Unit 7

The Balance of Payments

Balance of Payments - measure of money inflows and outflows between the United States and the Rest of the World (ROW)

-inflows are referred to as credits

-outflows are referred to as debits

The balance of payments is divided into 3  accounts

-current account

-capital/financial account

-official reserves account

Every transactions in the balance of payments is recorded twice in accordance with stand accounting practice

-Ex. US manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland

A credit of $50 million to the current account (- $50 million worth of farm equipment or physical assets)

A debit of $50 million to the capital/financial account 

Current Account

Balance of trade or Net Exports

-exports of goods/services - import of goods/services

-exports create a credit to the balance of payments

-imports create a debit to the balance of payments

Net Foreign Income

-income earned by US owned foreign assets - income paid to foreign held US assets

- ex. Interest payments on us owned Brazilian bonds - interest payments on German owned US Treasury bonds

Net Transfers (tend to be unilateral)

-foreign aid to a debit to the current account

-ex. Mexican migrant workers send money to family in Mexico

Capital/Financial Account

-the balance of capital ownership

-includes the purchase of both real and financial assets

-direct investment in the US is a credit to the capital account

-ex. The Toyota Factory in San Antonio

-direct investment by US firms/individuals in a foreign country are debits to the capital account

-ex. The Intel Factory in San Jose, Costa Rico

Capital/Financial Account

-purchase of foreign financial assets represents a debit to the capital account

-ex. Warren Buffet buys stock in Pentrochina

-purchase of domestic financial assets by foreigners represents a credit to the capital account

-ex. The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current and Capital Account

-the current account and the capital account should zero each other out.

IF THE CURRENT ACCOUNT HAS A NEGATIVE BALANCE (DEFICIT), THEN THE CAPITAL ACCOUNT SHOULD HAVE A POSITIVE BALANCE (SURPLUS)

Official Reserves

-the foreign currency holdings of the United States Federal Reserve System

-when there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments

-when there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments

-the official reserves zero out the balance of payments 

Active v. Passive Official Reserves

-the United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

-the People's Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the United States.

Balance of Trade: 

1. Goods and Services Export - Goods and Services Import

2. Goods exports + Goods imports

You can get a trade deficit (imports>exports) or trade surplus (exports>imports)

Current Account:

1. Balance of Trade + Net Investment + Net Transfer

Capital Account:

Foreign purchases of US assets + US purchases of assets abroad

Official Reserve:

Current Account + Capital Account

Good Imports + Service Imports

Foreign Exchange Market

Foreign Exchange - the buying and selling of currency.

The exchange rate (e) is fester mined in the foreign currency markets.

The exchange rate is the price of currency.

Do not try to calculate the exact exchange rate.

TIPS

•Always change the Demand line on one currency graph, the Supply line on the other currency's graph

•Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer

•If D on one graph increases, S on the other will also increase

•If D moves to the left, S will move to the left on the other graph

Changes in Exchange Rates

•Exchange rates are a function of the supply and demand for currency

• an increase in the supply of a currency will make it cheaper to buy one unit of that currency 

• a decrease in supply of a currency will make it more expensive to buy one unit of that currency

• an increase in the demand of a currency will make it more expensive to buy one unit of that currency 

• a decrease in demand of a currency will make it cheaper to buy one unit of that currency

Appreciation

Appreciation of a currency occurs when the exchange rate of that currency increases

-hypothetical: 100 yen used to buy $1 now two hundred ten buys $1

Depreciation

Depreciation of a currency occurs when the exchange rate of that currency decreases. 

Determinants of Exchange Rate

•consumer tastes

-the increase in demand of the yen leads to the appreciation of the Yen

•relative income

-imports tend to be normal goods

•relative price level

•speculation

Absolute Advantage v. Comparative Advantage

Absolute Advantage:

Individual- exists when a person can produce more of a certain good or service than someone else in the same amount of time

National- exists when a city can produce more of a good or service than another can in the same time period

•Faster, more, more efficient

Comparative advantage

Individual/national - exists when an individual or nation can produce a good or servers of a lower opportunity cost than can another individual or nation

•lower opportunity cost

Input Problems - the country or individual that uses the least amount of resources, land, or time, has the absolute advantage

Output Problems - the country or individual that can produce the most has the absolute advantage. The country that has the lowest opportunity cost has the comparative advantage in that product. It deals with production

Unit 5

Phillips Curve - Represents the relationship between unemployment and inflation. The trade off between inflation and unemployment only occurs in the short run.

