Economics 201: Test #2

investment demand (marginal efficiency of capital investment spendings is more volatile (unstable) and subject to sudden fluctuations than consumption expenditures because of its interest rate sensitivity as well as: > rapid technological change > changes in acquisition, maintenance, and operating costs > business taxes

"rapid technological change" fosters additional investment in new innovative and more cost efficient PRODUCTION PROCESSES. These major technological developments occur in "fits and starts" causing a boom or bust in investment spending. "changes in acquisition, maintenance, and operating costs" EX: the extensive use of micro computer chips has dramatically reduced the number of parts (and hence the cost). Use of electronic fuel injection systems instead of mechanical carburetors on all automobiles "business taxes" affect the after tax profitability of capital project investments. EX: an IRS ruling permitting the use of a more accelerated depreciation of machinery and equipment would STIMULATE FIRMS TO INCREASE THEIR INVESTMENT ON CAPITAL GOODS. so pretty much... the business taxes (tax form for business owners that combine business personal income, including self- employment taxes) affect the amount of disposable income a companies makes or produces. - Factors other than interest rates stimulate investment spending shift the investment demand curve to the right causing more investment to be undertaken at the current interest rate.

Consumption and Savings Schedule: There are several different theories which explain the relationship between consumption expenditures and disposable income: > absolute income hypothesis

* Absolute income hypothesis - it is the traditional keynesian model - It argues that consumption is dependent on the absolute level of income. - It argues that the "Average propensity to consume (APC) falls as income rises in the short run. - Empirical studies show in the long run average propensity to consume is constant. But in the short run the consumption function must shift upward over time. This upward shift may be caused by: 1) increased availability of consumer credit allows consumers to spend more than their income and 2) rising living standards cause goods which were once considered luxuries to become necessities.

Consumption and Savings Schedule: There are other Non- income determinants which affect the level of consumption expenditures and savings. > non income determinants which cause consumption and savings function to shift

* Future expectations: It suggests that people's current expectations of the economy are able to influence what the future state of the economy will become. EX 1) if households expect shortages to develop they buy and stockpile scare goods now. - raise consumption and lower saving. EX2) consumers adopt a "Buy now" psychology they expect higher prices and widespread product shortages in the future. - raise consumption and lower savings. Key terms: "buy now" ""They expect" "future" _______________________________________________ * Amount of accumulated wealth: the value of real assets (houses, land) and financial assets (cash, stocks, bonds). When wealth increases, households increase spending and reduce savings. EX 1) if households have amassed a small fortune in savings and retirement accounts they begin to feel wealthier. This "Wealth Effect" causes them to spend more and save less. - Consumption increases and saving decrease. EX 2) The real and financial assets of households increased during a "boom" decade of unprecedented property and stock market gains. _______________________________________________ * Level of consumer debt and attitude toward thrift: increased borrowing increases current consumption. More so, easy to obtain credit cards promote more consumption in the short run. Ex 1) Consumers begin paying paying down their record levels of debt resulting from their "buying binges" based on easy installment credit. key words: "debt" "levels" "borrowing" "credit cards" _______________________________________________ *Inflation: It's a rise in prices. A sustained increase in the general price level in an economy. Inflation means an increase in the cost of living as the price of goods and services rise. EX1) unexpected rapid increases in the price level encourage consumers to buy now to avoid further price increases. - raise consumption and decrease savings. EX 2) Major foreign war involving the United States results in "Double Digit" inflation (when prices rise between 10 and 99% per year) and REDUCES the purchasing power of accumulated savings. "reduces" indicates that -consumption goes down and saving go up. Key terms: "rise in prices" "increase price level" "price increases" "rapid increase" _______________________________________________ *Stock and condition of durable goods: Durable goods are those goods that go on yielding services to the consumer over a number of periods in the future. expensive items that last three or more years. businesses and consumers generally place orders for durable goods when they are confident the economy is improving. An increase in durable goods orders signifies an economy trending upwards. It is also is an indicator of future increases in stock prices. EX 1) Consumer stock of durable goods (appliances and cars) is low because of wartime rationing and need to be replaced as the war ends. - Increase in consumption and a decrease in savings. - After world war II, consumers automobiles and appliances were broken and worn out so they went on durable goods spending spree when factories converted to making civilian goods. _______________________________________________ * Changes in taxation: Ex 1) A "Tax Rebate" of $500- $1,000 per household is instituted in order to get a sluggish economy moving. - both graphs shift in the same direction. EX 2) If the government gives a tax rebate it would represent an increase in disposable income. Consumers spend part of the rebate and save part of the rebate, thus both consumption and savings schedules would shift upward. - consumption goes up and savings go up. *changes in taxation are the only non- income determinant that causes both the consumption and savings graphs to shift in the SAME direction. Keywords: tax rebate, tax, refund. tax rebate- means a partial refund to someone who has paid too much money for tax, rent, or utility.

Consumption and Savings Schedule: There are several different theories which explain the relationship between consumption expenditures and disposable income: > relative income hypothesis

*relative income hypothesis - states that consumption depends on the relative level of income. - individuals in both rich and poor income classes spend about the same proportion of their absolute income because of: "The demonstration effect" - to keep up with those earning similar amounts, to emulate those earning more (keeping up with the Jones); and to impress those lower on the income scale; 2) The Ratchet Effect-- People are unwilling to give up standards of living they have grown accustomed to and attempt to maintain past levels of consumption even though their income has fallen.

aggregate supply and demand model: reasons for downward sloping aggregate demand curve: > Wealth Effect

- A decrease in consumer wealth shift aggregate demand (AD) curve to the left. - increase in consumer indebtedness would decrease consumption and shift aggregate demand curve to the left. - increases in taxes will decrease consumption and AD curve to the left. - a higher price level (raised prices) causes the real purchasing power of accumulated financial assets (savings) to decreases which causes people to feel poorer, thus dampening their spending in discretionary items.

Classical Macroeconomy: The Keynesian Theory of National output and unemployment is associated with 20th century British economist John Maynard Keynes who criticized the classical viewpoint and came to a different conclusion about the role of government in economic affairs: > employment Act of 1964 > Keynesian Macroeconomics in textbooks

- Employment act of 1946 affirmed/declared the Keynesian view of Macroeconomic po;ocy. Provision of the law included: a) creating the "Council of Economic Advisors"- every president since Harry Truman had a council of economic advisors to suggest appropriate economic policies for the prevailing conditions. b) making the U.S. government responsible for promoting full employment and price stability- it did not specify specific policies to accomplish this. c) provision making the Federal Government an employer of last resort, which would hire unemployed workers if they could not find a job in a private industry was CUT from the final law. - During the 1950's and 1960's Keynesian Macroeconomics was put into textbooks as the one I am using in this course

Equilibrium GDP vs Full employment: Determining Equilibrium level of gross domestic production ( GDP) in a two sector economy with only households spending on consumption and firms spending on investment (capital) goods: > Leakage

- SAVINGS is a LEAKAGE- Money TAKEN OUT of the spending stream does not result in a rise of further rounds of income (the multiplier process). Thus, leakages from the spending stream causes levels if income to decrease- they have a CONTRACTIONARY EFFECT on the economy. EX: the paradox of thrift states increased savings by an individual is considered to be a VIRTUE. They may save up to buy a big ticket without borrowing, accumulate a nest egg for retirement, or have some money put aside for a rainy day- all good things. However, if EVERYONE suddenly increased their savings= bad things results. increased savings means less consumotionspendings and fewer goods will need to be produced > lower level of production > translates into more unemployment. * people who are unemployed are very likely to be more successful in saving more money. * collectively, increased savings can be vice (fault, taint, corruption- bad rather than good) * Taxes and money spent on the purchase of imports from foreigner also considered to be leakages.

