Econ 202 TEST 2
A formula for the multiplier
1 / 1-MPC Change in equilibrium real gdp / change in autonomous expenditure = 1 / 1-MPC
Government Purchases
Do not include transfer payments War in iraq caused real federal spening to rise 60% Obama tried to lower it
Macroeconomic equilibrium
Equilibrium occurs where aggregate expenditure = GDP (total spending = total production)
Determining the level of aggregate expenditure in the economy
look closely at the four components: consumption, planned investment, government, net exports
Aggregate Supply
shows the effect of changes in the price level on the quantity of goods and services that firms are willing and able to supply. because the effect of changes in the price level on aggregate supply is very different in the short run from what it is in the long run.
Great moderation
very high fluctuations since 1900-1950s The absence of sever recessions in the US since the mid-1980s
Aggregate Demand
Aggregate Demand and aggregate supply model - a model that explains short run fluctuations in real GDP and the price level. Fluctuations in real GDP and the price level are caused by shifts in the aggregate demand curve or in the aggregate supply curve Aggregate demand curve - shows the relationship between price level and the quantity of real gdp demanded by households, firms, and the government Short-run aggregate supply (SRAS) - a curve that shows the relationship in the short run between the price level and quantity of real GDP supplied by firms.
Aggregate Expenditure
Total spending in the economy; the sum of consumption, planned investment, government purchases, and net exports. Four components of aggregate expenditure that equal GDP 1. Consumption - spending by households on goods and services 2. planned investment - planned spending by firms on capital goods such as factories, office buildings, and machine tools 3. Government purchases - spending by local, state and federal gov on goods and services 4. net exports - spending by foreign firms and households on goods and services produced in the US minus spending by US firms and households on goods and services produced in other countries AE = C + I + G + NX
business cycle
alternating periods of economic expansion and economic recession
the connection between economic prosperity and health
direct effect of economic growth on living standards by looking in improvements in health in high income countries. link between health and economic growth.
The Market for Loanable Funds
the interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.
lecture 17
*John Maynard Keynes vs Friedrich August von Hayek* (LOOK THIS UP) youtube video - Variables that shift the short-run aggregate supply curve 1. An increase in Inputs Positive (e.g. capital and labor) 2. Productivity Positive 3. Expected future Negative prices
what determines the rate of long-run growth
-increases in real GDP per capita depend on increases in labor productivity labor productivity - the quantity of goods and services that can be produced by one worker or by one hour of work. If analyzing long-run growth, economists usually measure labor productivity as output per hour of work to avoid the effects of fluctuations in the length of the workday and in the fraction of the population employeed. If the quantity of goods and services consumed by the average person is to increase, the quantity of goods and services produced per hour of work must also increase. economists believe wo factors determine labor productivity: 1. the quantity of capital per hour worked - capital - manufactured goods that are used to produce other goods and services. the total amount of physical capital available in a country is known as the country's capital stock. As the capital stock per hour worked increases, worker productivity increases. Human capital refers to the accumulated knowledge and skills workers acquire from education and training or their life experiences. 2. the level of technology Economic growth depends more on technological change than on increases in capital per hour worked. Technology refers to the processes a firm uses to turn inputs into output firms can produce, using a given quantity of inputs. Technological change is an increase in the quantity of output firms can produce, using a given quantity of inputs. exp: a firm's managers may rearrange a factory floor or the layout of a retail store to increase producitn sales. Very important point is that just accumulating more inputs - such as labor, capital, and natural resources - will not ensure that an economy experiences economic growth unless technological change also occurs. additional requirement for economic growth is that the government must provide secure rights to private property. A market system cannot function unless rights to private property are secure. In addition, the government can help the market work and aid economic growth by establishing an independent court system that enforces contracts between private individuals
Variables That shift the aggregate demand curve
1. Changes in government policies - The federal gov uses monetary policy and fiscal policy to shift the aggregate demand curve monetary policy - the actions the federal reserve takes to manage the money supply and interest rates to puruse macroeconomic policy objectives. Actions such like high employment, price stability. fiscal policy - changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. because gov purchases are one component of aggregate demand, an increase in government purchases shifts the aggregate demand curve to the right and a decrease in gov purchases shifts the aggregate demand curve to the left. Higher personal income taxes reduce consumption spending and shift the aggregate demand curve to the left. Lower personal income taxes shift to right. 2. Changes in the expectations of household firms - if households become more optimistic about their future incomes, they are likely to increase their current consumption. 3. Changes in foreign variables - exchange rate, an increase in net exports at every price level will shift the aggregate demand curve to the right. Net exports will increase if real GDP grows more slowly in the US than in other countries or if the value of the dollar falls against other coutnries. A change in net exports that results form a change in price level will not shift
Planned investment
1. Expectations of future profitability - a firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain strong for at least several years. When moves into a recession, may firms postpone buying investment goods even if the demand for their own product is strong. The optimism or pessimism of firms is an important determinant of investment spending.Residential construction is included in investment spending 2. Interest rate - the higher the interest rate, the more expensive it is for firms and households to borrow. A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. 3. Taxes - Focus on the profit that remain after paid taxes. Fed gov imposes a corporate income tax on the profits corporations earn, including from new buildings, equipment, and other investment goods they purchase. An increase in the corporate income tax decreases the after-tax profitability of investment spending. Investment tax incentives also increase investment spending. 4. Cash Flow - the difference between the cash revenues received by a firm and the cash spending by the firm. The more profitable a firm is, the greater the cash flow, and the greater its ability to finance investment.
