econ 2010 2nd unit

Efffect Tax Rate= Total Tax Liability / Nominal Income


T= (r1*L)+r2*(Inominal-L)


Real post tax Income= Inominal-T / 1+i


Inflation rate (i)= (Current CPI- previous CPI / previous CPI) * 100


Inflation Rate = (Current GDP deflator - previous GDP deflator / previous GDP deflator) * 100


CPI= (Cost of market basket in current year / cost of market basket in base year)


GDP Deflator = (Nominal GDP / real GDP) * 100


Real value (purchasing power) = nomival value / 1+i


Real interest rate (exact fisher equation) = Nominal interest rate - anticipated interest rate or r= i- pi OR r=i+pi


nominal quantity = current dollar value


real quantity = nominal quantity / price index


Real GDPt = Nominal GDPt / price indext


Real Wage = Nominal wage / CPI


Nominal wage = real wage * price index


Anticipated interest rate = nominal interest rate - real interest rate


GDP = C + I + G + Xn


Disposable income = Consumption + saving (YD = C + S)


APC = Total consumption / total disposable income


MPC= Change in consumption / Change in disposable income


MPS = 1 - MPC


Consumption Function : C = a + bYD


Injection = ( I + G + X)




Macro consequences:

Uncertainity- Creates unpredictability in the economic environment, hindering long-term business planning, investment, and consumer spending.

Inflation- A general and sustained increase in overall price levels over time, which erodes purchasing power.

Speculation- High-risk financial transactions undertaken in anticipation of future price changes, which can lead to asset bubbles and market instability.

Bracket creep- Occurs when inflation pushes income earners into higher tax brackets, resulting in higher tax payments without an increase in real purchasing power.

Deflation Dangers- The economic risks associated with falling prices, such as delayed consumer spending, higher real debt burdens, and economic stagnation.


Speculation:

If you expect prices to rise, it makes sense to buy things now for resale later.

People will withhold resources from production hoping to sell at higher prices.


Bracket Creep:

An example of bracket creep occurs when an individual's nominal wage increases to keep up with inflation, pushing them into a higher tax bracket without increasing their real purchasing power.


Scenario:

  • Base Salary: Suppose a person earns 50,00050,000 per year. In this tax system, income up to 50,00050,000 is taxed at 15%15\%, while any income above 50,00050,000 is taxed at 25%25\%.

  • Inflation & Pay Increase: Over the year, general inflation rises by 10%10\%. To maintain their standard of living, their employer gives them a 10%10\% cost-of-living pay raise, increasing their nominal income to 55,00055,000.

  • Tax Impact: While their pre-tax purchasing power remains unchanged, the additional 5,0005,000 crosses into the higher 25%25\% tax bracket.

  • Result: Because a larger portion of their income is now taxed at 25%25\%, their total tax burden increases disproportionately. As a result, their real post-tax purchasing power decreases despite receiving a raise.


Deflation Dangers:

With deflation the average price level is falling

Declining price levels affect assest value.


Price Index:

Measures the avergae price of given quality of goods and services relative ot the price of the same goods and services in a base year.


Consumer price index (CPI!!!):

a measure of changes in the average of consumer goods and services

cost of living during a particular period

(current - previous / previous) * 100


Infaltion:

annual percentage increase in the average price level

not a change in any specific price

(CPI year 2 - CPI year 1 / CPI year 1) × 100

Hyperinflation- government keeps printing money to pay off debts. (excess 200)


Demand-pull inflation

Demand pulls up price, buyers outpace production capacity


Cost-Push inflation

Negative supply shock- increases the cost of produiton and forces prodcuers to increase prices.


GDP Deflator:

a price index that refers to all goods and services in the GDP

Usually lower inflation rate than GDP/CPI?

real GDP year t = Nominal GDP in year t / price index


Problems with the CPI:

Substitution Bias- when prices fall for a specific itme in the CPI basket, consumers naturally switch to cheaper alternatives (substitutes)

New Products- CPI basket only updates peridoically. Brand new products arent immediately included.

