Unit 3

Unit 3

Aggregate Demand 

AD is the demand by consumers, business,government , and foreign countries. 

What definitely doesn't shit the curve 

Changes in price level cause w move along the curve. 

 WHY IS AD DOWNWARD SLOPING ?

1. Real balance effect 

. Higher price levels reduce the purchasing power of money 

. This decreases the quantity of expenditures 

. Lower price levels increase purchasing power and increase expenditures. 

1. Interest Rate Effect 

. When the price level increase, lenders need to charge higher interest rates to get a REAL return in their loans. 

. Higher interest rates discourage consumer spending and business investment. 

1. Foreign Trade Effect 

. When US price level rises, foreign buyers purchase fewer US. Goods and Americans by more foreign goods

. Exports fall and imports rise causing GDP demanded to fall (Xn Decreases)

Shifters of aggregate demand = GDP= C+ I + G+ Xn

. 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➡️

. Decrease in AD=AD⬅️

CONSUMPTION

1. Consumer wealth 

. More wealth = more spending (ad shift ➡️)

. Less wealth = less spending ( ad shift ⬅️)

1. Consumer expectation 

Positive expectations - more spending ➡️

Negative expectation - less spending 

1. Household indebtedness

Less debt= more spending 

More debt= less spending 

1. Taxes 

Less taxes - more spending 

More taxes - less spending 

Gross private investment 

Investment spending is sensitive to 

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 

. Expectations of future profitability 

. Technology 

. Degree of excess capacity ( existing stock of capital)

. Business taxes 

Government Spending 

. More government spending (AD➡️)

. Less government spending (AD⬅️)

Net Exports

Sensitive to -

. Exchange Rates ( International value of $)

. Strong $ = more imports and fewer exports = AD ⬅️

. Weak $ = fewer import and more exports = AD ➡️

Relative Income

. Strong foreign Economies = more exports = AD➡️

. Weak Foreign Economies = less imports = AD⬅️ 

Disposable income 

. With disposable 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 disposable income 
• The propensity to save 

Do households consume if Dl = 0

• autonomous consumption 
• Dissaving 

Saving 

• households not spending
• The ability to save is constrained by 

. The amount of disposable income 

. The propensity to consume 

• do households save if Dl=0 

No 

Average propensity to save 

APC+ APS = 1 

1 - APC = APS

1 - APS = APC

APC > 1

MPC ( marginal propensity to consume)

The fraction of any change in disposable income that is consumed 

MPC = change in consumption / change in income 

MPC= ^c/^di

Marginal propensity to save (MPS)

The fraction of any change on disposable income that is saved. 

MPS= change in savings / change in disposable income 

MPS= ^s/^di

Marginal propensities 

MPC + MPS = 1

• MPC= 1 -MPS
• MPS = 1-MPC

Remember people do two things with their disposable income consumer it if save it. 

The spending multiplier effect 

An initial change in spending ( c ig g Xn) cause a larger change in aggregate spending or aggregate demand ( ad)

Multiplier = change in AD/ change in spending 

Multiplier = ^ AD/

Calculating the spending multiple 

Multiplier = 1/1-MPC or 1/MPS 

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

Tax multiplier 

When the government taxes the multiplier works in reverse 

Why?

• Because now money is leaving the circular flow 
• Tax multiplier ( it's negative ) 
• MPC/1-MPC OR -MPC/MPS

There is tax- cut then the multiplier is + because there is more money in the circular flow.

Long run aggregate supply ( LRAS)

The long aggregate supply or Lara marks the level of full employment in the economy 

Because input prices are completely flexible in the long run changes in price level do not change firms. This means Lars is vertical at the economy's level of 

full employment 

Changes in SRAS

An increase in SRAS is serve as a shift. To the right. SARS 

a decrease in SARS is seen as a shift to the left SRAS 

they key to understanding shifts in SARS is per unit cost of production 

Per unit production cost = total input cost / total output 

Determinants of SARS 

1. Input prices - domestic resource prices 
2. 1. Wages (75% of all business cost )

      2. Cost of capital 

      3.raw materials 

      4. Market power 

Increase income prices = SRAS ⬅️

Decrease income prices = SRAS ➡️

1. Productivity = total output/ total input 

More productivity = lower unit production cost = SRAS ➡️

Lower productivity = higher until production cost = SRAS ⬅️

1. Legal institution environment 

Taxes and subsided - taxes on business increase per unit production cost = SRAS ⬅️

Subsidies to business reduce per unit production cost = SRAS ➡️

Government regulation 

Government regulation creates a cost of compliance = SRAS ⬅️

Deregulation reduces compliance costs = SRAS ➡️

FULL EMPLOYMENT

Full employment equilibrium exists where AD intersects SRAS and LARS at the same point 

Recessionary Gap 

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

Inflationary Gap 

An inflationary gap exist when equilibrium occurs beyond full employment output 

Nominal wages is the amount of money received by a worker per unit of time (clock by the hour or by they day)

Real wages amount of goods and services a worker can purchase with their nominal wage. 

     Real wage is the purchasing power of your nominal wage 

Sticky wages 

It is the nominal wage level that is set according to an initial price level and it does not vary due to labor contracts or other restrictions. 

Output depends upon changes in the employment level 

Implication for inflation 

1. Output is independent of changes in the price level 

Interest rate in 

What is investment ?

Money spent or expenditures on 

• new plants 
• capital equipment 
• Technology ( hardware and software)
• New homes 
• Inventories ( goods sold by producers) 

Expected rate of Returns 

How does business make investment decisions ?

• cast / benefits analysis 

How does business determined the benefits ?

• expected rate of return 

How does business count the cost 

• interest cost 

How does business determine the amount of investment they undertake ?

• compare expected rate of return to invest cost 

.  If expected return > interest rate cost the invest 

.  If expected return < in test Cost then do not invest 

Real v nominal interest rate 

What's the difference 

• Nominal isn't he observable rate of interest. Real subtracts out inflation (pie%) and is only known ex post facto 

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

R%=i% - pie%

What then determines the cost of an investment decision 

• real interest rate (r%).

Fiscal policy 

Changes in the expenditures it tax revenues of the federal government 

2 tools 

  Taxes - gov increase or decrease taxes 

 Spending - gov inc or dec spending 

Deficits, surpluses, and debt 

• Balanced budget

Revenues = expenditures 

• budget deficit

Revenues < Expenditures 

• budget surplus 

Revenues > expenditures 

• Government debt 

Sum of all deficits - sum of all surpluses. Government must borrow money when it runs a budget deficit.  

• Governments borrows from 

. Individual 

. Corporations 

. Financial institutions 

. Foreign entities or foreign governments 

Fiscal policy two options 

• discretionary fiscal policy : action ( expansionary Fiscal policy - deficit)
• Contractionary fiscal policy - think surplus 

Non -Discretionary  fiscal policy ( no action)

Discretionary- increasing or decreasing government spending and or taxes in order to return the economy into full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem. 

Automatic - unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recessions and inflation automatic fiscal policy takes place without having to respond to current economic problems. 

Contraction are 

Expansionary fiscal policy 

• combat recessions 
• Govt spending ⬆️
• Taxes ⬇️

Contractionary Fiscal Policy 

• combat inflation 
• Govt spending ⬇️
• Taxes ⬆️

Automatic or built in stabilizers 

 Anything that increase the government budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers. Ex social security, Medicare, unemployment, veterans benefit. 

Progressive tax system 

average tax rate ( tax revenue / GDP) rises with GDP