Macroeconomic - Unit 3

Aggregate Demand(AD)

Definitions

SRAS - Short-run aggregate supply

Aggregate Price Level - PL

As - Aggregate supply curve

Ad - Aggregate demand curve

QAD - Quantity of aggregate output demanded

QAS - Quantity of aggregate output supplied

Exports - Purchase of domestic goods/services by foreign buyers

Imports - Purchase of foreign goods/services by domestic buyers

Interest Rate - The interest rate is the percentage of a loan or deposit (savings) that a lender charges or a bank pays, usually expressed annually.

Real GDP (Horizontal axis)

= Aggregate Output - all else equal, a change in GDP_R (Real GDP) is accompanied by a change in employment.

(GDP_R increase, employment increases, and unemployment decreases. GDP_R decreases, unemployment increases, and employment decreases).

= Aggregate Spending - C + I + G + Xn (exports -imports)

= Aggregate Income - W_(wages) + R_(rent) + I_(interest) + P_(profit)

*Measures changes in aggregate output, which tells what’s happening to aggregate spending, income, and unemployment rate_(UR).

Aggregate Price Level (PL)

*Measures inflation (Based on the GDP Deflator, a price index, not an inflation rate).

Aggregate Demand Curve

* Demand for all goods/services purchased in product markets.

The downward sloping AD curve represents the inverse (Negative) relationship between PL and quantity of aggregate output demanded.

• When PL decreases, the quantity of aggregate output demanded increases. (A decrease in PL is a movement down and right along an aggregate demand curve).

• When PL increases, the quantity of aggregate output demanded decreases. (Increase in PL is a movement up and left of the aggregate demand curve

Summary: AD - sum of all goods/services in an economy by C, I, G, and X_n

Three Reasons for the Negative Slope of Aggregate Demand Curves

1. Real Wealth Effect

2. Interest Rate Effect

3. Exchange Rate Effect

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Review: Change in quantity demanded Vs. change in demand

• Change in quantity demanded is a movement along a demand curve and is caused by a change in PRICE.

• Change in demand shifts the ENTIRE demand curve and is caused by a change in non-price determinants of demand.

  * A change in demand is a change in quantity demanded at EVERY PRICE.

Review: Change in QAD Vs. change in AD

• Change in quantity of aggregate output demanded is a movement on the AD curve is caused by a change in PL.

• Change in AD shifts the ENTIRE AD curve and is caused by a change in non-price level determinants of AD.

  * A change in AD is a change in QAD at every PL.

1. Real Wealth Effect - (Real Balance Effect)

A change in PL causes the purchasing power of a given amount of wealth to change.

EX. You have 11,000 and the PL is 100, if the PL rises to 110 you will be able to purchase fewer goods/services, since the inflation rate is 10%. (Nominal wealth did not change, the real value changed).

• When PL increases, purchasing power of a given wealth decreases, which leads to a decrease in QAD (Up and left along an AD curve).

• When PL decreases, purchasing power of a given wealth increases, which leads to an increase in QAD. (Down and right an AD curve).

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2. Interest Rate Effect

- Money is exchanged by buyers and sellers in the (Money market).

- Price of money IS the interest rate

- When demand for money increases, price of money (Interest rate) increases.

- Change in PL causes a change in demand for money, which leads to a change in interest rate, which causes a change in the cost of goods/services purchased with borrowed money.

• When PL increases, people need more money to purchase a given amount of goods/services (An increase in money demanded, causes an increase in interest rate and an increase in costs of goods/services paid for with borrowed money. When PL increases it leads to a decrease in QAD).

• When PL decreases, people need less money to purchase a given amount of goods/services (A decrease in money demanded, causes a decrease in interest rate, which leads to the costs of goods/services paid for with borrowed money to decrease. When PL decrease, it leads to a increase in QAD).

  * Change in interest rate shifts AD curve.

  * When PL change there is an interest rate effect that causes a change in QAD.

