ECON TEST 3

Week 12, 13, lec 27, 28, 29, 30, 31,

Marginal propensity to consume, or MPC:

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

MPC=

 consumer spending

— ————————

 Disposable income (where  = change)

• For example, if consumer spending goes up by $6 and disposable

income goes up by $10, MPC = $6/10 = 0.6

Marginal propensity to save, or MPS:

the fraction of an additional dollar of disposable income that is saved.

MPS = 1 − MPC

The multiplier

1

— —-

1 - MPC

autonomous change in aggregate spending

An initial change in aggregate spending at a given level of real GDP is called an

the multiplier is the

ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change

Taxes and multiplier

𝟏

—- —————————————- × $ 𝟏𝟎𝟎 𝒃𝒊𝒍𝒍𝒊𝒐𝒏

𝟏 − (𝑴𝑷𝑪 × 𝟏 − 𝒕 )

The aggregate demand curve(AD) shows

the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world

The interest rate effect:

If prices are higher, then there is less money left for lending and this will push up the interest rate. A higher interest rate will in turn reduce aggregate spending and equilibrium output.

The Wealth Effect:

The effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets

Events that increase the quantity of aggregate output demanded at any given aggregate price level shift the AD curve to the

right

Events that decrease the quantity of aggregate output demanded at any given aggregate price level shift the AD curve to the

left

Change in Consumption

An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the right. An event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate-demand curve to the left

Change in Investment

An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate- demand curve to the left.

Change in Government Purchases

An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left

An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes a currency depreciation) shifts the aggregate- demand curve to the

right

An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes a currency appreciation) shifts the aggregate-demand curve to the

left

The aggregate supply curve shows the relationship between the economy’s aggregate price level and the total quantity of aggregate output producers are willing to supply:

• The short-run aggregate supply curve

• The long-run aggregate supply curve

There is a positive relationship in the short run between the

aggregate price level and the aggregate output supplied

The Short-run Aggregate Supply Curve is upward sloping because

a higher price level leads to a higher profit per unit of output and a higher aggregate output given fixed nominal wages

Nominal wages are sticky in the

short run

Nominal wage:

the dollar amount of the wage paid.

Sticky wages:

nominal wages that are slow to fall even in the face of high

unemployment and slow to rise even in the face of labor shortages

The short-run aggregate supply

curve shifts leftward, and the

quantity of aggregate output

supplied at any given inflation

rate _____

falls

The short-run aggregate supply curve shifts rightward, and the quantity of aggregate output supplied at any given inflation rate _____

rises.

The SRAS curve shifts because of changes in: Commodity Prices

is a standardized input bought and sold in bulk quantities. An increase in the price of a commodity raises production costs and reduces the quantity of aggregate output supplied at any given aggregate price level. This shifts the aggregate supply curve to the left

The SRAS curve shifts because of changes in:

Nominal wages:

A rise in nominal wages increases production costs and shifts the short-run aggregate supply curve to the left

Ex. Suppose there is an economy- wide rise in the cost of health care insurance premiums paid by employers as part of employees’ wages. From the employers’ perspective, this is equivalent to rise in nominal wages because it is an increase in employer- paid compensation

The SRAS curve shifts because of changes in:

3. Productivity:

If a worker can produce more output with the same inputs, the short-run aggregate supply curve shifts to the right

ex. (New regulations that require workers to spend more time filling out forms Æ reduce the number of unit of output a worker can produce)

Since contracts are renegotiated in the long run, in the long run,

nominal wages will fully adjust to the inflation rate (they are flexible, not sticky). In the long run, the inflation rate has no effect on the quantity of aggregate output supplied

The long-run aggregate supply curve shows the

relationship between the aggregate price level and the quantity of aggregate output supplied that holds if all prices, including nominal wages, were fully flexible.

