ap macro unit 5

Investment and Real Interest Rate (AP Macro)

📌 

Key Concepts:

• Investment = Marginal Benefit vs. Marginal Cost decision
  
  

• Marginal Benefit = Expected Rate of Return (r)
  
  

• Marginal Cost = Real Interest Rate (i)
  
  

💰 

Expected Rate of Return (r):

• Businesses invest only if they expect profit.
  
  

• Example:
  
  

  • A sanding machine costs $1,000
    
    

  • Expected revenue = $1,100
    
    

  • Expected profit = $100
    
    

  • Rate of return = $100 / $1,000 = 10%
    
    

• ⚠ Not guaranteed—investment always involves risk.
  
  

📉 

Real Interest Rate (i):

• Real interest = nominal rate - inflation
  
  

• If a loan interest rate is 7%, interest cost = $70
  
  

• Profit = $100 (expected) – $70 (interest) = $30
  
  

• If r > i, invest ✅
  
  

• If r < i, do not invest ❌
  
  

🧠 

Key Rule for Businesses:

• Invest in all projects where r > i
  
  

• Stop investing when r = i
  
  

🔁 

Opportunity Cost (Even with own money):

• If a firm uses saved money, the opportunity cost is the interest they could’ve earned by lending that money.
  
  

• So even when not borrowing, compare r to i.
  
  

💡 

Why Use Real Interest Rate?

• Nominal interest includes inflation.
  
  

• Real interest gives the true cost of borrowing.
  
  

• If:
  
  

  • Expected return = 10% real
    
    

  • Nominal interest = 15%
    
    

  • Inflation = 10%
    
    

  • Real interest = 15% - 10% = 5%
    
    

  • → Since 10% > 5%, investment is profitable
    
    

📈 

Investment Demand Curve:

• Created by ranking all investment projects by their expected return.
  
  

• Example:
  
  

  • $5B worth of projects return 14–16%
    
    

  • $5B return 12–14%
    
    

  • $5B return 10–12%, etc.
    
    

• If r = 12% → $10B in total qualify (12%+ returns)
  
  

• This data forms the Investment Demand (ID) Curve
  
  

📉 

Shape of ID Curve:

• Downward sloping
  
  

• Shows inverse relationship between real interest rate (i) and investment quantity
  
  

• Why? As interest rates fall, more projects become profitable.
  
  

✅ 

Figure 24.5 Quiz Summary:

1. Investment & real interest rate: inverse relationship ✅
   
   

2. More investment = lower real interest rates ✅
   
   

3. If i falls from 6% → 4% → Investment increases from $25B to $30B ✅
   
   

4. Investment = $30B when interest rate = 4% ✅
   
   

Key Concept: Investment Demand Curve

• Shows how much businesses will invest at different real interest rates, holding other factors constant.
  
  

• A movement along the curve = change in real interest rate.
  
  

• A shift of the curve = change in any other factor (non-interest-rate determinant).
  
  

Shifts in Investment Demand Curve

• Rightward shift = ↑ investment demand (businesses expect higher returns)
  
  

• Leftward shift = ↓ investment demand (businesses expect lower returns)
  
  

Non-Interest-Rate Determinants (Factors that Shift the Curve)

1. 

Acquisition, Maintenance, and Operating Costs

• ↑ Costs (e.g., machines more expensive, energy costs rise) → ↓ expected returns → shift left
  
  

• ↓ Costs → ↑ expected returns → shift right
  
  

2. 

Business Taxes

• ↑ Taxes → ↓ after-tax profit → shift left
  
  

• ↓ Taxes → ↑ after-tax profit → shift right
  
  

3. 

Technological Change

• New/better tech = more efficient production → ↑ expected returns → shift right
  
  

4. 

Stock of Capital Goods on Hand

• If overstocked (already have too much capital) → no need for more → shift left
  
  

• If understocked (can’t meet demand) → need more capital → shift right
  
  

5. 

Planned Inventory Changes

• If firms plan to increase inventories → count as investment → shift right
  
  

• If firms plan to decrease inventories → less investment → shift left
  
  

6. 

