Section 4: Module 16, 17, 18, 19 and 21!!

Interest rate effect of a change in the aggregate price level

**Basically as price level INCREASES, interest rates INCREASE(because lenders need to get a REAL return on their loans), and the high interest rates result in LESS investment and consumption.

behavior of producers in perfectly competitive markets;

*Take prices as given - IF aggregate price level falls, the price received by the producer of a final good falls. Bc many production costs are fixed in the short run, production-cost/unit of output doesn't fall by the same proportion as the fall in the price of output. So the profit per unit of output declines, leading perfectly competitive producers to reduce the quantity supplied in the short run. - BUT if aggregate price level rises, producer receives a higher price for its final good... production cost per unit of output doesn't rise by the same proportion as the rise in the price of a unit.... Profit per unit of output rises and output increases

behavior of imperfectly competitive market producer

*able to set its own price. - a rise in the demand for this producer's product, means it will be able to sell more at any given price. Strong demand for its products means it will probably choose to increase its prices and output, as a way of increasing profit per unit of output. - Conversely, if there is a fall in demand, firms will normally try to limit the fall in their sales by cutting prices.

Name one cause of a positive demand shock

- an increase in wealth - The Great depression ended w a positive demand shock because of increased govt purchases during World War II

wages

- companies usually won't reduce wages during poor economic times— unless the downturn has been particularly long and severe—for fear of generating worker resentment. - Correspondingly, they typically won't raise wages during better econ times—until they're at risk of losing workers to competitors—bc they don't want to encourage workers to routinely demand higher wages.

Factors that shift the short-run aggregate supply curve

1. Changes in commodity prices - If they fall, short-run aggregate supply increases (right) - If they rise, ... decreases (left) 2. Changes in nominal wages - If they fall, supply increases (right) - If they rise, supply decreases (left) 3. Changes in productivity - If they fall, supply decreases (left) - if they rise, supply increases (right)

4 factors that shift aggregate demand

1. Expectations 2. Wealth point (i.e. if real value of assets increases bc of a SURGE IN REAL ESTATE VALUES) 3. Size of existing stock of physical capital 4. Government policies (including fall in tax rates I think)

What are the 2 reasons Aggregate Demand curve slopes DOWNwards?

1. Wealth Effect of a change in the aggregate price level 2. Interest rate effect of a change in the aggregate price level

Name the 2 Changes and directions that would cause the aggregate consumption function to shift UP.

1. an increase in expected future disposable income AND 2. An increase in aggregate wealth

Factors that can shift LRAS to the RIGHT

1. increases in the quantity of resources, including land, labor, capital, and entrepreneurship 2. increases in the quality of resources, as with a better-educated workforce 3. technological progress long-run economic growth is almost the growth in the economy's potential output. We generally think of the LRAS curve as shifting to the RIGHT OVER TIME as an economy experiences long- run growth.

Explain why a decline in investment spending caused by a change in business expectations leads to a fall in consumer spending.

A decline in investment spending, like a rise in investment spending, has a multiplier effect on real GDP—the only difference in this case is that real GDP falls instead of rises. The fall in I leads to an initial fall in real GDP, which leads to a fall in disposable income (because less production means a decrease in payments to workers), which leads to lower consumer spending, which leads to another fall in real GDP, and so on. So consumer spending falls as an indirect result of the fall in investment spending.

A negative supply shock (a)_________ production costs and (b)_______ the quantity producers are willing to supply at any given aggregate price level,

A negative supply shock (a)RAISES production costs and (b)REDUCES the quantity producers are willing to supply at any given aggregate price level, leading to a leftward shift of the SRAS curve. - EX: disruptions to world oil supplies

Permanent Income Hypothesis

A theory of consumption in which an individual determines current consumption based on anticipated average lifetime income.

How does any change in spending (C, I, and G: Consumer spending, Investment, or GOV) relate to the multiplier?

Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP.

Why isn't the influence of commodity prices already captured by the short-run aggregate supply curve (It's not shown up and down the curve, you have to SHIFT the curve)?

Bc commodities are NOT final goods so their prices are not included in the aggregate price level. - Commodities are also a cost of production to most producers, just like nominal wages are.

How does the economy self correct in the face of a recessionary gap?

Bc of high unemployment, nominal wages eventually fall, as do any other sticky prices, ultimately leading producers to INCREASE output. As a result, a recessionary gap causes the SRAS to gradually shift to the right. This process continues until SRAS1 reaches its new position at SRAS2, bringing the economy to equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long-run macroeconomic equilibrium; ***it is back at potential output Y1 but at a lower aggregate price level, P3, reflecting a long-run fall in the aggregate price level.***

The country of Boldovia has no unemployment insurance benefits and a tax system using only lump-sum taxes. The neighboring country of Moldovia has generous unemployment benefits and a tax system in which residents must pay a percentage of their income. Which country will experience greater variation in real GDP in response to demand shocks, positive and negative? Explain.