The long run is the

time it takes for all prices (including nominal wages) to adjust

In the long run, prices have

no effect on aggregate output because prices (including nominal wages) are fully flexible

Potential output is the

level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible

The level of real GDP is almost always either above or below potential output because of

short-run fluctuations

GDP growth is shown by outward shift of the

LRAS

GDP Growth can be caused by:

1. More immigration or pop growth - L^

2. Expansion of factories and stores - K^

3. More people go to college - H ^

4. The internet increases the speed of innovation - A ^

LRAS would shift inward if we had

Natural disasters or wars

The AD–AS model uses the aggregate supply curve and the aggregate demand curve together to analyze

economic fluctuations

The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is

equal to the quantity demanded

An event that shifts the aggregate demand curve is a

demand shock

Demand shocks shift AD, moving the aggregate price level and aggregatecoutput in the

same direction

An event that shifts the aggregate supply curve is a

supply shock

Supply shocks shift SRAS, moving the inflation rate and aggregate output in

opposite directions

The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the

long-run aggregate supply curve

Recessionary gap:

when aggregate output is below potential output

Inflationary gap:

when aggregate output is above potential output

Output gap:

the percentage difference between actual aggregate output and potential output

EQ:

Actual aggregate output - Potential output

— —————————————————- X100

Potential Output

In the long run the economy is self-correcting:

Demand shocks have only a short-run effect on aggregate output

If policy makers react quickly to the fall in aggregate demand, they can use _____________ to shift the aggregate demand curve back to the right.

monetary or fiscal policy

Macroeconomic policy would be desirable because:

– the temporary fall in aggregate output is associated with high unemployment; and

– preventing deflation is a good thing

POLICY IN THE FACE OF DEMAND SHOCKS

• Does this mean that policy makers should always act to offset declines in aggregate demand?

Not necessarily.

Because the government can affect spending by consumers and firms, the government can shift the

aggregate demand curve

Why would the government want to shift the aggregate demand curve?

It wants to close either a recessionary gap or an inflationary gap

Fiscal policy:

the use of taxes or government purchases of goods and services to shift the aggregate demand curve

Expansionary fiscal policy:

fiscal policy that increases aggregate demand.

• An increase in government purchases of goods and services

• A cut in taxes

• An increase in government transfers

• Expansionary fiscal policy can close a recessionary gap

Contractionary fiscal policy: fiscal policy that decreases aggregate demand.

• A reduction in government purchases of goods and services

• An increase in taxes

• A reduction in government transfers

❑ Contractionary fiscal policy can close an inflationary gap

Automatic stabilizers are

government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands

Taxes and some government transfers act as ___________ as tax

revenue responds positively to changes in real GDP and some government

transfers respond negatively to changes in real GDP

automatic stabilizers

Discretionary fiscal policy is fiscal policy that is the

result of deliberate actions by policy makers rather than rules

Mechanism of Operation

❑Automatic Stabilizers:

These work automatically, without any need for new government action. They are built into the economy’s structure, adjusting in response to economic conditions

Mechanism of Operation for Discretionary Fiscal Policy:

This requires deliberate action from the government, typically through legislation

Timing and Responsiveness

❑Automatic Stabilizers:

They respond in real-time as economic conditions change. Since they are pre-set to adjust based on economic indicators (like unemployment rates or income levels), they provide immediate stabilization when a downturn or upturn begins

Timing and Responsiveness for Discretionary Fiscal Policy:

It takes longer to implement because it requires government decision-making. Policymakers must first recognize economic shifts, then plan, approve, and execute changes, which may take months to a year. As a result, discretionary policy is often slower to affect the economy compared to automatic stabilizers

Flexibility and Control

❑ Automatic Stabilizers:

They operate within fixed rules, offering less flexibility for targeted interventions. While they can help moderate economic fluctuations, they are not designed for specific issues or sectors of the economy.

Flexibility and Control Discretionary Fiscal Policy:

This is highly flexible and can be tailored to address specific economic needs. For instance, if a recession affects certain industries, policymakers can direct funds toward those areas. This targeted approach allows for a more precise impact, but it also requires accurate forecasting and timing

lec 28 last slide figure out how to put pic here

Money:

any asset that can easily be used to purchase goods and services

Currency in circulation:

cash held by the public

Checkable bank deposits:

bank accounts on which people can write checks

money supply

is the total value of financial assets in the economy that are considered money

Medium of exchange:

something people accept as payment for goods and services.

➢ An asset that individuals acquire for the purpose of trading rather

than for their own consumption

Store of value:

money is a means of holding purchasing power over time.

➢ It enables people to save the money they earn today and use it to

buy the goods and services they want tomorrow.