Long Run Phillips curve occurs at the natural rate of unemployment. If the natural rate of unemployment changes, then the Long Run Phillip's curve changes. It is represented by a vertical line. There is no trade off between unemployment and inflation in the long run. That means the economy produces at a full employment level. LRPC will only shift if the LRAS curve shifts, otherwise it is assumed to be stable. 

NRU = seasonal, frictional, and structural

The major LRPC assumption is that more worker benefits create high natural rates and fewer worker benefits create lower natural rates. 

Short Run Phillips Curve - there is an inverse relationship between inflation and unemployment. It has a relevance to Okun's law. Since wages are sticky, inflation changes, moves the points on the SRPC. If inflation persists and the expected rate of inflation rise, then the entire SRPC moves upward, which causes stagflation. If inflation expectation drops due to new technology or economic growth, then the SRPC will move downward. Aggregate supply shocks can cause both higher rates of inflation and higher rates of unemployment. Supply shocks are rapid and significant increases in resource cost

The misery index - combination of unemployment and inflation in any given year. Single digit misery is good.

Supply side economics - the belief that the AS curve will determine levels of inflation unemployment and economic growth. To increase the economy, the AS curve should shift to the right, which will always benefit the company first. Supply side economists focus of marginal tax rates.

Marginal tax rates - amount paid on the last dollar earned or on each additional dollar earned. By reducing the marginal tax rate, supply siders believe that you will encourage more people to work longer and forego leisure time for extra income

They support policies that promote GDP growth by arguing that the high marginal tax rate along with the current system of transfer payments. they provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Reganomics - lowered the marginal tax rate to get the US out of a recession which lead to a recession.

Ladder curve - a trade off between tax rates and government revenue. It is used to support the supply side argument.

3 criticism of the Laffer Curve

1. Research suggests that the impact of tax rates on incentives to work, save, and invest are small

2. Tax cuts increase demands, which can fuel inflation and causes demand to exceed supply. 

3. Where the economy is actually located on the curve is difficult to determine.

Monetary Policy Video

Unit 4

Money is any asset that can be used to purchase goods and services

3 uses of money:

1st use - medium of exchange. It is used to determine value

2nd use - unit of account. Used to compare prices.

3rd use - store a value. Keep in mind that some people choose to hide their money. 

3 types of money:

Commodity money - has value within itself. 3 examples: salt, olive oil, and gold

Representative money - represents something of value. Ex. IOU

Fiat - money because the government says so. Consists of paper currency and coins 

Currency is not the same thing as money.

6 characteristics of money:

1. Durability

2. Portability

3. Divisibility

4. Uniformity

5. Limited supply

6. Acceptability

Money supply - total value of financial assets available in the US economy

M1 Money 

- liquid assets (easily to convert to cash). Coins, currency, checkable deposits/demand deposits, travelers checks

M2 Money 

Not as liquid as M1 money

- saving account 

- money market account

3 purposes of financial institutions

1. Store money

2. Save money

3. Loan money. 2 reasons to loan money: credit cards and mortgages

4 ways to save

1. Savings account

2. Checking account

3. Money market account

4. Certificate of deposit (CD)

Loans

Banks operate on a fractional reserve system which means they keep a fraction of the funds and loan out the rest

Interest Rates:

-principle: amount of money borrowed

-interest: price payed for the use of borrowed money

• simple interest: paid on the principle

I = (P x R x T)/100

I; simple interest 

P; principal

R; interest rate

T; time

• compound interest: paid on the principle plus the accumulative interest. 

5 types of financial institutions

1. Commercial bank

2. Savings and loan institutions

3. Mutual savings bank

4. Credit unions

5. Finance companies

Investment - redirecting resources; consume now for the future. 

