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Unit Three Schedule

Macro Unit 3
Chapters: 9, 10, 11, 12, and 17(p. 334-338)
Macro Unit 3 Section 1

        Aggregate Demand and Aggregate Supply

Earlier we learned about supply and demand curves. Yet the single product supply and demand model does not explain

1) why prices rise or fall in general

2) What determines aggregate (combined) output

3) What determines changes in level of aggregate output.

In order to look at it from a macro level we must combine the prices of all goods. And the equilibrium quantities. This is the aggregate (combined)

Aggregate Demand: is a schedule .... which shows the various amounts of goods and services (Real Domestic Output, Real GDP) which consumers, businesses, governments and foreign buyers collectively will desire to purchase at each price level (CPI, PPI…).   

This is the same thing as saying the amount of GDP that all buyers in an economy will buy at all possible levels of prices.

Price levels are measured as price indexes.

However, the inverse relationship does not apply in the same manner as the single demand curve. In the single product demand curve it had an inverse relationship because of the substitution effect (as the price of an item increases the more of a substitute they will purchase and therefore the less of the this product they will want, and income effect (the more income one has the more of a product they will demand.)

In the Aggregate model we can not substitute for everything. (things do not become cheaper relative to other products.)

And all income varies with aggregate output. (Because of the circular flow model if the price is higher wages will be higher.)

What then is the explanation for the inverse relationship of the AD curve. (Why is it downward sloping?)

1) Wealth, or real balances effect: When prices fall the money that people have will be worth more. (The real value will be worth more.) And vice versa

2) Interest- Rate Effect: As the price level rises so will the interest rate. This will reduce consumption. (This is because the higher prices means consumers (business, individuals...) will need more money. They will seek to borrow it and this will drive up interest rates. (We will learn about this in detail next unit) Eventually what will happen is that consumers will decide not to make purchases because interest rates are too high.

VERY IMPORTANT LATER

3) Foreign Purchases Effect: When price levels in the United States increase this means U.S. prices are higher than foreign prices. Purchase of exports will decrease causing amount of Goods and Services demanded to decrease.

A model should predict why prices are stable in some periods but surge in others. AD when combined with AS should predict this.

Determinants of Aggregate Demand 

Increase in Aggregate Demand

Decrease in Aggregate Demand

What causes AD curve to shift? (change in AD v. change in quantity of real output demanded)

Known as Determinants of Aggregate Demand because they determine the location of the demand curve.

1) Change in consumer spending (C) caused by changes in

        a) consumer wealth: When people have less money to save. This causes the curve to shift to the left. (decrease in AD) This has nothing to do with price. This is a change in real income due to non-market factors. (Decrease in stock prices will lead to less wealth.)

       b) consumer expectations: If people think that their future income will decrease or that inflation will decrease (it will be cheaper to buy later) they will spend less now. This will cause the AD curve to shift left. This is why they poll people about consumer confidence.

       c) Consumer indebtedness: If people have spent a lot in the past and are in debt they are going to spend less now. This will shift the curve to the left.

       d) Taxes (Fiscal Policy): If taxes increase the people have less money and will then spend less. AD shifts to the left

      e) interest rates (monetary policy): When interest rates increase AD decreases

Notice that C, D and E (above) all affect disposable income

2) Change in investment spending (I): people (businesses) changing spending on capital goods will affect AD curve.

      a) Interest Rates: Increase in interest rates will decrease AD (Business will buy less capital goods). This in not the interest rate effect. It has nothing to do with the price. Rather it has to do with changes in interest rates through something like a change in the money supply (which we will learn later).

      b) profit expectations on Investment projects: If the business foresee profits for investment they will increase demand for consumer goods. This will shift the AD curve.   IF we are in a huge depression and i is = 0, business will still not increase I unless they have expectations for a good return on investment.

     c) Business Taxes: Increase business taxes will lead to a decrease in investment spending and the AD curve will shift to left.

     d) technology: new technology increases investment spending.

      e) Amount of excess capacity: If they are not using the capital they have they will not purchase new capital. This will cause a decrease in AD. If they are not at full capacity then they will increase I.

3) Change in government spending (G): Increased government spending (without change in taxes or interest rates) will increase AD. This could be a planned Fiscal policy move or they may just want to increase G. (give more money to education....)

4) Change in net exports (Xn) (unrelated to price level)

     a) income abroad: Increase in foreign demand will cause an increase in AD for U.S.

     b) Exchange Rates: If the dollar becomes worth less (depreciates) in terms to anther currency. This means they have more real income and our AD will increase.

Aggregate Supply:  is a schedule, showing the level of real domestic output available at each possible price level.

There are three parts the AS curve.

