Unit 3

Long Run: Period of time where input prices are flexible and adjustable to changes in price level.

• Level of RGDP supplied is independent of price level 

Short Run: Period of time where input prices are sticky and do not adjust to change in price level

• Level of RGDP supplied directly related to price level 

RGDP = output 

Long- Run AS (LRAS):
-LRAS makes level of full employment in economy (analogues to PPC)
-Because input prices completely flexible in long-run, changes in price level do not change firms real profits and do not change firms level of output. This means LRAS is vertical at economy's level of full employment.

Short-Run AS (SRAS)
-Because input prices are sticky in short run, the SRAS is upward sloping
Changes in SRAS

• increase in SRAS = shifts right 
• decrease in SRAS = shifts left 
• 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 affect unit production cost)

Input Prices:

• Domestic Resource Prices 
• Wages (75% all business costs)
• Cost of capital 
• Raw material (commodity prices)

Foreign Resource Prices:
Strong $ = lower foreign resource prices 
Weak $ = higher foreign resource prices 

Market Power:

• Monopolies and cartels (Ex. OPEC dollars for oil) control resources, control prices of resources 

Increase in resource prices = SRAS shifts left
Decrease in resource prices = SRAS shifts right

Productivity:

• P = total output / total inputs 
• More production = lower unit production costs (SRAS shifts right) 
• Lower production - high unit production cost (SRAS shifts left) 

Legal Institution Environment
Taxes & Subsidies 

• Taxes ($ to gov.) to business increase per unit production cost = SRAS shifts left 
• Subsidies ($ from gov.) to business reduce per unit production cost = SRAS shifts right 

Government Regulation:

• Governemnt regulation creates cost of compliance = SRAS shifts left 
• Deregulation reduces cost of compliance = SRAS shifts right 

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. 
• Three reasons AD is downward sloping 

• 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 to purchase more output 

• 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 

• 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 two parts to a shift in AD: 

• A change in C, Ig, G, and/or X 

• A multiplier effect that produces a greater change than the original change in the four components 

• Increases in AD equals AD -->
• Decreases in AD equals AD <--

•  Increase in Aggregate Demand 

• Decrease in Aggregate Demand 

• Consumption
• Consumer Wealth 
• More wealth equals more spending (AD shifts -->) 
• Less wealth equals less spending (AD shifts <--)

•  Consumer expectations 
• Positive expectations equals more spending (AD shifts -->) 
• Negative expectation equals less spending (AD shifts <--) 

• Household indebtedness
• Less debt equals more spending (AD shifts -->) 
• More debt equals less spending (AD shifts <--)
• Taxes
• Less taxes equals more spending (AD shifts -->) 
• More taxes equals less spending (AD shifts <--) 
• Gross Private Investment 
• Investment spending is sensitive to: 
• The real interest rate 
• Lower real interest rate equals more investment (AD -->) 
• Higher real interest rate equals less investment (AD <--)  
• Expected returns 
• Higher expected returns equals more investment (AD -->) 
• Lower expected returns equals less investment (AD <--) 
• Expected returns are influenced by 
• Expectations for future profitability 
• Technology 
• Degree of excess capacity (existing stock of capital)

• Government Spending  
• More government spending (AD -->) 
• Less government spending (AD <--) 

• Net Exports
• Net exports are sensitive to: 
• Exchange rates (international value of $) 
• Strong $ equals more imports and fewer exports equals (AD <--) 
• Weak $ equals fewer impots and more exports equals (AD -->) 

•  Relative income 
• Strong foreign economies equals more exports equals (AD -->) 
• Weak foreign economies equals less exports equals (AD <--)

The AS/AD Model 
AS & AD determines current output and price level

• Full employment 
• Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point 
• Recessionary gap 
• A recessionary gap exists when equilibrium occurs below full employment output.  

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

Interest Rates & Investment Demand 
What is investment?

•  Money spent or expenditures on 
• New plants (factories) 
• Capital equipment (machinery) 
• 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 benefits? Expected rate of run
• 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 costs
• If expected return is greater than interest cost, then invest
• If expected return is less than interest cost, then do not invest

Real v. Normal

• Whats the difference? Nominal is the observable rate of interest. Real subtracts out inflation and is only known ex post facto.
• How do you compute the real interest rate? r% equals i% - pi%
• What then, determines the cost of an investment decision? The real interest rate
• What is the slope 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

Shifts in Investment Demand (ID)

Cost of Production

• Lower costs shift ID to the right
• Higher costs shift ID to the left

Business Taxes

• Lower Business taxes shift ID to the right
• Higher Business taxes shift ID to the left

Technological Change

• New Technology shifts ID to the right
• Lack of technological change shifts ID to the left