Equilibrium GDP vs Full Employment GDP Determining the equilibrium level of gross domestic product including government. > including government spending in GDP. " C + I + G = GDP " > recessionary gap

- When government spending is included in this model the equilibrium level of GDP now occurs where the level of consumption, investment, and government spending (aggregate) = GDP (output) a) amount of spending on consumption, investing, and government spending is just sufficient to buy back current output of goods produced (equilibrium) so there are NO CHANGES in levels b) graphically equilibrium occurs C + I + G (aggregate expenditures) line intersects the diagonal 45 degree line. - it shows aggregate expenditure (on the y-axis) equals output GDP (on the x-axis) i) if consumption + investment + government spendings (aggregate expenditures exceeds output, which is represented as " C + I + G > GDP " then more goods and services are being purchased than produced. This causes inventories to decline and production is increased to replace the deleted inventory. This leads to increase in employment, income, and spending so income expands. ii) If output (GDP) exceeds consumption + Investment + government spending (aggregate expenditures) which is represented as " C + I + G < GDP ". This means more goods and services are being produced than purchased. This results in a rising inventory. Thus, production is going to decrease to reduce the accumulated inventory which causes a decrease in employment, income, and spending so the economy contracts. * LOOK AT TABLE 11 IN CH. 11 NOTES - assume full employment level of GDP of $4,000. This level of output and employment is not sustainable because aggregate expenditures are not enough to purchase that level of output . C + I + G (aggregate expenditure) $3,750 at the $4,000 level of GDP. They are producing more goods than people are buying. Thus, they need to lay people off to get production back in line with consumption and spendings. a) This can lead to a "recessionary gap" which exists when equilibrium GDP is less than the full employment GDP. ~ recessionary gap can be calculated as the difference between full employment and equilibrium levels of GDP: can be calculated as: Full employment - equilibrium levels of GDP= recessionary gap full employment: 4,000 GDP equilibrium 3,000 GDP - ____________________________________________ Recessionary Gap 1,000

Fiscal Policy Automatic Stabilizers help stimulate the economy in a downturn when unemployment begins to and help to restrain inflation when economy begin to overheat. > automatic stabilizers

- automatic stabilizers are already built into existing laws and government regulations they DO NOT require any congressional legislation or president action since they are already law. - automatic stabilizers help reduce severity of unemployment and inflation problems, but they do not eliminate them entirely. Automatic stabilizers may need to supplemented with discretionary fiscal policy (government policy that change government spending or taxes) Automatic stabilizers: a) income tax collection- income tax revenue increases with the growth of production and employment but falls off when the economy slows down and enters a recession. b) unemployment compensation and welfare payments- these benefits are paid to those who are out of work. These transfer payments increase during bust times when workers are laid off but decrease in boom times when employment picks back up. c) corporate dividends( a sum of money paid regularly by a company to its shareholder out of its profits" - companies are reluctant to cut dividends when sales and profits fall because they depress the price of its stock, so they help support the economy during a downturn. d) Farm Programs and Aid- Agriculture Price and Income supports attempt to stabilize the income fluctuations of farmers.

investment demand (marginal efficiency on capital): Shifts in the investment demand curve: Business taxes

- business tax is a tax on business income. The government can influence the level of investment by the taz structure they impose on businesses. when government gives tax incentives for investing in ne capital such as allowing businesses to depreciate new capital at a faster rate or giving tax credit credits for new :green" investments this encourages additional investment all levels of the real interest rate and shift the investment demand curve to the right. if the government withdraws these tax incentives then the investment demand curve shifts to the left. - estimated taxes for business owners. The estimated tax form for business owners combines business and personal income and taxes, including self- employment taxes. EX: increase as congress raises the corporate income tax rate and severely restricts the use of accelerated depreciation. - aggregate demand curve will shift to the left. as taxes go > businesses can't write of equipment as fast > leads to lower investment.

Equilibrium GDP vs Full employment: equilibrium level of Gross Domestic Product (GDP) in a two sector economy with only households spending on consumption and firms spendings on investment (capital) goods. > equilibrium level of GDP: I = S

- equilibrium level of GDP in a two sector economy occurs when planned (desired) investment spending on New Plant and equipment is EQUAL to savings ( I = S ) EX: planned investment + inventory changes(unplanned investment) = personal savings. so pretty much... GDP can also occur when I = S. So your planned investment + inventory changed (unplanned investment) equal personal savings. THEN, compare planned investment with personal savings. It is not GDP if planned investment is more personal savings, it is not GDP if planned investment is less than personal savings, it IS GDP when planned investment = personal savings. i) if inventories increase... so planned investment + unplanned investment is greater than > savings firms will decrease production and employment because of build up in inventories of unsold goods. ii) if inventory decrease... so planned investment + unplanned investment in inventory is less than savings then firms will increase production and employment because of the depletion of inventories

aggregate supply and demand model: causes of shifts in the aggregate supply and demand curve. For Supply: > expectations > technology > Mergers > Resources shocks

- expectations: consumer expectations about the future of the economy can have a strong impact on consumption. Optimism about the economy will increase consumption and shift AS to the right. while pessimism dampens consumer spending and shifts the AS curve to the left. EX: consumers EXPECT their real income (after taxes) to rise FUTURE. supply, increase- shift rightward - technology: technological improvement in an industry might make old equipment obsolete and stimulate productivity shifting AS curve to the right. If workers become more productive because of investment in physical or human capital, the economy will be able to produce more. If workers become less productive because of outmoded equipment the economy will be less productive shifting AS to the left. EX: TECHNOLOGY break through increases PRODUCTIVITY and lower per unit cost of production. supply, shift rightward - Mergers: a combination of two things, especially companies into one. EX: a large number of CORPORATE takeovers increases the degree of monopoly "supplier" power in certain industries. supply, shift leftward - resource shocks: a unexpected event that changes the supply of a product or commodity. A positive supply shock causes increase in output and decrease in prices. A negative supply shock decreases production and raises prices. EX: a renewed Arab OIL cartel drastically CUTS it OUTPUT of crude OIL resulting in a much higher petroleum price. supply, shift leftward

aggregate supply and demand model: reasons for downward sloping aggregate demand. > foreign purchase effect

- if income abroad fall relative to income in the US, the AD curve will shift left to a decrease in net exports. * if foreigner are not able to buy US products then we are not making any money so we can't buy foreign goods products. - A higher U.S. price level causes american goods to become more expensive relative to foreign goods. As a result the quantity of U.S. exports decrease, while quantity of U.S. imports increase. * if the value of a country's import exceeds the value of its exports, the country has a negative balance of trade.

Equilibrium GDP vvs Full employment GDP Autonomous changes in consumption or investment spending cause a multiplied increase in GDP because of the multiplier process. > how how to find increase in GDP > how to find new GDP based on the increase.

- increase in GDP is not just the initial amount of increase in investment spending. The total increase in GDP is a multiple of the original increase in investment spending. it is calculated as: The initial change in investment spending multiplied by the value of the multiplier. initial amount: $125 tax multiplier: 4 125 X 4= 500 this says that GDP has increased by 500 dollars. Thus, GDP increased by $500 (4 times the change in investment spending of $ 125 billion) - to find the new GDP based from the increase: take the increase in GDP and ADD it to the current GDP 500 + 2 ,500 billion= 3, 000 New GDP is $3,000 billion

Aggregate supply and demand model Shifts in Aggregate Demand Curve (When Aggregate supply curve remains stationary) can be classified as: > increase in Aggregate Demand

- increase in aggregate demand is when demand shifts to the right and aggregate supply remains stationary. this results in Demand-pull inflation. demand- pull inflation causes an increase in price level with only a small increase in National Output. a) demand pull inflation is caused by a rightward shift in the aggregate demand curve faster than GDP (output) can grow. This often occurs during major wars. i) production bottlenecks and shortage of skilled specialized workers and resources develop. since supply of resources are scarce relative to the demand for them. Firms must big higher prices to acquire these resources which causes an increase in the firm's product prices. ii) during a recession excess capacity and high unemployment keeps inflation low. idle resources can be hired without exerting upward pressure on wages and prices when production expands during economic recovery (keynesian (horizontal) stage. iii) hen the economy approaches full employment (vertical ) range of the aggregate supply curve there is "to much money(excess spending) chasing too few goods" (maximum output) so wages and prices prices begin to rise rapidly. b) when demand pull inflation occurs, the appropriate fiscal policy is to reduce government spending or to increase taxes in order to curb consumption expenditures and dampen aggregate demand. HISTORICAL ex: THE dramatic increase in military spending during the vietnam war accompanied with President JOhnson's great society way on poverty fueled demand pull inflation in the latter of the 1960's.

aggregate supply and demand model: reasons for downward sloping aggregate demand curve: > interest rates

- increase in the interest rate will reduce investment demand shifting AD curve to the left. - businesses taxes can be structured to discourage investment (shifting AD to the left) - A higher price level (raised prices) causes interest rates to rise. HIgher financing costs tends to discourage the purchase of "big ticket"durable goods such as cars and appliances by consumers and investments in capital equipment by businesses.

