ECON 2105 Test 3

Aggregate Demand

The total demand for goods and services in an economy; "spending side"

4 Major Pieces of Aggregate Demand

Consumption (C)

Investment (I)

Government (G)

Net Exports (NX)

Three Reasons for Inverse Relationship with Price Level (P) and Aggregate Demand Quantity

The Wealth Effect

The Interest Rate Effect

The International Trade Effect

The Wealth Effect

Change in quantity of aggregate demand that results from wealth changes due to price-level changes

The Interest Rate Effect

Change in price level leads to a change in interest rates and therefor a change in aggregate demand quantity

The International Trade Effect

Change in price level leads to a change in the quantity of net exports demanded

Shifts in Aggregate Demand

Real wealth

Expect income

Expected prices

Foreign income

Value of the dollar

Real wealth

National wealth increases so aggregate demand increase, and vice versa

Expected Income

If people expect higher income in the future, they spend more today, and vice versa

Expected Prices

If people expect higher prices in the future, they are more likely to spend today, and vice versa

Foreign Income

Income in the foreign nations grows, their demand for U.S. goods increases

Value of the Dollar

When the real value of the dollar rises relative to currencies of other countries, Americans find imports are less expensive

Aggregate Supply

The total supply of final goods and services in an economy; "supply side"

Shifts in LRAS

happens when there is a long run change in a nation's ability to produce output, or a change in y*

Shifts in SRAS

Supply shocks

Expected future prices

Corrections of past errors in expectations

Supply Shock

A surprise event that changes a firms production costs

Expected Future Costs

Real value of your future income depends on prices in the future; people negotiating wages makes production costs increase and therefor decrease profitability, and SRAS shifts right

Corrects of Past Errors in Expectations

When expectations are wrong, people want to readjust wages in later periods, this affects costs

How does AD-AS model help us understand the economy?

We use it to see how changes affect real GDP, price level, and unemployment

The Great Recession: When did it occur?

2007-2009 (18 months); longest recession since the great depression

Why was it called The Great Recession?

Because after it was over, unemployment remained high and real GDP grew slowly

Reason for the Decline in Aggregate Supply for the GR?

The Loanable Funds market; mortgage-backed securities were mainly held by the largest financial institutes in America, markets failed because people couldn't pay mortgages

2 Facts for Decline in Aggregate Demand for the GR

Fall in wealth

Fall in expected income

Fall in Wealth (GR)

Main piece of people's wealth generally is their homes when real estate values decreased, wealth also decreased

Fall in Expected Income (GR)

People realized there was an economic downturn and their confidence of their future income decreased

The Dodd-Frank Act

The primary regulatory response to the financial turmoil that contributed to The Great Recession

What happened to LRAS from The Great Recession?

LRAS declines

The Great Depression: When did it occur?

1929-1933 and 1937-1938

What was the Great Depression so bad?

1. It had two separate recession, first August 1929-March 1933 and second May 1937-June 1938

2. Prices declined through out the course of the decade

Reason for Decline in Aggregate Demand (GD)

Mainly caused by faulty macroeconomic policy

Macroeconomic Policy

Encompasses government acts to influence the macroeconomy

Fiscal Policy

Compromises the use of the governments budget tools, government spending, and taxes to influence the macroeconomy

Monetary Policy

Involves adjusting the money supply to influence the macroeconomy

Classical Economists

Stress the importance of aggregate supply and generally believe that the economy can adjust back to full employment equilibrium on its own

Keynesian Economists

Stress the importance of aggregate demand and generally believe that the economy needs help in moving back to full employment equilibrium

Who established this new (Keynesian) approach?

John Maynard Keynes, a British economist, formulated this approach; he published The General Theory of Employment, Interest, and Money

Classical Economists vs Keynesian Economists

Key Time Period:

Price Flexibility:

Savings:

Key Side of Market:

Market Tendency:

Government Interventions:

Classical Economists vs Keynesian Economists

Long run Short Run

Flexibility Sticky

Crucial to growth A drain on demand

Supply Demand

Stability; full employment instability cyclical unempl.

Not necessary Essential

Government Budget

A plan for both spending and raising funds for the government

Transfer Payments

Payments made to groups or individuals when no good or service is received in return (income assistance and social security)

Government Outlays

The part of the government budget that includes bot spending and transfer payments

Government Outlays Split into 3 Parts:

1. Mandatory outlays

2. Discretionary spending

3. Interest payments

Mandatory Outlay

Compromise government spending that is determined by on-going long-term obligations (ex. medicare and social security)

Discretionary Outlays

Compromise spending that can be altered when the government is setting its annual budget; can be altered month to month (ex. money for brides and roads, defense spending, government workers)

Social Security

A government administered retirement funding program; people pay into it while working then receive when they hit retirement age

Medicare

A mandated federal program that funds health care for retired; the law requires current workers to pay medicare taxes with a promise they will receive it upon retirement, like social security

Why do entitlement programs take up a lot of federal budget?

