macroeconomics chapters 8, 9, & 10

Keynesian Economics

*Great Depression *Classical economics failed to have a story for the Great Depression e.g. thepersitently long unemployment *The General Theory of Employment, Interest, and Money, 1936 *Demand can be forever inadequate for an economy to achieve full employment *Labor and production is determined by how much people spend *The size of the economy (real GDP) depends on the total amount of expenditures *Keynesian solution to the Great Depression is to increase expenditures, which will incentivize firms to hire on workers

How can full employment be reached?

*Increase autonomous spending *Increase government spending *Lower taxes *Raise transfer payments

What are the three ranges of the aggregate supply curve?

*Keynesian - Price level is constant/GDP changes *Intermediate - Price level and GDP vary *Classical - Price level changes/GDP is constant

What are the two opposing theories for the shape of the AS curve?

*Keynesian view *Classical view

What are the two categories of government policies

*Monetary policy *Fiscal policy

Desirable property of money

*Portable *Divisible *Uniform *Acceptable

Classical

* The economy is always tending toward a full employment equilibrium * Supply creates its own demand * A continuing depression is iimpossible because markets eliminate persistent shortages or surpluses * The economy is self-regulating and will correct itself without government interference.

Why is the aggregate curve downward sloping?

*A higher price level makes domestically produced goods more expensive than foreigh goods *A lower price level leads to a lower interest rate

Aggregate Expenditure Model

*A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant *Focuses on short-run determination of total output in an economy

What two concepts does the Aggregate Demand curve deal with?

*Average prices *Market basket of goods

Where can a bank hold its required reserves?

*Cash in the bank's vault *Deposits at a Federal Reserve bank

What affects the level of consumption?

*Current disposable income (receive in a year) *Household wealth [home, stocks, bank accts minus liabilities (mortgages, loans)] *Expected future income (current/future income) *Price level (higher prices result in lower spending) *Interest rate (higher real interest rates encourage saving rather than spending)

Inflation Gap

*Cut government spending *Increase taxes *Reduce transfer payments

How is the consumption function affected by Households expecting a prolong recession to begin next year?

Downward shift in the consumption function

How is the consumption function affected if the interest rate on consumer loans rises sharply?

Downward shift in the consumption function

How is the consumption function affected if the price level rises by 10%?

Downward shift in the consumption function

Macroeconomic Equilibrium

Equilibrium in the economy occurs when spending on output is equal to the value of output produced. Aggregate expenditure = GDP

What affects the level of investment (planned investment)

Expectations of future profitability *firms build factories, office buildings, machinery, and equipment when they are optimistic about future profitability Interest rate *Business investment is financed by borrowing, the real interest rate is an important consideration for investing Taxes *Higher corporate income taxes decrease the money available for reinvestment, and decrease incentives to invest.

Misperceptions Theory

Fail to accurately predict changes in the price level. Base their supply decisions on the relative price of their product

The most fundamental assumption behind the aggregate expenditure model is that prices in the economy are flexible. (T or F)

False

Banks do not create money, because that is the Fed's responsibility. (T or F)

False. Banks create money by making loans and depositing those loans into checkable deposit accounts.

Consumption Function

Graph or table that show the amount households spend for goods and serves at different levels of disposable income

Government spending

Include purchases at all levels of government: federal state, and local *Not transfer payments; only purchases for which the government receives some good or service Autonomous expenditure *government spending can be the result of political decisions regardless of national output.

The Multiplier Effect

Increase in equilibrium real GDP divided by the increase in autonomous expenditures (investment, government expenditure)

taxes

REDUCE disposable income, and as a result, reduce consumption and savings

true / false: there is no relationship between the level of income and investment

TRUE

Why does the AD curve slope downward?

*Real balances effect - Consumers spend more on g/s because lower prices make their dollars more valuable. *Interest-rate effect - Assuming a fixed money supply, an increase in the price level increases borrowing demand and in turn higher interest rates, which discourages consumer spending. *Net exports effect - A higher domestic price level makes U.S. goods more expensive compared to foreign goods. As a result, exports (X) decrease and imports (M) increase, which decreases real GDP through the net exports component (X-M).

