Unit 3
Aggregate Demand
- Inverse Relationship between Real GDP and Price level.
- Shows Demand overall
3 Reasons why AD is Downward Sloping:
Real
Balances Effect -
- when the price level is high, households and business
can't afford to purchase as much output
- when price level is low, households and business can
afford to purchase more output
Interest
Rate Effect -
- higher price level increases the interest rate which
tends to discourage investment
- lower price level decreases the interest rate which
tends to encourage investment
Foreign
Purchases 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 Aggregate Demand
·
Change in C, IG, G, and/or
Xn
- Increase = →
- Decrease = ←
Aggregate Supply
- The level of Real GDP (GDPr) that firms will produce at
each Price Level (PL)
Long-Run v. Short Run
- Long-Run:
Period of time where input prices are completely flexible and adjust to
changes in the price-level
- In the long-run, the level of 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)
- LRAS are vertically
Short-Run Aggregate Supply
(SRAS)
- Output will decrease because profit will not increase.
- Graph goes toward the sky.
Changes in SRAS
- An increase in SRAS is seen as a shift to the right.
SRAS -->
- A decrease in SRAS is seen as a shift to the left. SRAS
<--
- The key to understanding shifts in SRAS is per unit
cost of production
- Per-unit production 99= Total input cost/ Total output
Determinants of SRAS (all
of the following affect unit production cost)
- Input Prices - Factors of Production (Land, Labor,
Machinery, etc.)
- Productivity - Technology (How well an item works)
- Legal-Institutional Environment
Input Prices
- Increases in Resource Prices = SRAS <--
- Decreases in Resource Prices = SRAS -->
Productivity
- Productivity = Total Output/ Total Inputs
- More productivity = lower unit production cost = SRAS
-->
- Lower productivity = higher unit production cost = SRAS
<--
The AS/AD Model
·
The equilibrium of AS
& AD determines current output (GDPr) and the price level (PL)
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.
Changes in AD
Change in Consumption
·
↑: AD→, GDPr↑ & PL↑, U%↑& Inf%↑
·
↓: AD←, GDPr↓ & PL↓, U%↑ & Infl%↓
Change in Gross Private Investment
·
↑: AD→, GDPr↑ & PL↑, U%↑& Inf%↑
·
↓: AD←, GDPr↓ & PL↓, U%↑ &
Infl%↓
Change in Government Spending
·
↑: AD→, GDPr↑ & PL↑, U%↑& Inf%↑
·
↓: AD←, GDPr↓ & PL↓, U%↑ &
Infl%↓
Change in Net Export
·
↑: AD→, GDPr↑ & PL↑, U%↑& Inf%↑
·
↓: AD←, GDPr↓ & PL↓, U%↑ &
Infl%↓
Increase in AD
·
C↑, I↑, G↑, Xn↑: AD→, GDPr↑ & PL↑,
U%↑& Inf%↑
Decrease in AD
·
C↓, I↓, G↓, Xn↓: AD←, GDPr↓ & PL↓,
U%↑ & Infl%↓
Changes in SRAS
Changes in Prices
·
Input Prices↓: SRAS→, GDPr↑ & PL↓,
U%↓ & Infl%↓
·
Productivity↑: SRAS←, GDPr↑ & PL↓,
U%↓ & Infl%↓ **
Changes in Productivity
·
Productivity↑: SRAS→, GDPr↑ & PL↓,
U%↓ & Infl%↓
·
Productivity↓: SRAS←, GDPr↓ & PL↑,
U%↑ & Infl%↑
Changes in Legal-Institutional Environment
·
Deregulation: SRAS→, GDPr↑ & PL↓,
U%↓ & Infl%↓
·
Regulation: SRAS←, GDPr↓ & PL↑, U%↑
& Infl%↑
Increase in SRAS
·
Input Prices↓, Productivity↑, and
Deregulation: SRAS→, GDPr↑ & PL↓, U%↓ & Infl%↓
Decrease in SRAS
·
Input Prices↑, Productivity↓, and Regulation:
SRAS←, GDPr↓ & PL↑, U%↑ & Infl%↑
Expected Rates of Return
·
How does business make investment
decisions?
o Cost/Benefit
Analysis
·
How does business determine the
benefits?
o Expected
rate of return
·
How does business count the cost?
o Interest
costs
·
How does business determine the amount
of investment they undertake?
o Compare
expected rate of return to interest cost
o If
expected return > interest cost, then invest
o 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 (Infl%) and is only known ex post facto.