Expectations

• Optimistic about future sales, profits → ↑ expected returns → shift right
  
  

• Pessimistic → ↓ expected returns → shift left
  
  

Why Investment is Volatile (Unstable)

Investment fluctuates more than consumption due to several reasons:

1. 

Variability of Expectations

• Business expectations shift with news/events (laws, politics, global issues) → big changes in investment.
  
  

2. 

Durability of Capital Goods

• Capital goods last a long time → firms can delay replacing them during uncertain times → ↓ investment.
  
  

3. 

Irregularity of Innovation

• Innovations like AI, internet, etc., cause big waves of investment, but happen irregularly.
  
  

4. 

Variability of Profits

• Profits change year-to-year. High profits → more investment. Low profits → less investment.
  
  

Example: The Great Recession (2007–2009)

• Interest rates were near zero, so you’d expect more investment.
  
  

• But firms were pessimistic, had too much unused capital → curve shifted left, leading to less investment.
  
  

• Lenders also didn’t want to lend due to risk.
  
  

Quick Summary (Review 24.2)

• A firm invests if expected return ≥ real interest rate.
  
  

• Curve shifts due to:
  
  

  • Capital costs
    
    

  • Taxes
    
    

  • Technology
    
    

  • Capital stock on hand
    
    

  • Expectations
    
    

The multiplier effect is the idea that:

A change in spending (like investment, consumption, net exports, or government purchases) causes a larger change in real GDP.

Formula:

• Multiplier = Change in GDP / Initial Change in Spending
  
  

• Rearranged: Change in GDP = Multiplier × Initial Spending
  
  

📊 

Basic Example

• Investment rises by $30 billion
  
  

• GDP rises by $90 billion
  
  

• Multiplier = 3 (90 ÷ 30)
  
  

🔑 

Key Concepts

💰 1. 

Where the Multiplier Applies

• Most commonly tied to investment (because it’s volatile)
  
  

• Also works for: government spending, exports, autonomous consumption
  
  

⬆⬇ 2. 

It Works Both Ways

• More spending → larger GDP increase
  
  

• Less spending → larger GDP drop
  
  

🔄 

Why the Multiplier Effect Happens

1. Spending creates income
   
   

   • Your spending = someone else’s income
     
     

2. Income leads to more spending
   
   

   • Each person spends part of their income → triggers more income for others
     
     

🧮 

Multiplier & MPC/MPS

Definitions:

• MPC (Marginal Propensity to Consume) = % of income spent
  
  

• MPS (Marginal Propensity to Save) = % of income saved
  
  

  • MPC + MPS = 1
    
    

Formulas:

• Multiplier = 1 / (1 − MPC) or 1 / MPS
  
  

✅ Higher MPC → Bigger multiplier

⛔️ Higher MPS → Smaller multiplier

🧱 

How It Builds Up (Example with MPC = 0.75)

• Initial investment = $5 billion
  
  

• 1st round: $3.75 billion spent (0.75 × 5)
  
  

• 2nd round: $2.81 billion spent (0.75 × 3.75)
  
  

• 3rd round: $2.11 billion spent…
  
  

• Continues until the total = $20 billion GDP increase
  
  → Multiplier = 4
  
  

🤔 

Why It Eventually Stops

• Each round, less is spent due to saving
  
  

• The income “leaks” out through savings, taxes, or imports
  
  

📉 

Real-World Adjustments

• In real life, the multiplier is smaller than the formulas suggest
  
  

  • Because:
    
    

    • People buy imports
      
      

    • People pay taxes
      
      

    • Inflation reduces the real impact of spending
      
      

💡 Actual U.S. multiplier: likely between 0 and 2.5

🤹‍♂ 

Story Summary: “Toppling Dominoes”

A chain reaction shows how one spending cut (Ajani cancels car order) leads to a wide economic decline (TV canceled, vacation scrapped, loans denied, workers laid off). Even though it was a mistake, the damage had already spread—just like how reduced spending multiplies into wider economic effects.