Unit of account:

money provides a yardstick for measuring and comparing the values of a wide variety of goods and services.

Commodity money:

a good, normally gold or silver, used as a medium of exchange that has intrinsic value in other uses.

➢ For thousands of years, societies have used commodity money

Commodity-backed money:

a medium of exchange with no intrinsic value; the ultimate value is guaranteed by a promise that it can be converted into valuable goods.

➢ Advantage: it tied up fewer resources. Although a note-issuing bank still had to keep some gold and silver on hand, it had to keep only enough to satisfy demands for redemption of its notes, and it could lend out the remaining gold and silver.

Fiat money:

money whose value derives entirely from its official status as a means of payment.

➢ Advantages: It doesn’t use up any real resources beyond the paper it’s printed on, and the supply of money can be adjusted based on the needs of the economy.

➢ Disadvantages: It can be counterfeited, and governments can abuse the privilege of printing money

Monetary aggregate:

an overall measure of the money supply.

Two measures of the money supply:

➢ M1 includes only the most liquid forms of money.

➢ M2 includes near-moneys: financial assets that can’t be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits. Example: small-denomination certificates of deposit (CDs), which aren’t checkable but can be withdrawn at any time before their maturity date

Bank reserves:

the currency that banks hold in their vaults plus their deposits at the Federal Reserve

T-account:

a tool for analyzing a business’s financial position by showing the business’s assets and liabilities

The reserve ratio:

the fraction of bank deposits that a bank holds as reserves ($100,000/$1,000,000 = 10%)

Bank run:

a phenomenon in which many of a bank’s depositors try to withdraw their funds because they fear a bank failure

Capital requirements:

requirement that the owners of banks hold substantially more assets than the value of bank deposits

Reserve requirements:

rules set by the Federal Reserve that determine the minimum reserve ratio for a bank

Discount window:

an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble

Round 1: We start from zero and suppose that Alice comes into the bank and

deposits $100,000 in currency.

The bank now has $100,000 on deposit of which it can lend out 90% or $90,000

Round 2: The bank lends $90,000 to Pete.

Pete pays the $90,000 to Joe for a boat, and Joe deposits it in the bank

Round 3: Now, the bank is free to lend out

90% of this new deposit to Fred, which Fred pays to Lois for design and decorating services for his business office. Lois deposits the $81,000 in the bank.

• By these three steps, the money supply has gone from $100,000 to $271,000.

Case 1: Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution—that is, _______________________. In this imaginary economy, all deposits are held as reserves, so this system is called __________________. Now consider the money supply in this imaginary economy. Before First National Bank opens, the money supply is the $100 of currency that people are holding.

it accepts deposits but does not make loans, 100-percent-reserve banking,

Case 2: Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This means that it keeps ____________________________________________.

10 percent of its deposits in reserve and loans out the rest

Case 3: The creation of money does not stop with First National Bank. Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. If Second National also has a reserve ratio of 10 percent, it keeps assets of $_________________

9$ in reserve and makes $81 in loans

Case 4: Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, this bank keeps ______________________________

$8.10 in reserve and makes $72.90 in loans

The amount of money the banking system generates with each dollar of reserves is called the

money multiplier

What determines the size of the money multiplier?

• The money multiplier is the reciprocal of the reserve ratio.

• The reserve ratio for all banks in the economy

✓ Money Multiplier = 1/rr

• Excess reserves are a bank’s reserves over and above its required reserves

Short-term interest rates:

the interest rates on financial assets that mature within less than a year

Long-term interest rates:

interest rates on financial assets that mature a number of years in the future

The higher the interest rate,

The lower the interest rate,

the higher the opportunity cost of holding money., the lower the opportunity cost of holding money

The money demand curve (MD) shows the

relationship between the quantity of money demanded and the interest rate.

❑ It slopes downward:

❑ A higher interest rate reduces the quantity of money demanded.

❑ A lower interest rate increases the quantity of money demanded

SHIFTS OF THE MONEY DEMAND CURVE changes in aggregate price level

Higher prices mean we need more money for transactions (and vice versa)

SHIFTS OF THE MONEY DEMAND CURVE Changes in real GDP

More goods and services produced and sold means we need more money (and vice versa)