Unit 3: National Income and Price Determination

Stagflation happens when AS decreases, not when AD shifts/more labor=more production=lower prices

Aggregate demand

All the goods & services (real GDP) that buyers are willing and able to purchase at different price levels; The demand for all things that make up GDP by everyone

Relationship between Price Level and GDPr demanded

inverse relationship; If price level increases (inflation), then real GDP demand falls

Real Wealth Effect

Higher price levels reduce the purchasing power of people’s wealth. This makes people less willing & able to spend/consume

What is an interest rate?

Price of borrowing; % of what is owed that a borrower has to pay a lender

What two components of GDP will Interest Rate Effect impact?

Consumer spending & investment

What component of GDP will the Exchange rate effect impact?

exports-imports

Common causes for a change in consumer expenditures

change in consumer taxes (fiscal policy), consumer wealth/income, consumer expectations, change in interest rates (monetary policy)

Change in Consumer Taxes (fiscal policy)

congress can raise or lower taxes (fiscal policy); less taxes means more disposable income to use on G & S

Disposable Income

income available to spend after deductions (like taxes)

Change in Consumer Wealth/Income

more wealth/assets/income can increase people’s willingness to spend on C

Change in Consumer Expectations

people don’t spend as much when they are not confident in their future income & the economy

Change in Interest Rates (monetary policy)

lower interest rates increase people’s willingness to purchase big-ticket items

Common Causes for a Change in Investment Expenditures

Monetary Policy (Federal Reserve), Change in Expected returns, change in investment spending

Monetary Policy (Federal Reserve)

the Fed can change interest rates

1. If interest rates lower, businesses will invest in more physical capital because the price of borrowing has gone down

2. An increase in interest rates would discourage investments in physical capital because the price of borrowing has gone up

Change in Expected Returns (forecasts for the future)

expected future business conditions, new profitable technology, business taxes; businesses base their investments on the potential profitability of a project

Change in Investment Spending

if firms are worried that they are running low on physical capital, they are more likely to increase their investment in new physical capital

Change in Government Expenditures: Fiscal Policy (Congress)

Congress can increase or decrease taxes or government spending

Change in Net Export Expenditures

Exports-Imports; Export increase, increase aggregate demand; exports decrease, decrease in aggregate demand

What causes a change in net export expenditures

changes in relative incomes, relative prices, and exchange rates

Relative Income: How would the US net exports be impacted if Americans make more money?

Net exports would decrease because we are buying more imports

Relative prices: How would the US net exports be impacted if American price levels went up

Exports would decrease because foreigners wouldn’t be as willing or able to afford them

Exchange Rates: How would the US net exports be impacted if the American dollar strengthened compared to the Canadian dollar

net exports would fall because the US would buy more imports (from Canada) and less exports (because expensive)

Aggregate Supply

the production (supply) of GDPr (CIG X-M) by all firms

Short-Run

a period of time when wages & resource costs have NOT yet adjusted to inflation/deflation. Eventually, they will (long-run) increase but they haven’t yet. Resources costs might go up but not because of inflation

Relationship between price level and short run production

PL Increase=Increase in Qty produced

PL Decrease=Decrease in Qty produced

direct relationship

Shifters of Short-Run Aggregate Supply

Resource Costs
Actions of Gov’t towards businesses
Productivity/Technology

Change in Resource Prices (Input costs)

Labor costs increase=decrease production bc less money towards production
Capital: Decrease price of computers=increase production bc they can afford to produce more
Commodities: Oil price increase=decrease production bc less $ towards other resources

Actions of Government Toward Businesses

Business taxes decrease=increase production; more money towards resources
Subsidies increase=increase production; more money towards resources

Regulations reduced=increase production; more money towards resources

Productivity/Technology

Increase production because it makes production more efficient; assembly line

Explain why labor costs might not rise instantly when PL rises

Multi-year labor contracts

Explain why commercial rent might not rise instantly when PL rises

Annual leases for retail space

Explain why commodity prices might not rise instantly when PL rises

Monthly price agreements for commodities

Long-run

a period of time where resource costs have adjusted to inflation/deflation

What can firms do in the short-run but suffer in the long-run?

Raise prices of goods & services, higher resource prices

How does inflation impact producers’ production in the long run

If real profit doesn’t change when PL increases the firm has no incentive to increase output (production)

Where does the dot go if there is an unemployment rate above the natural rate of unemployment

Point inside the PPF with unemployment rate>6%

Classical Economic Theory

belief that all wages and resource costs are flexible

• Big Problem: high price level (inflation)—> labor will demand higher wages. Businesses can’t afford as many resources (like labor) as they could before. AS shifts left

• Big problem during a recession: high rates of unemployment (cyclical) so businesses can lower wages. More resources=more production. AS shifts right

Keynesian Economic theory

belief that wages and resources costs are sticky (resistant to change); since the economy will not return to full employment in a timely manner, we need the gov’t to intervene and return the economy to Full Employment

• Monetary Policy (Federal Reserve) & Fiscal Policy (Congress)

• Changes aggregate demand to return the economy to Full Employment

What is a big concern for an economy that is producing beyond full-employment

Inflation

Two tools of discretionary fiscal policy

1) Government Spending (& transfer payments)

2) Taxation

Expansionary Fiscal Policy

• used to reduce unemployment and increase GDPr

• increase gov’t spending & transfer payments and decrease taxes

Contractionary Fiscal Policy

• Reduce inflation, decrease GDPr

• decrease gov’t spending, increase taxes

Explain how transfer payments can speed up an economy that is in recession

Recessions=more poverty, more unemployment 

• More transfer payments to get these people to spend more than they otherwise would

Explain how transfer payments can slow down an economy that is producing beyond full employment

People who were receiving benefits don’t receive it anymore because they are employed again. Less money spent on goods and services

What is the progressive tax system?

Average tax burdens increase with income

Explain how the progressive tax system can speed up an economy that is in recession

1. Recessions: more people dropping down to lower tax brackets

2. Won’t have to pay as much in taxes

3. More disposable income

4. Purchase more G & S than they otherwise would

Explain how the progressive tax system can slow down an economy that is producing beyond full employment

1. Expansions: more people pushed up into higher tax brackets

2. Pay more in taxes

3. Less disposable income

4. Not be willing or able to purchase as many g & S than they otherwise would