Econ - Unit 3

Components of Aggregate Demand

Components of Aggregate Demand

Consumption, investment, government spending, net exports

Consumption

Current disposable income, changes in future income (expectations), changes in wealth(accumulated savings/investments)

Interest rates and investment spending

Affects residential construction, rate of return, needs to be higher than the cost of borrowing

Retained earnings

Using past profits to fund spending (opportunity cost of using those funds)

Real wealth effect

Higher PL decreases purchasing power, lowering the value of wealth

Interest rate effect

Higher interest rates equals less spending, higher PL means more borrowing which raises interest rates, discouraging spending

Exchange rate effect

Higher PL means greater demand for imports and lower PL means greater demand for exports

Shifts in AD

Expectations, wealth, stock of physical capital, government policies

MPC

Marginal propensity to consume, increase in spending when disposable income increases

MPS

Marginal propensity to save, increase in savings when disposable income rises

Expenditure Multiplier

1/ (1-MPC)

Tax Multiplier

Factor by which we multiply a change in tax collections to find total change in rGDP

• MPC/ (1-MPC)

Short Run Aggregate Supply

Relationship between aggregate PL and the quantity of aggregate output supplied

Shifts in SRAS

Changes in commodity prices (like oil), nominal wages, productivity (technology, human capital), or inflationary expectations (nominal wages)

Short Run

Time period in which many production costs, including nominal wages, are not fully flexible

Long Run

Time period in which all production costs, including nominal wages, are flexible

Long Run Aggregate Supply

Shows the relationship between PL and the quantity of output supplies that would exist if all prices, including nominal wages, are fully flexible

AD-AS Model

Basic model used to understand economic change, rGDP, unemployment, inflation

Short Run Macro Equilibrium

Point at which AD and SRAS intersect; assume that the economy is always in short run equilibrium

Long Run Macro Equilibrium

Occurs when the short run equilibrium is at the fill employment level of output; enough time has elapsed that the economy is on the LRAS; SRAS equal to potential output

Recessionary Gap

Aggregate output is below potential output

Inflationary Gap

Aggregate output is above potential output

Demand Shocks

Event that shifts the AD curve (consumer expectations/wealth, stock of physical capital, fiscal/monetary policy)

Supply Shocks

Event that shifts SRAS (commodity prices, inflationary expectations, nominal wages, productivity)

Cost Push Inflation

Significant increase in the prices of an input with economy-wide importance

Demand Pull Inflation

Caused by increases in AD

Long Run Self Adjustment

In the long run, in the absence of government policy, flexible prices and wages will adjust to restore full employment

Shifts in LRAS

Change in potential level of output, economy has experienced growth, technology/resources/labor force

Fiscal Policy

The use of government purchases or tax policy to stabilize the economy

Expansionary Policy

Used to increase AD in a recession using increased government purchases, increased transfers, or cut taxes

Contractionary Policy

Used to decrease AD in inflation using decreased government purchases, decreased transfers, or increased taxes

Balanced Budget Multiplier

Factor by which a change in both spending and taxes changes rGDP

Discretionary Fiscal Policy

Results of deliberate policy actions

Automatic Stabilizers

Spending and tax rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands; built-in fiscal policy that automatically work to stabilize the economy by increasing AD during recessions and decreasing AD during inflation

Adjustment to Negative Demand Shock

Long Run Self Adjustment (flexible prices/wages), discretionary fiscal policy (boost AD), automatic stabilizers

Adjustment to Positive Demand Shock

Long Run Self Adjustment (flexible prices/wages), discretionary fiscal policy (decrease AD), automatic stabilizers