1) Keynesian (Horizontal) Range: Here price level remains constant with substantial output variation. The economy is below full employment and will therefore have excess capacity. This means production can be increased without fear of having costs increase. 2) Classical (Vertical) Range: The economy is at full employment and any attempt to increase production will increase prices. Real domestic output will be constant. 3) Intermediate (Upsloping) Range: Expansion of real output is accompanied by a rising price level.

Increase in Aggregate Supply

Decrease in Aggregate Supply

 Determinants of Aggregate Supply: 

1) Change in input prices:

     a) availability of resources: (land, labor, capital and entrepreneuralship) if these resources are more expensive the production costs increase and AS will decrease (shift left)

     b) price of imported resources: If the prices increase the AS curve will decrease

     c) Market power: The ability to set a price above the point that would be reached in a competitive environment. (If Oil Cartel increases prices the production costs increase. If unions increase prices the production costs increase.)

2) Changes in productivity: (technology)

Productivity = real output/input If per unit cost decrease the companies become more productive and therefore will be willing to supply more. A shift in AS to the right.

3) Change in legal-institutional environment:

     a) Business taxes and subsidies: Higher taxes lead to increase unit costs. This means the AS will decrease (shift left)

     b) Government Regulation: Increase government regulations will lead to increased production costs. This will mean a decrease in AS.

Equilibrium price level and Equilibrium real domestic output

The intersection of these two is the equilibrium point.

How does an increase in AD change things for each of the ranges in the AS curve?

In intermediate and classical ranges, demand-pull inflation occurs with the increase in aggregate demand. This means shifts in aggregate demand are pulling up the price level. (The increase in price is caused by the increase in aggregate demand.)

What happens if Aggregate supply is shifted? (this might happen because of foreign inputs increased in price. Ex. when OPEC increased the price of oil)

If AS decreases we get cost-push inflation because the cost of production is pushing up the price.   If you go from AS1 to AS2 you will get falling employment rates and inflation.

In Macroeconomics a change in a variable that causes AS to shift can sometimes cause a shift in AD. Ex. If wages increase it becomes more costly for companies to produce so AS shifts. Yet employees now have more money so AD increases.

 Long Run Aggregate Supply:

Wages are responsive to changes in the price level. If the prices of things go up the workers realize that their wages can no longer buy what they used to. They demand a raise. When they do this increases the cost of doing business. This will shift the AS curve back to the left. In the long run the AS curve will be a vertical line because of this responsiveness to price changes.      The long run AS curve is a vertical line indicating the amount of goods and services a nation can produce using all of its productive resources as efficiently as possible.

 The Long Run AS curve is at full employment.

The LRAS curve also assumes that the nation is using all of the productive technologies available to it. In this manner it is similar to the productive possibilities curve. The LRAS curve moves outward when there is economic growth, but it is still a vertical line.

1. Something happens to increase AD.

2. Workers see that prices have risen and demand raises. This shifts AS to the left.

3. AS shifts so that the net effect is that prices rise but output does not increase.

The Long Run AS curve is at full employment.

Long Run AS and PPC: The LRAS curve assumes that the nation is using all of the productive technologies available to it.  In this manner, it is similar to the production possibilities curve.    The LRAS moves outward when there is economic growth, but it is still a vertical line.

           Increase in LRAS                                                                                               PPC shifts out

Unit 3 Lesson 2  Chapter 10 Keynesian Economics v. Classical Economics Classical theory of employment: believes that laissez faire capitalism is able to provide virtually continuous full employment. They felt that     1) under spending (not spending enough to keep full employment) would not occur.     2) If under spending did occur, price wage would adjust and there would not be declines in real output, employment or real incomes. This was based on Say's Law: Supply creates its own demand. They felt that when things are produced the wages created would pull that supply off the shelves. It is because of this theory that the vertical portion of the AS curve is called the classical range. AS is vertical because the economy will not allow employment to fall below full employment. AD is stable if the monetary supply is stable. Demand is based on nothing more than the amount of money available. Keynesian Economics: Keynes believes that product prices and wages are downwardly inflexible. (Companies will not lower their prices in time of hardship and workers will not accept wage cuts in times of hardship.) This is why the AS curve has the horizontal slope. It represents a point where the economy is not fully employed. AS is horizontal because the economy will be at under employed levels. They believe that once full employment is reached the AS will then become vertical. AD in unstable because of the variability in investment.