Product Quality- when a product increases in price, part of that might be because the quality improved. Can lead to overstate inflation becuase the CPI struggles to seperate true price increases from improvements in product quality.

CPI quality adjustment bias- quality improved so price increased however the CPI counts it as inflation.


Adjusting for inflation:

Nominal quantity- value measured in current dollar amounts without adjusting for inflation

real quantity- value measured in physical terms or adjusted for inflation to reflect true purchasing power.

deflating-the process of converting a nominal quantity into a real quantity by dividing it by a price index to remove the effect of inflation

Cost of living adjustment (COLA)- automatic adjustments of nominal income to the rate of inflation

Adjustable rate mortgage (ARM)- home loan that adjusts the nominal interest rate to chnaging rates of inflation


Real vs Nominal Interest Rates:

real interest rate- percentage increase in urchasing power that a borrower pays or a lender earns, adjusted for inflation

nominal interest rate- the interest rate stated on a loan or investment in actual dollar terms, without adjusting for inflation


Business Cycles:

There are 4 parts- peak, recssion, trough, and recovery

Peak- highest point of economic output, end of expansion phase and transition into a contraction

Recession- significant economic decline, shrinking real GDP, reduced ocnsumer spending.

Trough- lowest point of economic activity in a business cycle, end of recession and turning point where output begins to recover

Recovery- GDP increases

Cyclical unemploymnet rises sharply


Aggregate Demand:

Total quantity of output demanded at alternative price levels in a given time period.

AD slopes downward in the demand curve

Changes in price level cause move along the curve

Real balances effect (wealth effect)- money you hold is worth more when the price level falls, so you can buy more OR the money you hold is worth less when the price leve rises so you can buy less

Interest rate effect- lower interest rates promote more borrowing and spending OR higher interest rates deter borrowing and spending

Foreign trade effect- lower price levels in US convince customers to buy more American goods and fewer foreign goods OR higher price levels in the US prompt customers to buy less American goods and more foreign goods.


Aggregate Supply:

total quantity of output producers are willing and able to supply at alternative price levels in a given period.

Upward slope in the supply curve, cupplies bring more goods and services to the market at higher price levels.

Short run aggregate supply- wages and resource prices are sticky and wont change as price levels change. When price levels go up, businesses will produce more.

Long run aggregate supply- wages and input prices fully adjust to price changes.

Profit effect- in the short run, as the overall prices rise while resource costs remain fixed, profit margins widen, incentivizing firms to produce and supply more output.

Cost effect- as production increases beyond normal capacity, producers face rising marginal costs requiring higher output prices to cover these additional expenses.


Macro equilibrium:

The combination of price and level and real output that is compatiable with both AD and AS. (where AD and AS intersect)

Undesirablility- the quilibrium price or output level may not satisfy macroeconomic goals

Instability- even if the designated macro equilibrium is optimal, it may not last long.

Recessionary Gap- the amount by which equilibrium GDP falls short of full employment GDP. It does not reach our marco goal.

Equilibrium GDP- the value of total market output produced at macro equilibrium.


Shifters of Aggregate Demand:

CIGXn

RAG


Change in consumer spending- increase of disposable income, consumer expectations, household indebtness, taxes

Change in investment spending - real interest rates, future business expectations, productivity and technology, business taxes.

Change in government spending- government expenditures

Change in net exports- exchange rates, national income compared to abroad

If AD declined then it shifted left, away from full employment GDP as the country fell into recession.


