AGGREGATE DEMAND
Aggregate demand (AD) - Shows the amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible level
» The relationship between the price level and the level of real GDP is inverse
»»Three reasons why 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 of 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 relatively cheaper imports
-A lower price level increases the foreign demand for relatively cheaper US exports
»»Shifts in aggregate demand
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 four components
- increases In AD = AD >
- decreases in AD = AD <
»»Determinants
»Consumption - households spending is affected by:
-consumer wealth
More wealth = more spending AD shift >
Less wealth = less spending AD shift <
-consumer expectations
Positive expectations = more spending AD shift >
Negative expectations= less spending AD shift <
- households indebtedness
Less debt = more spending AD shift >
more debt = less spending AD shift <
-taxes
Less taxes = more spending AD shift >
More taxes= less spending AD shift <
»Gross private domestic investment
Investment spending is sensitive to:
-The real interest rate
Lower real interest rate = most 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 stress influenced by:
Expectations of future profitability
Technology
Degrees of excess capacity (existing stock of capital)
Business taxes
» government spending
More government spending AD >
Less government spending AD <
» net exports
Net exports are sensitive to:
-exchange rates (international value of $)
Strong $ = more imports and fewer exports = AD <
Weak $ = fewer imports and more exports = AD >
-relative income
Strong foreign economics = more exports = AD >
Weak foreign economics = less exports = AD <
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AGGREGATE SUPPLY
Aggregate supply - the level of real GDP (GDP r) that firms will produce
Long run
- Period of time where input pieces are completely flexible and adjust to changes in the piece level
-In the long run, the level of real GDP supplied is independent of the price level
-Measuring potential output
-Obsessing to see if all resources are used efficiently
-There is no pressure to raise or lure factor prices when on point b or equilibrium
- inefficient or under utilizing our resources on point a, factor prices are pressured to fall
- over utilizing at point c, factor prices are pressured to rise
»»Shifts in LRAS
Technology
Economic growth
Capital
Entrepreneurship
More resources available
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 on LRAS marks the level of full employment in the economy (analogous to PPC)
***vertical at full employment
Change in SRAS
-An increase in SRAS is seen as a shift to the right.
-A decrease in SRAS is seen as a shift to the left
-The key to understanding shifts in SRAS is per unit cost of production
Per unit production cost = total input cost / total output
»»Determinants of SRAS
Input prices
-Increases in resource prices = SRAS <
-Decreases in resource prices = SRAS >
Productivity
- Productivity = total output /total input
-more productivity = lower unit production cost = SRAS >
-lower productivity = higher unit production cost = SRAS <
Legal institutional environment
Keynesian range
-The followers of the Keynesian view believed in a horizontal AS curve because when the economy is below full employment AD shift outward.
-Increase in real GDP, Unemployment drops but the price level is constant, So demand creates is own supply
Classical range
-In the long run the AS curve is vertical because the only effects of an increase in AD is when we're already at full employment. Thus you have an increase in the price level and supply creates its own demand SA's law
Intermediate range
-AS off between the classical and Keynesian range when this occurs AS shifts outward price level and real GDP increases
As PPC increases real GDP decreases, inverse
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AD AND AS MODELS
The equilibrium of AS and AD determines current output (GDP r) and the price level (PL)
Equilibrium - when all three lines intersect: LRAS, SRAS, and AD
Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point
Recessionary gap
A recessionary gap exists when equilibrium occurs below full employment output. SRAS and AD intersects and shifts left but LRAS doesn't
Inflationary gap
An inflationary gap exists when equilibrium occurs beyond full employment output. SRAS and AD intersects and shifts to the right, while LRAS doesn't.
Changes (^) in AD
-When a determinant increases then AD shifts to the right, GDPr increases and PL increases, unemployment rate decreases and inflation rate increases.
-When a determinant decreases then AD shifts to the left, GDP r decreases and PL decreases, unemployment rate increases and inflation rate decreases.
Changes (^) in SRAS
-when a determinant decreases then AS shifts to the right, GDP r increases and PL decreases, unemployment decreases and inflation rate decrease
-when a determinant increases then AS shifts to the left, GDP r decreases and PL increases, unemployment increases and inflation rate increases
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INVESTMENT DEMAND
Investment
Money spent on expenditures on:
New plants (factories)
Capital equipment (machinery)
Technology (hardware and software)
New homes
Inventories (goods sold by producers)
»»Expected rates of return
How does business make investment decisions?
-cost/ benefit analysis
How does business determine the benefits?
-elected 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 elected return < interest cost, then do not invest
»»Real (r%) vs nominal (n%)
Nominal is the observable rate of interest. Real subtracts out inflation (pi%) and is only known ex post facto.
How do you compare 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 (ID)
Shape: downward sloping
Why? - when interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
-conversely, these are few investments that yield high rates of return, and many that yield low rates of return
Changes in r% cause changes in Ig. Factors other than r% may shift the entire ID curve.
»»Shifts in investment demand ID:
cost of production
Business taxes
Technological change
Stock of capital
Expectations
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CONSUMPTION AND DEMAND
Disposable income DI:
Income after taxes or net income
»»Two choices
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 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 is DI = 0?
NO
PAC average propensity to save and APC average propensity to consume
APC + APS = 1
APC > 1 then dissaving
-APS then dissaving
»»MPC and 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 every dollar that is saved
MPC + MPS = 1
»»determinants of C and S
Wealth
Expectations
Household debt
Taxes
»»The spending multiplier effect
An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or aggregate demand
Multiplier = change in AD / change in spending
Multiplier = ^ AD / ^ C, Ig, G, or Xn
Why does this happen?
Expenditures and income flow continuously which sets off a spending increase in the economy
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
»»Tax multiplier
When the government taxes, the multiplier works in reverse because now money is leaving the circular flow
-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
Step 1: calculate the MPC and MPS
Step 2: determine which multiplier to use, and whether it's + or -
Step 3: calculate the spending and/or tax multiplier
Step 4: calculate the change in AD
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FISCAL POLICY
Fiscal policy - Changes in the expenditures or tax revenues of the federal government
2 tools of the fiscal policy:
Taxes - government can increase or decrease taxes
Spending - government can increase our 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: 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
Government borrows from:
Individuals
»»Fiscal policy two options
Discretionary fiscal policy (action)
Expansionary fiscal policy - think deficit, recession
Contractionary fiscal policy - think surplus, inflationary period
Non-discretionary fiscal policy (no action)
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 and 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 fiscal policy - policy designed to decrease aggregate demand
- strategy for controlling inflation
-inflation is countered with Contractionary policy
-decrease government spending Gv
- increase taxes T^
Expansionary fiscal policy - policy designed to increase aggregate demand
- strategy for increasing GDP, combining a recession, and reducing unemployment
-recession is countered with expansionary policy
-increase government spending G^
- decrease taxes Tv
Progressive tax system - average tax rate (tax revenue/GDP) rises with GDP
Proportional tax system - average tax rate remains constant as GDP changes
Regressive tax system - average tax rate falls with GDP
the more progressive the tax system, the greater the economy's built in stability.