3. Exchange Rate Effect (Foreign Purchases)

A change in PL in country X makes country X’s goods/services relatively more or less expensive to foreign purchasers. Causes a change in quantity demanded for country X’s exports.

• When PL increases, domestic goods/services become relatively more expensive to foreign purchasers so a decrease in QAD.

• When PL decreases, domestic goods/services become relatively less expensive to foreign purchasers, so an increase in QAD.

  * Don’t confuse a change in exports with exchange rate effect. All 3 reasons are a function of a change in the PL.

Determinants of Aggregate Demand Curve

Determinants are:

C _{(consumer spending)}

I_{g (gross private domestic investment spending)}

G _{(Government Spending)}

X_{n (Exports - Imports)}

* Any change to these determinants will cause a shift in AD

Consumption Determinants- (Consumer Spending)

• Wealth (Financial, and real assets)

Consumers have more wealth, they buy more goods/services, so consumption increases

Consumers have less wealth, they buy less goods/services, so consumption decreases

• Income (Salary, wages)

Consumers have more income, they buy more goods/services, so consumption increases

Consumers have less income, they buy less goods/services, so consumption decreases

• Income taxes

Income taxes decrease, consumers have more disposable income (income to spend), they buy more goods/services, so consumption increases

Income taxes increase, consumers have less disposable income, they buy less goods/services, so consumption decreases

(Inverse relationship between income taxes and consumption. Connect changes in taxes to changes in disposable income.)

• Expectations of economic conditions

Expecting economic conditions to improve, they buy more goods/services, so consumption increases

Expecting economic conditions to deteriorate, they buy fewer goods/services, so consumption decreases.

• Interest Rate-sensitive components of consumption

Consumers goods and services paid for with borrowed money

EX: Automobiles, College education, Durable Goods (“Big-ticket items, like appliances).

• Interest Rates

Interest rate decreases, goods/services paid for with borrowed dollars become less expensive, so consumers buy more. Consumption increases

Interest rate increases, goods/services paid for with borrowed dollars become more expensive, consumers buy less of them. Consumption decreases.

Investment Spending Determinants

• Non-residential investment: Spending on capital goods (Machines, assembly lines, etc)

• Spending on productive capacity or capital stock

• Residential investment: Spending on new homes

• Business inventories: Amount of goods on hand to sell

Things that affect firm spending on these things

• Expectations of future economic conditions

Expecting economic conditions to improve, they buy more capital goods, so investment increases

Expecting economic conditions to deteriorate, they buy fewer capital goods, so investment decreases

• Interest Rates

Interest rates decrease, capital goods purchased with borrowed dollars become less expensive, so firms buy more capital goods. Investment increases

Interest rate increases, capital goods purchased with borrowed dollars become more expensive, so firms buy less capital goods. Investment decreases

• Unplanned changes in business inventories

Unplanned decreases in business inventories, firms have fewer goods/services on hand than expected, they increase spending on capital goods to produce more. Investment increases

Unplanned increases in business inventories, firms have more goods/services on hand than expected, they decrease spending on capital goods to produce less. Investment spending decreases.

Economic Policy and Aggregate Demand

Fiscal Policy (Keynesian) - Unit 2

AD= C + I + G + X_n

Changes in Taxation (T)

• (T) decreases, AD increases because disposable income (Y_d) increases, which causes consumption to increase

• (T) increases, AD decreases because disposable income (Y_d) decreases, which causes consumption to decrease

(Indirect, Inverse, effect)

Government Spending (G)

• (G) increases, AD increases because (G) is a component of AD

• (G) decreases, AD decreases because (G) is a component of AD

(Direct, positive, effect)

Monetary Policy - Unit 3

AD= C + I + G + X_n

Changes in Interests Rates

Consumption and investment are interest rate sensitive.