AD consumption shifts:

Chnage in income- an incccrease in income will increase consumption spending

Change in expectations- if consumer sbecome more worried or pessimistic autonomous consumption may decrease

Change in wealth- an increase in wealth will increase spending

Change in credit conditions- easier borrowing increases spending

Change in tax policies- lower taxes leave more money to spend


Investment:

expectations-higher expected profits increase investment, vice versa lower decrease

interest rates- lower rates make borrowing cheaper and increase investment, vice versa higher decreases.

technology and innovation- new technology increases efficiency and boosts investment

Buisness taxes-lower taxes leave more profit to invest, vice versa higher decreases


Keynesian Theory:

Demand sided theory

A recession originates with a deficiency of spending

Inflation originates with an excess in spending.


Monetary Theory:

Demand sided theory

Tight money might cause AD to shift too far to the left

Easy money might cause AD to shift too far to the right


Disposable Income:

Concumption is the expenditure by consumers on fianls goods and services

disposable income is consumption + savings

APC = Total consumption / total disposable income

MPC = chnage in consumption / chnage in disposable income

MPC is not as high as APC since consumers do not respond the same.

(Marginal propensity to save) MPS = 1 - MPC


Consumption Function:

C = a + bYD

Autonomous Consumption - consumer spending is not dependent on current income

The greater amount of wealth a person owns also affects the willingness to consume.

Changes in credit availability may alter consumer behavior

Taxes are a wedge between total income and disposable income.

Income-dependent consumption (bYD) is consumer spending that is incomme dependent.

C = total consumption

a = autonomous consumption

b= MPC

YD = disposable income



Here is a practical word problem to see how the consumption function works in a real-world scenario:

The Scenario for Consumption function

Imagine Alex gets a new job and calculates their household finances.

  • Even if Alex's disposable income drops to $0 (maybe living off savings or borrowing), they still need to spend $1,000 on essentials like rent and groceries (this is your autonomous consumption, or a).

  • Alex's Marginal Propensity to Consume (b) is 0.80, meaning for every extra dollar they earn, they spend 80% of it and save the rest.

  • This month, Alex's total disposable income (YD) is $4,000.

Step-by-Step Calculation

  1. Identify the formula:

    C=a+bYDC = a + bY_D

  2. Plug in the values from the problem:

    • a = 1000

    • b = 0.80

    • Y_D = 4000

    C=1000+(0.80×4000)C = 1000 + (0.80 \times 4000)

  3. Calculate the income-dependent spending:

    0.80×4000=32000.80 \times 4000 = 3200

  4. Add the autonomous consumption:

    C=1000+3200=4200C = 1000 + 3200 = 4200

Answer: Alex's total consumption (C) is $4,200.




The Scenario for MPC adn APC

Suppose Taylor tracks how spending changes as income rises over two months:

  • Month 1: Taylor's disposable income (YD) is $3,000, and total consumption (C) is $2,700.

  • Month 2: Taylor gets a raise. Disposable income increases to $4,000, and total consumption increases to $3,500.

Step-by-Step Calculations
1. Calculating APC (Average Propensity to Consume)

  • Let's find Taylor's APC for Month 2:

    APC=3,5004,000=0.875\text{APC} = \frac{3,500}{4,000} = 0.875

  • Meaning: Taylor spends 87.5%87.5\% of total disposable income in Month 2.

2. Calculating MPC (Marginal Propensity to Consume)

  • First, find the changes between Month 1 and Month 2:

    • Chnage in Consumption = 3,500 - 2,700 = 800800

    • Chnage in Disposable income = 4,000 - 3,000 = 1,0001,000

  • Now, calculate MPC:

    MPC=8001,000=0.80\text{MPC} = \frac{800}{1,000} = 0.80

  • Meaning: Out of every extra dollar Taylor earned from the raise, 80 cents was spent and 20 cents was saved since MPS = 1 - MPC, meaning 1−0.80=0.201 - 0.80 = 0.20).

