Unit 3 National Income & Price Determination

circular flow of income model

shows how money flows through an economy; model outlines relationship between consumers (households) and producers (firms)

resource market

households supply resources to firms (ex: land, labor, capital, & entrepreneurship) in exchange for wages

product market

households use the income they received in the resource market to buy goods & services from firms

leakages

when money flows out of the model (savings, taxes, and imports)
when ____ > injections, the economy is smaller

injections

when money flows in to the model (gov’t spendings, investment, and exports)
when ____ > leakages, the economy is larger

open economy

when a country buys goods and services produced by another country

imports

when a country purchases goods and services from abroad (leakage)

exports

when a country sells goods and services to abroad (injection)

business cycle diagram

a graphical representation (x-axis: time; y-axis: real GDP) showing the fluctuations in economic activity over time, including phases of expansion and contraction

peak

economic growth reaches its maximum at this point; the economy expands until it reaches the ____.
real GDP increased and unemployment is at a low

contraction

where output begins to decrease following a peak; firms need fewer workers, so unemployment decreases and real GDP decreases (if > 6 months = recession)

trough

end of the cycle; the economy enters a new stage

expansion

recovery stage; economy is recovering from the economic downturn and entering a new phase of economic growth

GDP

measures economic activity of a country either by calculating output, income, or spending

expenditure approach

method of calculating GDP in which we calculate the total of all spending on final goods & services produced within an economy during a period of time

final goods & services

products that are purchased for consumption by the end user and not used for further production

intermediate good

products used to produce final goods and services, not intended for sale to end users

GDP equation

C + I + G + Xn
C = consumer spending
I = investment/firms spending
G = government spending
Xn = net exports (X-M)

income approach

calculating GDP by adding up all income earned together

output approach

value of all final goods & services produced in an economy during a given period of time

nominal GDP

value of all final goods & services produced in an economy in current prices
percent change = (final-initial)/initial * 100

real GDP

value of final goods & services produced in an economy, adjusted for prices of a predetermined year; nominal GDP adjusted for inflation
percent change = nominal GDP * 100

………………….…GDP deflator

aggregate demand

the total output that all buyers in an economy are willing & able to buy @ different price levels in a given period of time

aggregate demand measures

demand of all consumers, firms, gov’t, and foreigners for goods & services

aggregate demand equation

C + I + G + Xn
C = consumer spending
I = investment/firms spending
G = government spending
Xn = net exports (X-M)

reasons for downward sloping demand curve

wealth effect, interest rate effect, & foreign trade effect

wealth effect

higher price levels make people feel less wealthy, so they will cut spending leading to less output being demanded; lower price levels make people feel better off and increase spending which leads to more output being demanded

interest rate effect

when price levels are higher, consumers & firms need more money leading to an increase in interest rates, which dampens spending and investment

foreign trade effect

at higher price levels, foreigners find U.S. good expensive and demand for exports decreases; lower price levels exports decrease

determinants of aggregate demand

consumer spending, investment spending, government spending, & net exports

consumer spending

if consumers feel more confident in the economy and spend more, making aggregate demand increase; but, if they don’t they will save more money, making aggregate demand decrease
- interest rates
- changes in wealth
- taxes
- household indebtedness

investment spending

spending by firms on capital goods such as machinery, equipment, and buildings
- business activity
- interest rates
- technology improves
- taxes
- debt

government spending

changes due to shifts in political priorities and an increase increases aggregate demand

net exports

changes in national income abroad will cause changes in ______
- exchange rates (value of one currency vs. another)
- trade protection (exports increase when restrictions = lifted)

aggregate supply

total supply of all goods & services produced in an economy

SRAS

short-run aggregate supply curve; as price levels (PL) increases, so does output, due to profit motive

determinants of SRAS

• changes in resource action: when resources become more expensive, there will be a decrease in amounts of goods & services produced

• changes in gov’t action: when a gov’t grants a subsidy, SRAS will increase

• changes in productivity: when labor becomes more productive, there is an increase in aggregate supply (ex: education & healthcare/technology improve)

short-run in aggregate supply (SRAS)

time period when resource wages & resource prices are inflexible

long-run in aggregate supply (LRAS)

time period when resource wages & resource prices are flexible; shifts when the quantity or quality of production of one of the FOPs changes
* when ____ moves, the entire equilibrium diagrams of the AD-AS model shift as well

inflationary gap

aggregate demand shifts to the right (increase in AD); economy experiences increase in price level leading to inflation
(real GDP > potential GDP)

recessionary gap

aggregate demand shifts to the left (decrease in AD); economy experiences decrease in price level leading to a recession
(real GDP < potential GDP)

stagflation

SRAS shifts left (sudden decrease in aggregate supply); increase in price levels & decrease in employment

increase in aggregate supply

SRAS shifts right (increase in aggregate supply); decrease in price levels & increase in employment

classical economics view of inflationary gap

argue that as price levels increase, workers will eventually feel the pain of inflation & will demand higher wages; as a result, resource prices will all increase which makes SRAS decrease, and the economy will be back at LRAS @ a higher price level

classical economics view of recessionary gap

argue that in the long run, workers will eventually accept lower wages; as a result, resource prices will all decrease which makes SRAS increase, and the economy will be back at LRAS @ a lower price level

Friedrich A. Von Hayek

Austrian-British economist; champion of Classical Economics

John Maynard Keynes

British economist: father of Keynesian Economics
- graph looks exponential with flat period and then increase
- gov’t’s job = to bring economy into equilibrium through specific policy actions (workers will not accept a lower wage & the gov’t’s job is to move aggregate demand back to equilibrium)

goal of macroeconomics

to experience economic growth while keeping th epains of too much inflation or unemployment from hurting people

two methods of correcting gaps

fiscal policy & monetary policy

fiscal policy

within congress; discretionary & non-discretionary
discretionary policy: congress passes laws to correct economy when needed (gov’t spending/taxes)
non-discretionary policy: involves systems already in place which automatically help stabilize the economy (unemployment benefits)

address inflationary gap

goal = AD decreases
decrease government spending
increase in personal &/or business income tax

address recessionary gap

goal = AD increases
increase government spending
decrease in personal &/or business income tax

unemployment benefits

enables people to keep spending which buffers Ad from decreasing as much as it would without this benefit

progressive income tax system

automatic stabilizer; if earner’s income increases, so does the income tax rate

MPC

marginal propensity to consume
______ + MPS = 1

MPS

marginal propensity to save
MPC + ______ = 1

change in real GDP formula (gov’t)

multiplier * change in gov’t spending
multiplier (Me) = 1/(1-MPC) = 1/(MPS)

change in real GDP formula (taxes)

tax multiplier * change in gov’t spending
multiplier (Me) = 1/(1-MPC) = 1/(MPS)
tax multiplier (Mt) = Me-1

government budget

revenue: $ coming into the federal gov’t in the form of personal & business income taxes
spending: President submits proposal to Congress outlining how federal $ from taxes should be spent
$ coming into gov’t by business/personal tax) & spending (proposal

U.S. Budget

33%: social security, unemployment, & labor
28%: medicare & healthcare coverage
15%: military
7%: interest on debt
17%: ambiguous spending (ex: education, etc.)

budget deficit

if expenditure > revenue country experiences deficit
requires borrowing from other countries (through bonds) adding to national debt

budget surplus

if expenditure < revenue country experiences surplus