What can cause a shift in the AS?

*Resources prices *Technological change *Taxes *Government regulations

What two concepts does the Market Demand curve deal with?

*Specific prices *Specific good or service

Say's Law

*Supply creates its own demand *Producers produce goods, consumers want and consumers have the money to buy because of the wages they were paid *Unemployment possible but it is a short-lived adjustment period in which wages and prices decline or people voluntarily choose not to work

Dissaving

Amount by which personal consumption expenditures exceed disposable income

The Interest Rate Effect

The impact on total spending (real GDP) caused by the direct relationship between the price level and the interest rate. Higher prices result in higher interest rates and lower consumption.

The Real Balance Effect

The impact on total spending (real GDP) caused by the inverse relationship between the price level and the real value of financial assets with finxed nominal value. If prices increase, a household's financial balances will not purchase as many goods and services; If prices fall, a household's purchasing power increases and it can purchase more with its financial assets

What happens when aggregate expenditure is less than real GDP?

There is an unplanned increase in business inventories. This unplanned change in inventories will prompt firms to decrease employment and production.

The MPC and MPS must always add up to one. (T or F)

True (MPC + MPS = 1)

What will happen to the U.S net export if U.S. GDP grow fastsers than foreign GDP? Why?

U.S. Net export will decrease Because U.S. demand for imports rises faster than foreigh demand for U.S. exports

What will happen to the U.S net export if U.S. price level rises faster than foreigh price levels? Why?

U.S. Net export will decrease Because U.S. goods become more expensive, imports rise, exports fall

What will happen to the U.S net export if U.S. $ rises in values relative to other currencies? Why?

U.S. Net export will decrease Because imports are cheaper, exports more expensive, imports rise, exports fall

What happens to unemployment and price when stagflation happens:

Unemployment goes up, and price level goes down

How is the consumption function affected if stock prices rise sharply?

Upward shift in the consumption function

When does the long-run equililibrium occur?

When the AD and SRAS curves intersect at the LRAS level. When the economy is in short-run equilibrium, and GDP is at its full employment level.

What are the aggregate exenditure model components?

C+I+G+NX or C+I+G +(EXPORT - IMPORT)

as income grows consumption will grow but not as fast

CONSUMPTION IS STABLE

Forms of money

Currency and checkable deposits

marginal propensity to save (MPS)

the change in savings resulting from a change in real disposable income. MPS=S/Y or MPS=savings/income

government spending

includes the wages and salaries of government employees, and the purchases of products and services from private businesses and the rest of the world. also includes the purchase of new structures and equipment

government purchases:

-DO NOT DEPEND ON THE LEVEL OF INCOME IN AN ECONOMY -they are autonomous -no other determinants

determinants of long run aggregate supply

-capitol available -size and quality of the labor force -the technology being employed

determinants of aggregate demand

-consumer spending -investment -gov spending and net exports

components of aggregate expenditure

-consumption -investment -government spending -net exports of goods and services **AE=C+I+G+NX NX=EXPORTS - IMPORTS

other determinants of investments

-expectations -technological change -operating cost -capital goods on hand

investment

-fixed investments, or investments in such things such as structures, equipment, software, and changes in private businesses; INCLUDES NEW HOUSING -15% of GDP

consumption

-goods and services purchased by residents and businesses of the United States; DOES NOT INCLUDE THE PURCHASING OF NEW HOUSING -70% of GDP

tools of discretionary fiscal policy

-government spending-taxes -disposable income

other determinants of net exports

-income of other countries -exchange rates

shifts of long run aggregate supply

-increase in technology -greater human capital increases in labor quality enhancement -trade increases -innovation, research, and development

determinants of short run aggregate supply

-input prices -productivity -taxes and regulations -market power of firms -expectation