Summarized shifts in the aggregate demand curve
1. an increase in interest rate shifts the aggregate demand curve left because higher interest rates raise the cost to firms and households of borrowing, reducing consumption and investment spending 2. an increase in gov purchase shifts the aggregate demand curve right government purchases are a component of aggregate demand 3. an increase in personal income tax or bus tax shifts the aggregate demand curve left because consumption spending falls when personal taxes rise, and investment falls when business taxes rise 4. an increase in household's expectations of future income shifts the aggregate demand curve right consumption spending increases 5. an increase in firms expectations of the future profitability of investment spending shifts the aggregate demand curve right because investment spending increases 6. an increase in the growth rate of domestic GDP relative to the growth rate of foreign GDP shifts the aggregate demand curve left because imports will increase faster than exports, reducing net exports 7. an increase in the exchange rate relative to foreign currencies shifts the aggregate demand curve left because imports will rise and exports will fall, reducing net exports
Shifts of the short-run aggregate supply curve versus movements along it
1. increases in the labor force and in the capital stock - as the labor force and the capital stock grow, firms will supply more output at every level, and the short run aggregate supply curve will shift to the right, workforce decreases, shift to the left 2. technological change - as positive technological change takes place, productivity increases, more goods and services, reduces firms costs and allows them to produce more at every output. Shifts to the right 3. expected changes in the future price level - if they believe price level is going to increase by 3 percent, they will adjust their wages and prices accordingly. If workers and firms expect the price level to increase by a certain percentage, the SRAS curve wil shift by an equivalent amount 4. adjustments of workers and firms to errors in past expectations about the price level - if workers and firms across the economy are adjusting to the price level being higher than expected, the SRAS curve will shift to the left. If they are adjusting to the price level being lower than expected, the SRAS curve will shift to the right. 5. unexpected changes in the price of an important natural resource - supply stock - an unexpected event that causes the short-run aggregate supply curve to the left.
A dynamic aggregate Demand and Aggregate supply Model
1. the economy does not experience continuing inflation, and the economy does not experience long run growth Result will be a model that takes into account that the economy is not static, with an unchanging level of potential real GDP and no continuing inflation, but dynamic, with potential real GDP that grows over time and inflation that continues every year. We can create a dynamic aggregate demand and aggregate supply model by making changes to the basic model that incorporate the following important macroeconomics 1. potential real GDP increases continually, shifting the long-run aggregate supply curve to the right 2. during most years, the aggregate demand curve shifts to the right 3. expect during periods when workers and firms expect high rates of inflation the short-run aggregate supply curve shifts to the right Changes in the price level and in real GDP in the short run are determined by shifts in the SAS and AD curves
summarize of the multiplier effect
1. the multiplier effect occurs both when autonomous expenditure increases and when it decreases. 2. the multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. 3. the larger the MPC, the larger the value of the multiplier. The direct relationship between the value of the MPC, the more additional consumption takes place after each rise in income during the multiplier process 4. The formula for the multiplier 1 /(1-MPC) is oversimplified because it ignores some real world complications, such as the effect that increases in GDP have on imports, inflations, interest rates, and individual income taxes. These effects combine to cause the simple formula to overstate the true value of the multiplier An increase in real GDP that increases imports will lower aggregate expenditure and decrease the value of the multiplier a larger multiplier means that small changes in spending lead to large changes in GDP, and thus a recession would be more severe
Graphing Macroeconomic Equilibrium
45degree - line diagram to illustrate macroeconomic equilibrium. Also referred to as the Keynesian cross because it is based on the analysis of John Maynard Keynes. The line represents all points that are equal distances from both axes. On the y axis - real aggregate expenditure on the x axis - Real national income / GDP We all know that all points of macroeconmic equilibrium must lie along the 45 line because macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP. To determine point that represent the actual level of equilibrium real gDP, given the actual level of planned real expenditure. To find this point, we need to draw a line on the graph to show the aggregate expenditure function. The aggregate expenditure function shows us the amount of planned aggregate expendture that will occur at every level of national income The lowest upward sloping line, C, represents consumption function. The quantities of planned investment government purchases, and net exports are constant because we assumed that the variables they depend on are constant. So the total of planned aggregate expenditure at any level of GDp plus the sum of the constant amounts of planned investment, gov purchases and net exports. We successively add each component of spending to the consumption function line to arrive at the line representing aggregate expenditure
