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