Financial assets - claims on property and income of borrower

Financial intermediaries - institution that channels funds from savers to borrowers. 3 purposes

1. Share risks through diversification. It is spreading out investment to reduce risk.

2. Provide information 

3. Liquidity (returns) - money investor receives above and beyond the sum of money that was initially invested. The higher the risk; the higher the returns

Bonds you loan

Stocks you own 

Bonds are loans, IOU, that represent debt that the government or a corporation must repay to an investor. They are generally low risk investment. There are 3 components

1. Coupon rate (interest rate that a bond issuer will pay to a bond holder)

2. Maturity (time at which payment to a bond holder is due)

3. PAR value (principle; amount an investor pays to purchase a bond)

Yield - annual rate of return on a bond of the bond were held to maturity

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?

Why? 

Opportunity cost and inflation

This is the reason for charging and paying interest

v = future value of money

p = present value of money 

r = real interest rate (nominal rate - inflation rate) expressed as a decimal

n = years

k = number of times interest is credited per year

The simple interest formula

v = (1+R)^n * p

The compound interest formula 

v = (1+ (r/k))^nk * p

The monetary equation of exchange

MV=PQ

M=money supply (M1 or M2)

V=money's velocity (M1 or M2)

P=price level (PL on the AS/AD diagram)

Q=real GDP (sometimes labeled Y on the AS/AD diagram)

Functions of FED

It issues paper currency

Sets reserve requirements and holds reserves of banks

It lends money to banks and charges them interest

They are a check clearing service banks

It acts as personal bank for the government

Supervises member banks

Controls the money supply in the economy

How do banks create money?

By lending out deposits that are used multiple times

Where do the loans come from?

From depositors who take cash and place it in their banks

How are the amounts of potential loans calculated?

Using their bank balance sheet, or T-accounts that consists of assets and liabilities for banks

Right side of the T-account sheet

1= demand deposits (DD) or checkable deposits

• cash deposits from the public

• they are liabilities because they belong to depositors

2= owners equity (stock shares)

• there are values of stocks held by the public ownership of bank shares

• if demand deposits come from someone's cash holdings, then DD is already part of money supply

• if the demand deposit comes in from the purchase of bonds (by the FED) then this creates new cash and therefore creates new Money Supply (M-1)

Bank Assets (left side of the T account sheet)

#1= required reserves (RR)

• these are the percentages of demand deposits that must be held in the vault so that some depositors have access to their money. Requirement can vary, but AP usually uses 5%, 10%, or 20% for easy calculations

#2= excess reserves (ER)

• these are the source of new loans. These amune are applied to the monetary multiplier/reserve Multiploer (DD=RR plus ER)

#3= bank property holdings (building and fixtures)

#4 = securities (federal bonds)

• these are bonds purchases by the bank, or new bonds sold to the bank by the Federal Reserve. These bonds can be purchased from the bank, turned into cash that immediately becomes available as "excess reserves"

#5= customer loans

• this can be amounts held by banks from previous transactions, owed to the bank by prior customers

Creating Money (using excess reserves)

• banks want to create profits. They generate profit by leading the excess reserves and collecting interest. Since each loan will go out into customer's business' accounts, more loans are created in decreasing amounts (because of reserve requirement). A rough estimate of the number of loan pints created by any first loan is the "money multiplier"

• money multiplier: checkable despisers multiplier, reserve multiplier, loan multiplier

• the formula: 1 divided by the reserve requirement (ratio)

RR=10%= 1/.1= monetary multiplier of 10

Excess reserves are multiplied by the multiplier to create new loans for the entire banking system and this create new money supply

Bank Balance Sheet

•assets and liabilities in a T account

Liabilities

•DD and Owner's Equity (stock shares)

Assets

•RR, ER, Bank Property, Securities, Loans

Assets must equal liabilities

•DD=RR + ER

Money is created through Moneyary Multiplier

• ER x 1/RR (multiplier) = new loans through the naming system

The money supply is affected

•cash from citizens becomes a DD, but does not change the money supply; the ER from this cash becomes an "immediate" loan amount

•ER x multiplier become new loans and do change the money supply

•the fed buying bonds crates new loans and changes the money supply

•if the fed buys bonds on the open market, this also becomes a new DD amount; if the Fed guys bonds from accounts already held by a particular bank, then the amount only becomes new excess reserves

•finally, bond "prices" move opposite to the changes in interest rates

-higher interest rates wil push bond prices downward (less money supply)

-lower interest rates will push bond prices upward (more money supply)

Type 1: calculate the initial change in excess reserves. (AKA the amount a single bank can loan from the initial deposit)

Type 2: calculate the change in loans in the banking system.