The paradox of thrift
An increase in savings can increase the rate of economic growth in the long run by providing funds for investment, but in the short run, if households save more of their income and spend less of it, aggregate expenditure and real GDP will decline. Keynes argued that if many households decide at the same time to increase their savings and reduce spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. The lower incomes in the recession might mean that total savings does not increase, despite individuals trying to. Paradox of thrift - what appears to be favorable to the long run performance of the economy might be counterproductive in the short run
The Aggregate expenditure model
Help begin to understand the relationship among some of these variables in the business cycle. GDP is the value of all the final goods and services produced in an economy during a particular year. Read GDP corrects nominal GDP for the effects of inflation. A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. Key idea is that in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.
Shifts of the Aggregate Demand Curve versus movements along it
IF the price level changes but other variables that affect the willingness of households, firms, and the government to spend are unchanged, the economy will move up or down a stationary aggregate demand curve. If any variable other than the price level changes, the aggregate demand curve will shift.
Adjustment to Macroeconomic Equilibrium
If aggregate expenditure is equal to GDP, then inventories are unchanged, and the economy is in macroeconomic equilibrium If aggregate expenditure is less than GDP, inventories rise, and GDP and employment decrease If aggregate expenditure is greater than GDP, inventories fall, and GDP and employment increase
The aggregate Demand curve
Increases in the price level cause aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise. 1. a rising price level deceases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect 2. if the price level in the United States rises relative to the price level in other countries, US exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall. A falling price level in the US has the reverse effect 3. When prices rise, firms and households need more money to finance buying and selling. If the central bank does not increase the money supply, the result will be an increase in the interest rate. At a higher interest rate, invesetment spneding falls as firms borrow less money to build new factories, falling price level has reverse effect. A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factores that affect aggregate expenditure. Curve shows the relationship between the price level and the level of planned aggregate expenditure in the economy. When the price level is 97, real GDP is 10.2 trillion. An increase in the price level to 100 causes consumption investment and net exports to fall, which reduces real GDP to 10 trillion. a change in price level causes a shift of the aggregate expenditure line a change in price level causes a movement along the aggregate demand curve
Appendix
Keynesian revolution - the name given to the widespread acceptance during the 1930s and 1940s of John Kenes monetary growth rule - a plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions monetarism - the macroeconomic theories of milton friedman and his followers, pariculary the idea that the quantity of money should be increased at a constant rate new classical macroeconomics - the theories of robert lucas and others, particulary the idea that workers and firms have rational expectations real business cycle model - a model that focuses on real, rather than monetary, causes of the business cycle.
Powerpoint 14
Leading and Lagging indicators: We saw that the unemployment rate and some measures of inflation were typically lagging indicators of the business cycle. Manufacturers' orders of goods and materials, which decrease inventories, is often a leading indicator, i.e. a predictor of the business cycle... as is "consumer expectations." Consumption and GDP and AE Recall that consumption accounts for roughly 70 percent of GDP in the U.S. economy so what ever happens to consumption will have a large impact on GDP Consumption function Dy = disposable income W = wealth E(y) = expected future income P = the price level r = the interest ate C = f(DY,W,E(y), P and r) MPC = Delta Consumption / Delta disposable income US today is between .7-.9 So an increase in disposable income of $1 will yield slightly less than $1 worth of an increase in AE and GDP The multiplier The way to think about the multiplier is: "Economic activity tends to generate more economic activity." Mathematically, the consumption multiplier is: Multiplier = (1/(1-MPC)) For example: if MPC = 0.75, then the multiplier is: 4 = (1/(1-0.75))=1/0.25.