🧠 

Quick Review

• Multiplier = shows how much GDP will change due to spending
  
  

• Higher MPC → Bigger GDP change
  
  

• Lower MPS → Bigger multiplier
  
  

• The process spreads income, which spreads spending
  
  

• Real-life multipliers are smaller due to leakages
  
  

Aggregate Demand (AD)

Definition

• Aggregate demand (AD) is the total amount of real GDP that households, businesses, the government, and foreign buyers want to buy at each possible price level.
  
  

Shape of the AD Curve

• Downward sloping (inverse relationship between price level and real GDP demanded).
  
  

Why the AD Curve Slopes Downward

It’s not because of the income effect or substitution effect (those explain individual product demand, not total output).

Instead, it's due to these three key effects:

🔹 1. Real-Balances Effect

• When price level rises → the real value (purchasing power) of money assets falls (e.g., your savings can buy less).
  
  

• People feel poorer, so they spend less.
  
  

• Result: Lower consumption, less GDP demanded.
  
  

🔹 2. Interest-Rate Effect

• Higher price level → higher demand for money (people need more cash to buy same goods).
  
  

• But money supply is fixed → interest rates rise.
  
  

• High interest rates = less investment by businesses and less borrowing by consumers.
  
  

• Result: Lower investment + consumption, less GDP demanded.
  
  

🔹 3. Foreign Purchases Effect

• U.S. price level ↑ (compared to other countries) → U.S. goods become more expensive to foreigners.
  
  

• Exports fall, imports rise → net exports drop.
  
  

• Result: Less GDP demanded from abroad.
  
  

📉 What Happens When the Price Level Falls?

• Opposite of above:
  
  

  • Real-balances effect: People feel wealthier → buy more.
    
    

  • Interest-rate effect: Interest rates drop → investment and spending rise.
    
    

  • Foreign purchases effect: Exports ↑, imports ↓ → net exports rise.
    
    

🧠 Tip to Remember the 3 Effects:

Think R.I.F.
Real-balances
Interest-rate
Foreign purchases

LO26.2 – Shifts in Aggregate Demand (AD)

🔄 What Causes a Shift in AD?

• A change in price level causes movement along the AD curve.
  
  

• A change in non-price factors (determinants) causes the entire curve to shift.
  
  

  • Rightward shift = Increase in AD
    
    

  • Leftward shift = Decrease in AD
    
    

📌 Two Components of a Shift in AD

1. Initial Change in Spending
   (Ex: Increase in investment, consumer spending, etc.)
   
   

2. Multiplier Effect
   
   

   • Multiplies the initial spending across the economy
     
     

   • Example: $5 billion investment × multiplier of 4 = $20 billion AD increase
     
     

🧠 Major Determinants of AD (a.k.a. AD Shifters)

Use the acronym C.I.G.Xn (Consumption, Investment, Government, Net Exports)

🏠 1. Consumer Spending (C)

Factors that shift consumer spending:

• Consumer Wealth
  ↑ Wealth → ↑ Consumption → AD shifts right
  ↓ Wealth → ↓ Consumption → AD shifts left
  
  

• Household Borrowing
  ↑ Borrowing → AD shifts right
  ↓ Borrowing or ↑ debt repayment → AD shifts left
  
  

• Consumer Expectations
  Expect ↑ future income/prices → spend more now → AD shifts right
  Expect ↓ future income/prices → spend less now → AD shifts left
  
  

• Personal Taxes
  ↓ Taxes → ↑ Disposable income → AD shifts right
  ↑ Taxes → ↓ Disposable income → AD shifts left
  
  

🏗 2. Investment Spending (I)

Factors that affect investment:

• Real Interest Rates
  ↑ Real interest rates → ↓ Investment → AD shifts left
  ↓ Real interest rates → ↑ Investment → AD shifts right
  
  

• Expected Returns
  ↑ Expected returns → ↑ Investment → AD shifts right
  ↓ Expected returns → ↓ Investment → AD shifts left
  
  

Expected returns depend on:

• Future business conditions (optimism = right shift)
  
  

• New technology (increases returns = right shift)
  
  

• Degree of excess capacity (more unused = left shift)
  
  

• Business taxes (higher taxes = lower returns = left shift)
  
  

🏛 3. Government Spending (G)

• ↑ Government spending → AD shifts right
  
  

