fiscal policy in response to economic problem 
• Automatic: unemployed compensation and marginal tax rates are example of automatic policies that help mitigate the effect of recession and inflation. It takes place without policy makers having to respond to current economic problems. 

Contractionary v. Expansionary Fiscal Policy:

• Contractionary: policy designed to decrease AD. Strategy for controlling inflation (decrease in spending & increase taxes)

• Expansionary: policy designed to increase AD. Strategy for increasing GDP, reduces unemployment & combatting recession. (increases government spending & decreases taxes) 

Automatic or built in stabilizer: 

• without requiring exilic action by policy makers 

Non-Discretionary Fiscal Policy: 

• 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