Type 3: Calculate the change in the money supply (sometimes type 2 and type 3 will have the same result i.e. No fed involvement)

Type 4: calculate the change in demand deposits

Creating a Bank

•Transaction #1

Vault cash: cash held by the bank

•Transaction #2

Acquiring propert and equipment

•Transction #3

Commercial bank functions

-accepting deposits

-making loans

•Transaction #4

Depositing reserves in a Federal Reserve bank

-required reserves

-reserve ratio

Reserve Ratio = (commercial bank's required reserves)/(commercial bank's checkable-deposit liabilities)

•transaction #5

Assumed the bank's deposits all cash on reserve at the Fed

Excess Reserves = Actual Reserves - Required Reserves

Required Reserves = checkable deposits x reserved ratio

Factors that weaken the effectiveness of the deposit multiplier:

1.) If banks fail to loan out all their excess reserves

2.) If bank customers take their loans in cash rather than in new checking deposits, it creates a cash or currency drain

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

MD/DM increases while IR decreases

MD/DM decreases while IR increases

Loanable Funds Market

•the market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)

•the demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.

•the supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

Changes in the Demand for Loanable Funds

•remember that demand for loanable funds = borrowing (I.e. Supply bonds)

•more borrowing = more demand for loanable funds (shift right)

•less borrowing = less demand for loanable funds (shift left)

•Examples

- government deficit spending = more borrowing = more demand for loanable funds

(Dlf) right r% increase

Less investment demand = less borrowing = less demand for loanable funds

(Dlf) left r% decrease

Changes in the supply of Loanable Finds

•remember that supply of loanable funds = saving (I.e. Demand for bonds)

•more saving = more supply of loanable funds (right)

•less saving = less supply of loanable funds (left)

•examples

- government budget surplus = more saving = more supply of loanable funds. Slf right r% decrease

- decrease in consumers' MPS = less saving = less supply of loan-able funds

Money & Banking / Monetary Policy

Video 1

Types of Money

1. Commodity Money is a good that functions as money. It is the most primitive. 

2. Representative Money is the thing you're using as money that represents another metal. The major drawback of this is that when the value of the metal changes, the value of the currency changes as well.

3. Fiat Money is money that is not backed by precious metal. Money that must be accepted for transaction that is backed by the word of government. 

Functions of Money

1. Medium of exchange is using money to buy things.

2. Store of value is putting money away and expecting it to be stable. 

3. Unit of account is its price implies its worth. Doesn't always imply quality. 

Video 2

People will tend to borrow more for transactions and hold assets when the interest rate is low. The supply of money is vertical in the money market because it does not vary based on the interest rate as opposed to the demand of money because the supply of money is set up by the Fed. When you increase demand, you put pressure on interest rate. To counteract interest rates from increasing during a recession, the Fed can increase the money supply. The Fed always try to stabilize the interest rate because if it is not stable, then you cannot predict level of investment consumer spending and manipulate aggregate demand.

Video 3

Reserve Requirement is the total amount the bank is required to hold. It can be in a vault or held by the Fed. This was one of the problems that led to the Great Depression because banks would not lend out money for people because they were scared to go under the reserve requirement.

Discount Rate is the interest rate at which banks can borrow money from the Fed.

Buy/Sell Bonds/Securities is if the Fed buys the bond, the public gets money and the other way around. 

Open Market Operations is the entity of the Fed that makes decisions about selling and buying bonds

Federal Funds Rate is the rate at which banks borrow money from each other. When the Fed buys bonds, it puts downward pressure on the Federal Funds Rate and the other way around. 

