Unit Three

Aggregate Demand

• 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

3 Reasons Why AD is Downward Sloping

1. Real Balances Effect

• When the price level is high households and businesses cannot afford to purchase much output.
• When the price level is low households and businesses can afford to purchase more output

1. 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

1. 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

• There are 2 parts to a shift in AD: 
• A change in C, I, G, Xn
• A multiplier effect that produces a greater change than the original change in the 4 components
• More government spending=AD->
• Less government spending=AD<-

Aggregate Supply

• The level of real GDP that firms will produce at each price level
• Long Run
• Period of time where input prices are completely flexible and adjust to changes in price level
• Level of real GDP supplied is independent of the price level
• Marks the level of full employment in the economy
• Analogous to PPC
• Is always vertical at full employment
• Shifts because of :
• Technology
• Capital resources
• Growth
• Entrepreneurship
• Resources available
• Short Run
• Period of time where input prices are sticky and do not adjust to changes in the price level
• Level of real GDP supplied is directly related to the price level
• Changes in SRAS:
• An increase is seen as a shift to the right
• A decrease is seen as a shift to the left
• The key to understanding shifts in SRAS is per unit cost production
• Per-unit production cost= total input cost/total output
• Determinants: 
• Input prices (Factors of Production)
• Productivity (Technology)
• Legal- institutional environment
• Input Prices: 
• Increases in resources prices=SRAS<-
• Decreases in resources prices=SRAS->
• Productivity
• Total output/total inputs
• More productivity= lower unit production cost=SRAS->
• Lower productivity=Higher unit production cost=SRAS<-

Ranges/Shapes/View of Aggregate Supply

Keynesian Range

• They believe in a horizontal curve because when the economy is below full employment, AD shifts outward (increase in GDPr, unemployment drops, price level is constant)
• Demand creates its own supply
• Competition is flawed
• In the long run we are all dead
• Depression REFUTES Say's Law
• Underspending persists
• Saving and Investments have different motivations
• Prices and wages are inflexible downward
• No competition
• C+I+G+Xn
• Fiscal Policy
• Active government
• AD determines output and employment
• Inflation is caused by too much demand

Intermediate Range

• This is where aggregate supply is between the Keynesian and Classical range
• GDP and Price level increase

Classical Range

• In the long run the AS curve is vertical because the effects of an increase in AD when we are already at full employment
• Supply creates its own demand
• Says Law
• Competition is good
• Invisible hand: Economy regulates itself
• In the long run the economy will balance at full employment
• Trickle Down Effect
• Underspending is likely
• Prices and wages are flexible downward
• If AD decreases, so does Price Level, which allows you to buy more
• AS determines output and employment
• MV=PQ
• Laissez Faire 
• Inflation is caused by too much money

What is Investment? 

• Money spent or expenditures on:
• New plants/factories
• Capital equipment
• Technology
• New homes
• Inventories

Expected Rates of Return: 

• Businesses make investment decisions by using a cost/benefit analysis
• Businesses determines benefits with expected rates of return
• Businesses count the cost with interest costs
• How does business determine the amount of investment they undertake?
• They compare expected rate of return to interest cost
• If expected return>interest cost : Invest
• If expected return<interest cost : Don't invest

Real V. Nominal

• What's the difference? 
• Nominal is the observable rate of intest
• Real subtracts out inflation

Investment Demand Curve

• Downward Sloping
• Because when interest rates are high, fewer investments are profitable; vise versa
• Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Shifts in Investment Demand

• Costs of production
• Business taxes
• Technological change
• Stock of capital
• Expectations

Disposable Income

• Income after taxes or net income
• DI=Gross income-Taxes
• Households can SPEND or SAVE

Consumption

• Household spending
• The ability to consume is constrained by the amount of disposable income and the propensity to save

Saving

• Household is not spending
• The ability to save is constrained by the amount of disposable income and the propensity to consume

Average Propensity to Consume (APC) and Avereage Propensity to Save (APS)

• APC+APS=1
• 1-APC=APS
• 1-APS=APC

MPC and MPS

• Marginal Propensity to Consume
• ^C/^DI
• % of every dollar earned that is spent
• Marginal Propensity to Save
• ^S/^DI
• % of every extra dollar earned that is saved
• MPC+MPS=1
• 1-MPC=MPS
• 1-MPS=MPC

Determinants of C and S

• Wealth
• Expectations
• Household debts
• Taxes

The Spending Multiplier

• An initial change in spending causes a larger change in aggregate spending or aggregate demand
• Multiplier= Change in AD/Change in Spending
• Multiplier=Change in AD/ Change in Consumption/Investment/Government Spending/Net Exports
• Exports and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier

• Multiplier (+) increase in spending
• Multiplier (-) decrease in spending
• Multiplier=1/1-MPC or 1/MPS

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse
• Because now money is leaving the circular flow
• Tax Multiplier= -MPC/1-MPC or -MPC/MPS
• IF there is a tax cut, then the multiplier is positive, because there is now more money in the circular flow
• Almost always negative

Fiscal Policy

• Change in the expenditures or tax revenues of the federal government
• 2 tools of Fiscal Policy
• Taxes: Government can increase or decrease taxes
• Spending: Government can increase or decrease spending
• Fiscal Policy's enacted to promote our nation's economic goals: full employment, price stability, and economic growth

Deficits, Surpluses, & Debt

• Balanced Budget
• Revenues=Expenditures
• Budget Deficit
• Revenues<Expenditures
• Budget Surplus
• Revenues>Expenditures
• Government Debt
• Sum of all deficits-Sum of all surplus
• Government must borrow money when it runs a budget deficit
• Government borrows from 
• Individuals
• Corporations
• Financial institutions
• Foreign entities or foreign governments

Fiscal Policy 2 Options

• Discretionary Fiscal Policy (Action)
• Expansionary- think deficit; recession
• Contractionary- think surplus; tight money
• Non-discretionary Fiscal Policy (No Action) 

Discretionary V. Automatic Fiscal Policy

• Discretionary
• Increase or decrease in government spending and/or taxes in order to return the economy to full employment
• Involves policy makers doing fiscal policy in response to an economic problem
• Automatic
• Unemployment Compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation
• Takes places without policy makers shaving to respond to current economic problems

Contractionary V. Expansionary Fiscal Policy

• Contractionary
• Policy designed to decrease aggregate demand
• Controls inflation
• Decrease in government spending
• Increase in taxes
• Expansionary
• Designed to increase aggregate demand
• Strategy for increasing GDP, combatting a recession, and reducing unemployment
• Increase in government spending
• Decrease in taxes

Progressive Tax System

• Average tax rate (tax revenue/GDP) rises with GDP
• The more progressive the tax system, the greater the economy's built in stability

Proportional Tax System

• Average Tax rate remains constant as GDP changes 

Regressive Tax System

• Average Tax rate falls with GDP

Reflection: 

This unit has been the hardest of the semester. I struggled grasping the basic concept of each section. After several tutorial sessions, questions, wrong answers, and reviewing for the past test, I feel as if I understand everything a little better than previously. Though I am going no where near a business occupation in the future, this unit of economics helped me see that some of these concepts can be used in life. Such as saving and spending, deficit, and disposable income. 

2 Months and 19 Days Until Graduation