Unemployment : The search model of unemployment duration: Job offer and Reservation wage rate curve

- job offer curve: shows the highest paying job an unemployed worker would find given the number of weeks they had been searching for work. Job offer curve slopes upward. Longer search time results in a job that pays more. -The reservation wage curve: shows the lowest annual wage an unemployed worker would accept is quite high. Unemployment continues reservation wage falls because of increasing financial pressure to resume working due to paying bills and debts out of accumulated savings. Social pressure is another explanation of why the reservation wage curve falls- unemployed workers may be tired of explaining to family and friends why they haven't found a job yet. - where the two curves intersect that is where the job offer wage equals (=) the reservation wage. y (vertical) - axis: Money Wage (annual) x (horizontal) - axis: duration of unemployment (in weeks) * LOOK AT GRAPH ON EXERCISE #8

Aggregate supply and demand model: reasons for shifts in Aggregate supply and demand. For Demand: > level of debt > tax incentives > government spendings > consumer wealth > personal taxes

- level of debt: increases in consumer indebtedness would decrease consumption and shift the AD to the left. While decreases in indebtedness would shift AD to the right. EX: consumer have HIGH levels of indebtedness resulting from past spending sprees based on easy credit and begin to pay it down. demand, shift leftward - tax incentives: it's a government measure that is to encourage individuals and businesses to spend money or to save money by reducing the amount of they gave to pay. So tax incentives reduce taxes for businesses and individuals in exchange for specific desirable actions or investment on their part. EX: a INVESTMENT tax credit law Encourages business to INCREASE their CAPITAL SPENDINGS on new plant and equipment. demand, shift rightward > government spendings: The political process will sometimes lead to increases or decreases in the level of government spending. Increases in government spending will shift the AD curve to the right; decreases in government spending will shift the AD curve to the left. EX: a big INCREASE in FEDERAL EXPENDITURES results from a POLICY decision to EXPAND NASA. Demand, shift rightward - consumer wealth: increases in consumer wealth would increase consumption at each price level and AD would shift rightward. decreases in consumer wealth would shift AD to the left. EX: a bug run up in the stock and real estate markets result in consumer amassing big "paper profits" demand, rightward shift - Personal taxes: tax paid on one's personal income. Increase in taxes will decrease consumption shifting the AD to the left, Decreases in taxes will increase consumption shifting the AD to the right. EX: A bill INCREASING the marginal INCOME tax rate it passed. demand, shift leftward

Aggregate supply and demand Model: The short run aggregate supply curve shows the total production of good and services by all firms at various price levels. It consists of three three distinct ranges: 1- Keynesian (horizontal) rangle

- occurs at low levels of output since there is high unemployment, there;s no upward pressure or prices. - as aggregate demand increases in the keynesian range of the aggregate supply curve then firms can expand by hiring idol resources which are available without raising wage rates or prices. i) John Maynard Keynes was writing during the great Depression of the 1930's when the economy was experiencing massive unemployment and idle capacity. shortages and bottle

Aggregate supply and demand model: The short run aggregate supply curve shows the total production of goods and services by all firms at various price levels. It consists of three distinct ranges: 2- intermediate (positively sloped) range

- occurs when economy begins to approach full employment of output. - shortages and bottlenecks of critical raw materials and resources begin to develop when the economy is close to full employment. shortages and bottlenecks of critical raw materials and resources begin to develop when economy is close to full employment. - to acquire scarce resources, firms must bid up wage rates of skilled labor which means they have to charge higher prices for their out.

Equilibrium VS full employment GDP: Autonomous changes in government spending (or tax cuts) cause a multiplied increase in GDP which close the recessionary gap: > balanced budget multiplier

- the increase in government spending are matched by an equal increase in taxes so there would be no deficit. a) balanced budget multiplier is EQUAL to the SPENDING multiplier. - the balanced budget multiplier is ALWAYS going to = 1. Balanced budget multiplier Formula: MPS/MPS= 1 ______________________________________________ need increase in government spending and taxes formula: recessionary Gap / balanced budget multiplier 1000/1= 1000 Thus, government spending taxes would have to be increased by $1000 to close the recessionary gap because the balanced budget multiplier only has a value of one.

Unemployment: Full employment is considered to be about a 4-5% rate of unemployment:

1) Full employment in a free market economy can NEVER be 100% employment of the labor force. Skills of some workers will not match the jobs available. 2) Full employment occurs when there is little or no cyclical (assembly line jobs) unemployment. There is only frictional, seasonal, and structural unemployment. a) full employment in the U.S. Economy is considered to be about a 4-5% unemployment rate. 3) at Full employment rate of unemployment, which is also called "Natural rate of unemployment" the economy's actual GDP is equal to = its potential GDP. a) quantity of job seekers equals the quantity of job vacancies, some unemployment exists because the frictionally unemployed are searching for jobs that utilize their skills. structurally unemployed are being re-trained and/or relocated for new jobs that are available. 4) actual rate of unemployment can sometimes does, drop below the natural rate of unemployment. Historically, this resulted in higher rates of inflation.

There are several alternative philosophies concerning the budget: Budget philosophies: > annually balanced budget > cyclically balanced budget > functional finance

1) annually balanced budget: argues the federal government should balance the budget every year so revenues always equal expenditures. This would prevent fiscal policy from being used to stabilize the economy in times of recession or inflation. a) raising taxes or cutting government expenditures to balance the budget in times of recession would only make things worse by increasing unemployment. b) in the 1980's there were attempts to pass a constitutional amendment mandating an annually balanced budget. it did not pass and it was not favored by more economist. c) CONSERVATIVE PHILOSOPHY 2) cyclically balanced budget: attempts to balance the budget over the length of the business cycle. surplus would be run up in times of prosperity which would then be used to offset deficits in times recession. This is what some governments now do with their "Rainy Day" funds. a) irregular length and severity of business fluctuations does not guarantee that surplus would equal deficits. Short prosperous periods combines with long recessionary period could still result in deficits over the business cycle. b) MODERATE PHILOSOPHY 3) Functional finance philosophy: argues that the budget should be used to promote full employment and stable prices regardless of its deficit consequences. there are high social costs associated with unemployment in the form of increased crime rates, higher drug/ alcohol abuse, more domestic violence, and rising number of broken homes. the government is responsible for getting the economy to operate its potential level of output, even if this results in a deficit and a deficit is a small price to pay for alleviating these pressing social problems.

Consumption and Savings Schedule: There are other non- income determinants which affect the level of consumption expenditures and savings: > movement along an existing consumption function graph > shifts of consumption and savings graph.

1) movement upward along an existing consumption function ^C caused by a increase in disposable income ^DI. Vice versa, decrease in disposable income causes movement down along an existing consumption function. 2) upward or downward shift in consumption function graph occurs when disposable income i held constant, but a non- income determinant of consumption charges. a) savings function and consumption function shift in opposite directions. EXCEPT when shift is caused by changes in taxation because it affects disposable income. Then they will Savings and Consumption graph will move in same direction.

Fiscal policy There are several time lags inherent in fiscal policy . these lags cause changes in government spending and taxes to occur too late and actually harm the economy if unemployment has given away inflationary pressures before they kick in and start stimulating the economy > recognition lag > administrative lag > operational

1) recognition lag: The time it takes to confirm the economy has actually entered a recession. statistics are often conflicting and a recession is only declared after real GDP declines by two consecutives quarters. 2) administrative lag- The time to design and implement a fiscal policy of spending increases/ or tax cuts to deal with the recession. Political infighting and wrangling by the democrats and republican parties often delay the passage of legislation needed to stimulate the economy. 3) Operational lag- the time it takes for the increase in government spending or cut in taxes to go through the multiplier process and improve the economy. Public works projects require long periods of planning and lengthy construction times before they impact the economy.

investment demand (marginal efficiency of capacity) The amount of a firm's investment in capital project (New factories and equipment) is based on their expected rate of return and the current market interest: > expected rate of return

A firm computes the expected rate of return (profitability) on each capital project it would like to undertake. a) the expected rate of return on an investment is equal to its profit. To find rate of return: total revenue generated by the capital' good minus all acquisitions and operating costs divided by its cost) i) EX (LOOK AT CH. 10 NOTES): Assume capital project E costs $75,000 and it generates $82,500 in revenue. The rate or return would be: 82,500- 75,000= 75000 7500/ 75000= .1 = 10% expected rate of return (profit) is 10% ii) all future revenues and costs are assumed to have been "discounted" back to their present day value iii) capital investment projects include: a) developing environmentally friendly package b) building new factory in a strategic location c) installing pollution declining/ reduction equipment d) introducing improved and redesigned product e) opening retail outlets in new aera. *B*) various investment projects are then ranked in descending order of their profitability from most profitable project (Highest expected rate of return) to the least profitable project (lowest expected rate of return). c) table and graph show the rate of return and cost of firms capital investment projects are ranked in descending order of the profitability. i) NOTE: Investment spending involves "lumpy" all or nothing capital projects so investment spending graph appears as a "descending step" diagram

Equilibrium VS full employment GDP: Appropriate fiscal policy i determined by the economy's condition- whether is it experiencing a recessionary gap or an inflationary gap. > Recessionary gap

A recessionary gap occurs when high unemployment causes actual output to be the economy potential GDP =. Hence, the Level of GDP where aggregate expenditure ( C + I + G)= Aggregate output (GDP) is to the left of the economy's full employment level of real output. so pretty much... high unemployment = low output that is far below economy's potential GDP. <-Recessionary Gap-> --I E I --------------------I F I---- Equilibrium Full GDP Employment a) possible policies to increase GDP to its full employment include: i) wait for private sector spending (consumption or investment) to pick up. This Would shift the aggregate expenditure graph upward, causing an increase in output employment. ii) increase government spending (on public works project) or reduce taxes which would stimulate consumption expenditures. This kind of expansionary fiscal policy would shift the aggregate expenditure graph upward. - in times of recession and high unemployment this stimulates the economy and results in an increase in output and employment with little to no increase in the price level (inflation) since high unemployment, firms can hire more workers without paying higher wages or raising prices.

