Unit III Notes

Welcome to UNIT 3 NOTES!! :) This is all about aggegrate demand and supply. Be prepared to study these concepts and become familiar with them!!!

• Aggregate Demand (AD)

• Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level
• The relationship between the price level and the level of Real GDP is inverse
• Price Level * Real GDP = AD
• Three Reasons AD is downward sloping
1. Real-Balances Effect
• When the price level is high households and businesses cannot afford to purchase as much output
• When the price level is low households and businesses can afford the purchase more output
2. Interest-Rate Effect
• A higher price-level increases the interest rate which tends to discourage investment
• A lower price-level decreases the interest rate which tends to encourage investment
3. Foreign Purchases Effect
• A higher price level increases the demand for relatively cheaper imports
• A lower price level increases the foreign demand for relatively cheaper U.S. exports
• Shifts in Aggregate Demand (AD)
• There are two parts to a shift in AD:
1. A change in C, I_G, G, and/or X_N
2. A multiplier effect that produces a great change than the original change in the 4 components
• Increases in AD = AD shift right
• Decreases in AD = AD shift left
• More Government Spending = AD shift right
• Less Government Spending = AD shift left
• Net Exports
• Exchange Rates (International value of $)
• Strong $ = More imports and Less Exports = (AD shift left)
• Weak $ = fewer imports and more exports = (AD shift right)
• Relative Income
• Strong Foreign Economies = More Exports = (AD shift right)
• Weak Foreign Economies = Less Exports = (AD shift left)
• Aggregate Supply (AS)
• The level of Real GDP that firms will produce at each Price Level
• Long-Run v. Short-Run
• Long-Run:
• Period of time where input prices are completely flexible and adjust to changes in the price-level
• In the long-run, the level of Real GDP supplied is independent of the price-level
• Short-Run:
• Period of time where input prices are sticky and do not adjust to changes in the price-level
• In the short-run, the level of Real GDP supplied is directly related to the price-level
• Long-Run Aggregate Supply (LRAS)
• The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC)
• LRAS is always vertical at full employment
• Changes in Short-Run Aggregate Supply (SRAS)
• An increase in SRAS is seen as a shift to the right
• A decrease is a shift to the left
• The key to understanding shifts in SRAS is per unit cost of production
• Per-Unit production cost = total input cost / total output
• Determinants of SRAS (all of the following affect unit production cost)
• Input prices = land, labor, machinery, ETC.
• Productivity = technology
• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw Materials (commodity prices)
• Foreign Resource Prices
• Strong $ = lower foreign resource prices
• Weak $ = higher foreign resource prices
• Increases in Resource Prices = SRAS shift LEFT
• Decreases in Resource Prices = SRAS shift RIGHT
• Productivity
• Productivity = total output / total inputs
• More productivity = lower unit production cost = SRAS shift RIGHT
• Lower productivity = higher unit production cost = SRAS shift LEFT
• Legal-Institutional Environment
• Taxes

• Keynesian Range – They believe in a horizontal curve because when the economy is below full employment A.D. shifts outward.
• Increase in Real GDP, unemployment drops, and the price level is constant
• Demand creates its own supply
• Recession
• Intermediate range - this is where A.S. is between Keynesian and classical range. When this occurs, both GDP and the price level increases.
• Classical range – in the long run the A.S. curve is vertical because the only effects of an increase in A.D. when we are already at full employment. Thus supply creates its own demand. (Say’s Law)
• The AS/AD Model
• The equilibrium of AS & AD determines current output (GRP_R) and the price level (PL)

• Recessionary Gap
• A recessionary hap exists when equilibrium occurs below full employment output

• Inflationary Gap
• An inflation gap exists when equilibrium occurs beyond full employment output

