Eco Unit II Day Three

Recitation Quiz and Class Structure

  • Fall break resulted in missed Tuesday recitations.

  • Extra time allocated to make up for missed recitations—30 minutes at the end of class.

  • Important: Recitation quizzes must be completed during class or a homework help session, not taken home.

Unit Two Goals

  • Focus for Unit Two: Measure the macro economy.

    • Key topics discussed:

    • Measuring production

    • Measuring inflation

    • Measuring unemployment

    • Determining interest rates

  • Today's goal: Integrate these measurements into a model of the macro economy.

  • Key date mentioned: Unit Two exam is one week from now.

Multiple Choice Review

  • Quick-fire multiple-choice problems (2 to 3 minutes to complete).

Macroeconomic Measurements and Equations

Private Savings Calculation

  • Formula: Private Savings = GDP - Taxes - Consumption

    • Example:

    • GDP = 500

    • Taxes = 150

    • Consumption = 300

    • Calculation: $500 - 150 - 300 = 50

Public Savings Calculation

  • Formula: Public Savings = Taxes - Government Spending

    • Example:

    • Taxes = 150

    • Government Spending = 200

    • Calculation: $150 - 200 = -50 (Budget deficit)

National Savings Calculation

  • Formula: National Savings = Private Savings + Public Savings

    • Calculation: Private Savings = 50, Public Savings = -50

    • Total: $50 - 50 = 0

Net Capital Inflow Calculation

  • Definition: Net capital inflow = Opposite of Net Exports

    • Example:

    • Given Net Exports = -50

    • Therefore, Net Capital Inflow = 50.

Investment Calculation

  • Formula: Investment = National Savings + Net Capital Inflow

    • Calculation: Investment = 0 + -50 = -50

Interest Rates

  • Definition: Interest rate is the price of money that equilibrates savings and investment.

  • Relationship to market behavior:

    • Supply and demand for financial assets defines equilibrium.

    • Interest rates adjust to clear the market for loanable funds.

Fisher Effect

  • Definition: The nominal interest rate is equal to the real interest rate plus expected inflation.

    • Formula: Nominal Interest Rate = Real Interest Rate + Expected Inflation

  • Implications:

    • Safety in expectations of inflation changes.

    • Surprise inflation reallocates purchasing power:

    • Real interest rate = Contract interest rate - Actual inflation.

Effects of Inflation & Deflation on Borrowers and Lenders

  • Surprise inflation:

    • Reduces real interest rate.

    • Benefits borrowers but harms lenders.

  • Surprise deflation:

    • Increases real interest rate.

    • Harms borrowers and benefits lenders, causing possible defaults.

Aggregate Demand and Supply Model

Overview of the Macro Economy Model

  • Named: Aggregate Demand/Aggregate Supply Model (AD-AS Model).

  • Focus on the overall system rather than individual markets.

    • Aggregate Supply: Total production in the economy.

    • Aggregate Demand: Total purchasing of produced goods in the economy.

Graphical Representation

  • Horizontal Axis: Real GDP (Total production).

  • Vertical Axis: Inflation (Price level changes).

  • Third macroeconomic variable: Unemployment represented implicitly.

  • Four main variables to observe in this model:

    1. Real GDP

    2. Inflation

    3. Unemployment

    4. Interest Rates impacting positions of curves.

Potential GDP and Long Run Aggregate Supply

  • Potential GDP = Maximum production capacity utilizing all resources.

  • Definition of Long Run Aggregate Supply:

    • Identical to Potential GDP.

    • Shows real production ignoring price fluctuations over the long term (typically a year).

Factors Affecting Aggregate Supply

  • Changes impacting long-run aggregate supply include:

    • Land, Labor, Capital, Human Capital, Technology.

  • Examples of shifts in Long Run Aggregate Supply:

    • Reduction in arable land due to climate change results in a decrease in Long Run Aggregate Supply.

    • Immigration increases labor force and thus increases production capability.

    • New technologies enhance production capacity.

    • Inflation has no direct effect on long-run aggregate supply as it does not affect fundamental factors of production.

Short Run Aggregate Supply

Introduction to Short Run Dynamics

  • Definition: Short Run Aggregate Supply depicts the relationship between inflation and production based on costs and wage stickiness.

  • Key determinant: Wage stickiness, causing slower adjustment times to inflation.

Effects of Inflation and Costs on Short Run Aggregate Supply

  • General principle: Rising prices lead firms to produce more (upward sloping supply curve).

    • Wages increase under new regulations (e.g., minimum wage laws) result in decreased aggregate supply.

  • Tariffs on imports raising input costs similarly decrease short run supply.

Aggregate Demand Factors

Concept Overview

  • Definition: Aggregate Demand indicates the total desire to purchase goods produced at a given inflation rate.

  • Aggregate Demand Curve slopes downward due to:

    • High inflation diminishing consumption and investment.

Impact of Interest Rates

  • High interest rates emerge from inflation leading to lower investment (and, conversely, low interest rates from low inflation encourage investment).

Changes and Shifts in Aggregate Demand

  • Tariffs reducing imports lead to increased net exports and consequently an increase in aggregate demand.

  • Fear of recession leading to decreased consumption and lowered aggregate demand.

Short and Long Run Equilibrium

  • Long Run Equilibrium: Point at which inflation aligns with potential GDP and natural unemployment rate.

Shocks to Equilibrium

  • Positive Demand Shock: Increased demand results in higher inflation and GDP, but can lead to inflationary gaps as seen during high government spending scenarios (e.g., 2021 stimulus).

  • Negative Demand Shock: Results in decreased aggregate GDP and increased unemployment.

Calculation of Output Gaps

  • Formula: Output gap = (Real GDP - Potential GDP) / Potential GDP x 100.

    • Example from 2020 shows a negative output gap indicating a recessionary gap.

Negative Supply Shocks

  • Definition: Occurs when short run aggregate supply decreases, leading to higher inflation without the corresponding increase in output.

  • Resulting conditions: Stagflation—a rise in prices alongside falling GDP and rising unemployment. Current concerns indicate the U.S. may be entering a stagflation phase due to negative supply shocks affecting production.