Lesson 6 & 7

Circumstances and policies abroad can affect the real GDP in the US in a private open economy model

-An increase in real output and incomes in other nations that trade with the US will increase net exports, and thus real GDP -A depreciation in the value of the dollar will increase the purchasing power of foreign currency and increase US exports, and thus real GDP -During recession, nations often look for ways to increase exports and decrease imports to boost net exports and GDP; it's tempting to pursue a policy of raising tariffs or devaluing currency, but it's short-sighted because other nations are likely to retaliate and start a trade war (this happened in the great depression)

Legal and institutional environment

1. Increase AS -decrease in business taxes -increase in business subsidies -decrease in government regulation 2. Decrease AS -increase in business taxes -decrease in business subsidies -increase in government regulation

Reasons for the inverse relationship between real output and price level and the downward slope of the aggregate demand surve

1. Real balances effect 2. interest-rate effect 3. foreign purchases effect

Non-income determinants of consumption and saving

1. Wealth: the amount of wealth affect the amount that households spend and save 2. Borrowing: the level of household borrowing influences consumption 3. Expectations: expectations about the future affect spending and saving decisions 4. Real interest rates: real interest rates change spending and saving decisions 5. taxes: an increase in taxes will reduce both consumption and saving; a decrease in taxes will increase both Both consumption and saving schedules tend to be stable over time unless changes by major tax increases or decreases; the stability arises from long-term planning and because some non-income determinants cause shifts that offset each other

Non-interest determinants of investment demand

1. acquisition, maintenance, and operating costs - an increase will decrease investment demand 2. business taxes - an increase will decrease investment demand 3. technological progress - an increase will increase investment demand 4. stock of existing capital goods (relative to output and sales) - an overstock will decrease investment demand 5. planned changes in inventory - planned increase in inventories will increased investment demand 6. expectations of the future - if expectations are positive, increase in investment demand

Reasons for downward inflexibility of the price level

1. price war - fear of starting one 2. menu costs - costs relating to changing prices 3. wages - if wages are determined by long-term contracts, can't be changed in short run 4. morale, effort, and productivity - may be affected by changes in wage rates 5. minimum wage - puts a legal floor on wages for least skilled workers

Input prices

A change in input prices for resources used in production will change AS in the short-run Lower input prices increase AS; higher input prices decrease AS Includes both domestic and imported resource prices: 1. Domestic resource prices: include the prices for labor, capital, and natural resources used for production 2. Imported resources prices: include cost of paying for resources imported from other nations -If dollar appreciates (gets stronger), it will cost less to pay for imported resources, and AS will increase -If dollar depreciates (gets weaker), it will cost more to import resources, and AS will decrease

Lump-sum tax

A lump-sum tax is a fixed amount of tax revenue collected regardless of the level of GDP Model assumes that taxes are purely personal taxes and lump-sum taxes

Relationship between APC and APS

APC + APS = 1

Average propensity to consume (APC)

APC = consumption / income The percentage of income spent for consumption APC falls as DI increases

Average propensity to save (APS)

APS = saving / income The percentage of income saved APS increases as DI increases

Actual investment, planned investment, and unplanned investment

Actual investment = planned + unplanned investment At any level of real GDP, saving = actual investment (they are both defined at the output of the economy - consumption) Saving and planned investment may not equal real GDP because there may be unplanned investment Only at the equilibrium level of real GDP will saving and planned investment be equal (there is no unplanned investment)

Foreign purchases effect

An increase in the price level (relative to foreign price levels) will reduce U.S. exports, because U.S. products are now more expensive for foreigners, and expand U.S. imports, because foreign products are less expensive for U.S. consumers. As a consequence, net exports will decrease, which means there will be a decrease in the quantity of goods and services demanded in the U.S. economy as the price level rises. A decrease in the price level (relative to foreign price levels) has the opposite effects

Real balances effect

An increase in the price level decreases the purchasing power of financial assets with a fixed money value, and because those who own such assets are now poorer, they spend less for goods and services A decrease in the price level has the opposite effect

Multiplier effect

An initial change in spending results in a change in real GDP that is greater than the initial change in spending There is a direct relationship between a change in spending and a change in real GDP, assuming prices are sticky

Increase in aggregate supply

Arising from an increase in productivity, this has the beneficial effects of improving real domestic output and employment while maintaining stable price level (double bonus) Between 1996 and 2000, there was strong economy growth, full employment, and low inflation. These outcomes occurred because of a increase in aggregate demand in combination with an increase in aggregate supply from an increase in productivity due to technological change.

