Boston University EC102 Watson Midterm 2

Aggregate Expenditure

- total spending on final goods and services in an economy during a given period, usually a year

- GDP

aggregate expenditure formula

AE = C + I + G + NX

Consumer spending

- some categories are more unpredictable to change than consumption as a whole

- production for cars and larger items tends to take hits during recessions

- largest GDP category

- cutting back on spending can have big impacts

current disposable income

- income after taxes are paid and government transfers are received

- most important variable of consumption

- not national income

The five most important variables that determine the level of consumption are

- current disposable income

- household wealth

- expected future income

- the price level

- the interest rate

when CDI increases, consumption

increases

when CDI decreases, consumption

decreases

household wealth

Assets (properties, ownings, etc.) - Liabilities (debts, loans, etc)

when wealth increases, consumption

increases

when wealth decreases, consumption

decreases

Expected Future Income

the amount of income people expect to have in the future

when expected future income increases, consumption

increases

when expected future income decreases, consumption

decreases

Changes in the price level

how prices change in the future

when the price level increases, consumption

decreases

when the price level decreases, consumption

increases

real interest rate

the interest rate corrected for the effects of inflation (nominal - inflation)

when the interest rate increases, consumption

decreases (it costs more to borrow to finance consumption, more incentive to save)

when the interest rate decreases, consumption

increases (costs less to borrow to finance consumption, less incentive to save)

consumption function

the relationship between consumption spending and disposable income

Marginal Propensity to Consume (MPC)

- the increase in consumer spending when disposable income rises by $1

- the slope of the consumption function

- change in consumption/change in disposable income

- ex. if .84, then out of every additional dollar, each person on average spends .84 of that dollar

Marginal Propensity to Save (MPS)

- the increase in household savings when disposable income rises by $1

- change in saving/change in disposable income

MPC + MPS =

1

investment

- spending on capital equipment, inventories, and structures, including household purchases of new housing

- plants and equipment is biggest percentage

- housing is around 20%

- change in inventories less than 5%

- change in K

change in inventories

- good that has been produced, but not yet been sold

- raw, unused materials

- goods that aren't finished yet

- 500B added - 400B sold = 100B

what part of aggregate expenditure is most volatile to change?

investment

Determinants of Investment

- expectations of future profitability

- taxes

- cash flow

- real interest rate (when rates go up, investment goes down)

Financing Alternatives with External Funds

- borrowing money with bank loans or bonds

- sell shares of stock

net exports

- spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports)

- exports - imports

what happens to net exports in a recession?

they typically go up as the US exports more products and imports less

nominal exchange rate (E)

- the value of one country's currency in terms of another country's currency

- number of units of foreign currency per unit of domestic currency

appreciation of currency

- a rise in the price of one currency relative to another

- when it takes more money to purchase a singular unit of a currency

- the foreign currency depreciates

depreciation of currency

- a fall in the price of one currency relative to another

- when it takes less money to purchase a singular unit of currency

- the foreign currency appreciates

how to swap between currencies?

- divide singular unit by exchange rate

- 1 pound/1.128 euros = 0.886 pounds per 1 euro

how to calculate price in another currency?

- multiply the price by the exchange rate

- 1 pound = $1.618 - 129 pounds * 1.618 = $208.74

How are exchange rates determined?

- Exchange rates are determined by the demand and supply for different currencies

what are the three determinants of exchange rate demand?

- demand from foreign firms for US goods and services

- foreign firms wanting to invest in physical or financial assets

- currency traders believing the value of currency will rise

what is the most important determinant of exchange rates?

- interest rates

- increases in US rates leads to increase for US assets

- leads to increase in dollar demand

- leads to appreciation of the dollar

real exchange rate (e)

- the price of domestic goods in terms of foreign goods

real exchange rate formula

- (nominal exchange rate x domestic price)/foreign price

- US watch $100, swiss price 300SF, E - $1 = 1.5SF

- watch costs 150SF

- e = 1/2

- US watch is half the price of swiss watch

- 1/2 swiss watch = 1 American watch

how does the real exchange rate change?

- if any variable changes

- if the dollar appreciates (1.5SF/$1 - 3SF/$1) - leads to = prices

- if domestic prices change ($100-$300), leads to pricier US watches

- if foreign prices change (300SF - 100SF), foreign prices drop, domestic goes up

Purchasing Power Parity

- A monetary measurement of development that takes into account what money buys in different countries

- theory that, adjusted for nominal exchange rates, the same goods should cost the same wherever in the world they're sold

- if PPP holds, then e should equal 1, 1 unit should sell for the same amount as 1 foreign unit

Big Mac Index

- Tool for calculating purchasing power parity that compares prices of a Big Mac throughout the world

- if e>1 then E is too high, and the foreign currency is undervalued

- if e<1 then E is too low, and the foreign currency is overvalued

Calculating PPP adjusted exchange rate

- foreign price of product/domestic price of product

- provides exchange rate that would cause PPP to hold

Limitations of PPP

- many goods cannot be easily traded (services, price differences on goods cannot be arbitraged away)

- foreign, domestic goods, not perfect substitutes (Toyota vs chevy)

impact of inflation on exchange rates

- greater the inflation in a foreign country, the foreign currency should depreciate

- greater the domestic inflation, E falls, dollar depreciates

trade deficit

- An excess of imports over exports

trade surplus

- when a country exports more than it imports

balanced trade

- a situation in which exports equal imports

Determinants of Exports

- real exchange rate (e)

- gdp of trading partners

- tastes and preferences of foreigners

- trade policies

most important determinant of exports

- real exchange rate (e)

when e rises, exports

decrease

when e falls, exports

increase

what causes e to rise?

- when nominal E rises

- domestic prices rise

- foreign prices drop

- domestic goods become more expensive for foreign buyers

when foreign GDP rises, exports

rise

when foreign GDP declines, exports

decline

- decline GDP leads to less money for international purchases

trade policies

- keeping currencies undervalued

- tariffs and quotas

Determinants of Imports

- real exchange rate (e)

- domestic GDP

- domestic tastes

- trade policies

when e rises, imports

rise

- foreign goods become cheaper

when e falls, imports

fall

when domestic GDP increases, imports

increase

when domestic GDP falls, imports

decrease

- lower GDP means people cut on spending

Determinants of Net Exports

- real exchange rate (e)

- foreign gdp (exports only!)

- domestic gdp (imports only!)

- tastes

- trade policies

when e rises, net exports

- decrease

- exports decrease

- imports increase

- net exports decrease

when e falls, net exports

- increase

- exports increase

- imports decrease

- net exports increase

when foreign gdp increases, net exports

- increase

- exports increase

when foreign gdp decreases, net exports

- decrease

- exports decrease

when domestic gdp increases, net exports

- decrease

- imports increase

when domestic gdp decreases, net exports

- increase

- imports decrease

when interest rates increase compared globally, net exports

- decrease

- demand for $ assets increase

- demand for $ increases

- E increases

- e increases

- exports drop, imports increase

- net exports drop

- everything flips if interest rates decrease

aggregate demand curve

- the amount of goods and services in the economy that will be purchased at all possible price levels

a change in the price level causes

- movement along the AD curve

- a decrease in AE is a move up on the curve

Why is the AD curve sloped downward?

- When prices are lower, there is increased international competitiveness so more exports and less imports. Net exports are higher at low prices

- Higher prices mean inflation, peoples savings are falling in value and buy less, encourage ppl to save not spend

- wealth effect

- interest rate effect

- international trade effect

wealth effect

- The tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls.

- when wealth increases, consumption increases

- when the price level rises, wealth falls, consumption falls, aggregate expenditure falls

interest rate effect

- The tendency for increases in the price level to increase the demand for money, raise interest rates, and, as a result, reduce total spending and real output in the economy (and the reverse for price-level decreases).