Stock of Capital

• If an economy is low on capital then ID shifts to the right
• If an economy has much capital then ID shifts to the left

Expectations

• Positive expectations shift ID to the right
• Negative expectations shift ID to the left

Long Run AS- it represents a point on an economy's productiojn possibilities curve

• Always vertical
• Always stable at full empoyment
• LRAS doesn't change as the price level changes
• The only things that can shift LRAS's are change in resources, change in technology or economic growth

Three Schools of Economy

Classical

• John B. Say
• Adam Smith 
• David Ricardo
• Alfred marshall
• Competition is good
• Invisible hand (market wikll take care of itself)
• Say's Law (supply creates it own demand)
• AS determines output
• Economy is always close to or at full employment
• In the long run the economy will balance at full employment
• The trickle down effect will help the rich first and the rest later
• Savings (leakage) equals Investment (injection)
• Because of the cost of borrowing our savings leak out
• Prices in wages are flexible downward
• Whatever output is produces will be demanded
• Instituted the concept of lazzie-faire

Keynesian

• John Maynard Keynes
• Competition is flawed
• AD is the key and not AS
• Leaks cause constant recession
• Savings cause recessions
• He also believed in the ratchet effect and sticky wages block Say's Law
• In the long run we are all dead
• Demand creates its own supply, therefore the AD curve is unstable
• Savers does not equal Investors
• They save and invest for different reasons
• The economy is not always close to or at full employment
• Prices in wages are inflexible downward
• Monopolistic competition
• There is government intervention (through Fiscal ot Monetary Policy)

Monetary

• Allen Greenspan
• Ben Bernanka
• Congress can't time policy options
• Government can best control the health of the economy by regulating banks and interest rates
• Easy money (recession)
• Tight money (inflation)
• Change to required reserves if needed
• Use bonds through open market operation
• use the interest rate to change the discount rate and the federal fund rate

Consumption and Saving

Disposable Income- Income after taxes or net income

• DI equals Gross income minus taxes

2 choices

• With disposable income households can either:

1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)

Consumption

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

Do households consume if DI equals 0?

• Autonomous Consumption
• Dissaving

APC equals C/DI equals DI that is spent

Saving

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

Do households save if DI equals 0? No

APS equals S/DI equals DI that is not spent

APC & APS

• APC + APS equals 1
• 1- APC equals APS
• 1- APS equals APC
• APC> 1 : Dissaving
• - APS: Dissaving

MPC & MPS
 Marginal Propensity to Consume

• Change in C / DI
• % of every extra dollar earned that is spent

Marginal Propensity to Save

• Change in S / DI
• % of every extra dollar that is saved
• MPC + MPS equals 1
• 1-MPC equals MPS

The Spending Multiplier Effect

• An initial change in spending cause a larger change in aggregate sopending or aggregate demand.
• Multiplier equals Change in AD/ Change in spending
• Multiplier equals Cahnge in AD/ Change in C, G, I, or X

Why does this happen?

• Expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier

• 1/1-MPC  or   1/MPS
• Multipliers are positive when there is an increase in spending and negative when there is a decrease

Calculating the Tax Multipliers

• -MPC/1-MPC   or    -MPC/MPS
• If there is a tax cut, then the multiplier is positive because there's now more money in the circular flow

Fiscal Policy
Changes 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 is enacted to promote our nations economic goals: full employment, price stability, and economic growth

Deficits, Surpluses, and Debt

Balanced Budget

• Revenues equal 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
• Financila Institutions
• Foreign entities or foreign governments

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 Policies
Discretionary
 Increasing or decreasing government spending and/or taxes in order to return the economy to full employment. Discretionary policy involves policymakers 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. Automatic fiscal policy takes place without policy makers having to respend to current economic problems.

Contractionary vs. Expansionary Fiscal Policy

• Contractionary fiscal policy - policy designed to decrease aggregate demand
• Strategy for controlling inflation

•  Expansionary fiscal policy - policy designed to increase aggregate demand 
• Strategy for increasing GOP, combating a recession and reducing unemployment 

• Expansionary Fiscal Policy
• Increase government spending (G increases) 
• Decrease taxes

• Contractionary Fiscal Policy
• Decrease government spending (G decreases) 
• Increase taxes (T increases) 

 

• Automatic or Built in Stabilizers
• Anything that increases the government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers

• Economic importance: 
• Taxes reduce spending and aggregate demand 
• Reductions in spending are desirable when the economy is moving toward inflation 
• Increases in spending are desirable when the economy i s heading toward recession 

• Automatic Stabilizers 
• Welfare checks, food stamps. unemployment checks, corporate dividends, social security, veteran benefits.

• 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 
• Average tax rate falls with GDP