Boldovia will experience greater variation in its real GDP than Moldovia because Moldovia has automatic stabiliz- ers while Boldovia does not. In Moldovia the effects of slumps will be lessened by unemployment insurance ben- efits, which will support residents' incomes, while the effects of booms will be diminished because tax revenues will go up. In contrast, incomes will not be supported in Boldovia during slumps because there is no unemploy- ment insurance. In addition, because Boldovia has lump- sum taxes, its booms will not be diminished by increases in tax revenue.

consumption function equation

C = A + MPC x YD c = individual household consumer spending yd = individual household current disposable income. a = constant term. Individual household autonomous consumer spending --> amount a household would spend if it had NO disposable income. - assume that "a" > 0 bc a household with no disposable income is able to fund some consumption by borrowing or using savings.

demand shock

Event that shifts the AD curve. Demand shocks cause aggregate output and the aggregate price level to move in the same direction (pos shift and UP) OR (neg shift and DOWN). A POS shock will cause a shortage and drive the price higher. A NEG shock will lead to oversupply and a lower price. EX: - Great Depression was caused by a neg. demand shock, the collapse of wealth and of business and consumer confidence that followed the stock market crash of 1929 and banking crises. The Depression was ended by a pos. demand shock—the huge increase in govt purchases during World War II - 2008: negative demand shock as the housing market turned from boom to bust

contractionary fiscal policy

Fiscal policy used to decrease aggregate demand or supply. Deliberate measures to decrease government expenditures, increase taxes, or both. Appropriate during periods of inflation.

GDP = x and Multiplier = 7. If G (gov spending) falls by 5, what happens to GDP?

GDP new = GDP initial + (Change in spending x Multiplier) GDP new = x + (G-5)

If GDP = 2,500 and Multiplier = 3. If C rises by 10, what is the new level of GDP?

GDP new = GDP initial + (Change in spending x Multiplier) ***This formula works for changes in C, G, and I! GDP new = 2500 + (10 x 3) GDP new = 2500 + 30 GDP new = 2530

Wealth Effect of a change in the aggregate price level

Higher price levels reduce the purchasing power of money. Since your money is worth less you spend LESS. Lower price levels mean the purchasing power increases, your money is worth more and therefore you spend MORE.

Explain why a $500 million reduction in government purchases of goods and services will generate a larger fall in real GDP than a $500 million tax increase

If govt purchases of goods and services fall by $500 million, the initial fall in aggregate spending is $500 million. If there is a $500 million tax increase, the initial fall in aggregate spending is MPC × $500 million, which is less than $500 million because some of the tax payments are made with money that would otherwise have been saved rather than spent.

short-run aggregate supply curve is UPWARD sloping, bc prices are set somewhat differently in different kinds of markets

In perfectly competitive markets, producers take prices as given; in imperfectly competitive markets, producers have some ability to choose the prices they charge. In both kinds markets, there is a short- run pos. relationship between prices & output,

consumption function (linear equation BREAK DOWN)

Linear equation a = y-intercept slope = MPC

What changes in the 4 factors could move the aggregate demand curve to the left?

Moving the curve to the LEFT, means a decrease in aggregate demand. - Consumers/produces less confident - Decrease in wealth caused by stock market decline - More existing stock of physical capital - A decrease in govt spending or in the money supply.

What changes in the 4 factors could move the aggregate demand curve to the right?

Moving the curve to the right, means an increase in aggregate DEMAND. - Consumers/Producers more confident - Increase in wealth - A DECREASE in existing stock of physical capital - An increase in govt spending or in the money supply

Can an economy be in both LRAS and SRAS curves?

No. the economy is always in one of only 2 states - If the economy is on the short-run but not the LRAS curve, the SRAS curve will shift over time until the economy is at a point where both curves cross—a pt where actual aggregate output = potential output. **Only EXCEPTION: It can be on both curves simultaneously by being at a point where the curves cross.

output gap formula

Output gap = (Actual aggregate output − Potential output) /potential output × 100

Profit per unit of output FORMULA

Profit per unit of output = Price per unit of output − Production cost per unit of output

Tax laws are written, so that most sources of government revenue increase automatically when real GDP increases. Give some examples of such taxes.

