Unit 3 Study guide

Aggregate Demand

1. Explain why the AD curve is down-sloping, and what it represents

   1. As the PL increases, people want to buy less goods

      1. Real Wealth effect:  higher price levels diminish consumer purchasing power, leading to a decrease in the quantity of goods demanded (AD)

      2. Interest rate effect: When the price level rises, consumers and businesses require more money for transactions, leading to higher interest rates. This results in reduced investment and consumer spending, further decreasing the quantity of goods demanded.

      3. Net export effect: A change in the price level changes the amount that people from other countries are willing and able to purchase (exports increase)

2. Know the determinants (shifters) of the AD curve (BASICALLY.. C + I + G + Xn)

   1. Consumer spending

      1. wealth

      2. borrowing

      3. expectations

      4. taxes

   2. investment

      1. real interest rates

      2. expected returns

         1. future conditions

         2. technology

         3. capacity

         4. business taxes

      3. Government policies

         1. fiscal policies

         2. monetary policies

      4. Net exports

         1. national income abroad

         2. exchange rates

         3. government trade policies

Examples:

Aggregate Supply 

• Explain why the AS curve is up-sloping, and what it represents

  • positive relationship between price level and quantity supplied, indicating that as prices increase, producers are willing to supply more goods and services to the market.

  • represents the total production of goods and services that firms in the economy are wiling and able to supply at various price levels → output changes in response to changes in price

• Know the determinants (shifters) of the AS curve (basically anything that affects production from a producer’s standpoint)

  • input/resource prices

    • wages

    • commodity prices

  • productivity

  • business taxes and regulations

• Explain the difference between the 3 types of AS curves: Immediate Short Run, Short Run, and Long Run
  

Equilibrium in the AS/AD Model 

• Determine equilibrium Price and Quantity in the AS/AD Model

• Know the difference between Recessionary and Inflationary gap 

  • recessionary:

    • Occurs when the actual output of an economy is less than its potential output at full employment.

    • Characterized by high unemployment and underutilized resources.

    • Indicates a lack of aggregate demand in the economy, leading to lower consumer spending and investment.

  • Inflationary:

    • occurs when the actual output exceeds the potential output of the economy

    • characterized by low unemployment (possibly near or below the natural rate) and high demand for goods and services

    • this typically leads to increased inflationary pressures as demand outstrips supply

• Explain what effect various demand/supply (both positive and negative) shocks would have on equilibrium. 

• Apply the concepts of Stagflation, Demand-Pull Inflation, Cost-Push Inflation and Recession to the AS/AD Model 

  • stagflation

    

  • demand-pull inflation

    

  • cost-push inflation

    

  • recession

    
    

Basic Economic Relationships

• Explain the following concepts:

  • MPC/MPS

    • MPC: the fraction of additional income that a household consumes rather than saves

    • Formula: MPC = change in spending/change in DI

  • Aggregate Consumption Function (introduced in Chapter 10, explained more in lecture on Thursday, 2/18)

    • represents the total consumption expenditure in the economy at different levels of income

    • typically illustrated with a positive slope, indicating that as disposable income increases, consumption also increases

    • factors influencing the curve include: household wealth, expected future income, taxes, and real interest rates

  • Investment Demand 

    • refers to the amount of spending on capital goods that businesses are willing to undertake at various interest rates and economic conditions

    • influenced by factors such as interest rates, expected returns on investment, business taxes, and overall economic outlook

    • higher interest rates typically reduce investment demand, while lower rates, encourage more investment spendin
      

Fiscal Policy

• Multipliers

  • Spending Multiplier: Be able to calculate how much the government should spend/cut back in order to close the output gap.

  • Tax Multiplier: Be able to calculate how much the government should increase/decrease taxes in order to close the output gap. 

  • Transfer Multiplier: Be able to calculate how much the government should increase/decrease transfers in order to close the output gap (your textbook does not cover the transfer multiplier; we do this in class). 

• Government Actions

  • How could a Keynesian Economist (Discretionary) vs a Neo-classical Economist address issues like Stagflation, Demand-Pull Inflation, and Recession?

    • Keynesian: “in the long run, we are all dead”

      • believe that we shouldn’t wait for the economy to self correct, and thus take government action (fiscal policy) to correct the economy

    • Neo-Classical Economist

      • believe that we should wait for the economy to self correct through flexible nominal wages because in the long run, wages are flexible

  • Explain the difference between Contractionary and Expansionary Fiscal Policy.

    • Contractionary Fiscal Policy: which 3 actions can the Government take?

      • Spending: decrease

      • Taxes: increase

      • Transfers: decrease

    • Expansionary Fiscal Policy: which 3 actions can the Government take?

      • spending: increase

      • taxes: decrease

      • transfers: increase

  • Explain the time lag issue and other issues with Fiscal Policy 

  • Explain what an Automatic Stabilizer is, and give examples

    • government policy already in place to counterbalance fluctuations in the economy without the need for explicit government intervention or action → automatically adjust to economic conditions

    • EX:

      • unemployment insurance

      • progressive taxation

      • welfare programs

      • food assistance programs

  • Explain the mechanism behind the “Crowding Out” effect

    • occurs when government spending increases, leading to higher interest rates

    • government competes with businesses and individuals for available funds

    • higher interest rates make borrowing more expensive for private sector, resulting in reduced business investments

    • instead of boosting the economy, government spending may reduce private sector spending

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Things to note:

• transfer payments aren’t a part of GDP, therefore they count towards consumer spending

• change in price level doesn’t change supply but expected price level does

• anything that shift production possibilities curve shifts aggregate supply

• interest rates are counted in investment → therefore part of AD (C + I + G + Xn)