2/24/17: Multipliers

• The Spending Multiplier Effect
• An initial change in spending (C, Ig, G, Xn) causes a larger change in Aggregate Spending or Aggregate Demand.
• Multiplier = Change in AD / Change in Spending 
• Multiplier = Change in AD / Change in C, Ig, G or Xn
• Why does this 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 positive (+) when there is an increase in spending & negative (-) when there is a decrease.

• Calculating the Tax Multiplier
• When the government taxes, the multiplier works in reverse.
• Why?
• Because now money is leaving circular flow.
• Tax Multiplier (Note: it's negative)
• -MPC / 1-MPC or -MPC / MPS
• If there is a tax cut, then the multiplier is positive (+) now, because there is now more money in the circular flow. 

2/23/17: Consumption & Savings

• Disposable Income (DI)
• Income after taxes or net income
• DI = Gross income - Taxes
• 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 contained 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 DI = 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 DI
• % of every extra dollar earned that is spent.
• Marginal Propensity to Save
• Change in Savings / Change in DI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

• Determinants of Consumption & Savings 
• Wealth
• Expectations
• Household debts
• Taxes

2/21/17: AS & AD

• The AS/AD Model
• The equilibrium of AS & AD determines current output (GDPr) and the price level (PL).
• Full Employment 
• Equilibrium exists where AD intersects SRAS & LRAS at the same point.
• Inflationary Gap
• Output if high & unemployment is less than NRU
• Actual GDP is above potential GDP

• Recessionary Gap
• Output low & unemployment is more than NRU

2/21/17: Aggregate Supply

• Aggregate Supply
• Level of real GDP that firms will produce at each level.
• Long-run
• Period of time were 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)
• Analogous to PPC
• Marks level of full employment in the economy 
• Short Run Aggregate Supply (SRAS)
• Because input prices are sticky in the short-run, the SRAS

• Changes in SRAS
• An increase in SRAS is seen as a shift to the right
• A decree in SRAS is seen as a shift to the left
• The key to understanding shifts in the SRAS is per unit cost of production 
• Per unit production cost = Total input cost / Total output

• Determinants of SRAS
• Input prices
• Productivity
• Legal Institutional Environment
• Input Prices
• Domestic Input Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (Commodity prices)
• Foreign Input Prices
• String $ = Lower foreign resource prices
• Weak $ = Higher foreign resource prices
• Market Power
• Monopolies & cartels that control resources control the price of those resources
• Increase in Resource Prices = SRAR shift left
• Decrease in Resource Prices = SRAS shift right
• Productivity
• Total Output / Total Input
• More productivity = Lower unit production cost
• SRAS shift right
• More productivity = Higher unit of production cost
• SRAS shift right
• Legal Institutional Environment
• Taxes & Subsidies
• Taxes ($ to gov't) on business increase per unit production cost = SRAS shift left 
• Subsidies ($ from gov't) to business price per unit of production cost = SRAS shift right
• Government Regulation
• Government regulation creates a cost of compliance = SRAS shift left
• Deregulation reduces compliance costs = SRAS shift right 

2/16/17: Interest Rates & Investment Demand

• Investment 
• Money spend or expenditures on:
• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & 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 cost
• How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest cost 
• If expected return > interest cost = Investment
• If expected return < interest cost = Don't invest
• Real & Nominal
• r% (real) = i% (nominal) - π% (inflation)
• What then determines the cost of an investment decision?
• The real interest rate
• Investment Demand Curve
• What is the shape of 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
• Business taxes
• Technological change
• Stock of capital
• Expectations

                                                

2/15/17: Aggregate Demand

• Aggregate Demand Curve
• AD is the demand by consumers, businesses, government, and foreign countries.
• Changes in price level cause a move along the curve, not a shift of the curve. 
• Aggregate Demand (AD)
• Shows the amount of real GDP that the private, public & foreign sector collectively desire to purchase at each possible price level.
• The relationship between the price level & the level of real GDP is inverse (one decreases, other increases.)

1. 3 Reasons why AD is downward sloping
1. Wealth Effect
• Higher prices reduce purchasing power of $
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power & increase expenditures
• Price level goes up, GDP demand goes down
• Ex) If balance in your bank is $50,000, but inflation erodes your purchasing power you will likely reduce your spending 

               2. Interest Rate Effect

• As price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.
• Higher interest rates discourage consumer spending & business investment.
• Price level goes up, GDP down (& vice versa)
• Ex) Increase in price leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. 

               3. Foreign Trade Effect

• When U.S price level rises, foreign buyers purchase fewer U.S goods & Americans buy more foreign goods.
• Exports fall & imports rise, causing real GDP demanded to fall (Xn decreases)
• Ex) If prices triple in the U.S, Canada will no longer buy U.S goods, causing quantity demanded of U.S products to fall.