Powerpoint 12
Long run economic growth: There is no single definition; however, it is generally defined as long-run increases the average standard of living The best measure of the standard living is real GDP per capita The growth in real GDP per capita 1900-2010: Measured in 2005 dollars, real GDP per capita in the US grew from 5,600 in 1900 to 42,200 in 2010 This is an average annual compounded rate of 1.83 percent GDP = GDP GDP/ POP = GDP/POP = per capita GDP Let LF= labor force Per capita GDP = (gDP/Pop) * (LF/LF) =GDP/LF * LF/POP =APl * LFPR So if you want to increase the standard of living the key is labor productivity (APl) If you want to improve the standard of living, then you have to increase labor productivity 1. education (human capital) 2. investment in physical capital 3. technological change Saving, investment, and credit markets Savings; in fact, from your text: Savings = Investment; i.e. S = I. How do savings generate invesment? Via "financial intermediation." Bringing savers and borrowers together, which takes us back to... Credit markets. The impact of a change in the demand for credit is responsible by 1. technological change 2. an upturn (or downturn) in the business cycle
Potential GDP
Since economists take a long-run perspective in discussing economic growth, the concept of potential GDP is useful Level of real GDP attained when all firms are producing at capacity. The capacity of a firm is not the maximum output the firm is capable of producing. If all firms in the economy were operating at capacity, the level of total production of final good and services would equal potential GDP. Potential GDP increases over time as the labor force grows, new factories and office buildings are built, new machinery and equipment are installed and technological change takes place GROWTH IN POTENTIAL GDP in the US is estimated to be about 3.3 percent per year Actual level of real GDP may increase by more or less than 3.3 percent as the economy moves through the business cycle.
Consumption
Most important variables 1. current disposable income - most important determinant. Income remaining to households after they have paid the personal income tax and received government transfer payments. Higher their disposable income, the more they spend. increase when income increases, and decrease when income decreases 2. household wealth - value of its assets minus the value of its liabilities. home, stock, bonds, and bank accounts. When the wealth of households increases, consumption should increase. Shares of stock are important category to household wealth. 3. expected future income - we can conclude that current income explains current consumption only when current income is not unusually high or unusually low compared with expected future income 4. the price level - measures the average prices of goods and services in the economy. The effect of an increase in the price of one product on the quantity demanded of that product is different from the effect of an increase in the price level on total spending by households on goods and services. Price level affect consumption through their effect on household wealth. An increase in price level will result in a decrease in the real value of household wealth. If price level falls, your bank account value increases, and your consumption increases 5. the interest rate - when interest rate is high, the reward for saving is increased, and households are likely to save more and spend less. consumption spending depends on real interest rate. Spending on durable goods is most likely to be affected by changes in the interest rate because a high real interest rate increases the cost of spending financed by borrowing.
Income, Consumption and saving
National income = Consumption + Savings + Taxes When national income increases, there must be some combination of an increase in consumption, saving, and taxes Change in national income = change in consumption + change in saving + change in taxes Y(GDP) = C+S+T DY = DC + DS + DT Since taxes are a constant amount DY = DC + DS Marginal propensity to save - The amount by which saving changes when disposable income changes. We can measure the MPS as the change in saving divided by the change in disposable income. In calculating the MPS, as in calculating the MPC, we can safely ignore the difference between national income and disposable income DY/DY = DC/DY + DS/DY 1 = MPC + MPS When taxes are constant, the marginal propensity to consume plus the marginal propensity to save must always equal 1.
showing a recession on the 45degree line diagram
Notice that macroeconomic equilibrium can occur at any point on the 45degre line. Ideally, we would like equilibrium to occur at potential GDP. At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment. If there is insufficient total spending, equilibrium will occur at a lower level of real gap. An unplanned decrease in inventories, results in increasing production, an unplanned increase in inventories, results in decreasing production
The difference between planned investment and actual investment
Planned investment spending rather than actual investment spending, is a component of aggregate expenditure. Changes in inventories are included as part of investment spending. We assume that the amount business plan to spend on stuff is equal to what they will actually spend,but the amount business plan to spend on inventories may be different form the amount they actually spend. EXP: Produce 1.5 mil books, if sells all 1.5 mil, inventories will be unchanged, but only sells 1.2 mil, it will have an increase in unplanned inventory. Changes in inventories depend on sales of goods, which firms cannot always forecast with perfect accuracy. As a whole, we can say that actual investment spending will be greater than planned investment spending when there is an unplanned increase in inventories. Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories. Therefore, actual investment will equal planned investment only when there is no unplanned change in inventories.