Consumption and Savings Schedule: The savings function shows a direct (positive) relationship between the amount of personal savings and the level of disposable income. APC% + APS%= 1 or 100% MPC% + MPS% = 1 or 1000%

APC% + APS% =1 or 100% since all disposable income must either be spent on consumption or saved (not spent) MPC% + MPC% = 1 or 100% since anu increases in disposable must either be spent on additional consumption or more saving.

Business Cycle: The business cycle is irregular fluctuations in the unemployment rate and GDP. It consist of four phases: 2: recession or decline phase

Actual GDP begins to fall as the economy as slackens. New fall off and inventory levels begin to rise. to get production back in line with sales, firms lay off unneeded workers. In turn, unemployed cut their spendings due to loss of income, which means less orders for other businesses. a) recession occurs when real GDP adjusted for declines for two consecutive quarters (6 months). b) economic cost of recession is a loss of the real goods and services that could have been produced if the economy were operating at full employment level of output. c) social consequences of recession: increase in anxiety, depression, the decline in physical health, increased drug and alcohol abuse, and suicide that accompanies economic hardship.

Investment Demand (Marginal efficiency of capital) The amount of firm's investment in capital projects (New factories and equipment) is based on their expected rate of return and the current market interest rate. > Inverse (Negative) relationship between interest rates and level of investment

An inverse (Negative) relationship exists between interest rates and the level of investment. a) HIGHER interest rate > LOWER investment spendings. This dampens the economy because fewer capital projects are profitable. b) LOWER interest rates= raises investment spending. It also stimulates the economy because more capital projects are profitable.

Business Cycle: There are several theories about what causes business cycles: ~ innovation Theories

Argue major innovation and their related spin-offs such as electric lighting, mass-produced automobiles, personal computers, and the internet cause a long rising level of economic activity, which peaks once society has fully adopted and there is no other major innovation on the horizon. a) American/ Austrian economist Joseph Schumpeter described the "Creative destruction" process cause by dynamic entrepreneurs who create a euphoric economic environment with their bold risk-taking and revolutionary innovations.

Consumption and Savings Schedule: The Consumption Function shows a Direct (Positive) relationship between the amount of consumption expenditures and the level of disposable income. > Disposable Income is the primary determinant of consumption expenditures.

As levels of disposable income increase, consumption expenditures also increase ( ^ DI --> ^ C) indicating a positive or direct relationship. a) disposable income is measured on the Horizontal Axis. Consumption is measured on the vertical Axis resulting to CONSUMPTION FUNCTION. The graph is a straight line which slopes upward and to the right. b) higher income families are willing and able to spend larger amount on consumption than lower income families. * LOOK at table 1 in ch. 10 notes. TO FIND DISPOSABLE INCOME: Consumption + Savings = DI TO FIND SAVING/ DISSAVINGS: Disposable - consumption = S

Consumption and Savings Schedule: The Savings Function shows a direct (positive relationship between the amount of personal savings and the level of disposable income. > Savings

As the level of disposable income increases, personal savings also increases. As a result, the savings function graph is a straight line which slopes upward and to the right. a) Higher income families save larger amounts than lower income families. b) low levels of disposable income savings may be negative because consumption expenditures (how much we spend) may be greater than disposable income. This is because people are or buying on credit and people are spending some of their past savings. A B C D E ____________________________________________________ $ personal Savings: -125 0 +125 +250 +375 $ $ Disposable Income: 1,500 2,000 2,500 3,000 3,500 S < 0 S = 0 S > 0 S > 0 S > 0

Consumption and Savings Schedule: To reduce the complexity of the Keynesian Model Income, output, and employment, several simplifying assumptions are made: > Autonomous Investment

Autonomous Investment- assumed that intended (planned) investment spending by firms on new and equipment is independent (autonomous) of the level of Gross Domestic Product. Investment is treated as constant dollar amount at all levels of GDP. AKA: Investment by businesses or the government that is not related to changes in demand; for example, investment in public services.

Consumption and Savings Schedule: The savings function shows a direct positive relationship between the amount of personal savings and the level of disposable income. > Average Propensity to save (APS)

Average Propensity to save (APS) is a relative (percentage %) number which measures the proportion of total disposable income that is saved. a) The formula to calculate Average Propensity to Save is: saving/ divided by disposable income. APS= S/ DI b) EX: Disposable income is 2,500 (point C) and personal savings is $125. Thus, APS is 125 (savings) divided by $2,500 (disposable income. This will equal 5% c) Average propensity to save (APS) rises as disposable income increases. - pretty much an increase in disposable income (the more they money they have ) causes an increase in APS (because they can save more) - higher income families save a larger percentage of their total disposable income than lower income families.

Consumption and Savings Schedule: The consumption Function shows a direct (positive) relationship between the amount of consumption expenditures and the level of disposable income. > Average Propensity to consume (APC)

Average propensity to consume (APC) is a relative (percentage%) number which measures the proportion of total disposable income that is spent on consumption expenditures. (NOT FINDING THE DIFFERENCE, COMPUTING THE NUMBERS STRAIGHT OUT OF THE GRAPH) a) Formula to calculate average propensity to consume is: consumption / disposable income. APC= C / DI b) Example: Disposable is $2,500 (point C), and the Consumption Expenditure is 2375 APC= 2,375/ 2,500 = 0.95 x 100= 95% - so pretty much to find Average Propensity to consume take the amount of the consumption expenditures directly from the graph and divided it by the amount of disposable income. (We are not finding their difference.) Then multiply that total by 100 to make it a percent. c) The average propensity to consume declines as disposable income increases. pretty much... as disposable income increases so do consumption. Thus, the more we spend from our total disposable income it will cause a decrease in our APC (total disposable income) - Higher income families spend a smaller percentage of total disposable income on consumption than lower families.

Business Cycles: Business cycle is the irregular fluctuations of unemployment and GDP. It consists four phases: Peak/ property, recession/ decline, trough, and recovery/ expansion.

Business cycles are unique and occur at irregular intervals. They have varying durations and severities. Also, they have various underlying causal factors.

investment demand (marginal efficiency on capital): Shifts in the investment demand curve: > capacity utilization

Capacity utilization is the extent to which an enterprise on a nation uses its installed production capacity. It is the relationship between output that is produced with the installed equipment, and the potential output which could be produced with it if capacity was not fully used. Moreso, business that already have a significant stock or capital on hand are less likely to incest in additional capital. For instance, a company that has excess office space or idol plant is not as likely to increase in additional capital as a business that is operating at or beyond capacity. At any rate given level of the real interest rate, you would expect more investment by a firm that is short on capital good than by a firm that has an adequate stock of capital on hand. Many plants and factories are running at a fraction of their full capacity and much machinery and equipment is sitting idle because of a recession and a decline in consumer demand. -The graphs shift to the left. In this case they cancel buying new equipment

Consumption and Savings Schedule: To reduce the complexity of the Keynesian Model Income, output, and employment, several simplifying assumptions are made: > Closed economy

Closed economy- it is assumed that there are no exports or imports of goods.

Unemployment: There are several major types of causes of unemployment: ~ Seasonal unemployment

Due to the time of year (season) or effects of weather on production. Working at a ski resort is a "winter job" while working at a Theme Park is a "Summer Job". These workers are unemployed during the offseason. Unemployment in industries such as agriculture and construction can be strongly impacted by weather.

