Unit 3 Notes - February 25th, 2016

Consumption & Saving

Disposable Income (DI)

·         Income after taxes // Net Income

·         DI = Gross Income – Taxes (DI = GI – T)

2 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:

o   The amount of disposable income

o   The propensity to save

·         Do households consume if DI = 0? Yes.

o   Autonomous Consumption

o   Dissaving

Saving:

·         Households not spending

·         The ability to save is constrained by:

o   The amount of disposable income

o   The propensity to consume

·         Do households save if DI = 0?  No. It’s not an option.

Average Propensity to Consume (APC) and Average Propensity to Save (APS)

·         APC + APS = 1

·         1 – APC = APS

·         1 – APS = APC

·         APC > 1 = Dissaving

·         -APS = Dissaving

Marginal Propensities

Marginal Propensity to Consume (MPC): Fraction of any change in disposable income that is consumed.

MPC = Change in Consumption / Change in Disposable Income

MPC = ▲C / ▲DI

Marginal Propensity to Save (MPS): Fraction of any change in disposable income that is saved.

MPS = Change in Savings / Change in Disposable Income

MPS = ▲S / ▲DI

MPC + MPS = 1

MPC = 1 – MPS

MPS = 1 – MPC

People who do things with DI consume it or save it.

Multipliers

The Spending Multiplier Effect: An initial change in spending (C, IG, G, Xn) causes a larger change in aggregate spending, or aggregate demand (AD)

Multiplier = Change in AD / Change in Spending

Multiplier = ▲AD / ▲C, IG, G, or Xn

Calculating the Spending Multiplier:

Spending Multiplier = 1 / 1 – MPC or 1 / MPS

Multipliers are positive when there is an increase in spending and negative when there is a decrease in spending.

Calculating the Taxing Multiplier:

Tax Multiplier (Negative) = -MPC / 1 – MPC or –MPC / MPS

When the government taxes, the multiplier works in reverse because the money is now leaving the circular flow.

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

Unit 3 Notes - February 23rd, 2016

Investment Demand Curve (ID)

What is the shape of the Investment Demand Curve?

·         Downward sloping

Why?

·         When interest rates are high, fewer investments are profitable; When interest rates are low, more investments are possible.

Shifts in Investment Demand

Cost of Production:

·         Lower costs shift ID to the right.

·         Higher costs shift ID to the left.

Business Taxes:

·         Lower Business Taxes shift ID to the right.

·         Higher Business Taxes shift ID to the left.

Technological Change:

·         New Technology shift ID to the right.

·         Lack of Technology shift ID to the left.

Stock of Capital:

·         Low on Capital shifts ID to the right.

·         Much Capital shifts ID to the left.

Expectations:

·         Positive Expectations shift ID to the right.

·         Negative Expectations shift ID to the left.

Unit 3 Notes - February 22nd, 2016

Nominal Wages vs Real Wages

Nominal Wages: The amount of money received by a worker per unit of time.

Real Wages: The amount of goods and services a worker can purchase with their nominal wages. (The purchasing power of your nominal wages)

Stick Wages: The nominal wage level is set according to an initial price level and does not vary to labor contracts or other restrictions.

	Price	Wages	Employment Level	Implications
Recession [Keynesian Range]	Fixed	Fixed	Flexible	Output depends on changes in the employment levels
Intermediate	Flexible	Fixed	Flexible	Output depends on changes in price and the employment level
Inflation [Classical Range]	Flexible	Flexible	Fixed	Output is independent of changes in the price level

Interest Rates and Investment Demand

What is Investment?

·         Money spent or expenditures on:

o   New Plants [Factories]

o   Capital Equipment [Machinery]

o   Technology [Hardware and Software]

o   New Homes

o   Inventories [Goods sold by Producers]

Expected Rates of Return

·         How does business make investment decisions?

o   Cost/Benefit Analysis

·         How does business determine the benefits?

o   Expected Rate of Return

·         How does business count the cost?

o   Interest Costs

·         How does business determine the amount of investments they undertake?

o   By comparing the expected rate of return to interest cost.

§  If Expected Rate of Return > Interest Cost, then Invest.

§  If Expected Rate of Return < Interest Cost, do not Invest.

Real (r%) vs Nominal (i%)

What’s the difference?

·         Nominal is the observable rate of interest. Real subtracts out Inflation (π%) and is only known ex post facto.

How do you compute the Real Interest Rate (r%)?

·         r% = i% - π% [Real = Nominal – Inflation]

What then, determines the cost of an investment decision?

·         The Real Interest Rate (r%)

Unit 3 Notes - February 19th, 2016

Full Employment

Full Employment Equilibrium exists where AD intersects SRAS & LRAS at the same point.

Recessionary Gap

A Recessionary Gap exists when equilibrium occurs below the Full Employment output.

Inflationary Gap

An Inflationary Gap exists when equilibrium occurs beyond the Full Employment output.

