Unit III

Aggregate Demand - shows the amount of RGDP that the private, public and foreign sector collectively desire to purchase at each positive price

• relationship between price and RGDP is inverse
• price of Y
• Quantity of X

Why AD is Downward Sloping

• Real Balancing Effect
•  price is high; businesses and households cannot afford to buy as much output 
• Interest-Rate Effect
• high price level increases interest rate, discourages investment
• Foreign Purchases Effect
•  higher price level increases the demand for relatively cheaper imports

Shifts in AD

• Change in C, Ig, G and Xn
•  a multiplier effect that produces a greater change than the original change in the 4 components
• Consumption
• Affected by:
• consumer wealth
• more wealth, AD increases
• Consumer Expectations
•  positive, AD increases
•  Household indebtedness
• less debt, AD increases
• Taxes
• Less Taxes, AD increases

• Gross Private Investment
• Affected by:
• · The real interest rate
•  low interest rate, AD increases
• Expected Returns
•  Higher Expected Returns, AD increases
•  Influenced by
•  expectations of future profitability
• technology
•  degree of excess capability
• business taxes
• Government Spending
• More, AD increases
• Net Exports
• Affected by:
•  Exchange Rate
•  strong money = more imports fewer exports, AD decreases
• weak money = fewer imports and more exports AD increases
• Relative Income
• Strong Foreign Economy = increase in exports, AD increases
• Weak Foreign Economy = decrease in exports, AD decreases

Aggregate Supply

• Long Run 
• · input prices are completely flexible and adjust to changes in the price level
•  level of RGDP supplied is independent of the Price Level 
• marks the level of full employment in the economy (analogous to PPC) 
• Vertical 
• Short Run
•  input prices are sticky and do not adjust to changes in the PL
•  level of RGDP supplied is directly related to the PL
• Changes in SRAS
• Increase in SRAS seen as shift to right: SRAS →
• Decreases in SRAS shift to left: SRAS ←
• Per unit of production:
• (Per Unit Production Cost = Total Input Cost / Total Output)
• Determinants of SRAS
• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign Resource Prices
• Strong money = Lower Foreign Resource Prices
• Weak money= Higher Foreign Resource Prices
• Productivity
• (Productivity = Total Output / Total Input)
• More Productivity = Lower Unit Production Costs = SRAS shifts right
• Lower Productivity = Higher Unit Production Costs = SRAS shifts left
• Legal-Institutional Environment
• Taxes and Subsidies
• Taxes ($ to government) on businesses increase per unit production costs = SRAS shifts left
• Subsidies ($ from government) on businesses reduce per unit production cost = SRAS shifts right
• Government Regulation
• Government regulation creates a cost of compliance = SRAS shifts left
• Deregulation reduces compliance costs = SRAS shifts right

The AS/AD Model 

• the equilibrium of AS & AD determined where AD intersects SRAS & LRAS at the same point

Recessionary Gap

• exists when equilibrium occurs below Full Employment output

Inflationary Gap

• exists when equilibrium occurs beyond full employment output

3 Ranges

• Horizontal or Keynesian Range
• It includes only levels of real output that are less than the FE output.
• It implies that the economy is in recession.
• Vertical or Classical Range
• The economy reaches its full capacity real output.
• Increase in PL = constant production
• Intermediate
• Expansion of real output and price level

Consumption and Saving

• Disposable Income (▵DI)
• income after taxes, net income
• DI= gross income - taxes
• households cane either consume or save
• Consumption - household spending
• the ability to consume is constrained by:
• the amount of DI
• the propensity to save
• Do household consume if DI=0?
• Yes; autonomous consumption 
• Average Propensity to Consume (APC) = C/DI = % of DI that is spent
• Saving - household NOT spending
• the ability to save is constrained by:
• the amount of DI
• the propensity to consume
• Do household save if DI=0?
• No
• Average Propensity to Save (APS) = S/DI = % of DI that is saved
• Equations
• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1, dissaving
• -APS, dissavings
• Marginal Propensity to Consume (MPC) = C/DI = % of every extra dollar earned that is spent
• Marginal Propensity to Save (MPS) = S/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 debt, taxes

Spending Multiplier Effect

• an initial change in spending (C, Ig, G, Xn) causes a larger change in AS or AD
• AD/( C, Ig, G, Xn)
• Why does this happen?
• expectations and income flow continuously which sets off a spending increase in the economy
• = 1/(1-MPC) or 1/MPS
• (+) when increase in spending
• (-) when decrease in spending

Tax Multiplier 

• when the government taxes, the multiplier works in reverse because money is leaving circular flow
• = -MPC/(1-MPC) or -MPC/MPS
• if tax is cut, then multiplier is positive because there is more money in the circular flow

Interest Rates and Investment Demands

Investment

• Money spent on expenditures on:
• New plants or factories
• Capital equipment 
• Technology 
• New homes
• Inventories 
• Expected Rates of Return
• investment decisions
• Cost/Benefit analysis
• determine the benefits
• Expected rate of return
• count the cost
• Interest cost
• determine the amount of investment they undertake
• Compared expected rate of return to interest cost
• If expected return > interest cost, then invest.
• If expected return > interest cost, then do not cost.

Real (r%) v. Nominal (i%)

• Nominal is the observable rate of interest. Real accounts for inflation (π%), only known ex post facto.
• Computing r%: (r% = i% - π%)
• determining the cost of an investment decision
• Real interest rate (r%)

Investment Demand (ID)

• Downward sloping
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in ID

• Cost of production
• Business taxes
• Technological change
• Stock of capital
• Expectations

Fiscal Policy

• Fiscal policy is the changes in the expenditures or tax revenues of the federal government
• 2 tools of fiscal policy:
• Taxes: Government can increase or decrease taxes
• Spending: Government can increase or decrease spending
• enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced budget: Revenues = Budget
• Budget Deficit: Revenues < Budget
• Budget Surplus: Revenues > Budget
• Government Debt: sum of all deficits - sum of all surpluses
• Government must borrow money when it runs a budget deficit from:
• individuals, corporations, financial institutions, and foreign entities/governments

Fiscal Policy : Two Options

• Discretionary (actions)
• Expansionary - deficit
• to increase RGDP, combat recession, and reducing unemployment
• Government Spending increases, Taxes decrease
• creates inflation
• Contractionary  - surplus
• strategy for controlling inflation
• Government Spending decreases, Taxes increase
• Non-Discretionary (no action) - AUTOMATIC
• Discretionary increases or decreases taxes
• Automatic - takes in unemployment compensation, social security, etc, that help eases the effects of recession and inflation

Tax Systems

• Progressive Tax System
• Average tax rate that rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP

Graphs: