• Microsoft Encarta Example 

  • Bundled the physical encyclopedia with the internet 

    • WWW did not exist yet 

    • Could buy a computer with the encyclopedia instead of buying thousands of dollars in books 

  • Example of creative destruction; the invisible hand 

• Trade deficit = import > export 

• GDP = Consumption + Investment + Government + Nx (exports - imports) 

  • Multiplier Effect - change in spending changes real GDP more than the initial change in spending (or less, just not guaranteed to be equal) 

    • Cutting spending will have the same effect of exemplification, less gov’t spending leads to a drop in GDP 

    • Drop of GDP = high unemployment 

  • Multiplier = change in real GDP/initial change in spending 

  • Change in GDP = multiplier x initial change in spending 

• CONSUMPTION 

• Income Consumption and Savings 

  • Consumption and saving 

    • Primarily determined by direct income 

    • Direct relationship (direct income vs. consumption) 

      • When you have less money, consumption will be closer to the direct income as there is little left to save 

  • Consumption schedule 

    • Planned household spending 

  • Saving schedule 

    • Direct Income - Consumptions 

    • “Dissavings” 

      • Taking out loans

      • Not saving for future consumption 

• Favoring gov’t involvement = wants more gov’t spending to “fix the GDP” 

  • Most expansionary fiscal policy 

  • Impact of tax cut < gov’t spending 

• Liquidity trap

  • Money is given but not spent to banks 

    • Deficits could be the “cure,” increasing exports and forcing people to buy

• Average Propensities 

  • Average Propensity to Consume (APC) -  fraction of total income consumed

  • Average Propensity to Save (APS) -   fraction of total income consumed

    • APC + APS = 1

• Marginal Propensities (CHANGE IN)

  • MPC = change in consumption/change in income  

  • MPS = change in saving/change in income 

    • MPC + MPS = 1

    • AP’s + MP’s do not add up to a set number, they have to be from the same propensity group 

• Determinants 

  • Amount of disposable income is the main determinant 

  • Other Determinant (non income determinants) 

    • Wealth 

    • Borrowing 

    • Expectations 

    • Real interest rates 

  • Other considerations 

    • Switching to real GDP 

    • Schedule changes

    • Etc. 

• INVESTMENT 

• Investment Demand 

  • Shifts: 

    • Acquisition, maintenance, and operating costs

    • Business taxes

    • tech logical changes 

    • Stock of capital goods on hand 

    • Planned inventory changes 

    • Expectations 

• Classical Model 

  • Models create assumptions 

    • Pure competitions exist 

    • Wages and prices are flexible 

      • Wages are not always flexible; think of contracts 

    • Ppl motivated by rational self interest to maximize their utility 

      • Animal Spirits 

    • Ppl can NOT be fooled by the “money illusion”

      • Keynes believed that people can be tricked into going into work or spending money 

• Keynesian Aggregate Expenditures Model 

  • Issues 

    • Businesses pay no indirect taxes (ie. sales tax--but they do) 

    • Businesses distribute all of their profits to their shareholders

      • They don’t 

    • There is no depreciation (capital consumption allowance), so gross private domestic investment equals net investment 

    • Prices are fixed 

      • Not in the long run 

  • The economy is closed 

    • We live in a global market

    • Requires current efficiencies to maintain population levels (currently shrinking) 

• Classical Economics

  • Say’s Law - economy will automatically adjust; laissez-faire

• Keynesian economics 

  • Cyclical unemployment can occur 

  • Economy will not correct itself 

  • Gov’;t should actively manage macro instability (by spending more) 

• Equilibrium GDP 

  • Savings = planned investment 

• Aggregate supply/demand 

  • Same as a supply and demand curve but with the new terms 

  • Aggregate demand 

    • Substitution effect no longer applies 

    • Slopes downwards due to 

      • Real balance effect 

        • Change in consumption caused by the changed value of financial assets with fixed dollar values 

      • Interest effect 

      • Foreign purchases effect 

        • Change in the price level in a foreign country affect another’s purchasing power

    • Determinants 

      • Shift factors affecting CIGX 

        • Go to notes and see the determinants of consumer, investment, government spending, and net exports 

    • 2 components involved 

      • Change in one of the determinants 

      • AND multiplier effect 

  • Aggregate Supply 

    • In immediate short run, aggregate supply is fixed 

    • Determinants 

      • Changes in production 

      • Changes in domestic resource prices 

        • Labor

        • Capital 

        • Land 

      • Prices of imported resources 

        • Imported oil

        • Exchange rates 

• Productivity 

  • Real output per unit of input 

    • Increases reduce cost…

• Legal changes alter per-unit costs of output 

  • Taxes and subsidies 

  • Extent of gov’t regulation 

    • India having business regulated by the gov’t creating high costs that are passed to the consumers

