Unit 3

2/11/15

   Ø  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.

·         Looking at output. Once price level goes up the quantity goes down and once price goes down quantity goes up. Inverse relationships.

Ø  Aggregated Demand Graph

    Ø  Three reasons AD is downward sloping

-          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.

-          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

-          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.

Ø  Shift 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.

-         Increase in AD=AD right

-          Decrease in AD=AD left

   Ø  Consumption

·         Household spending is affected by:

-          Consumer wealth

o   More wealth=more spending (AD shifts right)

o   Less wealth=less spending (AD shifts left)

-          Consumer expectations

o   Positive expectations = more spending (AD shifts right)

o   Negative expectations = less spending (AD shifts left)

-          House hold indebtedness

o   Less debt = more spending (AD shifts right)

o   More debt = less spending (AD shifts left)

-          Taxes

o   Less taxes = more spending (AD shifts right)

o   More taxes = less spending (AD shifts left)

   Ø  Gross Private Investment

·         Investment Spending is sensitive to:

-          The real Interest Rate

o   Lower Real interest Rate = more investment (AD right)

o   Higher Real interest Rate = less investment (AD left)

-          Expected Returns

o   Higher Expected Returns =More Investment (AD right)

o   Lower Expected Returns = Less investment (AD left)

o   Expected Returns are influenced by

-          Expectations of future profitability         

-          Technology

-          Degree of Excess Capacity (Existing Stock of Capital)

-          Business Taxes

   Ø  Government Spending

·         More Government Spending (AD right)

·         Less Government Spending (AD left)

   Ø  Net Exports

·         Net Exports are sensitive to:

-          Exchange Rates (International value of $)

o   Strong $ = More imports and fewer Exports = (AD left)

o   Weak $ = Fewer Imports  and More Exports = (AD right)

-          Relative Income

o   Strong Foreign Economies = More exports = (AD right)

o   Weak Foreign Economies = Less Exports = (AD left)

2/12/15

   Ø  Aggregate Supply

·         The level of Real GDP (GDP R) that firms will produce at each Price Level (PL)

   Ø  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 RGDP 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 RGDP supplied is directly related to the price-level

   Ø  Long-Run AS (LRAS)

·         The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC)

·         Price are completely flexible in the long-run, changes in 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 level of full employment.

-          *Long-run is vertical at full employment

   Ø  Long Run AS graph

   Ø  Short-Run Aggregate Supply (SRAS) Upward sloping

Input prices are sticky in the short run, the SRAS is upward sloping. This reflects the fact that in the short-run, increases in the price-level increase firm’s profits and create incentives to increase output.

   Ø  Short run Aggregate Supply Graph

   Ø  Changes in SRAS

·         An increase in SRAS is seen as a shift to the right. SRAS right

·         A decrease in SRAS is seen as a shift to the left. SRAS left

·         The key to understanding shifts in SRAS is per unit cost of production

·         Per-unit production cost = total input cost/ total output cost

   Ø  Change in SRAS( increase)

   Ø  Change in SRAS (Decrease

   Ø  Determinants of SRAS (all of the following affect unit production cost)

·         Input prices

-          Domestic Resource Prices

o   In wages, Raw materials,

o   Pay cost of capital

-          Foreign Resource Prices

o   Value of the dollar is it weak or strong?

o   Strong $ = Lower foreign resource prices

o   Weak $ = higher foreign resource prices

-          Market Power       

o   Monopolies and cartels that control resources control the price of those resources. (OPEC)

-          Increases in Resource Prices = SRAS left

-          Decreases in Resource prices = SRAS right

·         Productivity

o   Total output/total inputs

o   More productivity = lower unit production cost = SRAS right

o   Lower productivity = higher unit production cost = SRAS left

·         Legal- institutional Environment

o   Taxes and Subsidies

-          Taxes ($ to gov’t) on business increase per unit production cost =SRAS left

-          Subsidies ($ from gov’t) to business reduce per unit production cost = SRAS right

o   Government Regulation

-          Government regulation creates a cost of compliance = SRAS left (side regulations in businesses)

-          Deregulation reduces compliance costs = SRAS right (Deregulated airline, paid the same cost. Different destination, but later on cheap ticket, price of fair changed)

2/17/15

   Ø  Full Employment

·         Full Employment equilibrium exists where AD intersects SRAS & LRAS at the Same point.

   Ø  Recessionary Gap

·         A recessionary gap exists when equilibrium occurs below full employment output

o   AD Shifts to the left which decreases

   Ø  Inflationary gap

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

o   When there is an inflationary gap AD to the right increasing

   Ø  Investment Demand

·         What is investment?

o   Money Spent or expenditures on:

-          New plants (factories)

-          Capital equipment (machinery)

-          Technology (hardware & software)

-          New Homes

-          Inventories (goods sold by producers)

   Ø  Expected Rates of Return

·         How does business make investment decisions?

o   Cost/Benefit Analysis (red, if business 3 years you good)

·         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

-          If expected return > interest cost, then invest

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

   Ø  Real (r %) v. Nominal (i %)

·         What’s the difference?