Chapter 34: Exchange Rates Exchange rates are based on supply and demand for money. When we buy goods from other countries we actually pay in their currency. This means that if there price level goes down we will demand more of their products. If we demand more of their products we need more of their currency. This means an increase in the demand for their currency. Foreign exchange rate: the price of one currency in terms of another.             appreciation: an increase in the value of a currency in terms of other currencies. If it cost 20 cents to buy one franc today and 25 cents to buy one franc tomorrow we would say the franc has appreciated in terms of the dollar.                depreciation: a decrease in value of a currency in terms of other currencies. In this case the U.S. dollar has depreciated    If the Euro appreciates what happens to the demand for German goods?   If we have an increase in the demand for German products we have an increase in the demand for Euros. This means the price of a Euro goes up and the foreign exchange value of the dollar  decreases.                  If Germans then want to buy more American goods they would in effect supply more Euros. This shifts this supply curve (of Euros) out and lower the price of Euros for us.  Be careful what the axis is!

Unit 3 Lesson 3 Part 1 of 4      After the depression Keynesian Economics was a widely accepted theory.    The basic supply and demand model has however been gradually replacing it.  The Keynesian Cross was designed by Keynes to convince the government leaders to increase G in order to pull out of the recession . This is because of the multiplier effect of G Although it has fixed prices it shows with precision the changes in GDP. Most essay questions can be answered through supply and demand.   The following is for background knowledge.  Saving is that part of disposable income not spent so it too depends on DI.                    The 45 degree line is equal distance from both the horizontal and the vertical axis.  The difference between the 45 degree line and C is savings.  As DI increases consumption increases. Does this make sense? Of course. As we make more and more money we tend to spend more and more. The reality is that C increases as Y increases C increases less than Y increases S increases as Y increases Consumption (C) + Savings (S) = Disposable Income (DI) DI - C = Savings.   What would happen if C was above the 45degree line.      Why do you think that the consumption schedule is upward sloping?   Where C = 45 degree line this is the Break-even income. (Household consumes everything they earn.)      Average Propensity to Consume = Consumption (C) /Income (Y) APC= C/Y  This is the fraction of total income that is consumed     Average Propensity to Save = Savings (S)/Income (Y) APS= S/Y This is the fraction of total income that is saved. APC + APS = 1 Once we know the average propensities we must then calculate the marginals. These tell us how much they will consume/save when income changes. MPC = change in consumption/change in income  = ∆C/∆Y MPS = change in savings/change in income. Notice that the MPC is the numerical value of the slope of the C schedule. MPC + MPS = 1 Level of Output Consumption Savings APC APS MPC MPS $370 $375            390  390            410  405             What are the determinants of consumption and savings? (excluding income)  These will cause a shift in consumption.       WHY is it important to know what affects the consumption function?      Except for price level the following determinants of Consumption are the same determinants of AD.  1) Wealth: The greater the amount of wealth (cars, TV's, cash, savings accounts...) the less the incentive to save. People save to accumulate wealth. Once they have it they no longer need to save. 2) Price Level: An increase in the price level shifts the consumption schedule downward.  A change in price level changes the purchasing power of wealth. 2) Expectations: If they expect prices to rise in the future consumption will increase now. 3) Consumer indebtedness: If they are in debt they are going to consume less 4) Taxation: increase in taxes will lead to decreased consumption. NOTICE: We will see later that a change in taxes shifts both the savings and the consumption curve in the same way because if the government takes the money people will consume less and save less.   *** Change in amount consumed is movement along schedule *** Change in consumption schedule is a shift. It can shift up or down. **** WHICH WAY IS AN INCREASE IN CONSUMPTION?

Macro Unit 3 Lesson 3 Part 2

Chapter 10 (pp.187 - 193)

    Are individuals the only ones that consume?   No we also have businesses and governments.

Business consume through investment (I).

When we talk about I. It is autonomous (it doesn't vary as disposable income varies.)   We also assume that there is no savings for business. Although in a real world if income increases investment may increase.

There are two determinants for investment:

1. Expected Rate of Net Profit:

2. The Real Interest Rate: the financial cost that the business must pay to borrow money to purchase real capital (machinery...)

   If interest rates are very high the company may still invest but rather use its past savings rather than borrow money.

Autonomous spending does not just work for I but also G, and Xn.  This autonomous spending is very powerful.

 An increase in I has a multiplied effect on the economy. The problem is that if it decreases you have a big problem that must be corrected. Who has to correct this? 

Government and Xn

Xn 

     When we buy from others we have a leakage out of our economy. (Money is leaving.) When we sell to other countries we have an injection into our economy. The difference is net exports (foreign spending). X - M = NE

Unit 3 Lesson 3 Part 3 of 4

KEYNESIAN MULTIPLIER

   The Keynesians believe that consumption changes less than disposable income changes, affecting overall spending, output, and employment.  This lesson explains the multiplier, which can be used to predict how much expenditures, output, and employment can be expected to change if spending by consumers, businesses, and government changes as a result of forces other than changes in income.

The following shows the total income that is injected into the economy when new spending is introduced.