Unit III

INTRODUCTION

So it was a little difficult to get my notes all together, because of how disorganized I am. Hopefully, I gathered all the notes that I needed to understand this concept to explain.

AGGREGATE DEMAND (AD)

Aggregate Demand 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.

There are 3 reasons AD is downward sloping:

• Real Balance Effect
• When the price level is HIGH households and businesses CANNOT afford to purchase as much input. 
• When the price level is LOW households and businesses CAN afford to purchase more output.
• Interest Rate Effect
• a higher price level INCREASES the interest rate which lends to DISCOURAGE investment.
• a lower price level DECREASES the interest rate which lends to ENCOURAGE investment.
• Foreign Purchase 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.

Shifts in AD

There are two parts in a shift in AD:

• a change in C, I, G, and or Xn
• a multiplier effect that produces a greater change than the original change in the 4 components
• Increase in AD = AD -->
• Decrease in AD = AD <--

Determinants of AD Shifts

[C] Consumption

household spending is affected by:

• Consumer Wealth
• MORE wealth = MORE spending (AD shifts -->)
• LESS wealth = LESS spending (AD shifts <--)
• Consumer Expectations
• POSTIVE expectations = MORE spending
• NEGATIVE expectations = LESS spending
• Household Indebtedness
• LESS debt = MORE spending
• MORE debt = LESS spending

[Ig] Gross Private Investment

Investment Spending is sensitive to:

• The Real Interest Rate
• LOWER real interest rate = MORE investment
• HIGHER real interest rate = LESS investment
• Expected Returns
• HIGHER expected returns = MORE investment
• LOWER expected returns = LESS investment

Expected Returns are influenced by:

• Expectations of future profitability
• Technology
• Degree of excess capacity (Existing Stock of Capital)
• Business taxes

[G] Government Spending

• more government spending (AD -->)
• less government spending (AD <--)

[Xn] 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 economies = MORE exports = (AD -->)
• WEAK foreign economies = LESS exports = (AD <--)

AGGREGATE SUPPLY (AS)

Aggregate Supply is the level of Real GDP that firms will produce at each Price Level (PL).

Long-Run v. Short-Run

• Long-Run
• period of time where input prices are completely flexible and adjust to changes in the price level.
• in long run, the level of real GDP supplies is independent of price level.
• Short-Run
• Period of true where input prices are sticky and do not adjust to changes in price level.
• level of real GDP supplied directly related to price level. 

Long-Run Aggregate Supply (LRAS)

• The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC). LRAS is vertical at full employment.

Changes in SRAS

• an INCREASE in SRAS is seen as a shift to the RIGHT. (SRAS -->)
• a DECREASE in SRAS is seen as a shift to the LEFT. (SRAS <--)

Determinants of SRAS

• input prices
• increase in resource prices = SRAS <--
• decrease in resource prices = SRAS -->
• productivity
• productivity: total output/ total inputs
• MORE productivity = LOWER unit production cost = SRAS -->
• LOWER productivity = HIGHER unit production cost = SRAS <--
• [R] Resource Cost [domestic]
• Land- new raw materials (oil) are found
• Labor- labor force increases or wages decrease
• Capital - capital stock increases
• The number of sellers of resources increase
• [E] Environment [legal-institutional environment for business change]
• Subsidies are increased
• Regulations on businesses are decreased
• Business taxes decrease
• [P] Productivity
• Technological breakthrough leads to an increase in productivity [getting more outputs from the same inputs]

Keynesian View

• the followers of the Keynesian view believe in a horizontal AS curve, because when the economy is below full employment AD shifts outward. ( Increase in RGDP, Decrease in Unemployment, price level constant)

Classical (Vertical) View

• In the long run, the AS curve is vertical, because the only effects of an increase in the price level and supply creates its own demand. (Say's Law)

Intermediate Range

• AS is between the classical and Keynesian Range. When this occurs as AS shifts outward, price level and RGDP increases.