Productivity

As productivity (output/input) improves, per-unit production costs decrease and AS will increase As productivity decreases, per-unit production costs increase and AS will decrease

Changes in investment (or consumption)

Changes in investment (or consumption) will cause the equilibrium real GDP to change in the same direction by an amount greater than the initial change in investment (or consumption) due to the multiplier effect

Relationship between disposable income, consumption, and saving

Disposable income = consumption + saving Disposable income is the most important determinant of both consumption and saving In graph form, consumption is on vertical access and disposable income is on the horizontal access The 45-degree line would should where consumption would equal disposable income (break-even level income)

Relationship between equilibrium level of real GDP and full employment

Equilibrium real GDP may be: 1. less than full employment 2. at full employment 3. at full employment with inflation

Equilibrium real GDP from a leakages and injections perspective

From a leakages and injections perspective, the equilibrium GDP is the real GDP at which leakages (saving + imports + taxes) equals injections (investment + exports + government purchases) Sa + M + T = Ig + X + G

Wealth effect

If a household's wealth increases, people will spend more because they think they have more assets from which to support current consumption possibilities, and they will save less During a recession, there is typically a reverse wealth effect as wealth declines, and consequently people spend less and save more Such a situation creates a paradox of thrift in which more saving helps household budgets and at the same time the decline in spending from more saving worsens the recession

Equilibrium real GDP greater than full employment

If aggregate expenditures are greater than those consistent with full-employment real GDP, then there is an inflationary expenditures gap (vertical distance) This expenditures gap results from excess spending and will increase the price level, creating demand-pull inflation The size of the inflationary gap equals the amount by which the aggregate expenditures schedule must decrease (shift downward) if the economy is to achieve full-employment real GDP

Government spending

If tax collections and interest rates do not change as a result of spending, more government spending will increase AD; less government spending will decrease AD

Equilibrium real GDP less than full employment

If the equilibrium real GDP is less than the real GDP consistent with full-employment real GDP, there exists a recessionary expenditures gap Aggregate expenditures are less than what is needed to achieve full employment real GDP The size of the recessionary expenditures gap equals the amount by which the aggregate expenditures schedule must increase (shift upward) to increase real GDP to its full-employment level (vertical distance); the recessionary gap times the multiplier equals the negative GDP gap Keynes's solution to close a recessionary expenditures gap and achieve full-employment GDP was either to increase government spending or decrease taxes (which would work through the multiplier effect to lift aggregate expenditures) As an economy moves to full-employment, prices should not be assumed to be stuck, and thus will rise (this is a downfall of the model)

Investment spending

If the price level is constant, and businesses spend more on investment, AD will increase; if businesses spend less on investment, AD will decrease 2 factors that increase or decrease investment spending 1. real interest rates 2. expected returns (influenced by expectations about the future business conditions, state of technology, the degree of excess capacity, and business taxes)

Consumer spending

If the price level is constant, and consumers spend more, AD will increase; if consumers spend less, AD will decrease 4 factors that increase or decrease consumer spending 1. consumer wealth 2. household borrowing 3. consumer expectations 4. personal taxes

Net export spending

If the price level is constant, and net exports increase, the AD will increase; if net exports are negative, AD will decrease 2 factors explain increase/decrease in net export spending: 1. national income abroad 2. exchange rates (value of dollar)

Determinants of aggregate supply

Include changes in the prices of inputs for production, changes in productivity, and changes in the legal and institutional environment in the economy 1. input prices 2. productivity 3. legal and institutional environment

Borrowing

Increased borrowing will increase current consumption possibilities, which shift the consumption schedule upward But borrowing reduces wealth by increasing debt, which in turn reduces future consumption possibilities because the borrowed money must be repaid

Investment demand curve vs. investment schedule

Investment demand curve for business sector shows the inverse relationship between the real interest rate and the amount of total investment by the business sector Investment schedule for the economy shows the collective investment intentions of business firms at each possible level of disposable income or real GDP

Aggregate expenditures model background

Keynes developed the aggregate expenditures model occurred during the great depression when there was high unemployment and underutilized capital Prices were stuck or fixed because the oversupply of productive resources kept prices low As a result, business had to make output and employment decisions based on unplanned changes in inventories arising from economic shocks The model is valuable for analysis of our modern economy because in many cases prices are sticky or stuck in the short run The model is useful for understanding how economic shocks affect output and employment when prices are fixed or sticky

Relationship between MPC and MPS

MPC + MPS = 1

Marginal propensity to consume (MPC)

MPC = change in consumption / change in income The percentage of additional income spent for consumption Slope of consumption schedule

Marginal propensity to save (MPS)

MPS = change in saving / change in income The percentage of additional income saved Slope of saving schedule