1. People are living longer today than before

2. Those who paid into the programs for many years are now retired/drawing benefits

3. In addition to the normal retirees, baby boomers are now retiring

3 Fixes to Social Security and Medical Funding Problems

1. Increase the retirement age from 67 to 70

2. Adjust the benefits computation to the CPI instead of the average wages index

3. Means testing for social security and medical benefits (decrease benefits for those that can afford it)

3 Major Factors for Increased Spending

1. Increased spending on social security and medicare

2. Defense spending in wake of 9/11 terrorist attack

3. Government responses to the Great Recession, beginning with fiscal policy in 2008

How is virtually all of government revenue raised?

Through taxes

Two Largest Sources of Tax Revenue

1. Individual income taxes

2. Social insurance taxes (SS/Medicare)

What are these 2 largest tax sources referred to as

Payroll Taxes

Progressive Income Tax System

Is one in which people with higher incomes pay a larger portion of their income in taxes than people with lower incomes do

Marginal Tax Rate

the tax rate paid on an individual's next $ income

Average Tax Rate

The total tax paid divided by the amount of taxable income

Who pays for the government in a progressive tax system?

Wealthy citizens pay more than poor citizens, very wealthy pay most of all

Budget Deficit

Occurs when government outlays exceed revenue

Budget Surplus

Occurs when government revenue exceeds outlays

Negative Balance Means

Budget deficit

Positive Balance Means

Budget surplus

Debt

The sum total of accumulated budget deficits

Austerity

Involves strict budget regulations aimed at debt reduction

Concern With Foreign Ownership of U.S. Debt is

Fear that they will control the country politically as well as economically

How to Calculate Marginal Tax Rate

10% on income up to $8,700

15% on income up to $35,350

25% on income above $35,350

Example: Calculate the Marginal Tax Rate on $60,000 Income

.10 x 8,700 = 870.00

.15 x (35,350-8,700) = 3,997.50

.25 x (60,000-35,350) = 6,162.50

Total Tax Paid = 11,030.00

Two Tools the Government Uses to Try to Affect the Economy

Monetary policy and fiscal policy

Fiscal Policy

Makes use of the money supply to influence the economy

Expansionary Fiscal Policy

Occurs when the government increases spending or decreases taxes to stimulate the economy towards expansion

Two Fiscal Policy's Initiated During The Great Recession

Economics Stimulus Act of 2008

- George W. Bush

- Tax rebate for Americans

American Recovery and Reinvestment Act of 2009

- Obama

- Focused on taxes and spending

How does the government pay for all spending/shortfall in tax revenue?

By borrowing

Example: How does the government pay for an increase in government spending by $100 billion?

Borrowing; they would sell $100 billion worth of treasury bonds

Contractionary Fiscal Policy

Occurs when the government decreases spending or increases taxes to slow the economic expansion

2 Reasons Why the Government Might Want to Reduce Aggregate Demand

1. It can work to eliminate budget deficit and pay off some of the government debt

2. Government might want to reduce AD if it believes the economy is expanding beyond its long run capabilities

Countercyclical Fiscal Policy

Fiscal policy that seeks to counteract business-cycle fluctuations

3 Short Comings of Fiscal Policy

1. Time lags

2. Crowding-out

3. Savings shift

3 Time Lags

1. Recognition lag

2. Implementation lag

3. Impact lag

Recognition Lag

Factors that make it difficult to recognize when expansion or contraction starts

Implementation Lag

It takes time to implement policies

Impact Lag

It takes time for complete effects to materialize/take place

Automatic Stabilizers

Government programs that automatically implement countercyclical fiscal policy in response to the economic conditions

Automatic Stabilizer Government Programs

1. Progressive income tax rates

2. Taxes on corporate profits

3. Unemployment compensation

4. Welfare programs

Progressive Income Tax Rates

Guarantee individuals tax bill will fall during recessions and rise when income rises

Taxes on Corporate Profits

Lower total tax bills when profits are lower and raise total tax bills when profits are higher

Unemployment Compensation

Increase government spending automatically when number unemployed rises and vice versa

Welfare Programs

Increase government spending during downturns and decrease government spending during upturns

Crowding Out

Occurs when private spending falls in response to increase in government spending

Savings Shift

Savings rises when people anticipate higher future taxes

Supply Side Fiscal Policy

Involves the use of government spending and taxes to affect the production (supply) side of the economy; shifts LRAS -->

Currency

The paper bills and coins that are used to buy goods and services

3 Functions of Money

1. Medium of Exchange

2. Unit of Account

3. A Store of Value

Medium of Exchange

What people trade for goods and services

Unit of Account

Measure in which prices are quoted (expressing something in dollars and coins allows for accurate comparisons)

A Store of Value

A means for holding wealth

Barter

Involves the trade of a good or service without a commonly accepted medium of exchange

Double Coincidence of Wants

Occurs when each party in an exchange translation happens to have what the other party desires

Commodity Money

Involves the use of an actual good in place of money; ex. gold and silver

Commodity-Backed Money

Money that can be exchanged for a commodity at a fixed rate; ex. U.S. Dollar used to be equated to gold and silver

Fiat Money

Money that has no value except as the medium of exchange; our money is physically just a piece of paper

Checkable Deposits

Deposits in bank accounts from which depositors may make withdrawals by writing checks

M1

The money supply measure that is essentially composed of currency and checkable deposits

M2

The money supply measure that includes everything in M1 plus savings deposits, money market mutual funds, and small-denominational time deposits (CDs)