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MPC
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Marginal propensity to consume. The amount of which consumption increases for every additional dollar of disposable income
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MPS
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Marginal Propensity to Save. The fraction of each additional dollar of disposable income that is saved
= 1-Mpc
= 1-Mpc
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MPC + MPS =
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1
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The Multiplier Effect
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Because all new spending on C, G, or I ends up on the Other Side of the circular flow model as income for somebody else, it causes a chain reaction
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Spending Multiplier
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Multiplier for new government spending to find the total resulting increase in GDP. = 1/MPS
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Tax Multiplier
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Always 1 less than spending multiplier because when government gives tax refund or transfer payments to households, this injection has to go through peoples "consumption function" first and some of these dollars leak into savings. = Spending Multiplier*MPC or Spending multiplier - 1. If it is a tax, the multiplier is a negative number
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Balanced Budget Multiplier
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when government spending increases are matched with an equal size increase in taxes. Balanced Budget Multiplier is always 1
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Consumption Function Graph
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C = A (autonomous spending) + (MPC*DI)
Relationship between household consumer spending and household disposable income
Relationship between household consumer spending and household disposable income
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What are the 2 causes of change in consumption function graph?
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1. Change in expectations about future Disposable Income.
2. Change in Aggregate Wealth
2. Change in Aggregate Wealth
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Inventory
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Store of output produced but not yet sold. Firms adjust this before changing their output levels
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Investment Spending changes and equation
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Booms and busts that drive the business cycle.
I = I planned spending + I unplanned "inventory investment"
I = I planned spending + I unplanned "inventory investment"
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Inventory investment
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the value of the change in total inventories held in the economy during a given period
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3 Determinants of Investment Spending change
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1. Interest Rate (i)
2. Expectations about Future sales and GDP
3. Current Levels of production
2. Expectations about Future sales and GDP
3. Current Levels of production
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How does Interest rate affect investment spending?
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Increase in interest rate = investment spending Down
Decrease in interest rate = investment spending Up
Decrease in interest rate = investment spending Up
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How does expectations of future sales and GDP affect Investment spending?
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High future expected sales and GDP = Investment Spending Up
Low future expected sales and GDP = Investment spending Down
Low future expected sales and GDP = Investment spending Down
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How do current levels of production affect Investment Spending?
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Increased Demand = Decrease in unplanned inventory investment = Investment Spending Up
Decreased Demand = Increase in unplanned inventory investment = Investment Spending Down
High Current Capacity = Investment Spending Up
Low Current Capacity = Investment spending Down
Decreased Demand = Increase in unplanned inventory investment = Investment Spending Down
High Current Capacity = Investment Spending Up
Low Current Capacity = Investment spending Down
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Aggregate Demand (AD)
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Total amount of goods and services people want to buy at various price levels.
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Why is the AD curve downward sloping?
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1. Real Wealth Effect
2. Interest Rate Effect
3. Foreign Trade Effect
2. Interest Rate Effect
3. Foreign Trade Effect
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Real Wealth Effect
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A reason the AD curve is downward sloping. When price level increases, the value of assets such as cash and checking account balances decreases. When real purchasing power of assets declines, people will buy less.
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Interest Rate Effect
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When price level increases, real purchasing power of money decreases which increases the demand for loan money and decreases the supply of loanable funds. So banks increase interest rates which causes a decrease in RGDP because households and firms put off major purchases.
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Foreign Trade Effect
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When price level in country A increases, prices of imports from other countries become less expensive and exports from country A become more expensive. This causes more imports and less exports which decreases RGDP because NX becomes a more negative number.
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Demand Shocks
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Unexpected changes in aggregate demand
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What are the determinants of shifts in Aggregate Demand
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Anything that affects the GDP equation. C, G, I, or NX
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What are the 4 ways Consumer spending can increase causing an AD shift
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1. Expectations of inflation or shortages
2. Increased incomes or wealth
3. Optimism about jobs and future income
4. Increased household borrowing
2. Increased incomes or wealth
3. Optimism about jobs and future income
4. Increased household borrowing
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What are the 2 ways Investment spending can increase causing an AD shift
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1. Interest rate drops
2. Investors have positive expectations about future business conditions due to either new technology or dwindling inventory
2. Investors have positive expectations about future business conditions due to either new technology or dwindling inventory
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Expansionary Policy
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A fiscal policy used to encourage economic growth, often through increased spending or tax cuts
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Contractionary policy
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a fiscal policy used to reduce economic growth, often through decreased spending or higher taxes
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What are the 3 ways Government spending can increase causing a shift in AD
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1. Increased spending (Fiscal policy)
2. Increase in money supply (monetary policy)
3. Decrease in taxes or increase of transfer payments
2. Increase in money supply (monetary policy)
3. Decrease in taxes or increase of transfer payments
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Monetary policy
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Government policy that attempts to manage the economy by controlling the money supply and thus interest rates.