Effects of changes in consumption and spending on real GDP

Macroeconomics are more concerned with the effects of changes in consumption and spending on real GDP (rather than on disposable income), and so it replaces disposable income on the horizontal axis with GDP

Multiplier

Multiplier = change in real GDP / initial change in spending Change in real GDP = multiplier x initial change in spending Multiplier = [1/(1-MPC)] = [1/MPS] The initial change in spending typically comes from investment spending, but changes in consumption, net exports, or government spending can also have multiplier effects It is directly related to the MPC and inversely related to MPS The significance of the multiplier is that relatively small changes in the spending plans of business firms or households bring about large changes in the equilibrium real GDP For the US economy, the multiplier is estimated to be a high of 2.5 to a low of 0 depending on the assumptions made and analysis conducted

Equilibrium real output and price level

Occurs at intersection between aggregate demand and aggregate supply curves

Decrease in aggregate demand

Reduces real output and increases cyclical unemployment, but it may not decrease price level In 2008, there was a significant decline in investment spending that reduced aggregate demand and led to a fall in real output and a rise in cyclical unemployment. The rate of inflation fell, but there was no decline in the price level because the economy experiences a "GDP gap with no deflation" where the price level is inflexible downward The price level is largely influenced by labor costs which account for most of the input prices for the production of many goods and services

Increase in aggregate demand

Results in an increase in both real domestic output and the price level An increase in the price level beyond the full employment level of output is associated with demand-pull inflation A classic example is in the 1960s when there was a sizable increase in government spending for domestic programs and the war in Vietnam

Say's law

Say's law states that supply creates its own demand It implies that the production of goods will create the income needed to purchase the produced goods The Great Depression led to doubts about this law and it was challenged by Keynes, who showed that supply may not create its own demand because not all income needed to be spent in the period it was earned, thus creating conditions for high levels of unemployment and economic decline

Aggregate demand curve

Shows that the total quantity of goods and services (real output) that will be purchased (demanded) at different price levels There is an inverse/negative relationship between the amount of real output demanded and the price level, so the curve slopes downward

Investment demand curve

Shows the inverse relationship between the real rate of interest and the level of spending for capital goods (down sloping) The amount of investment is determined at the point where r = i

Aggregate supply curve

Shows the total quantity of goods and services that will be produced (supplied) at different price levels The shape of the aggregate supply curve will differ depending on the time horizon and how quickly input prices and output prices can change 3 time periods: 1. immediate short run - horizontal, input & output prices fixed 2. short run - upward sloping, input prices fixed, output prices can vary 3. long run - vertical, input & output prices can vary

Determinants of aggregate demand (non-price level)

Spending by domestic consumers, businesses, government, and foreign buyers that is independent of changes in the price level are determinants of aggregate demand The amount of changes in aggregate demand involves 2 components: 1. the amount of the initial change in one of the determinants 2. a multiplier effect that multiplies the initial change There are 4 major determinants of aggregate demand: 1. consumer spending 2. investment spending 3. government spending 4. net export spending

Effect of taxes on equilibrium real GDP

Taxes decrease consumption and the aggregate expenditures schedule by the amount of the tax times the MPC Taxes decrease saving by the amount of the tax times the MPS An increase in taxes has a negative multiplier effect on the equilibrium real GDP

Immediate short run aggregate supply curve

The aggregate supply curve is horizontal because both input prices (ex. wages) and output prices remain fixed (ex. firm setting fixed price for customers) The horizontal shape implies that the total amount of output supplied in the economy depends directly on the amount of spending at the fixed price level

Short run aggregate supply curve

The aggregate supply curve is up-sloping because input prices are fixed or highly inflexible and output prices are flexible, and thus changes in the price level increase/decrease the real profits of firms The curve is relatively flat below the full-employment level of output because there is excess capacity and unemployed resources so per-unit production costs stay relatively constant as output expands (unemployed resources and unused capacity allow firms to respond to price-level rises with large increases in real output) But beyond the full-employment level of output, per-unit production costs rise rapidly as output increases because resources are fully employed and efficiency falls (resource shortages and capacity limitations make it difficult to expand real output as the price level rises)

Long run aggregate supply curve

The aggregate supply curve is vertical at the full-employment level of output for the economy because both input prices and output prices are flexible (in the long-run, the economy will produce the full-employment output level no matter what the price level is) Any change in output prices is matched by a change in input prices, so there is no profit incentive for firms to produce more than is possible at full-employment output