equations I need to know
Real GDP per capital increased x times = real gdp older year / real gdp younger year rules of 70 = 70/growth rate growth rate of real gdp = higher gdp - lower gdp / lower gdp (100) I = investment S = Sprivate + Spublic C = Consumption G = government purchases Y = GDP TR = government Transfers NX = net exports GDP = Y = C + I + G + NX Investment-saving equality = S = y-c-g (closed economy) Sprivate = (Y+TR) - (C+T) (closed economy)Spublic = T - G - TR (closed economy) G= Y-C-I AE = C + I + G + NX I = planned investment MPC = change in consumption / change in disposable income MPS= change in saving / divided by change in disposable income national income = GDP = Disposable income + net taxes multiplier effect = 1/1-mpc multiplier *change in autonomous spending = change in gap
The effect of the business cycle on the unemployment rate
Recessions cause the inflation rate to fall, but they cause the unemployment rate to increase can still rise when expanding for two reasons 1. increasing more slowly than the growth in the labor force resulting from population growth 2.some firms continue to operate well below their capacity even after a recession has ended.
Will the U.S Economy return to stability
Relative stability from 1950-2007 1. The increasing importance of services and the declining importance of goods. Services such as medical care become big part of GDP, less relative decline. 2. The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed. 3. Active federal government policies to stabilize the economy. use macroeconomic policy to end recessions and prolong expansions 4. The increased stability of the financial system.
How do we know when the economy is in a recession
The Business cycle dating committee of the national bureau of economic research (NBER), a private research group located in cambridge, mass. A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade
Lecture 15
The aggregate Demand Curve: The aggregate demand curve illustrates the relationship between the Price Level and Aggregate expenditures The short-run aggregate supply chain: The short-run aggregate supply curve illustrates the relationship between the Price Level - e.g. the CPI or the GDP deflator - and the quantity of real GDP produced by firms and government purchases variables that shift the aggregate demand curve 1. Consumption positive 2. Investment positive 3. Government positive Purchases 4. Net Exports positive 5. Interest rates negative 6. Taxes negative
Why Aggregate Demand Curve downward sloping
The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. Assumption that gov purchases are determined by policy decisions of lawmakers and not affected by changes in the price level the wealth effect - when the price level rises, the real value of househol dwealth declines, and so will consumption. When the price level falls, the real value of households wealth increases, and so will consumption. interest rate effect - Higher price level increases the interest rate and reduces investment spending, it also reduces the quantity of goods and services demanded. A lower price level will decrease the interest rate and increase investment spending, thereby increasing the quantity of goods and services demanded. The international trade effect - price level rises relative to other countries, US exports will become more relatively expensive, and foreign imports will become relatively less expensive. Shift in buying those foreign imports or for foreigners, buying their own. Causing net imports to fall, thereby reducing the quantity of goods and services demanded. VIce versa
Demand and supply in the loanable funds market
The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects. In determine whether to borrow funds, firms compare the return they expect to make on an investment with the interest rate they must pay to borrow the necessary funds. The demand is downward sloping because the lower the interest rate, the more investment projects firms can profitably undertake, and the greater the quantity of loanable funds they will demand The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. When households she, they reduce the amount of goods and services they can consume and enjoy today. Will be determined in part by the interest rate they receive when they lend their savings. The higher the interest rate, the greater the reward for saving and the larger the amount of funds households will save. Upward sloping, higher the rate, greater the quantity supplied nominal interest rate is stated interest rate on loan real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate Equilibrium is in the real interest rate, not nominal
The recession of 07-09
The end of the housing buble the financial crisis rapid increase in oil prices during 08
The relationship between consumption and national income
The first step in examining the relationship between consumption and GDP is to recall that the differences between GDP and national income are small and can be ignored. Disposable income = national income + TR - Taxes Taxes minus gov transfers are referred to as net taxes Net taxes are not constant amount because they are affected by changes in income. As income rises, net taxes rise because some taxes, such as the personal income tax, increase and some government rasnfer payments suh as gov payments to unemployed workers, fall. DELTA C / DELTA Y = DELTA C / DELTA YD We can calucate the MPC using either the change in national income or disposable income.
business cycle
The fluctuations in real GDp per capital reflect the underlying fluctuations in read GDP, US economy experiences business cycles that consist of alternating periods of expanding and contracting. Expansion phase - producton, employment and income are increasing. The period of expansion ends with a business cycle peak. Following the business cycle peak, production, employment, and income decline as the economy enters the recession phase Recession phase - the recession comes to an end with a business cycle trough, after which another period of expansion begins.