• Interest rates decrease, Interest rate-sensitive consumption increase, so Investment Increase (AD Increase)

• Interest rates Increase, Interest rate-sensitive consumption decreases, so investment decrease (AD decrease

Net Exports Determinants

• Relative Incomes

• Relative prices

• Exchange Rates

Ex:

Real GDP in Japan rises, US exports to Japan will increase because Japanese consumers have more income

PL In US decrease relative to PL in Germany, US exports to Germany will increase because US goods/services are relatively less expensive

The US dollars appreciate relative to the Indian Rupee, US exports to India will decrease because US goods/services are relatively more expensive.

• Exports and AD are positively related

- Exports increase, AD increase

- Exports decrease AD decrease

• Imports and AD are inversely related

- Imports increase, AD decrease

- Imports decrease, AD increase

Multipliers

Autonomous Expenditure

“Autonomous” means independent (Spending that is independent of income)

“Expenditure” means the spending of something

Households (C), firms (I), and government (G), must spend money on certain things regardless of how much income they generate

• This spending, which is independent, is referred to as autonomous expenditure

If autonomous C, I, or G changes by $1, AD will change by more than $1

“One person’s spending is another person’s income”

• Changes in C, I, and G, results in a change in autonomous expenditures whereas the change in taxes (or transfers) does not

Marginal propensity to consume and Marginal propensity to save -(MPC and MPS)

Gross Income - Total household income (Wages, interest earned on financial assets. Money that comes in)

“Marginal” means the next (In this case) / additional / change

“Propensity” means likely

Gross income — Income Tax = Disposable Income (Y_d)

Spending (On consumer goods/services) + Savings = Disposable Income (Y_d)
With disposable income you can either spend money on goods/services (Consumption) or you can save it.

Average propensity to consume (APC) - is the percentage of (Y_d) that is spent.

Consumption / disposable Income (Y_d) = APC

Average propensity to save (APS) - is the percentage of (Y_d) that is saved.

Savings / disposable Income (Y_d) = APC

MPC is the percentage of an additional $1 earned in (Y_d) that is spent on consumption (how much are you likely to consume of the next $1 in disposable income that you earn)

MPS is the percentage of an additional $1 earned in (Y_d) that is saved

Change in consumption / change in disposable income (Y_d) = MPC

Change in savings / change in change in disposable income (Y_d) = MPS

* The greater the MPC, the greater the total change in AD will be

(MPC decreases, the total change in AD decreases - Vice Versa)

* The total change in AD that results from a change in autonomous expenditure depends on/ is the function of MPC

* An increase in the MPC makes the MPS smaller

The Spending Multiplier (Expenditure Multiplier)

MPC + MPS = 1

A $1 change in autonomous expenditure leads to a total change in AD greater than $1 because one person’s spending is another person’s income

The expenditure multiplier quantifies the total change in AD that results from an initial change in autonomous spending

1 / (1 - MPC) = 1 / MPS = Spending Multiplier

EX: If MPC = .80, the spending multiplier = 1 - .80 = .20, so 1 / .20 = 5

* The smaller the MPS, the larger the multiplier

Initial change in expenditure X The spending multiplier = The change in total expenditures

• Change in total expenditure is also (Total change in spending, aggregate expenditures, Real GDP, and Income)

• Initial change in expenditure is also (Initial change in C, I, G, X, or M, increase in consumption, decrease in government spending, increase in autonomous I_g, decrease in exports)

• Spending multiplier is also (1 / MPS or 1 / (1 - MPC)

* C, I, G, and Exports are positively and directly related to aggregate demand (One increases/decreases AD increases/decreases)

* If Imports increases AD decreases if imports decrease AD increase

(when imports increase, it means that more goods and services are being purchased from other countries rather than domestically produced goods and services, so Net Exports decrease since its exports - Imports. Vise versa)

The Tax Multiplier, The Transfer Multiplier, and The Balanced Budget Multiplier

The tax multiplier quantifies the total change in AD that results from an initial change in taxes or transfer payment