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

·         How do you compute the real interest rate (r %)?

o   r % = i % - π% (inflation rate) π is inflation

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

o   The real interest rate (r %)

   Ø  Investment Demand Curve (ID)

·         What is the shape of the investment demand curve?

o   Downward sloping

·         Why?

o   When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable. (High, fewer buyers, low, more buyers)

-          Changes in r% cause changes in Ig. Factors other than r% may shift the entire ID curve

2/18/15

   Ø  Shifts in Investment Demand (ID)

·         Cost of production

·         Lower costs shift ID right

·         Higher Costs shift ID left

   Ø  Business Taxes

·         Lower business taxes ID right

·         Higher business taxes ID left

   Ø  Technological Change

·         New technology shifts ID right

·         Lack of technological change shifts ID left

   Ø  Stock of Capital

·         If an economy is low on capital, then ID right

·         If an economy has more capital, then ID left

   Ø  Expectations

·         Positive expectations shift right

·         Negative goes left

   Ø  Long-run AS

•   Always vertical at full employment, it represents a point on an economy production possibilities curve
• Long-run AS Does not change as the price level change.
•   Change long-run AS same as the PPC curve outward
•  Only shifts: Change of resources, change in technology, and economic growth

2/25/15

   Ø  Fiscal Policy

·         Changes in the expenditures a tax revenue of the federal government

·         2 Tools of fiscal policy:

o   Taxes government can increase or decrease taxes

o   Spending- government can increase or decrease spending

   Ø  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

o   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 governments

·         Fiscal Policy Two Options

o   Discretionary Fiscal Policy (action)

o   Expansionary fiscal policy – think deficit

o   Contractionary fiscal policy- think surplus

o   Non- discretionary fiscal policy (no action)

   Ø  Discretionary v. Automatic Fiscal Policies

·         Discretionary- 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- 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.

   Ø  Contractionary vs. Expansionary Fiscal Policy

·         Contractionary fiscal policy- policy designed to decrease aggregate demand

-          Strategy for controlling inflation

·         Expansionary fiscal policy- policy designed to increase aggregate demand

-          Strategy for increasing GDP, combating a recession, & reducing unemployment.

-          Increase government spending (G up)

-          Decrease taxes (T down)

·         Contractionary fiscal policy

-          Decrease government spending

-          Increase Taxes

-          RECESSION TO INFLATION OR TO INFLATION TO RECESSION

   Ø  Automatic or Built-In Stabilizers

-          Anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy.

·         Automatic Stabilizers (Food stamps etc.) Fiscal is run by congress.

o   Transfer Payments

-          Welfare checks

-          Food stamps

-          Unemployment checks

o   Nondiscretionary Fiscal Policy ( Automatic Stabilizers)

-          Corporate Dividends

-          Social Security

-          Veteran’s Benefits

   Ø  Tax System

·         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 

Three Economic Schools
Classical	Keynesian	Monetary
Ø  Adam Smith     Ø  John B. Say                           Ø  David Ricardo     Ø  Alfred Martial        -          Competition is good        -          Adam smith made the invisible hand “don’t need government help for business”        -          Says-Law     o   Supply creates its own demand     o   Determines output        -          In the LR the economy would balance at full    employment     o   The economy is always close or at full employment       -            AS=AD     o   At full employment equilibrium       -          Triple effect down effect     o   Halves and halves not       -          Savings (leakage) =investment (injection)       o   Savings increase with interest rate       -          Prices and wages are flexible downward -          Lassies fair	Ø  John Maynad Caynes        -          Competition is flawed        -          Ad is key not AS      o   Ad determines its own output and demand creates its own supply        -          Leaks cause constant recessions        -          Savings cause recessions        -          Savers and investors save and invest for different reasons savings are inverse to the interest rate.       -          Ratchet and sticky wages saves law       -          Prices and wages are flexible downward       -          So there is no mechanism is able for full employment in the LR we’re all dead       -          The economy is not always close to or at full employment       -          Government Intervention       -          Fiscal policy     o   Add stabilizers     o   Expansionary and Conpansionary	Ø  Alen Greenspan    Ø  Ben Bernanke       -       Fine tuning is needed       -          Voters won’t allow contractionary options       -          Congress can’t time policy options       -          Institute easy money and tightly money       -          Change required reserve if need       -          Buy and sell bonds through open market operations       -          Use interest rates to change the discount rate and the federal fund rate.