The Multiplier effect
The increase in planned investment spending has had a multiplied effect on equilibrium real GDP. It is not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium GDP. Autonomous expenditure - an expenditure that does not depend on the level of GDP Multiplier - The increase in equilibrium real GDP divided by the increase in autonomous expenditure Multiplier effect - the process by which an increase in autonomous expenditure leads to a larger increase in real GDP EXP: Suppose whole 100 billion increase in investment spending shown in the figure consists of firms building additional factories and office buildings. Initonally, this additional spending will cause the construction of factoreis and office buildings to increase by 100 billion so GDp will also increase by 100 billion. this increase in real GDP of 100 billion is also an increase in national income of 100 billion. After receiving this additional icome, these people will increase their consumption. If the MPC is .75, we can assume that there will be a 75 billion increase so GDP will rise by 75, which is another 75 billion to the national as well. In addition, this increase of 75 billion will than meet another .75 and increase the consumption by 56 billion. This is a continuing trend until the additional ends at 0. which hits 400. Delta Y / Delta I = change in real gdp / change in investment spending 400/100 = 4 which is the multiplier.
recessions
The short run effect of a decline in aggregate demand - suppose that rising interest rates cause firms to reduce spending. The decline in investment that results will shift the aggregate demand curve to the left. The economy moves to a new short run macroeconomic equilibrium, where the AD2 curve intersects the SRAS curve. In the new shortrun equilibrium, real GDP has declines. The lower level of GDP will result in declining profitability for many firms and layoffs for some workers: the economy will be in recession Adjustment back to potential GDP in the long run - it only a decrease in the price level. Automatic mechanism - takes severl years to return to potential GDP. because it occurs without any actions by the government.
expansion
The short run effect of an increase in aggregate demand - an increase in aggregaet demand causes an increase in real GDP. beyond normal capacity and structurally or frictionally employed people would be the long term effect - only an increase in the price level
Supply Stock
The short-run effect of a supply stock - price level is higher in the new short-run equilibirum. Stagflation - a combination of inflation and recession, usually resulting from a supply stock. An increase in oil prices shifts SRAS to the left moving short-run equilibrium to point B, with lower real GDP and a higher price level Adjustment back to potential GDP in the long run - recession caused by a supply stock increases unemployment and reduces output. The recession caused by the supply shock eventually leads to falling wages and prices, shifting SRAS back to its original position. Equilibrium moves from point B to potential GDP at the original price level
THE MACROECONOMICS OF SAVING AND INVESTMENT
The total value of saving in the economy must equal the total value of investment. National income accounting refers to the methods the Bureau of Economic Analysis uses to keep track of total production and total income in the economy GDP = Y Consumption = C Investment = I Government purchases = G Net Exports = NX Y = C + I + G + NX In an open economy, there is interaction with other economies in terms of both trading of goods and services and borrowing and lending In a closed economy, there is not trading or borrowing and lending with other economies. For a closed economy, net exports are zero, so the equation looks like Y = C + I + G We can rearrange this relationship, we have an expression for investment in terms of I = Y - C - G this expression tells us that in a closed economy, investment spending is equal to total income minus consumption and government purchases We can also get expression for total savings. Private saving is equal to what households retain of their income after purchasing goods and services and taxes (t). Households receive income for supplying the factors of production to firms. This portion is Y. Households also receive income form government in the form of transfer payments (TR) Sprivate = Y + TR - C - T The government also engages in saving. Public saving equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households Spublic = T - G - TR So the total saving (s) in the econonmy is equal to the sum of both S = Sprivate + Spublic S = (Y+TR-C-T)+(T-G-TR) S = Y - C - G S = I - Therefore total savings equals total investment When the government spends the same amount that it collects in taxes, there is a balanced budget. When the government spends more than it collects in taxes, there is a budget deficit. In the case of a deficit, T is less than G + TR, which means that public saving is negative. (negative also means dissaving) It can be negative because when the federal gov runs a budget deficit, the U.S. department of the treasury sells treasury bonds to borrow the money necessary to fund the gap between taxes and spending. Instead of adding to the total amount of saving availalbe to be borrowed for investment spending, the gov is subtracting it. Households borrow more than they save, the total amount of saving will also fall. lower level of investment spending in the economy when there is a budget deficit than when there is a balanced budget. When the government spends less than it collects in taxes, there is a budget surplus. A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending. There is a higher level of investment spending in economy when there is a budget surplus than when there is a balanced budget
Powerpoint 13
Unemployment rate and the inflation rate tend to be "lagging indicators" of the business cycle i.e. they tend to follow what's happening to real GDP Componentes of Aggregate expenditures (AE) 1. C= consumption 2. I = planned investment 3. G = govt expenditures 4. NX = net exports Planned investment and the change in business inventories Let Delta BI = change in business inventories Then investment will equal planned investment when DELTA BI = 0 If DELTA BI = 0 then AE = GDP (macroeconomic equilibrium) If DELTA BI > 0 then AE < GDP If DELTA BI < 0 then AE > GDP Because Delta BI is a key indicator for the business cycle
short run aggregate demand
an increase in aggregate demand increases the price level and actual GDP beyond potential GDP where as long run, an automatic mechanism brings the economy back to potential GDP but the price level remains higher
What happens during the business cycle
as the economy nears the end of an expansion, interest rates are usually rising, and the wages of workers are usually rising faster than prices. As a result of rising interest rates and rising wages, the profits of firms will be falling. Both households and firms have substantially increased their debts. A recession will begin with a decline in spending by firms on capital goods. As spending declines, firms selling capital goods and consumer durables will find their sales declines. Declining sales lead to lay off workers. Rising unemployment and falling profits reduce income, with leads to further declines in spending. As continues, gradually improve, declies in spending end, households reduce their debt, increasing ability to spend, and interest rates decline, making it more likely that they will borrow to finance. increase during a likely expansion.