Unit 3 Notes - February 18th, 2016

Aggregate Supply (AS): The level of Real GDP (GDP_R) that firms will produce at each Price Level (PL)

Long Run vs Short Run

·         Long Run: The Period of time where input prices are completely flexible and adjust to changes in price level.

o   In the long run, the level of Real GDP supplied is independent of the Price Level.

·         Short Run: The Period of time where input prices are sticky and do not adust to changes in the price level.

o   In the short run, the level of Real GDP supplied is directly related to the Price Level.

Long Run Aggregate Supply (LRAS): Marks the level of full employment in the economy. (Analogous to PPC)

·         Because input prices are completely flexible in the Long Run, changes in price level do not change firms’ real profits and therefore do not change firms’ level of output. LRAS is vertical at the economy’s level of full employment (FE / Y_F / Y*)

Changes in Short Run Aggregate Supply (SRAS)

·         Increase in SRAS = Shift to the Right

·         Decrease in SRAS = Shift to the Left

·         Understanding shifts is per unit cost of production.

·         Per-Unit Production Cost = [Total Input Cost] / [Total Output]

Determinants of SRAS

·         Input Prices:

o   Domestic Resource Prices

§  Wages (75% of all business costs)

§  Cost of Capital

§  Raw Materials (Commodity prices)

o   Foreign Resources Prices

o   Market Power

o   Increase in Resource Prices = SRAS Shifts Left

o   Decrease in Resource Prices =  SRAS Shifts Right

·         Productivity: [Total Output] / [Total Input]

o   More Productivity = Lower Unit Production Cost. [SRAS Shifts Right]

o   Less Productivity = Higher Unit Production Cost [ SRAS Shifts Left]

·         Legal-Institutional Environment:

o   Taxes & Subsidies

§  Taxes (Money goes to the government) on business increases per unit production cost = SRAS Shifts Left

§  Subsidies (Money from the government) to business reduces per unit production cost= SRAS Shifts Right

o   Government Regulation:

§  Government Regulation creates a cost of compliance = SRAS Shifts Left

§  Deregulation reduces compliance costs = SRAS Shifts Right

Unit 3 Notes - February 12th, 2016

Aggregate Demand (AD): The demand by consumers, businesses, the government, and foreign countries. [Aggregate Demand Curve]

·         What definitely doesn’t shift the curve?

·         Changes in price level cause a move along the curve.

Why is Aggregate Demand Downward sloping?

·         The Real-Balance Effect:

o   Higher price levels reduce the purchasing power of money.

o   This decreases the quantity of expenditures.

o   Lower price levels increase purchasing power and increase expenditures.

Example: If the balance in your bank was $50,000, but the inflation erodes your purchasing power, you will likely reduce your spending.

·         The Interest-Rate Effect:

o   When the price levels increases, lenders need to charge higher interest rates to get a REAL return on their loans.

o   Higher interest rates discourage spending and business investments.

·         The Foreign-Trade Effect:

o   When U.S. price levels rise, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods.

o   Exports fall and imports rise causing real GDP demand to fall. (Net Exports, Xn, Decreases)

Two Parts to a Shift in AD

·         Change in C, G, Ig, or Xn

·         A Multiplier effect that produces a greater change than the original change in the four components.

Increases in AD = AD shifting to the right. 

Decreases in AD = AD shifting to the left. 

Determinants of Aggregate Demand (AD)

·         Consumption (C)

o   Household spending is affected by:

§  Consumer Wealth:

·         More Wealth = More Spending. [AD Shifts Right]

·         Less Wealth = Less Spending. [AD Shifts Left]

§  Consumer Expectations:

·         Positive = More Spending. [AD Shifts Right]

·         Negative = Less Spending. [AD Shifts Left]

§  Household Indebtedness:

·         Less Debt = More Spending. [AD Shifts Right]

·         More Debt = Less Spending. [AD Shifts Left]

§  Taxes:

·         Less Taxes = More Spending. [AD Shifts Right]

·         More Taxes = Less Spending. [AD Shifts Left]

·         Gross Private Investment (Ig)

o   Investment spending is sensitive to:

§  The Real-Interest Rate:

·         Lower Real-Interest Rate = More Investment. [AD Shifts Right]

·         Higher Real-Interest Rate = Less Investment [AD Shifts Left]

§  Expected Returns:

·         Expected Returns are influenced by:

o   Expectations of future profitability

o   Technology

o   Degree of excess capacity (Existing stock capital)

o   Business Taxes

·         Higher Expected Returns = More [AD Shifts Right]

·         Lower Expected Returns = Less [AD Shifts Left]

·         Government Spending (G)

§  More Spending = AD Shifts Right

§  Less Spending = AD Shifts Left

·         Net Exports (Xn)

o   Net Exports are sensitive to:

§  Exchange Rates (International Value of Money):

·         Strong Money = More imports; Fewer exports. [AD Shifts Left]

·         Weak Money = Less imports; Fewer exports. [AD Shifts Right]

§  Relative Income:

·         Strong Foreign Economics = More Exports [AD Shifts Right]

·         Weak Foreign Economics =  Less Exports [AD Shifts Left]