• Shifts in Aggregate Demand 
• There are two parts to a shift in AD
• A chance in C, Ig, G, and Xn
• A multiplier effect that produces a greater change than the original change in the 4 components.
• Increases in AD = AD shift to the right
• Decreases in AD = AD shift to the left

• Determinants of AD
• Consumption (C)
• Gross private domestic income (Ig)
• Government purchases (G)
• Net exports (Xn)

1. Change in Consumer Spending
• Consumer wealth (boom in the stock market)
• Consumer expectations (people fear a recession)
• Household indebtedness (more consumer debt)
• Taxes (decrease in income taxes)
2. Change in Investment Spending
• Real interest rates (price of borrowing $)
• If interest rates increase..
• If interests rates decrease..
• Future business expectations (high expectations..)
• Productivity & technology (new robots)
• Business taxes
3. Change in Government Spending
• War
• Nationalized health care
• Decrease in defense spending
4. Change in Net Exports
• Exchange rates (if the U.S dollar depreciates relative to the euro)
• National income compare to abroad
• If a major importer has a recession
• If the U.S has a recession
• "If the U.S gets a cold, Canada gets pneumonia" 

• AD = GDP = C + Ig + G + Xn
• Government Spending
• More government spending = AD shift to right
• Less government spending = AD shift to right

2/9/17: What is Unemployment?

• Unemployment
• The percent of people in the labor force who want a job but are not working.

• Labor Force
• # of people in a country that are classified as either employed or unemployed.
• Employed
• Anyone who works at least 1 hour a month.
• Anyone considered temporarily absent from work.
• Part-time workers
• Those who are NOT in the labor force
• Kids
• Full-time students
• People in mental institutions
• Military personnel
• Stay at home moms & dads
• Retirees
• People who are incarcerated
• Discouraged workers (mentally & psychologically beaten down)
• Unemployment Rate
• # of Unemployed / # in Labor Force (employed + unemployed) x 100
• Standard Unemployment Rate
• 4 to 5%
• Higher than 5 = recession
• 4 Types of Unemployment
1. Frictional Unemployment
• "Temporarily unemplyed" or being between jobs
• Individuals are qualified workers with transferable skills but they aren't working.
2.  Seasonal Unemployment
• This is a specific type of frictional unemployment which is due to time of year & the nature of the job.
• These jobs will come back
3.  Structural Unemployment
• Changes in the structure of the labor force make some skills absolete.
• Workers do NOT have transferable skills & these jobs will never come back.
• The Permanent loss of these jobs is called "creative destruction" (new replaces old) 
4. Cyclical Unemployment
• Unemployment that results from economic downturns (recessions)
• As demand for goods & services falls

• Natural Rate of Unemployment (Full Employment)
• Frictional + Structural = NRU (4 to 5 %)

• Full employment means NO cyclical unemployment

• Okun's Law
• When unemployment rises 1 % above the natural rate, GDP falls by about 2%.

2/6/17: Inflation

• Inflation
• General rise of level of prices
• It reduces the "purchasing power" of money
• ex) It takes $2 to buy today what $1 bought in 1982.

• Three Causes of Inflation 
1. Printing too much money (The Quantity Theory)
2. Demand-Pull Inflation
• Caused by excess of demand over output, that pulls prices upward.
• "too many dollars chasing too few goods"
3. Cost-Push Inflation
• Higher production cost increases prices.
• Standard Inflation Rate
• 2 to 3 %
• Formula for Inflation Rate
• (Current year price index - Base year price index) / Base year price index x 100
• Rule of 70
• Used to calculate the # of years it will take for the price level to double at any given rate of inflation.
• 70 / Annual Inflation Rate
• Deflation
• General decline in the price level.
• Disinflation
• Occurs when the inflation rate declines.

• Real Interest Rate
• The percentage increase in purchasing power that a borrower pays to the lender (adjusted for inflation)
• Real = Nominal interest rate - Expected inflation 
• Nominal Interest Rate
• The percentage increase in money that the borrower pays back to the lender not adjusting for inflation.
• Unanticipated Inflation
• Hurt by inflation
• Lenders: People who lend money (at fixed interest rate)
• People with fixed income
• Savers
• Helped by Inflation
• Borrowers: People who borrow money
• A business where the price of the product increases faster than the price of resources.

2/3/17: Real & Nominal GDP

• Nominal GDP
• The value of output produced in current prices.
• Can increase from year to year if either output or prices increase.
• P x Q (Price x Quantity)
• Real GDP
• Value of output produced in constant base year prices.
• Adjusted for inflation
• Can increase from year to year only if output increases
• P x Q (Price x Quantity of Base Year)

• Only in base year is Real GDP = to Nominal GDP
• In years after base year, Nominal GDP > Real GDP
• In years before base year, Real GDP > Nominal GDP

• GDP Deflator
• Price index used to adjust from Nominal to Real GDP
• Nominal GDP / Real GDP x 100
• CPI (Consumer Price Index)
• Measures inflation by taking changes in the price of a market basket of goods.
• Price of Market in Current Year / Price of Market in Base Year x 100