-MPC / (1 - MPC) = -(MPC / MPS) = Tax Multiplier

Transfer multiplier is the same formula for Tax multiplier, but without the negative signs (Direct relationship)

The negative sign in the tax multiplier is used to denote the inverse relationship between a change in taxes and the change in AD; e.g., when taxes increase, AD decreases; when taxes decrease, AD increases

The initial change in taxes X (negative) tax multiplier = The total change in AD (Change in taxes)

The initial change in transfers X the transfer multiplier = The total change in AD (Change in transfers)

Tax Multiplier is also (-MPC / MPS, -MPC / (1 - MPC)

• The spending multiplier is greater than the tax multiplier

The Balanced Budget Multiplier

• The spending multiplier minus the tax multiplier for a given MPC is always equal to 1 (Balanced budget multiplier)

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Short-Run Aggregate Supply(SRAS)

The Short Run

The factors of production (Inputs in production) include Labor, Capital, and Land

“Input costs” refers to the prices paid by firms for the purchase of these inputs in production

Firms often “fix” input prices over a period of time, for example:

• Multi-year labor contracts for employees

• Annual leases for retail space

• Monthly agreements for commodity prices

* The short-run refers to the time period in which at least one input price is fixed.

“Sticky” Input Prices and Wages

The short run is not a length of time. It is however long it takes for input prices to “catch up” with changes in PL

When wages and other input price changes lag behind PL changes, input prices are referred to as “sticky”

Short-Run Aggregate Supply (SRAS) Curve

Aggregate supply is the quantity of aggregate output supplied in an economy.

Short-run aggregate supply curve describes the relationship between PL and quantity of aggregate output supplied QAS in the short-run

The SRAS is upward sloping because of sticky wages and other input prices

• When PL increases, the quantity of aggregate output supplied QAS increases (Movement along a given SRAS curve is a change in QAS. Up and right the curve)

When input costs are “sticky” an increase in PL results in higher profits for firms; which incentivizes firms to produce more

Price Level (PL) - Input Costs = Profit

(If PL increases, profit increases. Vise Versa)

• When PL decreases, the quantity of aggregate output supplied QAS decreases (Movement along a given SRAS curve is a change in QAS. down and left the curve)

Since wages are “sticky” in the short-run, a decrease in PL results in lower profits for firms; which incentivizes firms to produce less

Short-Run Trade off Between Inflation and The Unemployment Rate.

Ceteris paribus (all else equal), in order to produce more output, firms must hire more workers. Along the SRAS curve the increase in PL leads to a decrease in unemployment

Ceteris paribus (all else equal), production of less output, firms require fewer workers. Along the SRAS curve the decrease in PL leads to a increase in unemployment

• PL increase, QAS increases, so unemployment decreases

• PL decreases, QAS decreases, so unemployment increases

Review: Change in QSRAS Vs. change in SRAS

Firms are profit-maximizing entities

Ceteris Paribus, a change in profitability (Increase/decrease) will incentivize firms to change how much they are producing (more/less)

Aggregate Price Level (Change in QSRAS) - Aggregate Input Costs (Change in SRAS) = Total Profits

When profits increase, the quantity of goods and services produced increase (Vise Versa)

Determinants of Short-Run Aggregate Supply (SRAS)

- Anything that makes it CHEAPER or EASIER to produce goods/services will increase SRAS, which is depicted by a rightward shift of the SRAS curve

• Decrease in input costs

Commodity prices (energy, grain, soil)

Wages

Labor

• Increase in productivity

Technological advances

• Government policy

Deregulation

Subsidies

* Don’t confuse wages from firms, costs to the employer (determinant of SRAS) with Income (Determinant of AD)

- Anything that makes it HARDER or MORE EXPENSIVE to produce goods/services will decrease SRAS, which is depicted by a leftward shift of the SRAS curve

• increase in input costs

Commodity prices (energy, grain, soil)