Sales tax receipts increase when real GDP rises because people with more income spend more on goods and services. Corporate profit tax receipts increase when real GDP rises bc profits increase when the economy expands.

long-run macroeconomic equilibrium

The econ. is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. (Intersection of 3 GRAPHS! SRAS, AD, and LRAS.

short-run macroeconomic equilibrium

The econ. is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. - ALSO The pt. at which the AD and SRAS curves intersect!

self-correcting

The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.

interest rate effect

The tendency for increases in the price level to cause people to hold more money, which increases the demand for money, thus raising interest rates. Higher interest rates reduce investment spending because it costs more to borrow money. Thus, a rise in the price level leads to less investment spending (and less output). an increase in the aggregate price level, decreases the purchasing power of goods, so the people try to hold more money, either by borrowing more or by selling assets (i.e bonds). This reduces the funds available for lending to other borrowers and drives interest rates up. A rise in the interest rate reduces investment spending because it makes the cost of borrowing higher. It also reduces consumer spending because households save more of their disposable income.

Wealth effect

The tendency for people to increase their consumption spending when their purchasing power increases and to decrease their consumption spending when the value of their purchasing power falls. Explanation: When aggregate price level increases, people lose purchasing power. This causes millions of people to scale back on their consumption plans, leading to a fall in spending on final goods and services.

aggregate price level

a measure of the overall level of prices in the economy

lump-sum tax

a tax of a fixed amount paid by all taxpayers. They don't depend on the taxpayers' incomes. - HOWEVER, these are rare. Instead, the great majority of tax revenue is raised via taxes that depend positively on the level of real GDP.

A POSITIVE demand shock shifts the AD curve to the(a)__________. The economy moves (b)_____________ along the SRAS curve

a. Right. b. UP. This leads to higher short-run equilibrium aggregate output and a higher short- run equilibrium aggregate price level. D

A decline in the price of a commodity, like oil (a) ___________ production costs across the country, and (b)__________ the quantity of aggregate output supplied at any given aggregate price level, shifting the short-run aggregate supply curve to (c)_____________

a. decreases b. increases c. right

An increase in the price of a commodity, like oil (a) ___________ production costs across the country, and (b)__________ the quantity of aggregate out- put supplied at any given aggregate price level, shifting the short-run aggregate supply curve to (c)_____________

a. increases b. decreases c. left

Consumer Confidence Index (CCI)

an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending. MEASURES CONSUMER EXPECTATIONS

autonomous change in aggregate spending

an initial rise/fall in aggregate spending that is the CAUSE of a series of income and spending changes - It's autonomous because it causes a chain reaction (look at at book) EX: - An increase in gov purchases of goods and services is an ex. of an autonomous increase in aggregate spending. - Any change in government purchases of goods and services will lead to an even greater change in real GDP. This chain reaction will cause the initial change in gov purchases to multiply through the economy, resulting in an even larger final change in real GDP.

The presence of taxes has what effect on the multiplier? They a. increase it b. decrease it c. destabilize it d. negate it e. have no effect on it

b. Taxes decrease the multiplier

Assume that taxes and interest rates remain unchanged when government spending increases, and that both savings and consumer spending increase when income increases. The ultimate effect on real GDP of a $100 million increase in government purchases of goods and services will be a. an increase of $100 million. b. an increase of more than $100 million. c. an increase of less than $100 million. d. an increase of either more than or less than $100 million, depending on the MPC. e. a decrease of $100 million.

b. increase of more than $100 million.

. The marginal propensity to consume I. has a negative relationship to the multiplier. II. is equal to 1. III. represents the proportion of consumers' disposable income that is spent. a. I only b. II only c. III only d. I and III only e. I, II, and III

c. represents the proportion of consumers' disposable income that is spent. ONLY

MPC formula

change in consumption / change in disposable income

automatic stabilizers

changes in fiscal policy that stimulate AD when the economy goes into a recession (or cause changes in fiscal policy to be contractionary during inflation) without policymakers having to take any deliberate action

stagflation

combo of inflation (RISING aggregate price level) and stagnating (or falling) aggregate output. - very unpleasant: falling aggregate output raises unemployment, and people feel that their purchasing power is squeezed by rising prices. Is also a dilemma for policy makers.

LEFT shift of the short-run aggregate supply curve.

decrease in SRAS Happens when producers REDUCE the quantity of aggregate output they are willing to supply at any given aggregate price level. CAUSES: - production costs rise (i.e. increase in oil prices). At any given price of output, a producer now earns a smaller profit per unit of output. As a result, producers reduce the quantity supplied at any given aggregate price level, - if there is an economy-wide rise in the cost of health care insurance premiums paid by employers as part of employees' wages. This is = to a rise in nominal. This rise in nominal wages increases production costs. - a fall in productivity—say, due to new regulations that require workers to spend more time filling out forms—reduces the number of units of output a worker can produce with the same quantity of inputs - oil price shock.

