UNIT 3

UNIT 3: Aggregate Demand and Aggregate Supply and determinants, SRAS vs. LRAS, The Spending Multiplier, The Three Great Schools of Economics, Fiscal Policy Options, Sticky Price, Sticky Wage models

February 12, 2016

Aggregate Demand Curve (AD):

• AD is the demand by consumers, businesses, government, and foreign countries.
• What definitely doesn't shift the curve? Changes in price level.

Why is AD downward sloping?

1.) Real-Balance Effect:

• Higher price levels reduce the purchasing power of money.
• This decreases the quantity of expenditures.
• Lower price levels increase purchasing power and increase expenditures.
• Ex: If the balance of your bank was $50,000, nut inflation erodes your purchasing power, you will likely reduce your spending. 

2.) Interest-Rate Effect:

• When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. 
• Higher interest rates discourage consumer spending and business investment. 

3.) Foreign Trade Effect: 

• When U.S. price level rises, foreign buyers purchase fewer U>S> goods and Americans buy more foreign goods. 
• Exports fall and imports rise, causing real GDP demanded to fall. (Xn decreases) 

Shifters of Aggregate Demand:

Shifts in Aggregate Demand (AD):

• There are two parts to a shift in AD:

       - A change in C, Ig, G, and/or Xn 
       - A multiplier effect that produces a greater change than the original change in the 4      
         components.

• Increases   in AD= AD ->
• Decreases in AD= AD <-

Increase in Aggregate Demand:

Decrease in Aggregate Demand:

Determinants of AD:

Consumption:
Household spending is affected by:
Consumer Wealth 

• More wealth = more spending (AD shifts ->)
• Less wealth = less spending (AD shifts <- )

Consumer Expectations

• Positive expectations = more spending (AD shifts ->)
• Negative expectations = less spending (AD shifts <-) 

Household indebtedness

• Less debt = more spending (AD shifts ->)
• More debt = less spending (AD shifts <- )

Taxes

• Less taxes = more spending (AD shifts ->)
• More taxes = less spending (AD shifts <- )

Gross Private Investment: 
Investment Spending is sensitive to:
The Real Interest Rate

• Lower Real Interest Rate = More Investment (AD ->)
• Higher Real Interest Rate = Less Investment (AD <- )

Expected Returns

• Higher Expected Returns = More Investment (AD ->)
• Lower Expected Returns = Less Investment (AD <- )
• Expected Returns are influenced by:

           - Expectations 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 Rates (International value of $)

• Strong $ = More imports & Fewer Exports = (AD <- )
• Weak  $ = Fewer Imports & More Exports = (AD ->)

Relative Income

• Strong Foreign Economics = More Exports = (AD ->)
• Weak Foreign Economics = Less Exports = (AD <- )

February 18, 2016

Aggregate Supply:

• The level of Real GDP (GDPR) that firms will produce at Price Level (PL). 

Long Run (Vertical):

• Period of time where input prices adjust to changes in the price level.
• The level of GDPR supplied is independent of PL.

Short Run:

• Period of time where input prices are and do not adjust to changes in PL.
• The Level of Real GDP supplied is directly related to PL.

LRAs (Long Run Aggregate Supply):

• LRAs marks level of full employment in the economy.
• Because input prices are comp. flexible in long-run, changes in PL do not change firms real profits, therefore not changing firms' level of output. this means LRAs is vertical at economy's level of full employment. 
• Formula: Full employment = FE, Yf or Y*

Changes in SRAs: 

• An increase in SRAs is seen as a shift to the right. SRAs -->
• Decrease in SRAs is seen as shift left. SRAs <--
• Key to understanding shifts in SRAs is per unit cost production,
• Formula: Per unit cost production = total input cost/ total output

Determinants of SRAs: 

• Input Prices 
• Productivity 
• Legal-Institutional Environment 

Input Prices:

- Domestic Resource Prices

• Wages (75% of all business costs)
• Cost of Capital
• Raw Materials (Commodity Prices) 

- Foreign Resource Prices
- Market Power
- Increase in Resource Prices = SRAs <--
- Decrease in Recourse Prices = SRAs --->

Productivity: 

• Formula: Productivity = Total output / Total input
• More Productivity = Lower unit production cost = SRAs -->
• Lower Productivity = higher unit production cost =  SRAs <-- 

Legal-Institutional Environment:

- Taxes & Subsidies

• Taxes ($ to govt) on business increase per unit production cost = SRAs <--
• Subsides ($ from govt) to business reduce per unit production cost = SRAs -->

- Government 

• Government regulation creates a cost of compliance = SRAs <--
• Deregulation reduces compliance costs = SRAs -->

Full Employment:

• Full Employment equilibrium exists where AD intersects SRAs & LRAs at the same point.
  

Recessionary Gap: 

• A recessionary gap exists when equilibrium occurs below full employment output.

Inflationary Gap:

• An inflationary gap exists when equilibrium occurs beyond full employment output.

February 22, 2016

(Notes on SRAs)

Nominal Wages:

• It is the amount of money received by a worker per unit of time.
• Ex: by an hour, by day, etc. 

Real Wages:

• It is the amount of goods and services a worker can purchase with their nominal wages.
• Purchasing power of nominal wages --> what you can and cannot buy 

Sticky Wages:

• The nominal wage level is set according to an initial price level and does not vary due to labor contracts or other restrictions. 

Investment:

- Money spent or expenditures on:

• New plants (factories) 
• Capital equipment (machinery) 
• Technology (hardware & software) 
• New homes
• 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 under take?

- Compare expected rate of return of investment cost 

• If expected return > interest cost, then invest
• If expected return < interest cost, then not invest 

Real (r%) v. Nominal (i%):
- What is the difference?

• Nominal is the observable rate of interest. 
• Real subtracts out inflation (π%) and is only known ex post facto. 

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

• r% = i% - π%

- What then, determines the cost of an investment decision?

• The real interest rate (r%)

February 23, 2016

Investment Demand Curve (ID):
What is the shape of the Investment Demand Curve?

• Downward Sloping

Why?

• When interest rate are high, fewer investments, are profitable; when interest rates are low, more investments are profitable. 

Shifts in Investment Demand (ID):

- Cost of Production

• Lower costs shift ID -->
• Higher costs shift ID <--

- Business Taxes

• Lower business taxes 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 -->
• If an economy has much capital, then ID <--

- Expectations

• Positive expectations shift ID -->
• Negative expectations shift ID <--

Consumption & Savings 

Disposable Income (DI):

Income after taxes or net income
Formula: DI = Gross Income - Taxes

2 Choices:
With disposable income, households can either:

1. Consume (spend money on goods & services)
2. Save (NOT spend money on goods & services)

Consumption:

House Hold 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
• dis-saving

Saving:

House Hold NOT Spending

- The ability to save is constrained

• The amount of disposable income
• The propensity to consume

- Do house holds save if DI= 0? No

Average Propensity to Consume & Average Propensity to Save

APC & APS:

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

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.