- when prices increase, interest rates increase, consumption falls, AE falls

- R increases, investment decreases

- leads to created demand for $ assets, demand for $, E rises, e rises, X falls, IM increases, NX falls

international trade effect

- occurs when a change in the price level leads to a change in the quantity of net exports demanded

- prices rise, e rises, exports fall, imports rise, ae falls

What causes the AD curve to shift?

- government policies (monetary and fiscal policy)

- changes in expectations of households and firms

- changes in foreign variables

how does monetary policy impact the AD curve? (interest rates)

- when interest rates rise, consumption, investment and NX fall

- curve shifts to the left

how does fiscal policy impact the AD curve? (spending, taxes)

- when gov spending rises, AD shifts left

- when gov spending falls, AD shifts right

- when taxes rise, consumption and investment fall, AD shifts left

- when taxes fall, consumption and investment rise, AD shifts right

how to changes in expectations impact the AD curve?

- optimism causes increase in consumption, AD goes right

- pessimism causes fall in consumption, AD goes left

- expected GDP increase, increases investment, AD to right

- expected GDP decreases, decreases investment, AD to left

how do changes in foreign variables impact the AD curve?

- fall in E, fall in e, NX increases, AD to the right

- increase in E, increase in e, NX falls, AD to the left

- increase in domestic GDP, imports rise, NX falls, AD to the left

- decrease in domestic GDP, imports fall, NX rises, AD to the right

- increase in foreign GDP, exports rise, NX rises, AD to the right

- decrease in foreign GDP, exports fall, NX falls, AD to the left

aggregate supply curve

- a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

- relation between price level and total amount of goods and services supplied

- long and short run supply

long-run aggregate supply curve

- shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible

- economy's capacity to produce in the long run

- unemployment is at a natural right

- shifts to the right as the economy improves

- because not impacted by price level, the graph is a vertical line

what impacts the long run supply curve?

- capital stock

- labor force

- technology

- NOT THE PRICE LEVEL

short-run aggregate supply curve

- shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed

- slopes upward

- degree of price flexibility determined by SRAS slope

why is the aggregate supply curve upward sloping?

- contracts make some wages and prices sticky and hard to change

- firms are slow to adjust wages

- menu costs make prices sticky

what causes changes in both SRAS and LRAS?

- increases in the labor force

- increases in capital

- technological change

what causes changes in SRAS?

- expected changes in the future price level

- adjustments of workers and firms to errors in past expectations of the price level

- unexpected changes in the price of a natural resource

what is the most important determinant of the SRAS?

- unexpected changes in the price of a natural resource

negative supply shock

- An unexpected decrease in the availability of a key resource that temporarily decreases productivity

- causes a shift to the left

- increase in the price level

positive supply shock

- An unexpected increase in the availability of a key resource that temporarily increases productivity

- causes a shift to the right

- decrease in the price level

long run equilibrium

- the price level and real GDP that occurs when (1) the actual price level equals the expected price level, (2) real GDP supplied equals potential output, and (3) real GDP supplied equals real GDP demanded

inflationary gap

- when aggregate output is above potential output

- unemployment is below the natural rate

- price level goes up

- GDP goes up in the short run

what happens to fix an inflationary gap?

- SRAS shifts up, new equilibrium is now at a higher price level

recessionary gap

- when aggregate output is below potential output

- unemployment is above the natural rate

- price level decreases

- GDP falls in the short run

what happens to fix a recessionary gap?

- SRAS shifts down, new equilibrium is at a lower price level

negative supply shock in equilibrium

- increase in the price level and recession due to the leftward shift of the SRAS

how are negative supply shocks fixed?

- SRAS shifts back toward the right to the original position

positive supply shock in equilibrium

- increase in GSP and decrease in the price level due to rightward shift of SRAS

how are positive supply shocks fixed?

- SRAS moves to the left again to the original position