Consumption function
because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income. Consumption function - the relationship between consumption spending and disposable income. Marginal Propensity to consume (MPC) - The slope of the consumption function, which is equal to the change in consumption divided by the change in disposable income - Change in consumption / change in disposable income = DELTA C / DELTA YD Tells us the percent of the increase in their household income spent. Change in consumption = change in disposable income * MPC
durable and non durable
durables - goods that are expected to last for three or more years. nondurables - goods that are expected to last for fewer than three years.
explaining movements in saving, investment, and interest rates
equilibrium in the market for loanable funds determines the quantity of loanable funds that will flow from lenders to borrowers each period. A shift in either the demand curve or the supply curve will change the equilibrium interest rate and the equilibrium quantity of loanable funds profitability of new investment increases due to technological change, firms will increase their demand for loanable funds. Increase in demand shifts curve right. New equilibrium and and interest rate increases. Increase in the quantity of loanable funds means that both the quantity of savings by households and the quantity of investment by firms have increased. This causes increase in capital stock and quantity of capital per hour worked government deficit pushes the supply of loandable funds is reduced, increasing the equilibrium interest rate and decreasing the equilibrium quantity of loanable funds Crowding out - a decline in private expenditures as result of an increase in government purchases By borrowing to finance its budget deficit, the government will have crowed out some firms that would have otherwise have been able to borrow to finance investment. household believe that deficits will be finanaced by higher taxes in the near future, and households increase their saving in anticipation of paying those higher taxes leads to a shift to the right for supply curve. government changed tax policy to tax only real interest payments shifts supply to right government budget surplus has oppostie effect, increases the amount of saving in the economy, shifting the supply of loanable funds to the right. The interest rate will be lower and the quantity of loanable funds will be higher.
Net Exports
exports - imports calculate net exports by taking the value of spending by foreign firms and households on goods and services produced in the US and subtracting the value of spending by U.S. firms and households on goods and services produced in other countries. Net exports usually increase when the U.S. economy is in a recession. 1. the price level in the US relative to the price levels in other countries - If inflation in the US is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries. This slower increase in the U.S. price level increases the demand for U.s. products relative to the demand for foreign products. so U.S. exports increase and U.S. imports decrease, which increases net exports. Vice Versa happens 2. the growth rate of gdp in the US relative to the growth rates of GDP in other countries - When income rise faster in the US than in other countries, US consumers' purchases foreign goods and services increase faster than foreign consumers' purchases of US goods and services. As a result, net export fall. When incomes in the US rise more slowly than income in other countreis, net exports rise 3. The exchange rate betwen the dollar and other currencies - As the value of the U.S. dollar rises, the foreign currency price of US products sold in other countries rises, and the dollar price of foreign products sold in the United States falls. An increase in the value of the dollar will reduce exports and increase imports, so net exports will fall
an overview of the financial markets
financial markets are markets where financial securities, such as stocks and bonds, are bought and sold. A financial security is a document sometimes in electronic form that states the terms under which funds pass from the buyer of the security who is providing funds-to the seller stocks are financial securities that represent partial ownership of a firm bonds are financial securities that represent promises to repay a fixed amount of funds financial intermediaries - firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers mutual funds - sell shares to savers and then use the funds to buy a portfolio of stocks, bonds, mortgages, and other financial securities. risk - the chance tat the value of a financial security will change relative to what you expect. liquidity - the ease with which a financial security can be exchanged for money. The financial system provides the service of liquidity by providing savers with markets in which they can sell their holdings to financial securities
Saving, investment and the financial system
firms can finance some of the xpanding activites from retained earnings, which are profits that are reinvested in the firm rather than paid to the firm's owners. Firms an acquire funds from households - either directly through financial markets such as stocks and bonds OR indirectly through financial intermediaries such as banks. Financial markets and financial intermediaries together comprise the financial system.