Consumption and Savings Schedule: To reduce the complexity of the Keynesian Model Income, output, and employment several simplifying assumptions are made: > Consumption + Savings= Disposable Income

Due to these assumptions, we can use to identify that consumption plus savings must always equal disposable income: Consumption + Saving= Disposable Income

Equilibrium GDP vs Full employment: equilibrium level of Gross Domestic (GDP, which is Output) in a two sector economy with only households spending on consumption and firms spendings on investment (consumption + investment = aggregate expenditures ) > Equilibrium level of GDP

Equilibrium level of GDP occurs when the level on consumption plus investment spending (aggregate expenditures) is equal to the national out (GDP) C + I = GDP - pretty much.... consumption expenditure + planned investment= aggregate expenditures. The aggregate expenditures = GDP (output) a) amount of spending on consumption and investment is just sufficient to buy back the current output of goods produced, so there no change in inventory levels. b) graphically, equilibrium occurs when the C+ I (aggregate expenditure) intersects the diagonal 45 degree line. i) if consumption + investment spending exceeds output (C + I > GDP) it means more goods and services are being purchased ban produced causing inventories to decline. Therefore, production is increased to replace depleted inventory this causes an increase in employment income and spending so the economy expands. EX: aggregate expenditures of 1, 750 but a GDP (output) of 1, 500. This causes inventory to decrease and output to increase. If output (GDP) exceeds consumption + investment (aggregate expenditures) ( C + I < GDP) then more goods and services are being produced than purchased which causes an increase in inventory and production to decrease which will reduce the accumulated inventory which leads to a decrease in employment, income, and spending so the economy contracts. EX: GDP (output) of 3,000 and aggregate expenditures of 2, 875. causes inventory to increase and production of goods to decrease.

Business Cycles: The business cycle is irregular fluctuations in the unemployment and GDP. It consist of four phases: 4th: expansion or recovery phase

Expansion or recovery phase increase in new orders cause production to expand and employment to decline. Economy activity starts to pick up, firms must buy new equipment to expand their capacity and replace worn out machinery. c) To qualify as a recovery, expansion of real GDP must reach the level of the previous peak. When it surpasses that level, the economy is in the peak or prosperity phase.

Equilibrium GDP vs Full employment: Determining the equilibrium level of gross domestic production (GDP) in a two sector economy with only household spending on consumption and firms spending on investment (capital) goods. > injection

INVESTMENT is an INJECTION- money PUT INTO the spending Stream. - does not come from current income, which gives rise of further rounds of income (multiplier process) - injections into the spending cause the level of income to increase. - injection has a EXPANSIONARY effect on the economy. - government spending and sales of exports to foreigners are also considered to be injections.

Equilibrium GDP vs Full employment: autonomous changes in consumption or investment spending cause a multiplied increase in GDP because of the multiplier process. > inflationary gap

Inflationary gap occurs when full employment causes actual output to be above the economy's potential GDP where aggregate expenditure ( C + I + G)= Aggregate output (GDP) is to the right of the economy's full employment level of real output. <-Inflationary Gaps-> --- I F I------------------ I E I ---- Full Equilibrium Employment GDP GDP a) labor shortages cause firms to bid up wage rate. This increase in the firm production costs result in higher product prices (inflation) b) possible policies to reduce GDP and restore price stability include: i) wait for private sector spending (consumption or investment) to fall this would shift the aggregate expenditures downward, thus, decreasing output and employment. ii) cutting government spending (on public works projects) or increasing taxes to stimulate consumption expenditures. This king of Contractionary fiscal policy would shift the aggregate expenditure graph downward.

Investment demand (marginal efficiency of capital) Firm's investment in capital project ( new factories and equipment) is based on their expected rate of return and current market interest. > investment decision rules

Investment decision rules firms use in evaluating capital project investment decisions are: a) ACCEPT a capital investment project only if its expected rate of return IS GREATER THAN (>) OR EQUAL TO (=) the interest rate on the borrowed money b) REJECT a capital investment project if its expected rate of return is LESS THAN (<) interest rate on the borrowed money. c) if the market rate of interest was 7% then firm would undertake projects B (12%) , E (10%) , and D (8%) because they are all HIGHER than the interest rate (7%). The total investment cost is $160,000 (each projects cost $ added together, hence, the cumulative cost) Project A (6%) and C (4%) would NOT be profitable when borrowing 7% because the expected rate of return is lower than the interest rate. it would NOT BE UNDERTAKEN. d) if the market rate of interest declines to 5%, project A (6%) would now become profitable because it's above the interest rate. The total investment spending would increase to 220,00, add the cost of project a ,hence, the cumulative cost.

Consumption and Savings Schedule: Consumption and Saving Schedule: The Consumption Function shows a Direct (Positive) relationship between the amount of consumption expenditures and the level of Disposable income. > Marginal Propensity to Consume (MPC)

It is a relative (percentage %) number which measures the proportion of an increase in disposable income that is spent on additional consumption. a) The formula to calculate Marginal Propensity to consume is: Increase in consumption / the increase in disposable income. MPC= ^C/ ^DI b) EX: if disposable increased from $2,500 to 3000 (Point C to D) and the resulting consumption expenditures rose from $2,375 to $2,750, then the marginal propensity to consume (MPC) would be $375 (the increase in Consumption divided by $500 (the increase in Disposable Income)= 75% *Pretty much.... to find the MPC compute the difference in consumption and Disposable Income, then take the difference in consumption and Disposable Income and divide them with each other in that order. Afterward, multiply the result by 100 to change it to a percentage. c) MPC is a CONSTANT straight line consumption function. In this example, every $500 increase in disposable income results in a constant $375 increase in consumption expenditures. Graphically, the Marginal Propensity to consume (MPC) represents the slope of the consumption graph.

Classical Macroeconomics: The keynesian Theory of National output and unemployment is associated with 20th century british economist John Maynard Keynes who criticized the classical viewpoint and came to a different conclusion about the role of government in economic affairs. > Why wages and prices are inflexible

Keynes believed that wages and prices were inflexible (sticky) downward. a) large corporations and big labor unions have a certain degree of monopoly power, which limits their ability for downward adjustment of prices and wages in recessionary times. Big firms often cut production rather than prices in hard times. b) wages and prices could creep upward over time, but they do not fall fast or far enough to correct the high unemployment of a slump ~ New (neo) Keynesian model provide theories about why wages and prices are often inflexible downward (sticky)- even in times of high recession: 1) Labor contracts theory: three year contracts are common in union industries so only a small proportion of them come up for renegotiation at any given time. Some unions have insisted on higher wages even in the face of declining employment and membership, management finds it easier to pay what the unions ask for than to suffer the aggravations and cost of protracted labour negotiations or a strike 2) Efficiency Wages Theory: firms pay wages higher than the market clearing level to minimize their overall labor costs per unit production. Higher wage levels reduce the defection of the firms good workers who could easily find jobs elsewhere and reduce "shirking" marginal employees. Higher wages provide incentive for higher employee productivity and lower training costs because of reduced employee turnover. (AKA wages offered is not the market clearing price. It's an incentive for managers to pay their employees more than the market clearing wage to increase productivity efficiency or reduce the cost associated with turnover (replacing employees) , because industries of the cost of replacing labors are high. 3) Menu Costs Theory: Costs to a firm when it changes its prices. Must print new prices and convey the new pricing details to its old (and now annoyed) customers. Even if these costs are small, their overall cumulative effects can be significant and provides a reason why many individual companies wait a while before altering their prices rather than raising their prices a little bit of several time throughout the year. 4) insider vs. outsider Theory: employees of a firm have already been trained in the way the company operates. It is not in their best interest to train new, lower paid people who want a job at the firm because it would end up reducing their bargaining position with the firm since lower wage replacement would exert downward pressure on the wages of current employees. Existing employees refuse to cooperate with training new workers unless they are offered similar pay. 5) Implicit Agreements Theory: workers are risk averse like to avoid monthly or yearly fluctuations in their income which would jeopardize their ability to meet fixed financial commitments, such as mortgage payments. Workers acquire "insurance" against unpleasant events by working for a dependable firm with the understanding that companies pay their workers a higher wage than it "needs to" in bad times, but in exchange workers stay with the company in good times, even though they might be able to receive higher wages elsewhere.

Classical Macroeconomy: They Keynesian Theory of National Output and Unemployment is associated with 20th century British economist John Maynard Keynes who criticized the classical viewpoint and came to a different conclusion about the role of government in economic affairs: > Keynes conclusions contrary to classical economist

Keynes concluded contrary to classical economists (Jean Baptise Say), that government intervention WAS APPROPRIATE in times of high unemployment because ,otherwise, the economy could become stuck in a recession for long periods of time. a) According to Keyne, increases in government spending or tax cuts would stimulate aggregate demand and move the economy back to full employment prosperity. b) This activist fiscal policy involved deficit financing by selling government bonds, the economy would recover sooner and once back at prosperity, the bonds could easily be repaid with increased tax revenues. c) economy is operating at less than full employment in a recession, it could be stimulated without causing any significant inflation because workers would be no position to request higher wages when unemployment is high and consumers would balk (unwilling or hesitant to accept the idea ) at firms charging higher prices in a recession.