• ↓ Government spending → AD shifts left
  
  

(Assuming no offset from tax/interest rate changes)

🌍 4. Net Export Spending (Xn = Exports - Imports)

Factors that influence net exports:

• National Income Abroad
  ↑ Foreign income → ↑ U.S. exports → AD shifts right
  ↓ Foreign income → ↓ U.S. exports → AD shifts left
  
  

• Exchange Rates
  
  

  • Dollar Depreciation → U.S. goods cheaper → ↑ Exports, ↓ Imports → AD shifts right
    
    

  • Dollar Appreciation → U.S. goods more expensive → ↓ Exports, ↑ Imports → AD shifts left
    
    

🧠 Tip to Remember AD Shifters

Use "C.I.G.Xn" + WET BCI

• Consumption (Wealth, Expectations, Taxes, Borrowing)
  
  

• Investment (Business confidence, Capacity, Interest rates)
  
  

• Government spending
  
  

• Xn = Net exports (Foreign income, Exchange rates)
  
  

📊 Visual Summary:

Definition of Aggregate Supply (AS):

Aggregate Supply is the total amount of real output (goods and services) that firms in an economy are willing to produce at different price levels.

⏱ Three Time Frames of AS:

💡 Immediate Short Run (AS_ISR):

• Both input (like wages) and output prices are fixed.
  
  

• Example: Companies commit to fixed prices in a catalog or contract.
  
  

• Firms supply however much is demanded at that fixed price.
  
  

• AS curve = horizontal, meaning price level doesn’t affect output.
  
  

💡 Short Run (AS):

• Input prices stay fixed (often because of contracts).
  
  

• Output prices are flexible (can change quickly).
  
  

• As price level rises → firms make more real profit → increase output.
  
  

• AS curve is upward sloping:
  
  

  • Flatter below full employment (Qf) → firms can use idle resources easily.
    
    

  • Steeper above Qf → harder and costlier to increase output due to resource shortages.
    
    

💡 Long Run (AS_LR):

• Both input and output prices are flexible.
  
  

• If price level rises, wages and costs rise too, so real profit stays the same.
  
  

• Firms have no incentive to change output.
  
  

• AS curve is vertical at full-employment output (Qf).
  
  

• Price level doesn’t affect output in the long run.
  
  

🎯 Why Focus on the Short Run?

• Real economies experience both output and price level changes.
  
  

• Only the short-run AS curve can explain both happening at the same time.
  
  

• Immediate short run assumes fixed prices (not always realistic), and long run assumes full employment (not always the case).
  
  

• Most policy tools (like taxes or spending) are aimed at managing short-run fluctuations (like recessions or inflation).
  
  

🔁 In Short:

Aggregate Supply Curve Recap

• Aggregate Supply (AS) shows the relationship between the price level and the total real output firms are willing to produce.
  
  

• The short-run AS curve is upward sloping: as prices rise (output prices), firms produce more because profits increase.
  
  

• The long-run AS curve is vertical at full employment output because all prices, including wages, fully adjust.
  
  

What Causes the AS Curve to Shift?

The AS curve shifts when factors other than the price level change and affect per-unit production costs or productivity. These shifts mean:

• Rightward shift: Firms produce more at every price level (increase in AS).
  
  

• Leftward shift: Firms produce less at every price level (decrease in AS).
  
  

Key Determinants (Factors) That Shift the Aggregate Supply Curve:

1. Input Prices (Resource Prices)
   
   

   • These are the costs of resources used in production (wages, machinery, land, imported goods).
     
     

   • Lower input prices → lower production costs → AS shifts right.
     
     

   • Higher input prices → higher production costs → AS shifts left.
     
     

2. Examples:
   
   

   • Increase in labor supply (e.g., immigration) lowers wages → AS shifts right.
     
     

   • Increase in wages due to early retirements → AS shifts left.
     
     

   • Cheaper machinery or land → AS shifts right.
     
     

   • Oil price spikes (like 1970s OPEC crisis) → AS shifts left.
     
     

   • Dollar appreciation reduces imported resource prices → AS shifts right.
     
     

3. Productivity
   
   

   • Productivity = output per unit of input.
     