Aggregate expenditures model

The basic premise of the aggregate expenditures model is that the amount of goods and services produced and the level of employment depend directly on the level of total spending In the aggregate expenditures model, the equilibrium GDP is the real GDP at which aggregate expenditures (consumption plus planned investment) equal real GDP C + Ig = GDP In graphical terms, the aggregate expenditures schedule crosses the 45-degree line The slope of this curve is equal to the MPC

Consumption schedule

The consumption schedule shows the amounts that households plan to spend for consumer goods at various levels of income, given a price level In aggregate, households increase their spending as their disposable income rises and spend a larger proportion of a small disposable income than of a large disposable income

Equilibrium GDP in a private open economy

The equilibrium GDP in a private open economy is =consumption + investment + net exports (exports - imports) GDP = C + Ig +Xn Any increase in net exports will increase the equilibrium real GDP with a multiplier effect

Equilibrium GDP in a private/closed economy where real GDP=DI

The equilibrium GDP is the real GDP at which aggregate expenditures (consumption plus planned investment) equal real GDP GDP = C + Ig Equilibrium is achieved when planned investment equals saving and there are no unplanned changes in inventories The 45 degree line represent equilibrium; the equilibrium level of GDP is the intersection of the aggregate expenditures schedule and the 45 degree line Actual investment = planned + unplanned investment Unplanned investment = unplanned changes in inventories At above equilibrium levels of GDP, saving is greater than planned investment, and there will be unintended or unplanned investment through increases in inventories At below equilibrium levels of GDP, planned investment is greater than saving, and there will be unintended or unplanned disinvestment through a decrease in inventories

Expected rate of return (r)

The expected rate of return is directly related to the net profits (revenues - operating costs) that are expected to result from an investment It is the marginal benefit of investment for a business Expected rate of return is not guaranteed rate of return

Investment decision

The investment decision is a marginal benefit and marginal cost decision that depends on the expected rate of return (r) from the purchase of additional capital goods and the real rate of interest (i) that must be paid for borrowing funds When r > i, a business will invest because it will be profitable When r<i, a business will not invest because it will be unprofitable

Amount of change in real GDP

The multiplier is the ratio of the change in the real GDP to the initial change in spending [change in real GDP/initial change in spending] Therefore, the amount of change in real GDP = initial change in spending x multiplier

Real rate of interest (i)

The real rate of interest is the price paid for the use of money It is the marginal cost of investment for a business The real rate of interest, rather than the nominal rate, is crucial in making investment decisions The nominal interest rate is expressed in dollars of current value, while the real interest rate is started in dollars of constant or inflation-adjusted value Real interest rate = nominal interest rate - rate of inflation

Saving schedule

The saving schedule indicates the amount households plan to save at different income levels, given a price level In aggregate households increase their saving as their disposable income rises and save a smaller proportion of a small disposable income than of a large disposable income Dissaving (consuming in excess of after-tax income) will occur at relatively low disposable incomes

Leakages

There are other leakages from consumption besides saving, such as spending on imports, payment of taxes, or inflation

Decrease in aggregate supply

There will be a decrease in real domestic output (economic growth) and employment, along with a rise in the price level, or cost-push inflation (double harm) This happened in the mid-1970s when the price of oil substantially increased and significantly increased the cost of production for many goods and services, and reduced productivity [this doesn't happen anymore because oil is not as significant of a resource as it was in the past]

Aggregate supply and demand

Tools used to explain what determines the economy's real output and price level Variable price-variable output model They are different from demand and supply, which is used to explain what determines output and price level of a particular product Think about the total quantity of all final goods and services demanded and supplied

Factors that explain instability in investment

Unlike consumption and saving, investment is inherently unstable 4 factors explain this instability in investment that shifts the investment demand curve and thus leads to significant changes in investment spending 1. variability of expectations - concerning factors such as exchange rates, the state of the economy, and the stock market can change quickly 2. durability of capital goods - when durable capital goods are replaced depends on the optimism or pessimism of business owners 3. irregularity of innovations - technological progress is highly variable and contributes to instability in investment spending decisions 4. variability of profits - influences the investment spending of businesses; current high profits encourage investment, current low profits discourage investment

Wealth

Wealth is the difference between the values of a household's assets and its liabilities An increase in wealth will increase consumption and decrease saving

Equilibrium real GDP when the government both taxes and purchases goods and services

When government both taxes and purchases goods and services, the equilibrium GDP is the real GDP at which aggregate expenditures (C + Ig + Xn + G) equals real GDP

Interest-rate effect

With the supply of money fixed, an increase in the price level increases the demand for money, increases interest rates, and as a result reduces those expenditures (by consumers and business firms) that are sensitive to increased interest rates A decrease in the price level has the opposite effect