lecture 18
fiscal policy a. republicans vs democrats b. the future path of U.S. gov. spending 2. chapter 7 appendix: other models of the macroeconomy There are three "elephants in the room": A. Social Security B. Medicaid C. Medicare In the next 10 years these items are projected to consume roughly 60% of federal spending (CBO, 49). If you add interest on the national debt, you're at roughly 75%. Key points: Keynes - Short-run aggregate demand and the multiplier Von Hayek - Long-run growth Marx - Ownership of the means of production and the distribution of output Key points (cont.): D. Monetarists (e.g. Friedman) - Emphasize the role of the Fed (we'll get to this) E. Real Business Cycles - The short-run and long-run aggregate supply functions are vertical F. The New Classical Model - Emphasizes the role of supply in AS-AD, and emphasizes "rational expectations" (we'll get to this)
long run aggregate supply curve
in the long run, changes in the price level do not affect the level of real GDP. Level of real GDP in the long run is called potential GDP. Changes in the price level do not affect potential GDP, as potential GDP depends on the size of the labor force, capital stock, and technology The long run aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied. The LRAS is a straight vertical line.
calculating growth rates and the rule of 70
the growth rate of real GDP or real GDP per capita during a particular year is equal to the percentage change from the pervious year. EXP: Measured in prices of the year 2005, real GDP equaled 12,703 billion and rose to 13,088 billion in 2010. We calculate the growth or real GDP in 2010 as: (13,088 billion - 12,703 billion)/(12,703) * 100 = 3.0% for longer period of time, we can use the average annual growth rate. exp: 2,004 billion in 1950, in 2010, 13,088. we compute the annual rowth rate that would result in 2004 billion increasing to 13088 billion over 60 years, which computes a 3.2 percent per year growth. one easy way to calculate approximately how many years it will take real gdp per capita to double is to use the *rule of 70*. The formula for the rule of 70 is: Number of years to double = 70/growth rate
effect of the business cycle on the inflation rate
the price level measures the average price of goods and services in the economy inflation rate - the percentage increase in the price level from one year to the next during economic expansion, the inflation rate usually decreases average decline in the inflation rate has been about 2.5 percentage. The unemployment rate increases and the inflation rate falls during recessions. As firms see their sales decline, they begin to reduce production and lay off workers One the other hand, the inflation rate increases and the unemployment rate falls during expansion
long run economic growth
the process by which rising productivity increases the average standard of living. The best measure of the standard of living is real gdp per person, which is usually referred to as real GDP per capita. So we measure long-run economic growth by increases in real GDP per capita over long periods of time, generally decades or more. We use real GDP rather than nominal GDP to adjust for change in the price level over time. large as it is, this increase in real gdp per capita actually understates the true increase in the standard of ilving of american in 2010 compared with 1900. level of education, life expectancy, crime, spiritual well-being, pollution, and many other factors ignored in calculating GDP contribute to a perosn's happiness nevertheless, economists rely heavily on comparisons of real gdp per capita because it is the best means of comparing the performance of one economy over time or the performance of different economies at any particular time
Short run aggregate supply curve
upward slope Over the short run, as the price level increases, the quantity of goods and services are willing to supply will increase. The main reason firms behave this way is that, as prices of final goods and services rise, prices of inputs such as the wage of workers or the price of natural resources - rise more slowly. Therefore, a higher price level leads to higher profits and increases the willingness of firms to supply more goods and services Secondary reason - the SRAS curve slopes upward is that as the price level rises or falls, some firms are slow to adjust their prices. A firm slow as price level increases, finds increasing sales, and therefore will increase production. A firm to slow to redue its price when the price level is decreasing may find its sales falling and therefore will decrease production Some workers fail to accurately predict changes in the price level. why? 1. contracts make some wages and prices "sticky" - hard to respond when locked into deal 2. Firms are often slow to adjust wages - wages and salaries only adjusted once a year 3. menu costs make sure prices sticky - the costs to firms changing prices, makes it harder to react because of a cost/benefit