Classical Macroeconomy: The Keynesian Theory of National output and unemployment is associated with 20th century british economist John Maynard Keynes who criticized the classical viewpoint and came to a different conclusion about the role of government in economic affairs: > Keynes' views on "pump priming" > losing some of its prestige in 1970's

Keynes's views on stimulating the economy with "pump priming" by government spending was considered very radical in the 1930s, but became accepted when the great depression caused massive unemployment. Today, Keynesian economics forms the foundation of Macroeconomic Theory. a) Keynesian Macroeconomics lost some of its prestige during the 1970s when it could not explain or deal with "Stagflation"- simultaneous high unemployment and high inflation.

Consumption and Savings Schedule: There are several different Theories which explain the relationship between consumption expenditures and disposable income: > Life Cycle Hypothesis

Life Cycle Hypothesis. - Individuals spread out their lifetime income to achieve an optimal pattern of consumption. - Income it low during early years after graduating high school/ college when one is starting out and building a career. - consumption expenditures are high during this early life period ( buying a car, home, etc.) * since consumption exceeds Income, savings are Negative. - Income declines later in life upon retirement and consumption expenditures also decline. * However, consumption is still greater than income, so savings are also negative in the later life period. - Middle years of life: income is higher than consumption so savings are positive. - Individual's consumption at any given point in time depends on their current income, wealth accumulated from past savings, and expected pattern of future income .

Consumption and Savings Schedule: To reduce the complexity of the Keynesian Model Income, output, and employment, several simplifying assumptions are made: > No government sector

No Government Sector- there is no government spending, taxes, or transfer.

Consumption and Savings Schedule: To reduce the complexity of the Keynesian Model Income, output, and employment, several simplifying assumptions are made: > No retained earnings

No retained earning- there are no undistributed corporate profits (retained earnings), for all receipts by businesses for their goods and services they produce are used to pay households for their resources.

Unemployment: There are several major types of causes of unemployment: ~ incidence or burden of unemployment

Not spread evenly among various occupational, Age, or Racial groups. The difference in the Unemployment rate by groups: a) blue-collar workers have a higher unemployment rate than white collar workers since blue collar workers are employed in more cyclically manufactured industries. Often employers have invested more in training their white-collar workers are reluctant to lose their lose investment by laying them off during a business slump. b) teenagers have a higher unemployment rate than adults, they have less job skills and seniority are often the first to be laid off. Teenagers also have less geographic mobility to move where the jobs are. c) Minorities have a higher unemployment rate than white because of discrimination. Location in higher unemployment areas (cities) rather than lower unemployment areas (suburbs) and lack transportation, which also contributes to higher unemployment rates. d) college graduates have lower unemployment rates than those who only completed High School, because of their higher skill levels, more permanent white collar jobs, and "bumping". e) Males and Females have approximately EQUAL unemployment rates.

Unemployment: There are several major types of causes of unemployment: ~ Structural unemployment

Occurs because of: a) permanent decline in industry- for instance, passenger trains being replaced by automobile or the movement of textiles manufacturing overseas~ or technology. b) automation and technology displace workers such as robotic welding machines replacing manual welders on automobile assembly lines. Structurally unemployed workers have obsolete job skills that need to be re-trained by learning to job skills that are in demand.

Business Cycle: The business Cycle is irregular fluctuations in the Unemployment Rate and GDP. It consist of four phases: 1: peak/ prosperity phase

Peak or Prosperity Phase: Actual GDP is at or near its potential since the economy is operating close to the full employment level of output. a) inflation results from excessive spending at the peak because production can not keep up with demand. Unemployment is low, so firms must bid up wage (increase wages) to acquire more workers. They must also expand their productive capacity to cope with the backlog of orders (Backlog is a buildup of work that needs to be completed. refer to company's sales orders waiting to be filled, or a stack of financial paperwork such as loan applications that need to be processed. )To recoup there higher costs, firms raise their product prices. Example: Real GDP rose by 75% between 1939 and 1945 because of the rapid expansion of military and defense production during WWII. Price control was used by the federal government to restrain wartime inflation.

Consumption and Savings Schedule: There are several different Theories which explain the relationship between consumption expenditures and disposable income: > Permanent Income Hypothesis

Permanent income Hypothesis- current income is divided into two components: 1) permanent Income which is the long term normal income expected to be received in the future and 2) transitory income which consists of temporary windfall gains or windfall losses experienced during the year. for EX: A windfall gain is winning the lottery, then it would be saved and gradually spent over the winner's lifetime. Another EX: Windfall loss would not cause a great fall in consumption since it would be spread out over one's lifetime. Thus fluctuations in transitory income have relatively small effects on permanent income and the level of consumption.

Classical Macroeconomics: The classical viewpoint of macroeconomy was associated with the 18th century economists and prevailed until the great depression of the 1930's > SAY'S LAW

Say's Law names after French jean Baptiste Say. He is best represented by the the book, "The Wealth of Nations" (1776) by scottish economist Adam Smith promoting the invisible hand" idea of self- interested actions unintentionally benefiting the public good. who stated that "supply creates its own demand". - he argued resources such as labor are paid enough wages to buy back the output they have produced, so the economy generates enough aggregate purchasing power to acquire its entire total output. In other words: resources like labor are paid enough wages to buy back the output they have produced, so the economy generates enough aggregate purchasing power to acquire/ buy back its ENTIRE total output. Thus, General overproduction (or a glut) all goods is impossible, so full employment prosperity is the normal equilibrium point for the overall economy a) while the economy might err by on producing too much of some good (Which would their prices to fall) and producing too little of other good (which would cause their prices their rise), it couldn't produce too much of all goods because of the fact that production generates income.

Equilibrium GDP vs Full Employment GDP Autonomous changes in government spending (or tax cuts) cause a multiplied increase in GDP which close the recessionary gap: > Tax Multiplier

Tax Multiplier - used to find the necessary cuts in taxes to close the recessionary gap. - THE TAX MULTIPLIER IS ALWAYS EQUAL TO THE SPENDING MULTIPLIER MINUS ONE. *EX FROM CH. 11 NOTES Tax multiplier formula: MPC/ MPS MPC= .75 MPS= .25 tax multiplier: .75 / .25= 3 Tax multiplier= 3 _____________________________________________ Formula to find the necessary cuts in taxes to close recessionary gap: the recessionary gap / the tax multiplier. 1,000 / 3= 333.3 needed decrease in taxes are 333 - tax multiplier is smaller than the spending multiplier (by 1), so taxes must be cute by a larger amount ($333) than the government spending increase ($250) to close the recessionary gap. - cut in taxes cause an increase in disposable income which causes increases consumption spending. This increase in consumption goes through the spending- respending process of the multiplier. - an increase in government spending without a increase in taxes or a cut in taxes without a decrease in government would cause a deficit that which would have to be financed by selling government bonds.

Classical Macroeconomics: The Classical viewpoint of Macroeconomy was associated with 18th Century Economists and prevailed until the Great Depression of the 1930's. > Prices, wages, and interest rates

The classical economists believed that prices, wages, and interest rates were flexible (both upward and downward). This flexibility would correct any product, employment, or investment imbalances in the economy so the supply of goods, labor, or loanable funds in these markets would always be equal to their demand. EXAMPLES: a) if interest rates were TOO high, savings by consumers would exceed than borrowing for investment by business, so interest rates would fall. Lower interest rates discourage some saving and encourage more borrowing. b) if interest rates were TOO low, borrowing for investment by businesses would now exceed savings by consumers so interest rates would rise. Higher interest rates would encourage more savings and discourage borrowings. c) interest rates fluctuate until the amount saved by households is equal to the amount borrowed and invested by firms.

Classical Macroeconomy: The classical viewpoints of macroeconomy was associated with 18th century economists and prevailed until the great depression of the 1930's. > " Voluntary" Unemployment

The classical economists believed unemployment was "Voluntary." EX: if the going wage rate was $7 an hour and unemployed workers would only accept jobs that paid $9 an hour, then they were simply "Voluntarily" unemployed because THEY would NOT ACCEPT the GOING WAGE, which would cause employers them if they took the going wage rate.