·
How do you compute the real interest
rate (r%)?
-
i% - infl%
·
What then, determines the cost of an
investment decision?
-
The real interest rate
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
-
Conversely, there are few investments
that yield high rates of return, and many that yield low rates of return
Shifts in Investment Demand (ID)
-
Cost of Production
-
Business Taxes
-
Technological Change
-
Stock of Capital
-
Expectations
Consumption & Spending
Disposable Income (DI)
-
Income after taxes or net income
-
DI = Gross Income – Taxes
2 Choices
With disposable income, households can either
-
Consume (spend money on goods &
services)
-
Save (not spend money on goods &
services)
Consumption
Household 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
-
Dissaving
Saving
Household NOT spending
The ability to save is constrained by
-
The amount of disposable income
-
The propensity to consume
Do households save if DI = 0?
-
NO
APC (Average Propensity to Consume) & APS (Average Propensity to
Save)
·
APC + APS = 1
·
1 – APC = APS
·
1 – APS = APC
·
APC > 1: Dissaving
·
- APS: Dissaving
MPC & MPS
Marginal Propensity to Consume
·
Change in Consumption/ Change in DI
·
% of every extra dollar earned that is
spent
Marginal Propensity to Save
·
Change in Saved/ Change in DI
·
% of every extra dollar earned that is
saved
MPC + MPS = 1
1 – MPC = MPS
1 – MPS = MPC
Determinants of C&S:
·
Wealth
·
Expectations
·
Household
·
Taxes
·
Debts
The Spending Multiplier Effect
·
An initial change in spending (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, Xn
Why does this happen?
-
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 1/MPS
·
Multipliers are (+) when there is an increase
in spending and (-) when there is a decrease.
Calculating the Tax Multiplier
·
When the government taxes, the
multiplier works in reverse
·
Why?
-
Because now money is leaving the
circular flow
·
Tax Multiplier (-)
-
= -MPC/1-MPC or -MPC/MPS
·
If there is a tax-CUT, then the
multiplier is (+), because there is now more money in the circular flow
Fiscal Policy
·
Changes in the expenditures or taxes
revenues of the federal government
o
2 tools of fiscal policy
§ 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, economic growth
Deficits, Surpluses, and Debt
·
Balanced budget
o
Revenues = Expenditures
·
Budget deficit
o
Revenues < Expenditures
·
Budget surplus
o
Revenues > Expenditures
·
Government debt
o
Sum of all deficits – Sum of all
surpluses
·
Government must borrow money when it
runs a budget deficit
·
Government borrows from
o
Individuals
o
Corporations
o
Financial institutions
o
Foreign entities or foreign government
Fiscal Policy Two Options
·
Discretionary Fiscal Policy (action)
o
Expansionary fiscal policy – think
deficit
o
Contractionary fiscal policy – think
surplus
·
Non-Discretionary Fiscal Policy (no
action)
Discretionary v. Automatic Fiscal Policies
·
Discretionary
o
Increasing or Decreasing Government
Spending and/or Taxes in order to return the economy to full employment.
Discretionary policy involves policy makers doing fiscal policy in response to
an economic problem
·
Automatic
o
Unemployment compensation & marginal
tax rates are example 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 aggregate demand
o
Strategy for controlling inflation
·
Expansionary fiscal policy
o
Strategy for increasing GDP, combatting
a recession, & reducing unemployment
Expansionary Fiscal Policy
·
Recession is countered with Expansionary
policy.
o
Increase government spending (G↑)
o
Decrease taxes (T↓)
Contractionary Fiscal Policy
·
Inflation is countered with
Contractionary policy.
o
Decrease government spending (G↓)
o
Increase taxes (T↑)
Tax Systems
·
Progressive Tax System
o
Average tax rate (tax revenue/GDP) rises
with GDP
·
Proportional Tax System
o
Average tax rate remains constant as GDP
changes
·
Regressive Tax System
o
Average tax rate falls with GDP
·
The more progressive the tax system, the
greater the economy’s built-n stability.