Expansionary (easy money)

Lowers Reserve Requirement is the money that suddenly becomes excess reserves.

Lowers Discount Rate

Buys Bonds/Securities

Contractionary (tight money)

Raises Reserve Requirement is the excess reserves that are turned into required reserves. 

Raises Discount Rate

Sells Bonds/Securities

Video 4

The supply of loan-able funds comes from the amount of money people have in banks. The more money people save, the more money banks have to loan out and create more money. It is a leakage, but helps the banks. Showing the government's deficit spending, the government has to be demanding money in order to spend the money. When you increase the demand for money, you increase the demand for loan-able funds. The other way to show an increase in interest in the loan-able funds graph is to decrease supply because when the government demands money, which is decreasing the supply of the nation's supply of funds. 

Video 5

Making loans is how banks create money.

Money Multiplier  is 1/ (Required Reserve/Reserve Ratio). 

Multiple Deposit Expansion is when you add up all the potential loans, you get the money you multiply with the money multiplier and the initial amount of loans. It does not guarantee that you get that much because we're making the assumption that in this process, there are no excess reserves left. If the bank holds excess reserves, it will reduce your total. When you're asked how much "additional" money, you would subtract your initial amount. 

Video 6

The majority of debt of the United States is held within the country. When the government is running a deficit, it borrows money from the money market. There will also be an increase in demand for loan-able funds. In the AD/AS graph, this will increase Aggregate Demand which will increase the price level. The Fisher Effect says that an increase in interest rate has to be equal to the increase in inflation. It is a 1 to 1 direct ratio. 

Unit 3

Aggregate Demand (AD)

• shows the amount of 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

Three Reasons AD is downward sloping

1. 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.

2. 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

3. Foreign

• A higher price level increases the foreign 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 two parts to a shift in AD: 1. a change in C, Ig, G, and/or Xn 2. A multiplier effect that producers 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 

Consumption

- 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 Domestic 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: Expectation of future profitability, Technology, and Degree of Excess Capacity (Existing Stock of Capital) 

Government Spending

• More Gov't spending (AD -->)
• Less Gov't 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 Economies = More exports (AD -->)
• Weak Foreign Economies = Less exports (AD <--)

Aggregate Supply

The level of real GDPR that firms will produce at each price level (PL) Real GDP - Real Output

Long - Run v. Short - Run

Long - Run 

- period of time where input prices are completely flexible and adjust to changes in the price level

- the level of the 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)

• the long-run aggregate supply or 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 the 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   

Short - Run Aggregate Supply (SRAS)

• because input prices are sticky in the short-run, the SRAS is upward sloping 

Changes in SRAS 

increase -->

decrease <--

• the key to understand shifts in SRAS is per unit production cost Per unit production cost = total input cost/ total output

Determinants of SRAS

• Input Prices
• Productivity
• Legal-Institution Environment

Input Prices

- Domestic Resource Prices

• wages (75% of all business costs)
• cost of capital
• Raw materials (commodity prices)

- Foreign Resource Prices 

• Strong $ = lower foreign resource prices
• weak $ = higher foreign resource prices

- Market Power

• Monopolies and cartels that control resources control the price of those resources 
• Increases in Resource prices = SRAS <--
• Decrease in Resource prices = SRAS -->

Productivity

-Productivity = total output/total inputs

• More productivity = lower unit production cost (SRAS -->)
• Lower productivity = higher unit production cost (SRAS <--)

Legal Institution Environment

- Taxes and subsidies

• Taxes ($ to gov't) to business increases per unit production cost (SRAS <--)
• Subsidies ($ from gov't) to business reduces per unit production cost (SRAS -->)
• Gov't Regulation creates a cost of compliance (SRAS <--)
• Deregulation reduces compliance costs (SRAS -->)

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

AD is decreasing during a recessionary gap

Inflationary Gap - an inflationary gap exists when equilibrium occurs beyond full employment out put 

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

- If expected return > interest cost, then invest

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

Real  (r%) v. Nominal (i%)

- What's the difference?

• Nominal is the observable rate of interest
• Real subtracts out inflation and is only known ex post facto

- How do you compete 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 

- What is the shape of the investment demand curve?