Consumption and Savings Schedule: The consumption Function shows a direct (positive) relationship between the amount of consumption expenditure and the level of disposable income. > 45* (Degree) reference line

The consumption graph is drawn against a 45 (degree) reference line which bisects the 90* right angle formed by the vertical axis (measuring consumption) and horizontal (measuring disposable income) a) 45* Line has a slope of. It represents all points where consumption= Disposable Income (C = DI) b) the actual consumption function graph has a slope less than one so it will appear flatter the 45* line. c) The result, consumption function graph intersects the 45* line ONE time at the "BREAKEVEN INCOME LEVEL" or "CROSS POINT" In that case, all disposable income ($2,000) is spent and the saving is zero. (The disposable income was $2,000 and the consumption, how much you spent, was 2,000. So it means you spent all of your disposable income and saved nothing.) i) disposable income levels less than (<) the breakeven income or cross point the consumption function graph will lie above the 45* line and the vertical distance between the graphs represent the dis-savings. ii) disposable income greater than (>) the breakeven income the consumption function graph will lie above the 45* line. The vertical distance between the two graphs represents the amount of savings.

Equilibrium GDP vs Full employment GDP: Autonomous changes in consumption or investment spending cause multiplied increase in GDP because of the multiplier process. > respending process

The multiplier process occurs of the respending process. - the initial increase in investment spending is received as income, the MPC will dictate how much of the initial investment they want to spend ( inc. GDP x MPC) - while MPS will dictate how much will be saved. (inc. GDP x MPS) - That portion spent on consumption (the total of the MPC) will be received as income by another group of people who will spend and save it determined by the MPC and MPS. for instance: $125 billion increase in investment spending is received as income. spend: _______________________ MPC= .75 125 x .75 = $93.75 Save: ________________________ MPS = .25 125 x .25 = $31. 25 The 93.75 that is spent on consumption will be received as income by another group of people who will in turn spend .75 of it ( $93.75 x .75 = $70.31) and save .25 of it ($93.75 x .25 = $23.44)

Business Cycle: The business cycle is irregular fluctuations in the unemployment rate and GDP. It consists of four phases: 3rd: trough phase

Trough phase, actual GDP is far below its potential and unemployment rate is high. Businesses go bankrupt and investment in new plant and equipment is low because firms now have the excess productive capacity- low levels of demand does not warrant buying new machinery or expanding capacity. a) EX: Great Depression with the stock market crash of 1929. the unemployment rate reached a high 25% of the labor force in 1933. Real GDP was 1/3 less in 1933 than in 1929. b) hardships caused by recessions and depressions can have positive effects of reducing the Rate the Inflation and driving inefficient firms out of business, which frees up resources to other more productive uses.

Unemployment: Labor force and unemployment calculations:

Unemployment Rate %= # Unemployed / # Labor force *unemployed is given so find labor force then divide the two numbers. * to find Labor force simply add the employed and unemployed (which is provided) so... take the unemployed and divide it by the labor force that you found by adding the employed and unemployed= Unemployed Rate. BUT TO MAKE IT A PERCENT MULTIPLY THAT TOTAL BY 100 TO = THE UNEMPLOYED RATE % Example #4 in packet: employed: 133.6 unemployed: 7.2 Not in the labor force: 134.5 Labor force: 133.6 + 7.2 = 140.8 7.2 / 140.8= 0.05.... 0.05... X 100= 5% Unemployment Rate %= 5%

Equilibrium GDP vs Full Employment GDP Autonomous changes in government spending (or tax cuts) cause a multiplied increase in GDP which closes the recessionary gap: > spending multiplier > Needed inc. gov't. spending

Used to find the necessary increase in government spending to close the recessionary gap (the difference between full employment GDP and equilibrium GDP), LOOK AT CHART IN CH. 11 NOTES FOR EX - spending multiplier formula: 1/ MPS 1/ .25= 4 Spending multiplier= 4 ____________________________________________ to find the necessary increase in government spending to close the recessionary gap: Formula: recessionary gap / spending multiplier. Spending Multiplier: 1/.25 =4 Recessionary Gap is 1,000 1,000 / 4= 250 The needed increase in government spending would have to $250 - the aggregate expenditure line (C + I + G) shifts upward by the amount of the autonomous increase in government spending by $250).This means the new higher C + I + G aggregate expenditure line now intersects the 45 degree line at the full employment level of 4,000. a) the increase in government spending of $250 resulted in a 1,000 increase in GDP (because we went from 3,000 to 4,000 so that is a $1,000 increase) because of the spending- responding process of the multiplier. b) total government spending is now $375 (the initial level of $125 plus the increase of $250). So when you add all the expenditures with the new government spending it will add up to be 4,000 in aggregate expenditure and that equals the GDAp that is also 4,000 (hence we have now Full employment equilibrium)

investment demand (marginal efficiency on capital): Shifts in the investment demand curve: > New technology

a business will be more likely to increase investment in an industry where technology is changing than in an industry with a more fixed technology. businesses recognize the need to keep up with competitors' utilization of modern technology. At any given level of the real interest rate you would expect investment demand to be higher the more technology is advancing EX: smart, inexpensive computer chips reduce the number of moving parts in new machinery and equipment while increasing its productivity significantly. Demand investment demand curve line would shift to the right.

Unemployment: The official unemployment rate is UNDERSTATED in times of recession because of the presence of: > Discouraged workers > Part Time and Temporary Workers

a) Discouraged workers: have stopped looking for work, because there are few jobs available. They are NOT COUNTED as being unemployed or in the labor force even though they would like to have a job because they are NOT actively looking for work. b) Part-Time and Temporary workers: counted as being fully employed, even though they may be looking for a permanent, full-time job during their off hours. c) offsetting these two understating factors are the fact that some employees work more than 40 hours a week even though they only count as a signal full-time worker, and some unemployed workers falsely state that they are looking for a job because it sounds better or it allows them to remain eligible for unemployment benefits when in fact they are not actually seeking employment.

investment demand (marginal efficiency on capital): shifts in the investment demand curve: > acquisition and maintenance cost

acquisition and maintenance cost: acquisition costs are total cost that a company recognizes for property equipment after adjusting for discounts, incentives, closing costs, and other necessary expenditures but before sales tax. Acquisition may also entail the amount needed to take over another firm or purchase an existing business from another company. maintenance costs are costs incurred to keep an item in good condition or goo working order. sometimes items that merely leased and not owned such as a leased car will require the operator to pay maintenance expenses. EX: decrease because of intensive world wide competition in machine and improved services and warranty agreements on new equipment - Demand curve shifts to the rights.

Business Cycle: There are several theories about what causes business cycles: ~ under consumption or over investment theories

argue significant increases in productivity from new production techniques are not matched by a similar rise in consumption. Often governed by social customs and spending habits which are much slower to change. * AKA: increases in productivity from new production techniques, are not matched by a similar rise in consumer demand, which is often governed by social customs and personal spending habits that are much slower to change. a) EX: British economist John Hobson argued imperialism by European countries at the turn of the 19th century was motivated by their need to find new captive markets for the excess output of manufactured goods.

Business Cycle: There are several theories about what causes the business Cycle: ~ Psychological Theories

believes the public can get caught up in predictions of collapse which generate a wave of pessimism depressing economic activity. Likewise, the expectation of prosperity can result in excessive optimism which sows the seeds of a boom. a) British Economist Arthur C. Pigou believed cycles were triggered by real underlying factors, which caused changes in prevailing attitudes of businessman, investors, and consumers.

Classical Macroeconomics: The classical viewpoint of macroeconomy was with 18th century economists and prevailed until the great depression of the 1930's. > inherent tendency to full employment- "Laissez faire"

classical economists believed the economy had an inherent tendency to gravitate to full employment if disturbed by a recession (usually caused by speculative bubbles or war) the economy would automatically correct itself if left alone. a) they believed government economic policy on non- intervention or "Laissez Faire" was more appropriate since government interference kept the market system from working properly and made things worse rather than better.

Discretionary Fiscal Policy requires legislation action- congress must pass a law authorizing change in taxes or government spending. > Discretionary fiscal policy

discretionary fiscal policy include: a) increasing public works expenditures to create new jobs. b) expanding or lengthening benefits such as unemployment compensation or welfare payment. c) cutting tax rates by instituting temporary tax rebates. i) temporary tax cuts changes have less effect than permanent ones because consumption expenditures are heavily influenced by permanent change in disposable income than by than by temporary windful changes in disposable income. d) about 80% of spending by the federal government is on entitlement programs such as such as social security which are "uncontrollable" because their current revenues and expenditures result from decisions made in previous years. - less than 20% of the federal budget is subject to discretionary changes.