APC looks at the total picture of spending relative to total income, MPC looks strictly at how the change in income affected new spending













Investment:

Second of Four AD components

Includes fixed expenditures, such as new plants, equipment, structures, and inventory

Expectations on future sales

Interest Rates are inversely related to investment spending. The higher the rate, the more costly it is to borrow

Technology and Innovation stimulate investment spending

Interest rates and expectations drive the investment curve

Government spending is the thrid AD component

If consumption and investment spending decline, the subsequent decline in state and local govenrment spending will aggravate rather than offest the leftward shift of the AD curve.

Federsal spending is not subject to balanced budget requirements

Federal government can increase its spending despite declining tax revenues

Nex Exports are the fourth component

total value of a nation’s exports - inports



Macro failure:

GDP growth rate must add up to 5%

Whenever equilibrium GDP differs from the eonomy’s full employment output goal

Cyclical unemployment occurs with recessionary GDP gap. (falls short of its full-employment GDP goal) negative output gap.

Recessionary Gap - forms equal to the difference between the equilibrium GDP and full employment GDP. ( Equilibrium GDP - Full employment GDP)

Demand pull inflation occurs with inflationary GDP gap (total spending AD is so high that it pushes the economy's equilibrium output beyond its full-employment capacity.) positive output gap. Investment increases and causes a shift of the AD curve to the right. Second shift to the right is due to increass consumption.

Equilibrium GDP is the value of total output produced at macro eqilibrium (AD= AS)

Full employment is the lowest rate of unemployment compatiable with price stability. (4-6%)

Demand Pull inflation (AD increase)- Total spending is so high that buyers outpace production capacity, "pulling" prices upward because the economy is pushed past its full-employment limit.

Cost push inflation (SRAS decrease)- This increases the cost of production (like raw materials or wages), forcing producers to hike their prices to protect profit margins.


Leakages and Injections:

Leakage- income that is generated in production but is diverted out of the circular flow

Saving, Imports, taxes reduce potential aggregate demand


Circular flow leakage can create potential for a spending shortfall

Injection- an addition of spending in the circular flow ( I + G+ X )

Investment spending, government spending, exports

For macro equilibium, leakages must equal injections


Multiplier Effect:

Aggregate Demand= C = I + G + (X- M)

If investment spending declines this will shift the AD curve leftward

Income dependent consumption- consumers with less income cannot purchase as many goods and services

Since consumption falls, AD will fall

This will lead to larger stocks of unsold goods, more job layoffs, and further reductions in income.

The decline in income caused by investment cutbacks set off the multiplier process, causing sequential shifts of the AD curve

Decline in investment creates a decline in income spending causing a negativ effect.

Multiplier- Multiple by which an inital chnage in spending will alter the total exspenditure after all spending cycles

Multiplier = 1/ 1- MPC

Multipler is governed by the size of the MPC

MPC decreases, multipler decreases; MPC increases, multiplier increases

MPS + MPC = 1


Example Questions (will be on exam):

Suppose your disposable income increases by $1,000, and as a result, you decide to increase your consumption spending by $800.

What is your Marginal Propensity to Consume (MPC) and your Marginal Propensity to Save (MPS)?

How to Solve It

  1. Find the MPC:

    • Formula: MPC = Change in Consumption / Change in Disposable Income

    • Calculation: $800 / $1000 = 0.8

    • This means for every extra dollar earned, 80 cents is spent.

  2. Find the MPS:

    • Formula: MPS = 1 - MPC

    • Calculation: 1 - 0.8 = 0.2

    • This means for every extra dollar earned, 20 cents is saved


  • Plug in the MPC:

    Multiplier=11−0.8\text{Multiplier} = \frac{1}{1 - 0.8}

  • Simplify the denominator:

    Multiplier=10.2\text{Multiplier} = \frac{1}{0.2}

  • Calculate the final multiplier:

    Multiplier = 5

  • A multiplier of 5 means that every $1 of new spending (like an investment increase or government project) will eventually generate a total of $5 in total economic output (GDP) after all the spending cycles work their way through the circular flow!


