Unit 3

2/19 Aggregate Demand

- Aggregate demand (AD) -shows the amount of real GDP that the private, public & foreign sector collectively desire to purchase at each possible price level -the relationship between the price level & the level of real GDP is inverse 

Three reasons AD is downward sloping: 
1. Real-balance effect     

• high price-level: households & firms can't afford to purchase as much output    
•  low price-level: households & firms can afford to purchase more output 

2. Interest-rate effect    

•  higher price-level increases the interest rate (discourages investment)    
•  lower price-level decreases the interest rate (encourages investment) 

3. 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 us exports 

Government Regulation

-Government regulation creates a cost of compliance = SRAS shifts left

-Government deregulation reduces compliance costs = SRAS shifts right

• The equilibrium of AD and AS determines current output (Real GDP) and price level (PL)
• Full employment equilibrium exists where AD intersects SRAR and LRAS (long run aggregate supply) at the same point
• Recessionary gap exists when equilibrium occurs below full employment output
• Inflationary gap exists when equilibrium occurs beyond full employment output
• LRAS represents full employment output

Shifts in Aggregate Demand (AD) 
-there are two parts to a shift in AD:     
1. change in consumption, investment, government purchases & net exports    
 2. a multiplier effect that produces a greater change then the original change in 4 components -increases in AD = AD → -decreases in AD = AD ← Determinants of AD: 1. Consumption:     Consumer Wealth:         

• more wealth: more spending  (AD shifts →)         
• less wealth: less spending (AD shifts ←)     

-Consumer Expectations:      

•    positive expectations: more spending  (AD shifts →)        
•  negative expectations: less spending (AD shifts ←)    

 -Household Indebtedness:         

• less debt: more spending (AD shifts →)         
• more debt: less spending (AD shifts ←)     

-Taxes:         

• less taxes: more spending (AD shifts →)         
• more taxes: less spending (AD shifts ←)

 2. Gross Private Domestic Investment:     
-Real Interest Rate:         

• lower real interest rate: more investment (AD shifts →)         
• higher real interest rate: less investment (AD shifts ←)  

-  Expected Returns:        

•  higher expected returns: more investment (AD shifts →)         
• lower expected returns: less investment (AD shifts ←)               
•  Expected returns are influenced by: expectations of future propensity, technology, dgree of excess capability, business tax

- Government Spending:

• more government spending (AD shifts →)
• less government spending (AD shifts ←)    

-Net exports
Net exports are sensitive to 
-Exchange Rates(international value of money)

• strong money : more import, few export (AD shifts →)
• weak money : fewer imports, more exports(AD shifts ←) 

-Relative Income 

• Strong foreign economies : (AD shifts →)
• Weak foreign economies: (AD shifts ←) 

2/24 Consumption

-Disposable Income : income after taxes or net income
DI = gross income- taxes
1. Consume(Spend money on goods/ services)
2. Save(Not save money on goods/services)

-Consumption
1. Household Spending
2. The ability to consume is constrained by

• amount of disposable income
• propensity to save

3. Do households consume if DI=0?

• autonomous consumption
• dissavings

-Savings
1. Household not spending 
2. Ability to save is constrained by

• amount of disposable income
• propensity to consume

3. Do households save if DI = 0?
*NO
-APS= S/DI = %DI

-Average propensity to consume/save 

• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1= Not saving
• -APS = Not saving

-Marginal Propensity to consume

• Change in consumption/change in disposable income
• % of every extra dollar earned that is spent

-Marginal propensity to save

• Change in savings/ change in disposable income
• % of every extra dollar earned that is saved

Formulas

• MPC+MPS = 1
• 1-MPC= MPS
• 1-MPS=MPC

-Determinants of C/S

• wealth
• expectation
• taxes
• household debt

-The spending multiplier effect: an initial change in spending causes a large change in aggregate spending or demand.

*multiplier = change in AD/ change in spending
*multiplier = change in AD/change in expenditure

-Calculating the spending multiplier

• MPS/MPC
• 1/1-MPC
• 1/MPS

Multipliers are positive when there is an increase in spending and negative when there's decrease.
-Calculating the tax multiplier

• When the government taxes, multiplier work in reverse
• Because money is leaving circular flow
• always negative
• -MPC/1-MPC
• -MPC/MPS

If there is a tax cut, then multiplier is positive because there is more money in the circular flow.

2/24 Investment

-Investment is money spent on expenditures on:

• new parts (factories)
• capital equipment (machinery)
• technology (hardware and software)
• new homes
• inventories (goods sold by producers)

Expected rate of Returns

-How does business make investment decisions?

• cost/benefit analysis

-How does business determine the benefits?

• expected rate of return

-How does business determine the cost?

• interest costs

-How does business determine the amount of investment they undertake?

• compare expected rate of return to interest cost
• if expected rate of return is greater than the interest cost, then invest
• if expected rate of return is less than the interest cost, then don't invest

Real (r%) v. Nominal(i%0

-What's the difference?

• nominal is the observable rate of interest
• real subtracts out inflation and is only known ex post facto

-How do you compute real?

• real = nominal - inflation

-Real interest rate determines the cost of an investment decision
Investment Curve ID

-What is the shape?

• downward sloping

-Why?

• when interest rates are higher, fewer investments are profitable
• when interest rates are lower, more investments are profitable

-Shifts in ID

• cost of production
• business taxes
• technological change 
• stock of capital
• expectations

2/27 Fiscal Policy

-Fiscal Policy- changes in the expenditure 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

*when one increases, the other decreases-Fiscal policy is enacted to promote our nation's economic goals which are:

• full employment

• price stability

• economic growth

Deficits, Surpluses, and Debts-Balanced Budget

• revenues = expenditures

-Budget Deficit

• revenues < expenditures

-Budget Surplus

• revenues > expenditures

-Government debt = sum of all deficits - sum of all expenditures-Government must borrow money when it runs a budget deficit

• government borrows from:

• individuals (through taxes)

• corporations (through taxes)

• financial institutions

• foreign entities/foreign governments

Discretionary Fiscal Policy-Discretionary FP (government takes action)- increase or decrease in taxes or government spending-Consists of:

• expansionary fiscal policy (think deficit)

• designed to increase AD

• strategy for increasing GDP, combating recession, and reducing unemployment

• recession is countered with expansionary FP

• increase in government spending

• decrease taxes

• if PL increased, this means expansionary FP creates some inflation

• contractionary fiscal policy (think surplus)

• inflation is countered with contractionary policy

• decrease in government spending

• increase taxes

• unemployment rate increased, this means it is contractionary

Non-Discretionary Fiscal Policy-Non-Discretionary FP (government takes no action)

• automatic FP

• unemployment compensation

• social security

-Automatic or Built-in stabilizer- anything that increases its budget surplus during inflation without requiring action from policy makers

• example: transferred payments, social security, unemployment compensation
• 
  

Tax Systems

-Progressive tax rate:average tax rate rises with GDP

- Proportional tax rate: remains constant as GDP changes

- Regressive tax system : Average tax rates fall with GDP