• Increase in SRAS
• SRAS shift right, GDP_R goes up & price level goes down, u% down and inflation % down
• Decease in SRAS
• SRAS shift left, GDP_R goes down & price level goes up, u% up and inflation % up
• Money spent or expenditures on:
• Capital Equipment (machinery)
• New plants (factories)
• Technology (Hardware and software)
• New homes
• Inventories (goods sold by producers)
• Expected Rates of Return
• How does business make investment decisions?
• Cost / Benefit Analysis
• How does business determine the benefits?
• Expected rate of return
• How does business count the cost?
• Interest costs
• How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest cost
• How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then don’t invest!
• Real (r%) v. Nominal (i%)
• What’s the difference?
• Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.
• How do you compute the real interest rate (r%)?
• r% = i% - π%
• What then, determines the cost of an investment decision?
• The real interest rate (r%)
• Investment Demand Curve (ID)
• What is the shape of the investment demand curve?
• Downward sloping
• Why?
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
• Conversely, there are few investments that yield high rates of return, and many that yield low rates of return
• Shifts in Investment Demand (ID)
• Cost of Production
• Business taxes
• Technological change
• Stock of capital
• Expectations
• Consumptions and savings!
• Disposable income (DI)
• Income after taxes or net income
• 2 Choices
• With disposable income, households can either
• Consume (spend money on goods & services)
• Save (not spend money on goods & services)
• Consumption
• Household spending
• The ability to consume is constrained by
• The amount of disposable income
• The propensity to save
• Do households consume if DI = 0?
• Autonomous consumption
• Dissaving
• Saving
• Household NOT spending
• The ability to save is constrained by
• The amount of disposable income
• The propensity to consume
• Do households save if ID = 0?
• NO
• APC & APS (Average propensity to consume & Average propensity to save)
• APC + APS = 1
• 1 – APC = APS
• 1 – APS = APC
• APC > 1 : Dissaving
• –APS : Dissaving
• MPC & MPS
• Marginal Propensity to Consume
• Change in consumption / change in disposable income
• % of every extra dollar earned that is spent
• Marginal Propensity to Save
• Change in saved / change in disposable income
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 – MPC = MPS
• 1 – MPS = MPC
• The spending multiplier effect
• An initial change in spending (C, I_G, G, X_N) causes a large change in aggregate spending, or Aggregate Demand (AD).
• Multiplier = change in AD / change in spending
• Multiplier = change in AD / change in C, I, G, or X
• Why does it happen?
• Expenditures and income flow continuously which sets off a spending increase in the economy.
• Calculating the Spending Multiplier
• The spending multiplier can be calculated from the MPC or the MPS
• Multiplier = 1/1-MPC or 1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease
• Calculating the Tax Multiplier
• When the government taxes, the multiplier works in reverse
• Why?
• Because now money is leaving the circular flow
• Tax Multiplier (note: it’s negative)
• = -MPC / 1-MPC or –MPC / MPS
• If there is a tax-CUT, then the multiplier is +, because there is now, more money in the circular flow

                                                Here is a video to help you learn how to calculate all this stuff.

Here is an Example:

• Ex. Assume Germany raises taxes on its citizens by 200 billion euros. Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the 200 billion euros change in taxes on German economy.
• Step 1: calculate MPC and MPS
• MPS = 25%(give in the problem) = .25
• MPC = 1.MPS = 1- .25 = .75
• Step 2: Determine which multiplier to use, and whether its + or –
• The problem mentions and increase in T use (-) tax multiplier
• Step 3: calculate the spending and/or tax multiplier
• -MPC/ MPS = -.75/ .25 = -3
• Step 4: calculate the change in AD
• (change in Tax) * Tax Multiplier
• (200 billion euros change in T) * (-3) = - 600 billion euro in AD
• Fiscal Policy
• Changes in the expenditures or tax revenues of the federal government
• 2 tools of fiscal policy:
• Taxes: Government can increase or decrease in tax
• Spending: government can increase or decrease in spending
• Fiscal policy is enacted to promote our nation’s economic goals : full employment, price stability, economic growth
• Deficits, Surpluses, and Debt
• Balanced budget
• Revenues = Expenditures
• Budget deficit
• Revenues < Expenditures
• Budget surplus
• Revenues > Expenditures
• Government debt
• Sum of all deficits – sum of all surpluses
• Government must borrow money when it runs a budget deficit
• Government borrows from :
• Individuals
• Corporations
• Financial institutions
• Foreign entities or foreign government
• Fiscal Policy Two Options
• Discretionary Fiscal Policy (action)
• Expansionary fiscal policy – think deficit
• Contractionary fiscal policy – think surplus
• Non-Discretionary Fiscal Policy (no action)
• Discretionary v. Automatic Fiscal Policy
• Discretionary:
• Increasing or decreasing Government spending and/or taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
• Automatic:
• Unemployment compensation & marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.
• Contractionary vs. Expansionary Fiscal Policy
• Contractionary fiscal policy : Policy designed to decrease aggregate demand
• Strategy for controlling inflation
• Expansion fiscal policy : policy designed to increase aggregate demand
• Strategy for increasing GDP, combatting a recession, & reducing unemployment
• Expansion Fiscal Policy
• Recession is countered with expansionary policy
• Increase government spending
• Decrease taxes
• Contractionary Fiscal Policy
• Inflation is countered with Contractionary policy
• Decrease government spending
• Increase taxes
• Progressive Tax System
• Average tax rate (tax revenue/GDP) rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Regressive Tax System
• The more progressive the tax system, the greater the economy’s built-in stability.