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What are the 2 ways Net Exports can increase causing an AD shift
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1. The exchange rate decreases so the dollar depreciates in comparison to other currencies. This causes LESS IMPORTS which INCREASES RGDP
2. Foreign Income increases so exports increase
2. Foreign Income increases so exports increase
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Supply Shocks
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Unexpected changes in aggregate supply
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Short Run Aggregate Supply
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Amount of Goods and services an economy will produce when prices are FIXED in the short run
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What are the 4 determinants that shift of the SRAS curve
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1. Change in Commodity prices
2. Change in nominal wages paid to employees
3. Any change in productivity
4. Change in expectations about inflation
2. Change in nominal wages paid to employees
3. Any change in productivity
4. Change in expectations about inflation
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How does a change in Commodity prices affect AS
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Increase of commodity prices = higher input cost = AS to the left
Decrease of commodity prices = lower input cost = AS to the right
Decrease of commodity prices = lower input cost = AS to the right
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How does change in nominal wages paid to employees affect AS
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Increase nominal wages paid to employees increases production cost so AS goes to the left
Decrease nominal wages paid to employees decreases production cost so AS goes to the right
Decrease nominal wages paid to employees decreases production cost so AS goes to the right
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How does change in productivity affect AS
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More productive = AS Right
Less productive = AS Left
Ex: Increased tech = AS Right
Ex: Increased Govt. Regulation = AS Left
Less productive = AS Left
Ex: Increased tech = AS Right
Ex: Increased Govt. Regulation = AS Left
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how do changes in expectations of Inflation affect AS
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Increased inflation expectation = workers pressure employers for increase in nominal wages = AS Left
Decreased inflation expectation = workers accept decreased nominal wages = AS Right
Decreased inflation expectation = workers accept decreased nominal wages = AS Right
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Long Run Aggregate Supply (LRAS)
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- Amount of goods and services an economy will produce when prices have a chance to adjust (UNSTUCK PRICES)
- In the Long run, changes in aggregate price level have NO effect on the quantity of output supplied
- In the Long run, all prices and wages are fully flexible because unstuck so they all change by the same proportion.
- In the Long run, changes in aggregate price level have NO effect on the quantity of output supplied
- In the Long run, all prices and wages are fully flexible because unstuck so they all change by the same proportion.
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Sticky Prices
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Prices that cannot adjust easily and are "stuck" in the short run
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Flexible Prices
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Prices that can adjust in the long run
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Full Employment Output Level
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Y star. The Output produced in an economy when there is full employment in the labor market and what all economies shoot for.
Economies Want to adjust back to full employment output but the adjustment is slow because of sticky prices. This slow process is a recession
Economies Want to adjust back to full employment output but the adjustment is slow because of sticky prices. This slow process is a recession
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Long Term Growth
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Over time, the whole economy can just do more GDP at every price level. LRAS shifts to the right.
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3 determinants of LRAS Growth
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1. Population
2. Capital Investment
3. Technology
2. Capital Investment
3. Technology
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Time Lags
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Make fiscal policy difficult because Government has to notice a recession first. Spending plan in congress takes months. If public expect an AD boost they will build it into their wage and price demands which will shift AS left First meaning that expansionary policy only works when its quick and a surprise
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Automatic Stabilizers and 2 that are in the US
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Government taxation and transfer payment rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands.
US Progressive Tax System
US Welfare, Food Stamps, Medicaid programs
US Progressive Tax System
US Welfare, Food Stamps, Medicaid programs
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How is the US Progressive Tax system an automatic stabilizer?
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As GDP goes up = Income tax receipts up because more people in a higher tax bracket= Brakes put on rapid expansion = C automatically goes down
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How are US Welfare, Food Stamps, and Medicaid programs automatic stabilizers?
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Recession = Transfer payments UP because more people need = Automatic AD UP
Too much Expansion = Less transfer payments because less people need = Automatic AD Down
Too much Expansion = Less transfer payments because less people need = Automatic AD Down
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Recessionary Gap
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when aggregate output is below potential output
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Inflationary Gap
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when aggregate output is above potential output
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Fiscal Policy
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Government policy that attempts to manage the economy by controlling taxing and spending.
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