Wages

Labor

• Destruction of resources (Natural Disasters)

• Government policy

Increased regulations

Business taxes, taxes on production

- Inflationary expectations are important determinants of short-run aggregate supply

• Firms expect PL to decrease, production will increase in the short run, and SRAS will shift right

• Firms expect PL to increase, production will decrease in the short run, and SRAS will shift left

Long-Run Aggregate Supply(LRAS)

The Short Run Vs. The Long Run

The Short Run

• Period of time during which at least one input is fixed

• “Sticky” wages and prices

• Producers increase/decrease production in response to changes in PL

The Long Run

• Period of time when all input prices are variable

• “Fully-flexible” wages and prices

• Producers have no incentive to change the level of output because input prices change in response to changes in the PL

Aggregate Supply

At recessionary levels of output, input prices are so “sticky” that because resources are unemployed, increases in demand for resources to produce more goods/services generate no increase in input prices (C increases to D)

• This is reflected by a horizontal (Straight) AS curve

As the economy approaches the limits of its productive capacity, increases in the price level cannot be met with additional output.

• There are no additional resources, so increases in demand for them to produce goods/services lead to an increase in input prices (Characterized as the LRAS, limits of productive capacity in the economy and that corresponds with what is called the full employment)

The maximum productive capacity of the economy (QAS_YF) is the quantity of aggregate output supplied when the economy is at full-employment (Also known as “potential output”)

Long Run Aggregate Supply

The level of output produced when an economy is operating at full-employment

The full-employment level of output (Y_F) = the potential output of an economy

The LRAS curve is a vertical line at the levels of output the economy produces at the natural rate of unemployment (NRU)

• In the long run, input prices and wages are fully flexible, and firms will produce (Y_F) at ANY price level

• In the long run, there is no trade off between inflation and unemployment

• In the longs run, Unemployment = NRU

Review: The Production Possibilities Curve (PPC)
The PPC describes the possible combinations of consumer goods and capital goods that can be produced in an economy that is employing all of its resources.

When the economy is producing a combination of consumer goods and capital goods on the PPC (Any point), the economy is operating at full employment, which means the Unemployment rate = The NRU

• Changes in the unemployment rate do not shift the PPC

• Changes in the NRU shifts the PPC

Comparing The PPC to the LRAS

Any point on the PPC curve represents the quantity of output (Consumer goods and capital goods) that the economy is producing

(Y_F) represents the value of output (Real GDP, in dollar) that is comprised of the consumer and the capital goods being produced

• When a point is on the LRAS it means that the actual unemployment rate = NRU

The PPC and LRAS are functions of the NRU, not the actual unemployment rate

A change in the actual unemployment rate will not shift the PPC or the LRAS

Determinants of LRAS
The same factors that causes the PPC to shift outward, causes the LRAS to shift to the right

• Changes in the NRU shifts the PPC and LRAS

* The full-employment level of output (Y_F) = the potential output of an economy = LRAS

Potential Output (LRAS) is independent of the price level

Equilibrium in The Aggregate Demand-Aggregate Supply (AD-AS) Model

SR / LR Equilibrium in The AD/AS Model

If the PL is higher than the equilibrium PL

• (QSRAS) Quantity of short-run aggregate output supplied will be greater than (QAD) quantity of aggregate output demanded

• Surplus (eliminated through falling prices)

Producers will lower prices, so (QSRAS) will decrease and (QAD) will increase, until the price level is such that the (QRAS) = (QAD)

If the PL is lower than the equilibrium PL

• (QSRAS) Quantity of short-run aggregate output supplied will be less than (QAD) quantity of aggregate output demanded

• Shortage (eliminated through rising prices)

Producers will increase prices, so (QSRAS) will increase and (QAD) will decrease, until the price level is such that the (QRAS) = (QAD)

