ARE YOU READY TO LEARN??

Unit IV Learner’s Guide

Aggregate Demand/SupplyInvestment

Consumption/SavingFiscal Policy

What is it?

• The relationship between price level(PL) and Real Gross Domestic Product(RGDP) is inverse

• Shows the amount of RGDP that the private, public, and foreign sector collectively desire to purchase at each possible PL

Reasons it is Downward Sloping?

• Real Balances Effect• Interest Rate Effect• Foreign purchases Effect

Model of AD

Shifts in AD

• Caused by changes in C(consumption), I(investment), G(government spending), Xn (net exports)

• in AD= shifts to the right

• in AD= shifts to the left

SHIFT TO THE RIGHT

SHIFT TO THE LEFT

What is it??

• The level of RGDP that firms will produce at each PL

• 2 types of AS:– Long Run (LRAS):period of time where input

prices are flexible and adjust to PL– Short Run (SRAS):period of time where input

prices are sticky and doesn’t adjust to PL

Long Run Aggregate Supply

• Marks level of full employment in economy• Analogous to PPC• Measures potential output• Causes of LRAS to shift:– Increase in capital– Technology– Eco growth– Entrepreneurship– Resource availability

LRAS Model

Short Run Aggregate Supply

• Shifts caused by change in input/resource prices

• in resource prices= SRAS shifts left• in resource prices= SRAS shifts right

• in SRAS= shifts to the right• in SRAS= shifts to the left

SRAS (cont’d.)

• Key to understanding shifts in SRAS is per unit production cost

• FORMULA: – per unit prod. cost= total input cost

total output• Productivity• FORMULA:

– Productivity= total output total input

• More prod.= lower unit prod. cost=SRAS • Less prod.= higher unit prod. cost= SRAS

SRAS Model

Full Employment

• Equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap

• Exists when equilibrium occurs below full employment output

Inflationary Gap

• Exists when equilibrium occurs beyond full employment output

Ranges/Shapes of AS

• Keynesian Range: – Has a horizontal AS curve when eco is below full employment

which cause AD to shift outward• RGDP , u% , PL is constant

– Demand creates its own supply• Intermediate Range:

– AS is in btwn Classical and Keynesian range– When occurs AS shifts outward

• GDP & PL

• Classical Range: – In Long Run, AS curve is vertical– Supply creates its own demand(Say’s Law)

Ranges/Shapes of AS Model

The Debate PT.1

The Debate PT.1(cont’d.)

The Debate PT.2

The Debate PT.2(cont’d.)

What is it??

• Money spent or expenditures on:– New plants(factories)– Capital equipment(machinery)– Technology(hardware/software)– New homes– Inventories(goods sold by prod)

Expected Rates of Return

• How does business make investment decisions?– Cost/benefit Analysis

• How does business count the cost?– Expected Rate of Return

• How does business determine the amount of investment they undertake?– Compare Expected Rate of Return to interest cost

• If E.R.R > interest cost, then invest• If E.R.R < interest cost, then don’t invest

Real v. Nominal

• Nominal: the observable rate of interest • Real: subtracts out inflation(π%) and is only

known – Example- post facto

• FORMULA (real int. rate (r%)):– r%= i% - π%

Investment Demand Curve(ID)

• Shape of curve is downward sloping• Why?

– When int. rates are high, fewer investments are profitable, when int. rates are low, more investments are profitable

– There are few investments that yield high rates of return, and many that yield low rates of return

• Shifts in ID Curve:• $ of prod• Business taxes• Tech change• Stock of capital• expectations

Consumption/Saving

What is Consumption?

• Household spending• Ability to consume is constrained by– Amt of disposable income (DI)– Propensity to save

• Do household consume if DI=0?– Autonomous consumption– Dissaving

• *Disposable Income : income after taxes or net income

What is Saving?

• Household NOT spending• Ability to save is constrained by – Amt of DI– Propensity to consume

• Do households save if DI=0?– NO!!

• *Disposable Income: income after taxes or net income

APS & APC

• APC= Average Propensity to Consume• APS= Average Propensity to Save• FORMULAS:– APC + APS= 1– 1 – APC= APS– 1 – APS= APC– APC > 1: dissaving– -APS: dissaving

MPC & MPS

• MPC= Marginal Propensity to Consume• MPS= Marginal Propensity to Save• % of every extra $ earned that is saved• FORMULAS:

– MPC= ∆ C ∆DI

– MPS= ∆ S ∆DI

– MPS + MPC= 1– 1 – MPC= MPS– 1- MPS= MPC

Determinants of C & S

• Wealth• Expectations• Household debt• Taxes

What is it?

• An initial ∆ in spending (C,I,G,Xn) causes a larger ∆ in aggregate spending or AD

• Why?– Expenditures and income flow continuously which

sets off a spending increase in the eco• FORMULA:– 1/ 1 – MPC OR 1/ MPS

• *multipliers are (+) where there is an increase in spending and (-) when there is a decrease.

Tax Multiplier

• When gov’t taxes, the multiplier works in reverse

• Why?– Because now money is leaving the circular flow

• FORMULAS:– -MPC/1 – MPC or –MPC/MPS

• *if there is a tax cut, then multiplier is (+) because there is now more $ in circular flow

What is it?

• Changes in the expenditures or tax revenues of the fed gov’t– 2 tools of fiscal policy:

• Taxes: gov’t can increase or decrease taxes• Spending: gov’t can increase or decrease spending

• Fiscal policy is enacted to promote our nation’s eco goals:– Full employment– Price stability– Eco growth

Deficits, Surpluses, and Debt

• Balanced budge– Revenues= expenditures

(profit) ($ spent)

• budget deficit– Revenues < expenditure

• Budget surplus– Revenues > expenditure

• Gov’t debt– Sum of all deficits – sum of all surpluses

• Gov’t must borrow $ when it runs a budget deficit• Gov’t borrows from:

• Individuals (savings bonds)• Corporations• Financial institution• Foreign gov’t/ entities

Fiscal Policies

• 2 options:– Discretionary Fiscal Policy (take action)• Expansionary Fiscal Policy (think deficit)• Contradictory Fiscal Policy (think surplus)

– Nondiscretionary Fiscal Policy (take NO action)

Discretionary v. Automatic Fiscal Policies

• Discretionary:– or gov’t spending and/or taxes in order to return the

eco to FE– Involves policy makers doing fiscal policy in response to

an eco problem• Automatic: – Unemployment compensation & marginal tax rates are

examples of automatic policies that help mitigate the effects of recession and inflation

– Takes place w/o policy makers having to respond to current eco problems

Contradictory v. Expansionary Fiscal Polices

• Contradictory:– Policy designed to decrease AD– Strategy for controlling inflation– Inflation is counted– gov’t spending – taxes

• Expansionary:– Policy designed to increase AD– Strategy for increasing GDP, combating recession– Reducing unemployment– Recession is counted– gov’t spending– taxes

Weaknesses of Fiscal Policy

• Progressive Tax System– Avg tax rate rises w/ GDP

• Proportional Tax System– Avg tax rate remains constant as GDP ∆

• Regressive Tax System– Avg tax rate falls w/ GDP

• *the more progressive the tax sys, the greater the econ’s built in stability

Thank you, Come again!!