     

   • Higher productivity means more output from the same input, reducing per-unit costs.
     
     

   • Increases in productivity shift AS right.
     
     

   • Decreases in productivity shift AS left.
     
     

4. Sources of productivity growth:
   
   

   • Better technology and equipment.
     
     

   • Better education and training.
     
     

   • Improved business organization.
     
     

   • Moving labor from low to high productivity sectors.
     
     

5. Legal-Institutional Environment
   
   

   • Changes in government policies affecting production costs.
     
     

   • Taxes and Subsidies
     
     

     • Higher business taxes increase costs → AS shifts left.
       
       

     • Subsidies reduce costs → AS shifts right.
       
       

   • Regulation
     
     

     • More regulation tends to increase costs → AS shifts left.
       
       

     • Deregulation may reduce costs → AS shifts right (but effects vary).
       
       

Summary

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

What is Equilibrium?

• Equilibrium occurs at the price level where the quantity of real output demanded equals the quantity of real output supplied.
  
  

• This happens at the intersection of the Aggregate Demand (AD) curve and the Aggregate Supply (AS) curve.
  
  

• At equilibrium, the price level and the real GDP (total output) are stable in the short run.
  
  

How AD and AS Determine Equilibrium

• The AD curve slopes downward because:
  
  

  • When the price level falls, people’s purchasing power increases (real balances effect), interest rates fall, and foreign demand for domestic goods rises, all causing an increase in the quantity of goods demanded.
    
    

• The AS curve slopes upward because:
  
  

  • When the price level rises, firms are willing to produce more since higher prices typically mean higher profits, especially as costs remain relatively fixed in the short run.
    
    

Example Using Figure 26.7

• At a price level of 100 (index), the real output demanded and supplied are both $510 billion → this is equilibrium.
  
  

• If the price level falls to 92:
  
  

  • Businesses will want to supply $502 billion (less than equilibrium).
    
    

  • Buyers will want to purchase $514 billion (more than supply).
    
    

  • This creates a shortage of $12 billion.
    
    

  • Because demand exceeds supply, competition among buyers will push the price level up, moving the economy back to equilibrium at 100.
    
    

• Conversely, if the price level rises above equilibrium, there will be a surplus, pushing prices back down to equilibrium.
  
  

Short-Run Equilibrium Behavior

• When there is a shortage (demand > supply), prices tend to rise.
  
  

• When there is a surplus (supply > demand), prices tend to fall.
  
  

• The economy naturally moves toward the equilibrium price level and output where AD = AS.
  
  

Quick Quiz Summary (from your notes)

1. Why does AD slope downward?
   Because decreases in price level increase real GDP demanded through real-balances effect, interest-rate effect, and foreign purchases effect.
   
   

2. Why does AS slope upward?
   Because higher price levels increase per-unit production costs, encouraging more output until full capacity.
   
   

3. What happens at price level 92?
   A shortage of real GDP ($12 billion), pushing the price level back up to equilibrium.
   
   

4. If real output demanded rises by $4 billion at each price level, what happens?
   The equilibrium price level rises (to 104 in the example).
   
   

Key Takeaway

The equilibrium price level and real GDP are determined where aggregate demand equals aggregate supply. The economy naturally adjusts through price changes to this point, at least in the short run.

Summary of Part 1: Changes in Equilibrium (LO26.6)

1. Demand-Pull Inflation

• When aggregate demand (AD) increases while the economy is at full employment, it shifts the AD curve rightward.
  
  

• This leads to a rise in the price level (P1 to P2) and output beyond full employment (Qf to Q1), creating an inflationary GDP gap.
  
  

• Real-world example: Vietnam War-era U.S. government spending led to inflation in the late 1960s.
  
  

• The multiplier effect is reduced because part of the output gain turns into higher prices.
  
  

2. Recession and Cyclical Unemployment (Decreases in AD)

• A leftward shift in AD (like during the 2008 crash) causes output to fall (Qf to Q1), creating a recessionary GDP gap.
  
  

• If prices are downwardly inflexible (sticky), the price level stays the same (P1), but output falls — this is typical in U.S. recessions.
  