THE AS/AD MODEL
The equilibrium of AS and AD determines current output (RGDP) and the price level (PL)

Full Employment

• Full Employment Equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap

• Exists when equilibrium occurs below full employment output.

Inflationary Gap

• exists when equilibrium occurs beyond full employment output.

Changes in AD

• Consumption/Government Spending/Net Export INCREASES
• AD shifts RIGHT.
• Real GDP INCREASES.
• Price Level INCREASES.
• unemployment DECREASES.
• inflation INCREASES.
• Consumption/Government Spending/Net Export DECREASES
• AD shifts LEFT.
• Real GDP DECREASES.
• Price Level DECREASES.
• unemployment INCREASES.
• inflation DECREASES.

 Changes in SRAS

• Input Prices/Productivity/Legal-Institutional Environment INCREASES
• SRAS shifts RIGHT
• Real GDP INCREASES
• Price Level DECREASES
• Unemployment DECREASES
• Inflation DECREASES
• Input Prices/Productivity/Legal-Institutional Environment DECREASES
• SRAS shifts LEFT
• Real GDP DECREASES
• Price Level INCREASES
• Unemployment INCREASES
• Inflation INCREASES

Long-Run Aggregate Supply (LRAS)

• LRAS measures potential output and assessing if resources are used efficiently.

 

• efficient at (B)
• no pressure to raise or lower fact or prices
• inefficient or under utilizers resources at (A)
• Factor prices are pressure to fall
• Over utilizing our resources at (C)
• Factor prices are pressured to rise.

Shift Causes

• Tech
• Economic Growth
• Capital
• Entrepreneurship
• more available resources

What is investment?

Money spent or expenditures on:

• New plants (factories)
• Capital Equipment (machinery)
• Technology (hardware and software)
• New Homes
• Inventions (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
• If expected return > interest cost, then invest.
• If expected return < interest cost, then DO NOT invest.

Real (r%) v. Nominal (n%)

• What's the difference?
• Nominal is the observable rate of interest. Real subtracts our inflation and is only known ex post facto.
• How do you compute the real interest rate (r%)?
• r% = i% - inflation rate
• What then, determines the cost of an investment decision?
• The real interest rate (r%)

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 profitable.
• there are few investments that yield high rates of return, and many that yield low rates of return.
• Shifts in Investment Demand (ID)
• Cost of Production
• Business Taxes
• Technological Change
• Expectations
• Stock of Capital

Consumption and Saving

• Disposable Income (DI)
• income after taxes or net income.
• Can either save or spend.
• 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 NOT spending
• the amount of DI
• The propensity to consume
• Do households save if DI = 0?
• NO

APC & APS

• Average Propensity to Consume (APC)
• Average Propensity to Save (APS)
• APC (+) APS = 1
• 1 (-) APC = APS
• 1 (-) APS = APC
• APC > 1 Dissaving
• -APC Dissaving

MPC & MPS

• Marginal Propensity to Consume (MPC)
• change in C/ change in DI % of every extra dollar earned that is spent
• Marginal Propensity to Save (MPS)
• change in S/ change in DI % of every extra dollar earned that is saved
• MPC (+) MPS = 1
• 1 (-) MPC = MPS
• 1 (-) MPS = MPC

Determinants of C & 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
• Why does it happen?
• Expenditures and income flow continuously which sets off a spending increases or the economy.
• Calculating the spending multiplier
• The spending multiplier can be calculated from MPC or MPS.
• Multiplier = 1/(1-MPC) or 1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease.

Calculating the Tax Multiplier

• When the government taxes, the multipliers works in reverse
• why?
• Because now money is leaving the circular flow
• Tax Multiplier (note: it's negative)
• -MPC/(1-MPC) or -MPC/MPS
• If there is a tax-cut, then the multiplier is positive, because there is now more money in the circular flow.

MPS, MPC, and Multipliers

• Step 1: Calculate the MPC and MPS
• Step 2: Determine which multiplier to use, and whether it's positive or negative
• Step 3: Calculate the Spending and/or tax multiplier
• Step 4: Calculate the change in AD