• Downward sloping

- Why?

• When interest rates are high, fewer investment are profitable

Shifts in Investment Demand (ID)

- Cost of Production 

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

- Business Tax

• Lower business taxes shift 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 shifts ID -->
• Negative Expectations shifts ID <--

LRAS curve represents a point on an economies production possibilities curve

always vertical, always stable at full employment

LRAS doesn't change as the price level changes

only things that can shift LRAS:

1. change in resources
2. change in technology
3. economic growth

whatever shifts production possibility outward is the same thing that shifts LRAS

3 Schools of Economics

Disposal Income (DI)

• Income after taxes or Net Income
• DI = Gross Income - Taxes

2 Choices

- with disposal income, households can either

• consume (spend money on goods and services)
• save (not spend money on goods and services)

Consumption

- household spending

- the ability to consume is constrained by 

• the amount of disposal income
• the propensity to save

- Do households consume if DI = 0?

• Autonomous consumption
• Dissaving
• APC = C/DI = % DI that is spent

Spending

- household NOT spending

- the ability to save is constrained by

• the amount of disposable income
• the propensity to consume

- DO household save if DI = 0?

• No

- APS = S/DI = % DI that is not spent

MPC & MPS

- Marginal Propensity to Consume

• change in C/change in DI
• % of every extra dollar earned that is spent

- Marginal Propensity to Save

• change in S/change in DI
• % of energy extra dollar earned that is saved

MPC + MPS = 1          1 - MPC = MPS

APC & APS

APC + APS = 1

1 - APC = APS

1 - APS = APC

APC > 1 : Dissaving

-AP : Dissaving

The Spending Multiplier Effect

- AN initial change in (C, Ig, G, Xn) causes a larger change in aggregate spending, or Aggregate Demand (AD)

- Multiplier = Change in AD/change in spending

-Multiplier = change in AD/change in C, Ig, G, or Xn

• 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 the MPS

- Multipliers are (+) when there is an increase in spending & (-) when there is a decrease

Tax Multiplier

- When the gov't taxes, the multiplier works in reverse

-Why?

• Because there is now more money in the circular flow

Fiscal Policy

2 options

- Taxes- gov't can increase or decrease taxes

- Spending- gov't can increase or decrease spending

Fiscal policy is enacted to promote our nation's economic goals: full employment, price stability, economic growth

• Discretionary Fiscal Policy (action)
• Expansionary Fiscal Policy - think deficit
• Contractionary Fiscal Policy - think surplus
• No - Discretionary Fiscal Policy (no action)

Discretionary v. Automatic Fiscal Policies

Discretionary

• Increasing or decreasing gov't spending and/or taxes in order to return the economy to full employment. Discretionary policy makers doing fiscal policy in response to an economic problem

Automatic

• Unemployment compensation + 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. 

Contractionary vs. Expansionary Fiscal Policy

• Contractionary Fiscal Policy- policy designed to decrease AD - strategy for controlling inflation, increase gov't spending, decrease taxes
• Expansionary Fiscal Policy - policy designed to increase AD - strategy for increasing GDP, combating a recession & reducing unemployment, decrease gov't spending, increase taxes

Automatic or Built - In Stabilizers

- Anything that increases the gov'ts budget deficit during a recession that increases its budget surplus during inflation without requiring explicit action by policy makers. 

- Economic Importance: 

• Taxes reduce spending & AD
• Reductions in spending are desirable when economy is moving toward inflation
• increase in spending are desirable when economy is heading toward recession

Progressive Tax System

•  Average tax rate (tax return/GDP) rises w/ GDP

Proportional Tax System

•  Average Tax rate remains constant as GDP changes

Regressive Tax System

• Average tax rate falls w/GDP

Deficits, Surpluses, and Debt

- Balanced Budget

• Revenues = Expenditures

- Budget Deficit

• Revenues < Expenditures

- Budget Surplus

• Revenues > Expenditures

- Gov't Debt

• Sum of all deficits - sum of all surpluses
• Gov't must borrow money when it runs a budget deficit
• Gov't borrows money through tax