. Which of the following is NOT an automatic stabilizer? a. income taxes b. unemployment insurance c. Medicaid d. food stamps e. monetary policy

e. Monetary policy

consumption function

equation showing how an individual household's consumer spending varies with the household's current disposable income.

supply shock

event that shifts the short-run SRAS curve. UNLIKE demand shocks, they cause the aggregate price level and aggregate output to move in OPPOSITE directions. - a positive supply shock reduces production costs and increases the quantity supplied at any given aggre- gate price level, leading to a rightward shift of the SRAS curve. EX: increasing use of the Internet and other information technologies caused productivity growth

Discretionary fiscal policy

fiscal policy that is the result of deliberate actions by policy makers rather than rules. But because of time lags, economists only suggest using these for special circumstances like very SEVERE recessions. *Is NOT the result of automatic stabilizers. - Ex: during a recession, the govt may pass legislation that cuts taxes and increases govt spending in order to stimulate the economy.

Usually, the average unemployed worker will spend a higher share of any increase in his or her disposable income than would the average recipient of dividend income. Basically, the unemployed tend to have a higher MPC than people who own a lot of stocks because the latter tend to be wealthier and save more of any increase in disposable income. If that's true, a dollar spent on unemployment benefits

increases aggregate demand more than a dollar's worth of dividend tax cuts

positive demand shock

leads to a higher aggregate price level and higher aggregate output

A negative demand shock shifts the AD curve to the ____

left. The economy moves DOWN along the SRAS curve from E1 to E2, leading to lower short-run equilibrium aggregate output and a lower short-run equilibrium aggregate price level

sticky wages

nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. - As a result of both formal and informal agreements, then, the economy is characterized by sticky wages: - nominal wages can't be sticky forever: ultimately, formal/informal agreements will be renegotiated to take into account changed econ. circumstances. **How long it takes for nominal wages to become flexible is an important part of what distinguishes the short run from the long run -

unplanned inventory investment

occurs when actual sales are more or less than businesses expected, leading to unplanned changes in inventories - if actual sales are less than businesses expected, there will be an unplanned increases in inventories. (POS. + unplanned inventory investment). - Sales in excess of expectations result in NEGATIVE unplanned inventory investment. - Rising inventories typically indicate positive unplanned inventory investment and a slowing economy, as sales are less than had been forecast. Falling inventories typically indicate negative unplanned inventory investment and a growing economy, as sales are greater than forecast.

cost-of-living-allowance

part of a union contract that provides for an additional increase in wages if prices go up. (not very common any more)

taxes that depend positively on real GDP _______ the size of the multiplier.

reduce

RIGHTward shift of the short-run aggregate supply curve.

shows an increase in short-run aggregate supply. Happens when producers INCREASE the quantity of aggregate output they are willing to supply at any given aggregate price level. CAUSE: - lower production cost (i.e. fall in nominal wage) —a producer now earns a higher profit per unit of output at any given price of output. This leads producers to increase the quantity of aggregate output supplied at any given aggregate price level. - an economy-wide fall in the cost of healthcare premiums paid by the employer. This is equivalent to a fall in nominal wages from the pov of employers; it reduces production costs - An increase in productivity means that a worker can produce more units of output with the same quantity of inputs.

short-run aggregate supply curve

shows the relationship between the aggregate price level and the QUANTITY OFF AGGREGATE OUTPUT supplied that exists IN THE SHORT RUN, the time period when many production costs can be taken as fixed. -POS relationship in the short run between the aggregate price level and the quantity of aggregate output supplied

Aggregate demand curve

shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.

aggregate supply curve

shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy

long-run aggregate supply curve

shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were FULLY FLEXIBLE. - 💥long run: the period of time over which all prices are fully flexible. In the long run, inflation or deflation has the same effect as someone changing all prices by the same proportion. As a result, changes in the aggregate price level do not change the quantity of aggregate output supplied in the long run.. . That's bc changes in the aggregate price level will, in the long run, be accompanied by = proportional changes in all input prices, including nominal wages. ** curve is VERT because changes in the aggregate price level in the long run have NO effect on aggregate output

examples of fiscal policy

social security spending, medicare spending, changes in tax rate

That employers are reluctant to decrease nominal wages during economic downturns and raise nominal wages during economic expansions leads nominal wages to be described as

stick wages

output gap

the % difference between actual aggregate output and potential output - the output gap always tends toward zero. - recessionary gap: output gap is NEGATIVE, nominal wages eventually fall, moving the econ back to potential output and bringing the output gap back to zero. - inflationary gap: output gap is POSITIVE, nominal wages eventually rise, moving the econ back to potential output and bringing the output gap back to 0.