Unit II

Unit II in macroeconomics is a little bit more complex than Unit I. This Unit has more equations and more math involved. I hope that my notes will help you to understand this unit and you can also use it for our next test! Here we GO!

• 4 types of Economic Systems
• Command Society aka Centrally Planned – government owns capital & land, and it controls labor
• Ex.: Cuba
• Traditional Society – 1. Habits    2. Rituals     3. Customs
  Decisions made by the elders and discourage new idea & technologies
• Ex.: tribes
• Free Market – people and firms act in their own best interest. Buyers & sellers exchange goods and services.
• Ex.: Hong Kong
• Mixed Economy – businesses are regulated by the government to protect the public’s interests
• Ex.: Canada, U.S., and Mexico
• Three Economic Questions
1. What goods and services should be produced?
2. How should these goods & services be produced?
3. Who will consume these goods & services?
• Market – it is an institution that allows buyers & sellers to trade
• Product V.S. Factor Market
• Product – the buyer is usually the consumer & the seller is a firm
• Factor (Resource) – F.O.P, the buyer is usually the firm and the seller is the factor owner.
• Household – a person or a group of people that share an income
• Gross Domestic Product (GDP) – total value of all final goods and services produced in the U.S. in a given year. Includes all production or income earned within the U.S. by U.S. and foreign producers.
• It does NOT include production outside of the U.S. even by Americans
• Gross National Product (GNP) – total value of all final goods and services produced by Americans in a year.
• Includes: production or incomes earned by Americans anywhere in the world.
• Excludes: production by non-Americans even in the U.S.

Just for comedy reasons... :)

• Formula for GDP : C + Ig + G + Xn
• C = Personal Consumption (67%)
• Purchases of finished goods and services
• Ex. you spend $7 to attend a movie.
• Ig = Gross Private Domestic Investment
• New factory equipment
• Construction of housing
• Factory equipment maintenance
• Unsold inventory of products build in a year
• Ex. A farmer purchases a new tractor.
• G = Government Spending
• Government purchases of goods and services
• Ex. Government closes school for the month of march.
• Xn = Net Export (Exports – Imports!!)
• Ex. A French company purchases a one-year membership to PartyPeople.com, a U.S. based
• Items that DO NOT count in GDP
• Used goods or second hand goods
• Gifts or transfers (gifts would be like a scholarship)
• Stocks and bonds
• Unreported business activities (waiter or waitress (cash tips))
• Illegal activities
• Financial transactions between banks
• Financial transactions between banks and businesses
• Intermediate goods (what you use to make a certain product)
• Intermediate goods (what you use to make a certain product)
• Non-market activities 
• Ex. Volunteering or baby sitting

A short video to help you understand what is counted and what is not counted in GDP.

• Expenditure approach VS Income approach
• Expenditure approach – income generated from production of goods and services
• C + Ig + G + Xn
• Income approach – we’re going to add all the income generated from the production of final output 
• W + R + I + P
• W = wages
• R = rents
• I = interests
• P = profits
• + Statistical Adjustments
• Both sides have to equal out 
• Net Domestic Product (NDP) – GDP adjusted for depreciation (aka consumption of fixed capital)
• GDP – Depreciation
• Gross National Product (GNP) - Depreciation
• Ex. something that loses value
• National Income (NI) – income earned by American owned resources whether it is here or abroad
• Net National Product (NNP)  – Indirect Business Taxes (IBT)
• CE + RI + II + CP + PI
• GDP – IBT – Depreciation  - Net foreign factor payment
• Personal Income (PI) - Income received by households regardless of the source
• Disposable Personal Income (DPI) – after tax income available for household consumption
• National Income (NI) – Household Taxes (HT) + GTP
• FORMULA FOR TRADE – exports – imports
• CE = Compensation of employee (wages), RI = rental income, II = interest income, CP = corporate profit, PI = Proprietor’s income
• Nominal GDP (NGDP) – measures GDP in current dollars no matter what the output is
• P * Q = NGDP
• Real GDP (RGDP) – measures GDP in constant dollars and is adjusted for inflation

This video explains nominal and real GDP!