    • Security in airports slow the productivity of working members of society 

• Fiscal policy

  • Deliberate changes in 

    • Gov’t spending 

    • Taxes 

    • Regulations 

  • Intentions made by policy makers

    • Achieve full-employment 

    • Control inflation 

    • Encourage economic growth 

  • Expansionary Fiscal policy 

    • Expansionary = boosting GDP 

  • Contractionary = lowering GDP 

    • Trying to control inflation but sinks the economy 

    • Used during demand-pull inflation 

      • Decrease gov’t spending 

      • Increase taxes 

      • Create a surplus 

    • Unemployment will go up; inflation tends to go down 

  • Problems

    • Timing problems 

      • Recognition lag - not realizing there is a problem

        • Problem: collecting past data; don’t know where we are at 

      • Administrative lag

        • Congress doesn’t get along 

      • Operational lag

        • Takes too long to spend money 

    • Political business cycles 

    • Future policy reversals 

      • New ppl entering positions in office and reversing prior “fixes” to the economy 

    • Off-setting state and local finance 

    • Crowding out effects 

• Monetary policy 

  • Central bank is engaging for the same intentions 

  • Popular because circumvents debate in society

• Policy prescriptions

  • To expand gov’t size: 

    • Increase gov’t spending during recession 

    • Increase taxes to control inflation

  • To reduce gov’t size: 

    • Decrease taxes in recession 

    • Decrease gov’t spending during recessions
      

• Built in stability 

  • Automatic stabilizers 

  1. Classical vs. Keynesian Model Assumptions

• Classical Model:

  • Assumes flexible prices and wages.

  • Believes markets self-adjust to macroeconomic disturbances.

  • Emphasizes the role of supply-side factors in determining output.

• Keynesian Model:

  • Assumes sticky prices and wages.

  • Believes in the possibility of involuntary unemployment.

  • Advocates for government intervention to stabilize output and employment.

  2. Consumption Function + Implications / Observations

• Consumption Function:

  • Describes the relationship between disposable income and consumption.

  • Implications: Higher disposable income generally leads to higher consumption, but at a diminishing rate.

  3. Effects of Stronger / Weaker Currency on GDP

• Stronger Currency:

  - Decreases net exports (exports - imports).

  - Can lead to a decrease in GDP due to reduced exports.

• Weaker Currency:

  - Increases net exports.

  - Can lead to an increase in GDP due to higher exports.

  4. Determinants of Aggregate Supply (AS) / Aggregate Demand (AD)

• Aggregate Supply (AS): determined by factors such as labor market conditions, technological changes, and input prices.

• Aggregate Demand (AD): Determined by factors such as consumption, investment, government spending, and net exports.

  5. Multiplier Effect

• Multiplier Effect:

  •  Describes how an initial change in spending leads to a larger final change in GDP.

  • Formula: Multiplier = 1 / (1 - MPC), where MPC is the marginal propensity to consume.

  6. Average vs. Marginal Propensity to Consume

• Average Propensity to Consume (APC):

  • Total consumption divided by total income.

• Marginal Propensity to Consume (MPC):

  • Change in consumption divided by change in income.

  7. MPS + MPC = 1

•   Marginal Propensity to Save (MPS)  :

  • Change in savings divided by change in income.

•  Relationship  : MPS + MPC = 1, indicating that all income is either consumed or saved.

  8. Saving vs. Dissaving

• Saving:

  •   Occurs when income exceeds consumption.

• Dissaving:

  •   Occurs when consumption exceeds income, typically financed by reducing savings or borrowing.

  9. Monetary vs. Fiscal Policy

• Monetary Policy:

  • Managed by central banks.

  • Involves controlling interest rates and money supply to influence economic activity.

• Fiscal Policy:

  • Managed by the government.

  • Involves adjusting government spending and taxation to achieve economic goals.

  10. Contractionary vs. Expansionary Policy

• Contractionary Policy:

  • Intended to reduce inflationary pressures.

  • Involves decreasing government spending or increasing taxes.

• Expansionary Policy:

  • Intended to stimulate economic growth.

  • Involves increasing government spending or decreasing taxes.

  11. Deficit vs. Surplus

• Deficit:

  • Occurs when government spending exceeds revenue in a fiscal year.

• Surplus:

  • Occurs when government revenue exceeds spending in a fiscal year.

  12. Full Employment

•   Occurs when there is no cyclical unemployment, only frictional and structural unemployment.

  13. Increase government spending to kickstart the economy

• Keynesian Perspective  :

  • Advocates for increased government spending during economic downturns to stimulate aggregate demand.

  14. Spending exceeds full employment GDP

• Inflationary Pressures  :

  • If spending exceeds the economy's capacity to produce (full employment GDP), it can lead to inflation.

  15. Crowding-Out Effect

•  Occurs when increased government borrowing (to finance deficits) leads to higher interest rates, reducing private sector investment.