UNIT III

UNIT III

Aggregate Demand:

- Aggregate demand - shows the amount od real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level.

      - the relationship between the price level and the level of real GDP is inverse

- 3 reasons AD is downward sloping

• Real Balance 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 in turn encourages investment
• Foreign Purchase 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 AD

• Changes in consumer, investment, and government spending and net exports
• a multiplier effect that produces a greater change than the original change in the 4 components
• increase in AD is a rightward shift; decrease would be a leftward shift
• Change in government spending & net exports
• increase = AD shift rightward, increased GDPr and price level, decrease in unemployment, and increase in interest rate
• decrease = AD shift leftward, GDPr and price level goes down, increase in unemployment and decrease interest rate

- Ranges/shapes/views of Aggregate supply

• Keynesian range: horizontal AS curve; below full employment; AD shift outward; increase in GDPr and a decrease in unemployment
• Intermediate range: AS shift outward, GDPr and Price level increases.
• Classical range - the long run AS curve; is vertical

 Aggregate Supply:

- The level of GDPr that firms will produce at each price level
-  Long-run

• period of time where input prices are completely flexible and adjust to changes in the price level
•   level of GDPr supplied is independent of the price level

- Short-run

• period of time where input prices are sticky and do not adjust to changes in price level
• directly related to price level

- Long-run Aggregate Supply (LRAS) - marks the level of full employment in the economy
     - measures potential output

• Causes for LRAS
• Increase in capital
• Change in technology
• Economic growth
• Entrepreneurship
• Increase in available resources

- Short-run Aggregate Supply (SRAS) - sticky wages = low profit = low production
     - increase in SRAS = rightward shift
     - decrease in SRAS = leftward shift
- Unit production cost = Total input cost / total output
- Determinants

• Input Prices
• Increase in resource prices is a leftward shift in AS
• Decrease in resource prices is a rightward shift in AS
• Productivity - total output / total input
• higher production = lower per unit production cost
• lower production = higher per unit production cost
• Legal Institution (environment)

- Full employment equilibrium = AD, SRAS, LRAS intersect
- Recessionary gap - equilibrium is below full employment (LRAS is to the right of intersection)

- Inflationary gap - equilibrium is beyond full employment (LRAS is to the left of intersection)


Multiplier

- Disposable income - income after taxes or net income

• With disposable income, households can either consume or save

- Consumption

• household spending
• ability to consume is constrained by:
• amount of disposable income
• propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• dissaving

- Saving

• household not spending
• ability to save is constrained by
• amount of disposable income
• propensity to consume
• DI = 0; no saving

- Average propensity to consume (APC) and Average propensity to save (APS)

• APC + APS = 1
• 1 - APC = APS; vice versa
• APC > 1 = dissaving
• -APS = dissaving

- Marginal propensity to consume and save (MPC and MPS)

• MPC 
• change in consumption / change in disposable income
• % of every extra dollar earned that is spent
• MPS
• change in saving / change in disposable income
• % of dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS; vice versa

- Determinants of consumption and saving

•  wealth
• expectation
• household debt
• taxes

The Spending Multiplier Effect

- an initial change in spending causes a larger change in aggregate spending or AD

• multiplier = change in AD / change in spending 

- Why it happens - expenditures and income flow continuously which sets off a spending increase in the economy
- spending multiplier = ( 1 / ( 1 - MPC ) ) or 1 / MPS
     - positive = increase in spending; negative = decrease in spending
- tax multiplier = -MPC / MPS
     - it is negative because money is leaving circular flow
     - a tax cut would mean a positive change


Investment

- What is investment? 
     - money spent or expenditures on

• new factories
• capital equipment
• technology
• new homes
• inventories

- Expected rates or return

• How do businesses make investment decisions?
• through cost and benefit analysis
• How do businesses determine the benefits?
• through the expected rate of return 
• How do businesses count the cost?
• through the interest costs 
• How do businesses determine the amount of investment they undertake?
• compare expected rate of return to interest cost
• if expected return > interest cost, then invest, if not, then do not invest.

Real (r%) vs. Nominal (i%) interest rate
- difference - nominal os observable rate of interest. Real interest rate subtracts out inflation
- How do you compute the real IR?
     - real interest rate = nominal interest rate - interest rate
- Real interest rate determines investment decisions

Investment Demand Curve

- Downward sloping because

• when interest rates are high, fewer investments are profitable; when IR is low, more investment is profitable
• conversely, there are few investments that yield high rates of return

- Shifts in ID

• cost of production
• change in technology
• business taxes
• stock of capital
• expectations

Fiscal Policy

- Change in the expenditure/tax revenues of the federal government

• taxes - government can increase or decrease taxes
• spending - government can increase or decrease spending

- Fiscal policy is enacted to promote our nation's economic goals; full employment, price stability, and economic growth
- Deficits, surpluses and debt

• Balance budget: revenues = expenditures
• Budget deficit: revenues < expenditures
•  Budget surplus: revenue > expenditures
• Government debt - sum of all deficit - sum of all surpluses
• Government must borrow money ifit is in a budget deficit
• can borrow from individuals, corporations, financial institutions, and foreign entities/government   

- Fiscal policy - Discretionary (action) - expansionary (deficit)
                                                              - contractionary (surplus)
                        - Non-discretionary (no action)
- Discretionary vs. Automatic fiscal policy

• Automatic - no government intervent
• Discretionary - increase or decrease in government spending/taxing to bring economy back into full employment

- Contractionary vs. Expansionary fiscal policy

• Contractionary - policy designed to decrease aggreage demand
• strategy to control inflation
• inflation is countered by contrationary policy
• decrease in government spending and increase in taxes
• Expansionary - designed to increase AD
• recession is counter with expansionary policy
• increase in government spending and decrease in taxes