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%)