ECON 202 Exam 3

Components of Aggregate Expenditure

1. Consumption (C)

2. Planned Investment (I^P)

3. Government Purchases (G)

4. Net Exports (NX)

Planned Investment

Actual investment – unplanned inventory changes (doesn’t include build-up of inventories)

Inventories

Products made but not sold

Macroeconomic Equilibrium

When output spending equals value of output (Aggregate expenditure = GDP)

Consumption Determinants

1. Current disposable income (Income – taxes + transfer payments)

2. Household wealth (Assets – liabilities)

3. Expected future income

4. Price level (inverse)

5. Interest rates (inverse)

6. Consumer confidence

Which consumption determinant is not a shifter?

Price level

Marginal Propensity to Consume (MPC)

The amount by which consumption changes when disposable income changes

MPC Equation

ΔC/ΔIncome (Y)

National Income (Y)

ΔC + ΔS + ΔT

Types of Retirement Saving Accounts

1. Individual Retirement Arrangement (IRA): account from financial institution allowing an individual to save for retirement without being taxed

2. 401k or 403b: similar to above, often matched by the employer, pre-taxed

Planned Investment Determinants

1. Expectations of future profitability

2. (Real) interest rates (inverse)

3. Taxes & regulations (inverse)

4. Cash flow (cash revenues of firm – cash spending)

Animal Spirits/Irrational Exuberance

How people arrive at financial decisions in times of economic stress or uncertainty (i.e., consumer confidence)

John Maynard Keynes

• The founder of macroeconomics

• Proposed alternative to Classical economics with focus on the short-run → prices and wages are fixed/rigid

• Argued deficits/debt are fine during a recession.

Net Exports Determinants

1. Exchange rates (depreciation → increase EX, decrease IM)

2. Trade barriers

Product Fragmentation

The production process is divided up between many countries

Shifters of Aggregate Demand

1. C+I+G+NX

2. Monetary and fiscal policy

Potential GDP

Level of real GDP when all firms are operating at capacity under normal hours and workforce (Potential GDP = natural rate of UNE = Y^N)

Short-Run

Time where at least one variable can’t fully adjust

Long-Run

Every variable is fully flexible

Excess Capacity

When real GDP < potential GDP → underproduction

Long-Run Aggregate Supply Shifters

1. Technology (A)

2. Labor (L)

3. Capital (K)

[Y = A x f(K, L)]

Natural Rate Hypothesis

The natural rate of UNE is independent of monetary policy (economy is self-correcting)

Process for Analyzing SR

1. Identify shifter

2. Identify what curve is shifted

3. Identify which direction shifted

Process for Analyzing LR

1. Reference business cycle

2. Define type of labor market

3. Identify shifter

Slack Labor Market

There are more workers than jobs, so firms have the leverage (contraction)

Tight Labor Market

There are more jobs than workers, so workers have the leverage (expansion)

Fiscal Policy

Changes in federal taxes and purchases intended to achieve a macroeconomic policy objective (ΔG and/or ΔT). Used countercyclically to moderate the business cycle.

Automatic Stabilizers

Fiscal policies that automatically adjust to increases or decreases in the business cycle (e.g., income tax, UNE insurance)

Discretionary Fiscal Policy

New legislation implemented to moderate the business cycle

What’s the biggest government expenditure?

Transfer payments (Social Security, UNE, Medicare)

Counterfactual Model Analysis

1. Identify business cycle and effect (either UNE or π)

2. Prescribe policy course

Expansionary Fiscal Policy

Increases government purchases or decreases taxes

Contractionary Fiscal Policy

Decreases government purchases or increases taxes

Multiplier Effect

The process by which a change in autonomous expenditure leads to a greater change in real GDP (Y)

Autonomous Expenditure (AE)

(Planned) investment, government purchases, and net exports → DON’T depend on GDP level

Autonomous Consumption

Consumption by households that are unrelated to income or production level (aka baseline expenditures)

Induced Consumption

Consumption by households that depends on income or production levels

Multiplier Equation

(ΔY/ΔAE) or (1/1-MPC)

Legislative/Law-Making Delay

The time it takes for a policy to be formulated/agreed upon

Implementation Delay

The time it takes for a policy to have an impact

Recognition Delay

The time is takes to recognize the need for a policy

Procyclical Fiscal Policy

Policies that boost the economy during expansion and tank it during recessions

Crowding Out

When public investment disincentivizes private investment

Government Purchases Multiplier

(ΔY/ΔG) or (1/1 – MPC)

Tax Multiplier

(ΔY/ΔT) or (-MPC/1 – MPC)

Relationship between the government purchases and tax multipliers

Tax multiplier will always be less than government multiplier

Effect of Decreasing Tax Rates

1. Increase disposable household income → increase C

2. Increase size of multiplier effect

Expansionary FP & Multiplier

Leads to positive multiplier

Contractionary FP & Multiplier

Leads to negative multiplier

Disposable Income Equilibrium Condition

Y = C+I+G

Equilibrium GDP Equation

ΔY = [ΔC – (MPC x ΔT) + ΔI + ΔG]/(1 – MPC)

Effect of Tax Rate on Multiplier

The lower the tax rate, the larger the multiplier

Effect of Open Economies/Imports on Multiplier

Spending on imports doesn’t lead to an increase in domestic income

Budget Deficit

When government spending is greater than tax revenue

Budget Surplus

When tax revenue is greater than government spending

Government Outlays

Government purchases + Transfer payments + Interest payments

Structural Deficit

The deficit if the economy is operating at full employment

Cyclical Deficit

The deficit if the real GDP doesn’t equal potential GDP (gap between structural and actual deficits)

National Debt

The total money owed by a government

Debt Held by Public

The money owed minus what a government owes itself (in government acounts)

National Debt & LR GDP

When debt grows faster than GDP in LR, it may crowd out private investment and require higher tax rates

Benefits of LR Debt

Debt is useful if it pays for future growth (e.g., education, infrastructure)

Pay-as-you-go System

(In Social Security) the current workers fund current recipients

What does trade/bartering require?

A double coincidence of wants

Commodity Money

Goods used as money that have inherent value outside of use as money

Three Functions of Money

1. Medium of exchange: acceptable to many parties as payment

2. Unit of account: a way of measuring value

3. Store of value: defers consumption by maintaining its value

What can serve as money?

1. Acceptable (Medium of exchange)

2. Standardize quality

3. Durable

4. Valuable relative to weight

5. Divisible for high and low prices

Fiat Money

Paper money authorized by central bank that doesn’t have to be exchanged for a commodity (like gold)

M1 Components

1. Currency in circulation

2. Checking account deposits

3. (Most) saving accounts

Bank Assets

Loans and reserves

Bank Liabilities

Deposits

Required Reserves (RR)

The amount of money banks are legally required to hold

Required Reserve Ratio (rrr)

The minimum fraction legally required for banks to hold

Excess Reserves (ER)

The amount above the RR that banks hold

What creates new money supply in banks?

New loans

Simple Money Multiplier

1/rrr

Change in Money Supply (ΔM^S) Calculation

[(1/rrr) x Initial Deposit] – ID

Scarce-Reserves Regime

Banks hold few reserves beyond those required

Ample-Reserves Regime

Banks hold much more in reserves than is required

Interest Rate on Reserve Balance (IORB)

Interest paid by the Federal Reserve on reserve balances kept with them

Short-Run Aggregate Supply Shifters

1. ALK

2. Expected inflation (π^e)

3. Input prices

   1. Nominal wages (W)

   2. Price of oil (P^oil)