Unit III

Aggregate Demand 

• Shows the amount of Real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level.

• Relationship between the price level and level of GDPr is inverse

3 Reasons AD is downward sloping

1. Real-Balances Effect
2. Interest-Rate Effect
3. Foreign Purchases Effect

Shifts in AD

• Change in C, Ig, G, or Xn
• Multiplier effect that produces a greater change than the original change in the 4 components
• Increase in AD, shift right
• Decrease in AD, shift left

Net Exports

• Exchange Rates (International value of U.S. dollar)
• Strong dollar = More imports and Less Exports = (AD shift left)
• Weak dollar = fewer imports and more exports = (AD shift right)

Relative Income

• Strong Foreign Economies = More Exports = AD shift right
• Weak Foreign Economies = Less Exports = AD shift left

Aggregate Supply

• The level of Real GDP that firms will produce at each price level

Long-Run v. Short-Run

• Long-Run
• Period of time where input prices are flexible and adjust to changes in the price-level
• In the long-run, the level of Real GDP is independent from price level
• Short-Run
• Period of time where input prices are sticky and do not adjust to changes in the price-level
• Real GDP is directly related to the price level

Long-Run Aggregate Supply (LRAS)

• marks the level of FE in the economy (same as the PPC)
• is always vertical at full employment

Changes in Short-Run Aggregate Supply (SRAS)

• increase in SRAS, shift to the right
• decrease, shift to the left
• the key to understanding shifts is per unit cost of production
• per-unit production cost = total input cost / total output

Determinants of SRAS 

• Input prices = land, labor, machinery, ETC.
• Productivity = technology

Ranges of Aggregate Supply (AS)

Keynesian Range

• Horizontal
• Followers believe in a horizontal AS curve because when the economy is below FE, AD shifts out
• Increase in GDPr, UE drops, price level is constant
• Demand creates its own supply

Intermediate Range

• AS is between the Classical and Keynesian Range
• AS shifts outward, price level and GDPr increases

Classical Range

• Vertical
• In the long run, AS curve is vertical because the only effects of an increase in AD is when we are already at FE
• Increase in price level
• Supply creates its own demand (Say's Law)

Recessionary Gap - when equilibrium occurs below FE output

Inflationary Gap - when equilibrium occurs beyond FE output

Investment

• Money spent or 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?
• expected 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
• expected return > interest cost = invest
• expected return < interest cost = don't invest
• Real (r %) v. Nominal (i %)
• Nominal is the observable rate of interest
• Real subtracts out inflation and is only known ex post facto
• Compute r%
• = nominal - inflation
• Real interest rate (r%) determines the cost of investment decision
• Investment Demand Curve (ID)
• Downward sloping
• Why?
• when interest rate are high, fewer investments are profitable
• when ir are low, investments are profitable
• Shifts in ID
• Cost of production
• Business taxes
• Technology changes
• Stock of capital
• Expectations
• Consumption and Savings
• Disposable income (DI)
• income after taxes
• net imcome
• Consumption
• Household spending
• Ability to consume is constrained by: amount of DI and propensity to save
• DI = 0 
• Dissaving
• Savings
• Household not spending
• Ability to save is constrained by: amount of DI and propensity to consume
• APS = average propensity to save
• APC = average propensity to consume
• APC + APS = 1
• APC > 1 dissaving
• MPC = marginal propensity to consume
• = change in consumption / change in DI
• MPS = marginal propensity to save
• = change in savings / change in DI
• MPS + MPC = 1

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 AD
• Multiplier - change in AD / change in spending
• 1 / MPS
• positive when increase in spending
• negative when decrease

Tax Multiplier

• when government taxes, the multiplier works in reverse
• money is leaving circular 
• Multiplier (negative) = - MPC / MPS

Fiscal Policy

• Expansionary and Contractionary policy
• Deficits and surplus
• Built in stability

Changes in expenditures or tax revenues of the federal government

2 tools of fiscal policy

1. Taxes - government can increase or decrease taxes
2. Spending - government can increase/decrease spending

Fiscal policy is enacted to promote our nation's economic goods = FE, price stability, economic growth

Deficits, Surpluses, 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 into a deficit
• Borrows from individuals, corporations, financial institutions, foreign entities/governments

2 options of fiscal policy

1. Discretionary Fiscal Policy (action)
1. Expansionary (deficit)
2. Contractionary (surplus)
2. Non-discretionary (no action)

Discretionary v. Automatic FP

Discretionary

• increasing/decreasing government spending/taxes in order to return the economy to FE
• involves policymakers

Automatic 

• UE compensation and marginal tax rates
• takes place without policymakers

Contractionary - policy designed to decrease AD

• strategy for controlling inflation
• decrease gov't spending/increase taxes

Expansionary - increase AD

• increasing GDP, combatting recession, reducing UE
• recession is countered with expansionary policy
• increase gov't spending/decrease taxes

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