Total change in spending = Multiplier * Initial change in aggregate spending

Suppose a local factory invests $10,000 to build a new extension (an initial change in investment spending).

Let's assume the Marginal Propensity to Consume (MPC) in this economy is 0.8 (meaning the multiplier is 5, as we calculated earlier).

The Formula

Total Change in Spending=Multiplier×Initial Change in Aggregate Spending\text{Total Change in Spending} = \text{Multiplier} \times \text{Initial Change in Aggregate Spending}

Step-by-Step Calculation

  1. Identify your variables:

    • Initial change in spending = $10,000

    • Multiplier = 5

  2. Plug them into the formula:

    Total Change in Spending=5×$10,000\text{Total Change in Spending} = 5 \times \$10,000

  3. Calculate the final economic impact:

    Total Change in Spending=$50,000\text{Total Change in Spending} = \mathbf{\$50,000}


  4. Even though the factory only spent $10,000 initially, that money gets passed along as income to construction workers, suppliers, and local businesses. Because of the multiplier effect, that single initial change ripples through the economy to create a total of $50,000 in overall economic output!






Suppose consumer confidence plummets due to economic uncertainty, causing an initial -$2,000 drop in consumer spending.

Assume the Marginal Propensity to Consume (MPC) in this economy is 0.8.

What is the multiplier, and what is the total decrease in Aggregate Demand?

Step 1: Find the Multiplier

  1. Formula:

    Multiplier=11−MPC\text{Multiplier} = \frac{1}{1 - MPC}

  2. Calculation:

    Multiplier=11−0.8=10.2=5\text{Multiplier} = \frac{1}{1 - 0.8} = \frac{1}{0.2} = \mathbf{5}

Step 2: Find the Total Decrease in Aggregate Demand

  1. Formula:

    Total Change in Spending=Multiplier×Initial Change in Spending\text{Total Change in Spending} = \text{Multiplier} \times \text{Initial Change in Spending}

  2. Calculation:

    \text{Total Change in Spending} = 5 \times (-\2,000) = \mathbf{-\10,000}

  3. Starting with a negative initial change of -$2,000 means the multiplier applies a negative downward pressure. Through the circular flow and subsequent job/income cuts, the economy experiences a total -$10,000 contraction in Aggregate Demand!



Deficits and Debt:

Deficit- spending is greater than revenue.

Surplus - revenue is greater than spending.

A fiscal stimulus package is desgined to move the econmy out of recession toward full employment GDP. Moves AD outward (increase)

Fiscal policy- the use of government taxes and spending to alter macroeconomic outcomes.

Use fiscal stimulus to eliminate unemployment, and fiscal restraint to control inflation

budget deficit- the amount by which government spending (G) exceeds government tax revenue (T) in a given time period.

Budget deficit = Government spending - tax revenues < 0

Balancing a budget during a recession would cause a greater recessionary gap

Government would have to decrease spending or increase taxes or both to maintain a balanced budget during a recession

Deficits result from both cyclinal shutdowns and discretionary policies.

Deficit spending occurs when government expenditures exceed tax revenues.

Fiscal restraint will decrease aggegate demand and cuase the bdget deficit to decrease or surpus to increase. Moves AD inward. (decrease)

Deficits increase debt by interest and higher debt levels making it harder to borrow

Automatic stabalizer- are federal expenditure or revenue items that automatically respond countercyclically to changes in incational income.

Unemployed Benefits- automatically turn on when someone becomes unemployed.

welfare benefits- occured automatically in response to worsened economic conditions.

Cyclical Deficit- that portion of the budget deficit attribuitable to short run changes in economic conditions.

Budget surplus- an excess of governemnt expenditures over a given period of time

national debt- accumulated debt of the federal government.

Treasury bonds are a liability for who gives them out and an asset for who aquires them.

refinancing- the issuance of new debts to pay off debt issued earlier

Debt is a % of GDP

Default-

Debt ceiling-