Business Cycle: There are several theories about what causes business cycles: ~ external shock theories

external shock theories: attribute business cycles to outside forces such as wars, weather (floods and droughts), gold discoveries, and speculative bubbles which jolt the economy in unexpected ways. a) EX: English economist William Stanley Jevon's "sunspot Theory" believed that nuclear storms on the sun's surface were correlated with changes in agriculture yields on earth (this has long since been disproved).

investment Demand (marginal efficiency of capital): The national debt imposes several burdens on the current and future generations. > Higher interest rates > Crowding out effect

higher interest rates result from sellling increased amount of government bonds may cause inflationary pressure which crows our private investment in capital goods and equipment when economy is close to full employment. Investors will om=ce to ecpect substantial inflation becuase of inerest payments will beome larger rates to compensate for the antisipated inflation. a) investors will hold smaller idle cash balances and since they expect the value of money to fall and they will buy more goods and real assets since prices are expected to rise because of anticipated inflation . b) interest charges on the federal government public Debt were $200 billion in 2005 making it an 4th largest expenditure item in the budget. c) "Crowding out Affect* crowding out of investment spending can occur when the higher interest rates caused by deficit financing makes the deficit financed increase in government spending to be less expansionary than it would be otherwise d) the sequence of events according to the crowding out effect is as follows inc. Gov't spendings > inc. deficit > inc interest rates> dec. in investment. spending.

Classical Macroeconomics: The keynesian Theory of national output and unemployment is associated with 20th century british economist John Maynard Keynes. He CRITICIZED the classical viewpoints and came to a different conclusion about the role of government in economic affairs: > John Maynard Keynes

in his 1936 book, "The General Theory of Employment, interest, and Money" John Maynard Keynes argued that savings may not always be equal to investment since they were done by different groups of people who have different motivations. a) savings is done by households out of their disposable income with the intention of putting some money aside for a rainy day or to accumulate the funds needed for the purchase of a big ticket item. Most important determinant of saving is the level of disposable income. For instance, when disposable income is VERY LOW, then households need all their income to buy necessities and cannot save even if interest rates are high. b) investment: in building new plants and installing additional equipment is done by business firms for the purpose of increasing their profit. A primary factor in determining whether to invest in new plant or equipment is the expected rate of return (Profit %) on the investment. if Rate of return on capital projects is below the interest rate firms pay on the borrowed funds, companies will cancel or postpone much of their intended investment spending. c) Keynes concluded changes in the interest rate may NOT guarantee that savings will automatically equal the level of intended investment at the full employment level of GDP. Primary determinants: (households) savings= disposable income (businesses) investment= expected rate of return secondary determinant: (households) savings= interest rate (businesses) investment= interest rate

Investment demand (marginal efficiency of capital): Firm's investment in capital projects (new factories and equipment) is based on their expected rate of return and the current market interest rate. > interest rate

interest rate is the COST OF BORROWING the money necessary to undertake any or all of the capital investment projects. a) It's assumed the firm borrows money in a competitive financial market so the amount of funds it borrows does not influence the going interest rate it has to pay. i) graphically, (current) interest rate% appears as a horizontal line.

Unemployment: There are several major types of causes of unemployment: ~ Cyclical unemployment

is caused by a temporary decline in demand, because of recession. This type of unemployment can be reduced by expansionary monetary and fiscal policies to stimulate the economy. When economy recovers and demand picks up, many cyclically unemployed workers are hired back.

Aggregate Supply and demand model: The short run aggregate supply curve shows the total production of goods and services by all firms at various price levels. It consists of three distinct ranges: 3- classical (vertical) range

occurs when economy is operating at full employment level. Increases in the Aggregate demand in the classical section of the aggregate supply curve results in rising prices, hence, inflation. - No increase in output because of lack of idle resources which prevents any increase in production. * classical economists believed the economy had an inherent tendency to gravitate to full employment. - price levels increase dramatically while output expands only slightly.

Unemployment: There are several major types or causes of unemployment: ~Frictional unemployment

people searching for better paying jobs and recent college graduates looking for first time jobs. Takes time for workers to match their skills with an employer needing them, so frictional unemployment can never be zero (except in a forced labor society)

Business Cycle: There are several theories about what causes business cycles: ~ Monetary Theories

rapid expansions or contractions in Money Supply affect interest rates, in turn, affect the availability of loans and credit. Low interest rates lead to speculative while high- interest rate induces a credit crunch. a) American Economist Milton Friedman's showed a close correlation between the stock of money and the expansion and contraction phases of the business cycle.

investment demand (marginal efficiency of capital) investment spending is more volatile (unstable) and subject to sudden fluctuations than consumption expenditures because of its interest rate sensitivity as well as: > variability of expectations > optimistic/ pessimistic expectations > durability of capital > existing capacity utilization > irregularity of innovation

reasons why capital and spending is very volatile: "Variability of expectations" changes in current and future profitability brought on by disparate factors such as domestic politic climate; antitrust laws, and court decisions; popular growth trends, and energy developments give rise to substantial shifts in businessmen optimism and pessimism about economic opportunities. "optimistic/ pessimistic expectations" by businessmen about the economy, legal developments, social changes, political events, and environmental/ energy problems which impact investment decisions by stimulating or dampening spending on capital projects. "durability of capital" plant and machinery have long useful lives. when business conditions are poor or uncertain, the purchases of new and modern equipment are postponed by decisions to repair and renovate older facilities and equipment or to use existing productive capacity. "Existing capacity utilization" excess unused plant and equipment occurs when sales are slack and firms let their old machinery wear out without replacing it. when sales increase unexpectedly, firms find their existing capacity inadequate and increase their investment spending to get their productive capacity back in line with sales. " irregularity of innovation" major technological progress and improvements such as railroads, electricity automobiles, and computer often occur in "waves" with a tremendous increase in investment spending on the new and related industry during the growth phase. But Investment expenditures significantly level off and eventually decline once the innovation reaches maturity and saturation of the market sets in. so pretty much... significant new products or production methods can rapidly spread through the economy and cause increase in investment, consumption, output, and employment; but the economy may slow down or possibly decline after new innovation has been absorbed.

Consumption and Savings Schedule: The savings function shows a direct (positive) relationship between the amount of personal savings and the level of disposable income. Marginal Propensity to Save (MPS)

relative (percentage %) number which measures the proportion of an increase in disposable income that is saved. a) Formula to calculate MPS: increase in saving divided by increase in disposable income. MPS= ^S / ^DI b) Disposable income increased from $2,500 to $3,000 (point C to D). and personal savings tose from $125 to $250. Thus, MPS would be $125 (inc. in savings) divided by $500 (inc. in disposable inc.) to equal 25% - so pretty much find the difference in personal savings and disposable income, then take those two totals and divide them in their order( savings / DI) Take that total and times it by 100 to make it a percentage. c) MPS is a constant for a straight lines savings function. Every $500 increase in disposable income (shift to the right 500) is a constant $125 increase in savings (shift up 125). Graphically the Marginal propensity to save (MPS) represents the slope of the savings graph.

Equilibrium GDP vs Full employment: Autonomous changes in consumption or investment spending causes a multiplied increase in GDP because of the multiplier process. > spending multiplier

spending multiplier is equal to 1 divided by the marginal propensity to save. 1/ MPS hints- MPS will always be less than 1. It will be a decimal or a fraction. Why? because people save less than 100% of any change in the income. Any change in income is partially saved and partially spent. what is saved and spent is determined by the consumer MPS and MPC. SO... Now that we know MPS is less than one when were finding the tax multiplier (1/ MPS) the total of the tax multiplier must always be greater than 1. MPS= .25 so... 1 / .25= 4 tax multiplier= 4 Total increase in GDP is $500. so... take the increase in GDP and ADD it to the GDP now to get the new GDP. GDP increased by 500 GDP was 2,500 500 + 2500 = $3000

Equilibrium VS full employment GDP: Autonomous changes in government spending (or tax cuts) cause a multiplied increase in GDP which closes the recessionary Gap. The formulas in summary:

spending multiplier: 1/MPS Tax multiplier: MPC / MPS Balanced budget multiplier: MPS / MPS= 1

Classical Macroeconomics: The classical viewpoint of macroeconomy was associated with 18th century economist and prevailed until the great depression of the 1930's. > disapproving classical viewpoints of Macroeconomy (SAY'S LAW)

the classical viewpoint could not explain massive unemployment and catastrophic drop in production that occurred during the great depression of the 1930's. The depression in the economy was continually stagnated for years instead of improving as predicted by classical Macroeconomics.

Equilibrium GDP vs Full employment: Autonomous changes in consumption or investment spending cause a multiplied increase in GDP because of the multiplier process.

when aggregate expenditure (consumption + investment) line shifts upward or downward because of autonomous increase or decrease in consumption expenditures or investment spending it induces (causes) a larger change in the level of GDP via the multiplier process.