LR Equilibrium in The AD/AS Model
When the economy is in the long-run equilibrium, current output (Level of Real GDP at the price level)) is equal to potential output (Found where SRAS = AD)

Potential output is represented by a vertical LRAS curve (Y_F)

Short-Run Output Gaps
When current output is not equal to potential output (Y_F), the economy is in short-run macroeconomic equilibrium

When current output is equal to potential output (Y_F), the economy is in long-run macroeconomic equilibrium

Changing economic conditions may produce an “output gap,” the situation that exists when the current level of output (Y_c) is not equal to (Y_F)

When the current output is less than potential output, the economy is in a recessionary gap (Unemployment rate is greater than) Negative output gap

When the current output is greater than potential output, the economy is in a an inflationary gap (Unemployment rate is less than NRU) Positive output gap

Changes in AD-AS Model in the Short-Run

Aggregate Demand Shocks:

Positive Shocks (Increase):

• Notice the impacts on inflation and output

• Note that Real GDP (Output) is also a proxy on our graph for employment increase, unemployment decreases

Negative Shock (Decrease):

• Notice the impacts on inflation and output

• With this shift, unemployment increases

Short-Run Aggregate Supply Shocks:
Positive Shocks (Increase - right):

• Notice the impacts on inflation and output

• Note that Real GDP (Output) is also a proxy on our graph for employment increase, unemployment decreases

Negative Shocks (Decrease - left):

• Notice the impact on inflation and output

• With this shift, Unemployment increases

Learn:

• Demand-pull inflation is inflation that is caused due to an increase in AD.

• Cost-push inflation (A determinant that decreases SRAS) is inflation that is caused due to a decrease in SRAS (Price level rices when SRAS decreases)

*Cost-push inflation graph is also known as modeling stagflation

Stagnant economy - output has decreased

Inflation - prices have increased

*Misery index that measures relationship between inflation and unemployment (decrease in productivity)

Long-Run Self- Adjustment

Long-Run Self-Adjustment

The classical theory of economics argued that prices and wages are completely flexible (the SRAS curve is vertical) and no policy action is advocated under this theory to combat economic crises. (Issues with this theory during economic crises)

• With long-run self-adjustment, businesses and workers will adjust their price and wage expectations to bring the economy back to equilibrium (Other languages is no policy action taken, or automatically adjust)

• A short-run and long-run aggregate supply curve is used in the modern approach to combine various economic theories and simplify the AD/AS model.

The LRAS doesn’t move in the self-adjustment scenarios — only moves when there are changes to land, labor, capital, or technology (Things that shift PPC)

* The economy can start in long-run equilibrium or it can start in a short-run recessionary gap or inflationary gap

• In recessionary gap, SRAS will increase until it aligns with the LRAS curve

• In inflationary gap, SRAS will decrease until it aligns with the LRAS curve

An economy self-adjusts in the long run through businesses and workers behaviors

• In a recessionary gap, an economy is operating at an output below full capacity (Higher unemployment)

(Businesses: Adjust their price expectations downward for goods/services)

(Workers: Adjust their wage expectations downward)

SRAS increases, resulting in a decrease in inflation and a decrease in unemployment

• When the economy is in a recessional gap, long-run adjustment will occur as prices and wages decrease (Businesses and Workers), leading to an increase in SRAS (Leads to a decrease in inflation and unemployment)

An economy self-adjusts in the long run through businesses and workers behaviors

• In an inflationary gap, an economy is “overheating” and running beyond full capacity (Lower unemployment)

(Businesses: Adjust their price expectations upward for goods/services)

(Workers: Adjust / their wage expectations upward)

SRAS decrease, resulting in an increase in inflation and an increase in unemployment

• When the economy is in a inflationary gap, long-run adjustment will occur as prices and wages increase (Businesses and Workers), leading to an decrease in SRAS (Leads to a increase in inflation and unemployment)

Fiscal Policy (Keynesian Theory)

Fiscal Policy is implemented by governments to intervene when the economy overheats or under-performs in an attempt to bring the economy back to full employment

Tools of fiscal policy include:

G = Changes in government Spending

T = Changes in taxes

Expansionary Fiscal Policy

Used when the economy is in a recessionary gap.