  

• The multiplier is at full strength in this case because there's no price-level change to reduce output impact.
  
  

Why Prices Are Sticky Downward:

• Fear of price wars: Firms avoid initiating cuts to prevent deeper competitor cuts.
  
  

• Menu costs: Repricing is costly (printing, advertising, logistics).
  
  

• Wage contracts: Long-term deals prevent wage reduction.
  
  

• Morale/productivity: Lower wages hurt effort and efficiency.
  
  

• Minimum wage: Creates a legal wage floor.
  
  

Ratchet Effect:

• Prices and wages go up with demand but resist going back down — like a ratchet tool that moves one way only.
  
  

3. Cost-Push Inflation (Decreases in AS)

• Leftward shifts in aggregate supply (AS) — e.g., oil shocks — raise costs and cause both inflation and a recession (Qf to Q1, P1 to P2).
  
  

• Example: 1970s oil crisis.
  
  

• Today, the economy is less vulnerable to oil price shocks, but not immune.
  
  

4. Increases in AS: Full Employment with Price Stability

• In the late 1990s, the U.S. had strong growth and low inflation.
  
  

• Why? Tech advances (computers, internet, etc.) increased productivity → rightward AS shift (AS1 to AS2).
  
  

• This allowed AD to rise (AD1 to AD2) without major inflation — output grew from Q1 to Q3, prices rose only slightly (P1 to P2).
  
  

• Some saw this as a “New Economy,” but the 2001 recession (after 9/11 and investment declines) reminded everyone of old economic rules.

Summary: The Great Moderation, the Great Recession, and the Weak Recovery

🔷 Part 1: The Great Moderation (Post-1982 to mid-2000s)

• After the 1982 recession, the U.S. economy entered a period of strong, steady growth.
  
  

• Low inflation and low unemployment became the norm.
  
  

• Recessions during this time were milder and less frequent.
  
  

• Economists called this period “The Great Moderation,” believing better economic policy had smoothed the business cycle.
  
  

• This confidence was later proven wrong when the Great Recession (2007–2009) hit unexpectedly and severely.
  
  

🔷 Part 2: The Great Recession and Its Aftermath

⚠ Causes of the 2007–2009 Recession:

• In the early 2000s, trillions were borrowed to buy homes, based on the false assumption that house prices would always rise.
  
  

• When home prices fell in 2006, many couldn’t repay loans, and banks were stuck with bad debt.
  
  

• This caused a banking crisis, freezing financial markets and triggering a recession.
  
  

📉 Recession Hits:

• The economy entered a steep downturn in late 2007.
  
  

• GDP fell 4.7%, and unemployment rose to 10.1%.
  
  

🚨 Government Response (Stimulus Efforts):

• Monetary policy: The Federal Reserve cut interest rates to near zero to encourage spending and investment.
  
  

• Fiscal policy: The government began massive deficit spending to increase aggregate demand (AD).
  
  

✅ These actions helped prevent a second Great Depression, but...

🔻 Why the Recovery Was So Weak (2009–2015)

Despite big stimulus efforts, recovery was slow and disappointing:

• Unemployment: Expected to fall to 5.2% by 2012, but was still 8.1%.
  
  

• GDP Growth: Stayed below 2.5% per year through 2015, much lower than past recoveries (e.g., 7.2% in the 1980s).
  
  

Reasons:

1. High Debt Levels: Consumers avoided new loans and focused on repaying old ones.
   
   

2. High Savings: People saved stimulus money instead of spending it.
   
   

3. Misaligned Stimulus: Aid was spread broadly, but hardest-hit sectors (like housing) got too little.
   
   

4. Inelastic Supply: In industries like dentistry or jewelry, demand increases only caused price increases, not more production.
   
   

🧠 Key Economic Concepts

• AD-AS Model: The economy’s output and price level are determined by the intersection of Aggregate Demand and Aggregate Supply.
  
  

• Demand-Pull Inflation: Too much AD → higher prices.
  
  

• Recession: Too little AD → lower output, unemployment.
  
  

• Cost-Push Inflation: A fall in AS raises prices.
  
  

• Balanced Growth: Achievable when AS grows with AD, often through productivity improvements