simple spending multiplier

-one persons spending becomes anothers income -1/ (1- MPC) ex: if MPC is .8 and a potential increase is too, then 100/(1-.8)=500 increase in spending

short run aggregate supply will shift to the left when

-technology declines -changes in human capital decline -taxes are higher -subsidies are lower additions in regulations -market power increases -negative business expectation -higher inflation expectations

short run aggregate supply will shift to the right when

-technology improves -changes in human capital improve -taxes are lower -subsidies are higher -reduction to regulations -market power increases -positive business expectations -lower inflation expectations

other determinants in consumption

-wealth -expectations -house hold debt -taxes

factors that shift the aggregate expenditure line

-wealth -financial wealth -physical wealth -interest rates -consumer confidence -technology -fiscal policy -exchange rates

aggegcate demand shifts to the left when:

-wealth decrease -consumer expectations worsen -household debt rise -taxes increase -interest rates rise -expected tare of return on investment is lower -government spending decreases -net exports decrease -income in other countries falls -appreciating dollar

aggregate demand shifts to the right when

-wealth increase -consumer expectation improve -household debt falls -taxes are lowered -interest rates fall -expected rate of return on investment is higher -net exports increase income in other countries rise -depreciating dollar

Stagflation

A combination of inflation and recession, usually resulting from supply shock.

Store of Value

A means of transferring purchasing power from the present to the future by keeping money in a savings account.

How is the consumption function affected if income tax rates increase?

A movement down along the consumption function

Near monies

Are interest-bearing deposits that are easy to convert into spendable funds (savings and small time deposits)

Real-balances Effect

As the aggregate price level rises, the purchasing power of households' saving balances will decline, causing the quantity of output demanded to decline.

Autonomous consumption

Consumption that is independent of the level of disposable income

Sticky-Wage Theory

Contracts make some wages and prices rise slowly

Net Exports Effect

Higher domestic prices make domestically produced items more expensive resulting in importing cheaper items.

What happens to Aggregate Expenditure if equal to GDP?

Inventories are unchanged and the economy is in macroeconomics e1quilibrium

What happens to Aggregate Expenditure if greater than GDP?

Inventories fall and GDP and employment increase

What happens to Aggregate Expenditure if less than GDP?

Inventories rises and GDP and employment decreases

Unit of Account

Money acts as a unit of account by providing buyers and sellers a common reference point for valuing goods and services.

Medium Exchange

Money provides an accepted method of payment for goods and services

Fiat Money

Money that has value because it is accepted by law.

Commodity Money

Money that is backed by a precious medal

Net exports

Net exports equals exports minus imports. It is affected by: *Price level U.S. vs price level in other countries *U.S. growth rate vs. growth rate other countries *U.S. dollar exchange rate

What will the price level do in the long-run, as a result of the business pessimism?

Price level decreases, the quantity of output returns to potential output, and the unemployment rate returns to the natural rate of unemployment

What will price level expectations be if during the transition from the short run to the long run?

Price level expections will adjust downward, and the short-run aggregate supply curve will shift to the right

When consumers expect an economic downturn, aggregate demand will move which way?

Shift left. Consumers will want to save more money and spend less resulting with AD shifting to left as consumers purchase less at all price levels

If price of crude oil rises significantly, the aggregate supply curve moves which way?

Shift left. Resulting in an increase in price levels, a decrease in real GDP, and a decrease in employment.

If the federal government increases the excise tax on gasoline in order to finance a deficit, the aggregate supply curve moves which way?

Shift left. This would increase the cost of producing goods and services.

If price of gasoline increases because of a catastrophic oil spill, the aggregate supply curve moves which way?

Shift left. When price of gasoline increases, this increase the cost of transportation of goods and services resulting in cost-push inflation

If the federal government increases spending for highways, bridges, and other infrastructure, aggregate demand will move which way?

Shift right.

If the U.S. increases exports of wheat and other crops to Russia, Ukraine, and other former Soviet republics, aggregate demand will move which way?

