Macroeconomics Test 3 (Units 12-15)

Units 12-15

ch. 12 main content

• aggregate demand

• changes in aggregate demand

• aggregate supply

• changes in aggregate supply

• equilibrium in the AD-AS Model

• changes in equilibrium

aggregate expenditure model

• very immediate short run

• prices are fixed and GDP is set

• NOT THE CASE FOR MOST OF THE TIME- GDP and prices change

Aggregate Demand

a key element of the aggregate demand-aggregate supply model (AD-AS model)

• curve

• real GDP (nations output) that buyers collectively desire to purchase at each possible price level

• buyers: domestic households, businesses, and govt. + international households, businesses, and gov.

• includes ALL products (education, health, shoes, coffee- everything)

• households- includes United States and international households, businesses (American and abroad)- essentially everyone that buys from American output, American and foreign alike.

Aggregate demand- more specific

Real output (GDP) desired at each price level (measure with PI)

inverse relationship:

• real balances effect- (purchasing power of nominal balances-real quantities) given by private consumption.

• interest rate effect- (price that must be paid for the use of borrowed money- demand for money) C + I. If the price level increases, and we used to buy an apple for $1, now the apple is $1.10, you’d need access to more physical money (its hard to get your hands on cash, so the interest rate moves up, because the price of money increases). Once the interest rate increases investment will decrease.

• foreign purchases effect- (Xn)- if price levels are high and you have a foreigner buying products from the US, theyd only be able to buy less. Higher price level= GDP decreases in terms of international trade because Americans will start buying from outer sources since it’s too expensive in the US, and foreigners won’t buy American products because its expensive.

if prices decrease, everything decreases, so your income moves as the economy moves (if price levels go down, you won’t just be able to buy more- because your income will decrease as well, so this is why the income effect is NOT the reason why the curve is down sloping).

Aggregate demand CURVE

• slopes downward

changes in aggregate demand- determinants

Determinants of aggregate demand: SHIFT FACTORS- affecting C, I, G, Xn. (other things equal- no more).

Two components involved:

1. change in one of the determinants (consumption, investment, govt. spending, net exports).

2. Multiplier effect

consumer spending

consumer wealth- assets (stocks, bonds, real estate)- liabilities (mortgages, student loans, credit card balances)- so assets minus liabilities

• if wealth increases, spending increases too.

• how does wealth increase?

consumer expectations- income, inflation

• if we think income will increase, we’ll demand more

• if we think inflation will hit badly, we will consume as much as possible in the present to avoid higher spending in the future.

• if we think inflation will be low, we’ll buy products later

household borrowing- consumption, saving pay off debts

• through borrowing, we can ask for a loan, and buy more in the present that otherwise wouldn’t be affordable

personal taxes- tax raises and cuts

investment spending- capital goods purchases

real interest rates- in response to money supply

If supply of money decreases, interest rate will increase:

if the fed gets scared of inflation and believes we are spending too much money, they will shorten the supply of money by emitting treasure bonds (they’ll collect money from us), and the supply will decrease. → impacts investment

expected returns on investment projects

• expectations about future business conditions

• technology- new technology can increase expected rate of return, so more projects will be undertaken

• degree of excess capacity (unused capital)

• business taxes (effect on after-tax profits)- of everything we buy, we must pay taxes. the higher the taxes, the lower the after-tax profit. If business taxes decrease, our after-tax profit INCREASES, and we can invest more, since well have more money.

expected rate of return will increase if we have higher hopes in regard to the future.

→ ex= more stability= more projects are feasible

Government spending

govt. spending increases:

• aggregate demand increases (as long as interest rates and tax rates do not change)

• more transportation projects

govt. spending decreases:

• aggregate demand decreases

• less military spending 

DIRECT RELATIONSHIP BETWEEN GOVERNMENT SPENDING AND AGGREGATE DEMAND

Net export spending

depends on 2 things:

1. national income abroad- if a country has more money to spend, they will increase American exports. If NI of another country decreases, they’ll decrease the amount of goods they buy from the US (American aggregate demand will decrease here).