• Firms – organization that produces goods and services for sale
• GDP Deflator: the measure of the level of prices of all new domestically produced final goods and services in an economy
• 
• Inflation Rate – a rise in the general level of prices

• Ex. A dollar today can buy less than it could yesterday.
• CPI – Consumer Price Index

• Deflation – A decline in the general price level.
• Disinflation – occurs when the inflation rate itself declines.
• Solving inflation problems: 2-3% inflation
• Rule of 70 – how many years will it take to double inflation.

• 
• Finding real interest rates:
• Real Interest Rate = Nominal interest rate – Inflation
• Real interest rate - the cost of borrowing or lending money that is adjusted for expected inflation. It is always expressed as a percentage!
• Nominal interest rate – it is an unadjusted cost of borrowing or lending money. It is always expressed as a percentage.
• Causes of inflation:
• Demand-pull – it is caused by an excess of demand over output that pulls prices upward
• output and employment rise while the price level is also rising
• spending increases faster than production
• 3 Sources:
1. increase in government purchases
2. excessive increases in the money supply
• create a condition called hyperinflation – a rapid rise in the inflation rate

                                              3.   rising incomes as the economy approaches full employment output

• Cost-push  (supply side economics) – caused by a rise in per unit production cost due to increasing resource cost
• 2 sources :
1. Supply shocks – dramatic rise in energy or raw material prices due to input shortages or growing demand for inputs
2. Price wage spiral – workers seek higher wages to offset higher consumer prices.
• Effects of inflation:
• Anticipated vs Unanticipated –
• Unanticipated inflation - has stronger effects because those expecting inflation may be able to adjust their work or spending habits to avoid or lessen the effects
• Wages and pensions may have cost of living adjustments (Cola) built in to offset anticipated inflation
• Fixed income group - they will be hurt because their real income suffers because their nominal income does not rise with prices.
• Savers – will be hurt by unanticipated inflation because inflation takes away from the interest earned on the account
• Borrowers – can be helped by unanticipated inflation while lenders – are hurt by unanticipated inflation because debts will be repaid with cheaper dollars than the ones that were loaned out
• GNP = GDP + Net foreign factor payment
• Net Private Domestic Investment + Depreciation = Gross Private Domestic Investment
• Unemployment: Failure to use unavailable resources
• Employed: Includes those that are self-employed
• Unemployed:
• New entrants
• Re-entrants
• Laid off
• Quit last job
• Not in the labor force:
• Armed services (military)
• Home makers (stay at home parent)
• Students
• Retirees
• Disabled people
• People in mental institutions
• In prison
•  Unemployment rate= 
• 
• Types of unemployment
• Frictional – transitional, temporary, short termed (searching for a job or in between jobs). It signals that new jobs are available and it reflects freedom of choice.
• Graduates from high school or college (looking for a job)
• People who quit or get fired
• People who are looking for a better job
• Cyclical – we have an economic downturn in the business cycle, because there is a deficient demand for goods and services. (it is caused by a recession) If you lose your job due to a recession, they do come back.
• Structural – deals with technology. A job may become obsolete due to changes in consumer’s taste
• Reasons:
• Automation
• Creative destruction – as jobs are created others are lost
• Change in skills
• Seasonal - jobs that are dependent upon the season or the weather
• Exs:
• Life guard
• Santa clause
• Easter bunny
• Construction workers (weather)
• Full Employment (FE) = natural rate of unemployment (NRU)
• It is equal to structural + frictional unemployment
• Full employment does not mean zero unemployment
• Okun’s Law
• Describes how unemployment relates to a nation’s GDP
• States that for every 1% unemployment above the NRU, a negative GDP gap of 2% will occur.
• Unequal burdens of unemployment:
1. Rates are lower for white-collar workers
2. Teenagers have the highest rates
3. Blacks have higher rates than whites
4. Rates for males and females are comparable