Shift right. An increase in exports increases the next export component of AD.

If a new U.S. president is elected, and the profite expections of business exectutives rise, aggregate demand will move which way?

Shift right. As profit expectations rise, businesses increase their investment spending on plant and equipment at all price levels

If power companies switch to solar power, and the price of electricity falls, the aggregate supply curve moves which way?

Shift right. Decrease in price of electricity will be general decrease in costs of producing goods and services.

An improvement in technology raises labor productivity, the aggregate supply curve moves which way?

Shift right. Resulting in a decrease in price levels, an increase in real GDP, and an increase in employment.

If spending on national defense doubles, the aggregate demand curve moves which way?

Shift right. Resulting in an increase in price levels, an increase in real GDP, and an increase in employment.

If the costs of imported goods increase, the aggregate demand curve moves which way?

Shift right. Resulting in an increase in price levels, an increase in real GDP, and an increase in employment.

If labor unions and all other workers agree to a cut in wages to stimulate the economy, the aggregate supply curve moves which way?

Shift right. When wage rates decrease, this decreases the cost of producing goods and services, resulting in decrease in overall costs.

Aggregate Demand Curve (AD)

Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government *vertical axis measures average price of g/s *horizontal axis measures value final g/s *

Sticky-Price Theory

Some firms are slow to adjust prices when level rises or falls

What is a supply shock?

Sudden movements in SRAS i.e. a sudden increase in oil prices shifts SRAS to the left.

Recession Gap

The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

Marginal propensity to consume (MPC)

The amount by which consumption spending changes when disposable income changes. *MPC is the slope of the consumption function MPC=change in consumption/chang in disposal income. i.e. national income rises by $2,000 billion, consumption rises by $1,500 billion. MPC=1,500/2,000=0.75 or MPC=C/Y

long run aggregate supply:

all variable in the economy can adjust and the economy will settle at full employment output Q0

expectation

as these improve, investment demands will increase

tax revenues and transfer payments...

automatically adjust to economic fluctuations without actions by congress

net exports:

autonomous level of income

M2

consists of M1 plus small time deposits and savings

M1

consists of checkable deposits and currency

saving

disposable income that households do not spend for consumer goods and services

net exports of goods and services

exports minus imports

discretionary fiscal policy

involves adjusting government spending and tax policies to move the economy toward full employment, encourage economic growth, and control inflation

demand size fiscal policies

involves using government spending, taxes and transfer payments to change aggregate

short run equilibrium

occurs at intersection of short run aggregate supply curve and aggregate demand curve CAN OCCUR BELOW FULLY EMPLOYMENT (recession) OR ABOVE FULL EMPLOYMENT (inflation)

long run equilibrium

occurs at the intersection of long run aggregate supply curve and the aggregate demand curve ECONOMY IS AT FULL RATE OF EMPLOYMENT

expectations

regarding future prices and income, expectation determine how much a person will spend today

automatic stabilizers

tax revenues and transfer payments automatically adjust to economic fluctuations without action by congress

household debt

the more debt a household has, the less they will be able to spend in a current period because they are paying off the debt

capital goods on hand

the more of these a firm has the less the firm will want to make new investments

wealth

the more wealth a family has, the higher its consumption on all levels of income. wealth affects the consumption schedule by shifting up or down depending on whether wealth rises or falls.

average propensity to consume

the percentage of income that is consumed. (consumption / income)

average propensity to save

the percentage of income that is saved (savings / income)

exchange rates:

the rates at which one price of currency can be exaggerated for another

If there is an decrease in AD curve...

there is a decrease in C, I, G, (X-M)

If there is an increase in AD curve...

there is an increase in C, I, G, (X-M)

technological change

these spur investments; THEY TAKE A LONG TIME TO REACH FULL POTENTIAL

Classical economist concluded that Say's Law is...

valid and that long-term unemployment is impossible because production of goods and services creates its own demand.

operating cost

when this rises, the rate of return on capital equipment declines, investment is postponed