2. exchange rates- price of foreign currencies in terms of US dollar

• dollar depreciation- outer countries will buy more for the US, which increases American aggregate demand

• dollar appreciation- if our coin gets stronger, it will be harder for outer countries to buy products from the US. 

aggregate supply

total real output produced at each price level

relationship depends on time horizon

• immediate short run- AS (aggregate supply) ISR (immediate short run) BOTH input and output prices stay fixed. wages, salaries are completely stuck.

• short run- (aggregate supply) input price is fixed, and output price is flexible. price of what we sell can move, but wages and salaries are completely fixed- ex= UPS, they have a lot of people and they have agreements of 5 years, so they cannot change the salary.

• long run- AS (aggregate supply) LR (long run) input prices are fixed, and output prices are flexible.

aggregate supply in the immediate short run

• x- real domestic output

• y- price level

• graph is completely, horizontally, straight.

• depends directly on the volume of spending

• wages and salaries are fixed by contractual agreements

• output prices= firms supply the level of output that is demanded at that price

• firms will try to change product prices

aggregate supply in the short run

MOST POPULAR

upward sloping curve

x- real domestic output

y- price level

• always has something fixed, ex= salaries

• direct relationship (if price level increases, so does GDP)

• we can increase production without increasing costs too much, BUT once we are producing more output after the point of full employment, we will need to have people working overtime. We will run out of resources (people and land alike), WHICH WOULD INCREASE COSTS OF PRDUCTION. this is why the curve curves upward significantly after full employment.

aggregate supply in the long run

• since all prices are changing, they are all flexible

• companies produce at the employment level

• VERTICAL STRAIGHT LINE

• in the very long run, since everything is adjusting, they will produce at what maximizes their profit.

changes in aggregate supply

• increase supply= shift right (economy is willing and able to offer more of everything, at all price levels. we produce AND charge more at all price levels).

• decrease supply= shift left

determinants of aggregate supply

SHIFTERS

• collectively position the AS curve- firms willing and able to produce and sell more real output at every price level (rightward shift)= increase AS.

• changes raise or lower per-unit production costs at each price level

→ if the per unit costs decreases, profits are larger bc. producers are willing and able to produce more.

PROFITS= REVENUES-COSTS

shifters of AS: #1- input prices

domestic resource prices:

• labor. ex.= wages decrease → decreases per unit production costs → increases P

• capital. ex.= price of steel decreases, so costs decrease, and profit increases

• land. ex.= non-resource becomes a resource (people can use them to make profitable investments), the curve shifts right bc. more is produced at every level of price

prices of imported resources:

• imported oil- price of oil in the world decreases, so prices are lower and profits increase

• exchange rates- if the dollar depreciates, everything becomes cheaper, per unit costs decrease, P increases

shifters: #2- productivity 

real output per unit of input

• increases in productivity reduce costs

• decreases in productivity increase costs

productivity= total output/total inputs

per-unit production cost= total input cost/total output

shifters: #3- legal-institutional environment

legal changes alter per-unit costs of output:

• business taxes and subsidies (subsidies

• government regulation- supply side proponents of deregulation- less paperwork and more efficiency

the equilibrium price level and equilibrium real GDP

• in base year, nominal prices = real prices (so we are in equilibrium)

An increase in Aggregate Demand that causes demand-pull inflation: Vietnam war

• when AS and AD intersect, we are at P1 and Qf and are at full employment

• during a war, the govt. has to produce amo, etc, so the curve shifts right and the multiplier is taken into effect. GDP increases by the amount of govt. spending X Multiplier.

→ we move from Qf to Q2

• inflationary GDP pushes prices upward

A decrease aggregate demand causes recession when price level is inflexible

• we are in the SR

• in SR, output is flexible, but input is fixed

• aggregate supply is fixed downwards, not upwards

• 75% of costs of a company come from wages, so unless they lower the wages of people, the only solution a company has is to fire people.

• you cannot change prices downward, ONLY UP

decreases in AD: recession and cyclical unemployment

prices are downwardly inflexible because:

• fear of price wars (successively deeper and deeper price cuts that result in reduced profits for all of the firms).