• Government Spending increases

Direct impact on AD

Larger magnitude of impact

• Taxes (Impact consumer relationship - disposable income) are cut or decreased

Indirect impact on AD

Smaller magnitude of impact

Contractionary Fiscal Policy

Used when the economy is in a inflationary gap.

• Government Spending decreases

Direct impact on AD

Larger magnitude of impact

• Taxes (Impact consumer relationship - disposable income) are increased

Indirect impact on AD

Smaller magnitude of impact

Economy in a recessionary gap

• Unemployment is growing

• Prices are falling

• Productivity is falling

Fiscal policy used to fix this gap is increasing government spending and decreasing taxes

(Government and consumption increase, leads to an increase in AD, PL and Output. Unemployment decreases)

Economy in a inflationary gap

• Unemployment is low

• Prices are rising

• Productivity is rising too fast for firms to keep up

Fiscal policy used to fix this gap is decreasing government spending and increasing taxes

(Government and consumption decrease, leads to a decrease in AD, PL and Output. Unemployment increases)

Changes in Government Spending and Taxes

Government spending as a spill over effect into other areas of spending in the economy.

(Government spending has a larger impact than the impact that increases taxes to pay for goods/services)

Aggregate demand will have a net increase due to the impacts of government spending outweighing the increases in taxes to offset the spending (A larger magnitude)

Multipliers

The tax multiplier is always one less than the spending multiplier

Automatic Stabilizers

Policies that are already in place in an economy due to previously passed legislation

• Income taxes

• Transfer Payments

Not discretionary - automatic stabilizers kick in automatically and do not need additional deliberation or legislation to start working

Recession Gap (Contraction)

• Unemployment insurance (compensation)

• Temporary assistance

Inflationary Gap (Expansion)

• Income Taxes

• Corporate Taxes

• Decrease in Unemployment insurance (compensation)

Automatic stabilizers kick in during recessionary and inflationary gaps

Automatic stabilizers are not discretionary fiscal policy measures, but they behave as expansionary fiscal policy during recessions and contractionary fiscal policy during periods of rapid growth.

Transfer Payments

• Not counted in GDP

• Intended to assist individuals who are hurt most by economic downturns

• Unemployment insurance is one form of transfer payments that put money in people’s hands (If people spend the money on goods/services, consumption increases, if money is not spent on goods/services, then no impact on AD curve)

Loanable Funds & Loose Ends

The components of AD (Specifically “C”and “I”)

AD = C (Consumption) + I (Investment) + G + N_x

Consumption Function (C): an equation showing how an individual household spending varies with the household’s disposable income.

Consumption Function: C=a+bY

a = constant

C = consumption spending

b = MPC

Y = Disposable income

• Disposable income is household income minus taxes plus government transfers.

The Loanable Funds Market is the private sector supply and demand of loans. (Shows the effect on real interest rate vs. investment)

Demand (Borrowers) - Inverse relationship between real interest rate and quantity of loans (x-axis).

Supply (Savings) - Direct relationship between real interest rate and quantity loans supplied (y-axis).

The Phillips Curve

The phillips curve shows the tradeoff between inflation and unemployment.

• High unemployment and low inflation = Recessionary Gap

• Low unemployment and High inflation = Inflationary Gap

Changes in AD: Movement along the SRPC.

- Increase in AD: movement left

- Decrease in AD: movement right

Changes in SRAS: Shifts the SPRC

- Increase in SRAS: shift left of SRPC

- Increase in SRAS: Shift right of SRPC

Short Run vs. Long Run

In the long run there is no tradeoff between inflation and unemployment.

(LRPC is vertical at the Natural Rate of Unemployment NRU)