Monetary policy

the CENTRAL BANK's use of changes in the quantity of money or the interest rate to stabilize the economy. - When the central bank increases amount of $$$ in circulation, households/firms have more $, which they are willing to lend out. The effect is to drive the interest rate down at any given aggregate price level, leading to higher investments and consumer spending. **Increasing the quantity of money shifts the AD to the right. - Conversely, decreasing the quantity of money shifts the aggregate demand curve to the LEFT.

short-run equilibrium aggregate price level.

the aggregate price level in the short-run macroeconomic equilibrium (y-val of the intersection)

AD-AS model

the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations

Marginal Propensity to Consume (MPC)

the increase in consumer spending when disposable income rises by $1 ** Is a number between 0 and 1

Marginal Prosperity to Save AND formula

the increase in household savings when disposable income rises by $1. OR the fraction of an additional dollar of disposable income that is saved. ***MPS = 1 − MPC. - the higher MPC is, the less disposable income "leaks out" into savings at each round of expansion.

planned investment spending (and what 3 factors it depends on)

the investment spending that businesses INTEND to undertake during a given period. (doesn't mean they'll ACTUALLY undertake it) -DEPENDS on 3 factors: 1. the interest rate 2. the expected future level of real GDP 3. current level of production capacity. 1. If interest rate rises, fewer firms will expect their projects to have a rate of return lower than the project's cost. AS A RESULT investment spending will be LOWER 2. higher expected future growth rate of real GDP results in a higher level of planned investment spending, and vice versa. 3. If a firm finds its existing production capacity insufficient for its future production needs, it will INCREASE investment spending to meet those needs.

Potential output

the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. *** where LRAS curve touches the horizontal axis (it's x-intercept)

short run equilibrium

the price level and real GDP that occur when the AD curve intersects the SRAS curve

Short-run equilibrium aggregate output

the quantity of aggregate output produced (OR REAL GDP) in the short-run macroeconomic equilibrium. (x-val of the intersection)

multiplier AND it's formula

the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. multiplier is 1/MPS OR 1/(1-MPC) 💥 - taxes and some govt programs act as automatic stabilizers, reducing the size of the multiplier. For ex, when incomes are high, tax payments are high as well, thus moderating increases in expenditures. And when incomes are relatively low, the unemployment insurance program pays more $$ out to individuals, thus boosting expenditures higher than they would otherwise be.

Long Run Aggregate Supply

the relationship between the quantity of real GDP supplied and the price level when the money wage rate changes in step with the price level to maintain full employment

AGGREGATE consumption function AND equation

the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending. - it has the same form as the household-level consumption function: C=A+MPC×YD C = AGGREGATE consumer spending YD = aggregate current disposable income A = aggregate autonomous consumer spending OR the y-intercept

Actual investment spending

the sum of planned investment spending + unplanned inventory investment I = IUnplanned + IPlanned

Fiscal policy

the use of taxes, government transfers, or government purchases of goods and services to STABILIZE the economy. - For recessions, gov.s increase spending, cut taxes, or both. - For inflation, they reduce spending or increasing taxes. - increase in govt purchases shifts AD to the right and a decrease shifts it to the left. - Higher tax rate or a reduction in gov transfers reduces the amount of disposable income received by consumers. This reduces consumer spending and shifts AD LEFT. - Lower tax or MORE gov transfers increases disposable income, increasing consumer spending and shifting the aggregate demand curve RIGHT.

inventory investment

the value of the change in total inventories held in the economy during a given period.

aggregate

total

examples of automatic stabilizers

unemployment compensation, corporate profit tax, progressive income tax

largest source of inflexible production cost is

wages

inflationary gap

when aggregate output (intersection pt. or equilibrium pt) is ABOVE potential output - ECONOMY SELF-CORRECTS again: An inflationary gap causes the SRAS curve to shift left gradually as producers reduce output in the face of rising nominal wages. This process continues until SRAS1 reaches its new position at SRAS2, bringing the econ. into equilibrium at E3, where AD2, SRAS2, and LRAS all intersect. At E3, the economy is back in long-run macroeconomic equilibrium. It is back at potential output, but at a higher price level, P3, reflecting a long-run rise in the aggregate price level. (check notes)

recessionary gap

when aggregate output is below potential output. - corresponds to high unemployment. *****This is also when the short run equilibrium level of real GDP is BELOW full employment level of real GDP.