• menu costs (printing new price lists or catalogs, re-pricing inventory, communicating new prices to customers)

• wage contracts (given inflexibility, firms minimize costs by paying efficiency wages)

• minimum wage law (wage law for low-skilled workers)- company that has people earning minimum wage=company must stick with this

A decrease in AS that causes cost-push inflation- 1973 OPEC slowed oil production

• decrease in oil production drove up the price of crude oil, which increased per unit cost productions & AS moved left

• left shift of AS from AS1 to AS2 raises the price level from P1 to P2 and produces cost-push inflation → real output declines → a recessionary gap of Q1-QF occurs

growth, full employment, and relative price stability

• we start at point a, have an increase in AD, which moves through the same AS, and we find a new equilibrium (point b).

• we also move from Q1 to Q2

• both AS and AD can shift because both curves shift to the right so P increases

COVID 19 inflation

• inflation in US had a 7% annual rate in 2021- highest since 1981

• result of rightward AD shift and a leftward AS shift, featuring both cost-push inflation and demand-pull inflation

• massive govt. spending pushed AD to the right, while supply chain disruptions pulled AS curve left

• we were left with unemployment, since prices are fixed downwards and companies couldn’t lower wages, people were fired

Ch. 13

fiscal policy, deficits, and debt

fiscal policy 

initiated on the advice of the council of economic advisors (CEA) and consists of:

deliberate changes in:

• government spending

• taxes

designed to:

1. achieve full employment

2. control inflation

3. encourage economic growth 

discretionary (deliberate manipulation of taxes and govt. spending by congress) or nondiscretionary

• money is spent by the government, without the government doing anything (money will be spent no matter what) = NONDISCRETIONARY

• GOVT. collects money through taxes- taxes to people, firms, tariffs

fiscal policy takes care of output- helps during a recession, when the output is affected.

→ they also pay attention to inflation, if the price level is too high

fiscal policy

counteracts what is currently happening

• through spending, the govt. can increase output, and will help decrease unemployment

• through taxes, the govt. can ONLY move everything back to where it should be, but they won’t change everything completely → they WON’T make big changes.

expansionary fiscal policy

used to combat a recession:

→ increase govt. spending

→ tax reductions ($6.67 X MPC 0.75= $5) (must be bigger than how we need the economy to move, because part of that tax cut goes towards savings)

→ combination of both ($1.5 + $3.5). If they decide to spend 1.5 billion dollars themselves, to get the 3.5 billion that we are missing, they’d need a tax cut to make sure that consumption also increases by 3.5 bill. dollars. (so, some is spent by govt., and some is personal spending).

→ create a budget deficit- the govt. has a certain amount of $ they can spend. Tax revenues the govt. receives will be larger than the deficit. (Tax revenues-govt. spending= budget deficit) → we will end up with a negative number.

contractionary fiscal policy

use during demand-pull inflation: they must contract (make smaller) the economy

• decrease govt. spending ($3)

• increase taxes ($4) → increase in taxes= consumption increases

• combination of both→ govt. must be careful when they achieve this, so the multiplier doesn’t go overboard. We don’t want to end up in a recession.

• create a budget surplus

the govt. will try to bring the economy back to full employment because this is what’hows most healthy for the economy.

how does gvt. CONTRACT economy?

1. increase taxes, so people spend less

2. decrease spending

built in stability

built in stabilizers:

• net taxes vary directly with GDP (income, sales, excise, and payroll)

• transfers vary inversely with GDP (unemployment compensation and welfare payments)

economic importance

tax progressivity:

• progressive tax system (average tax rate rises with GDP)- the more you earn, the more taxes you pay.

• proportional tax system (average tax rate remains constant with GDP). if you produce more, you always pay the same, regardless of what you earn.

• regressive tax system (average tax rate falls with GDP) The more you earn, the less you pay.

the more money the economy produces, the higher the GDP, the higher the net taxes the govt. receives. the more we produce, the more taxes we pay to the govt. and the less we spend (so the economy won’t move to the right extensively, because we won’t have as much to spend).

→ power to consume decreases

built in stability

Tax revenues, T, vary directly with GDP, and govt. spending, G, is assumed to be independent of GDP. as GDP falls in a recession, deficits occur automatically and help alleviate the recession. as GDP rises during expansion, surpluses occur automatically and help offset possible inflation.