Unit III: National Income & Price Determination

• Aggregate Demand (AD)
• Shows the amount of Real GDP that the private, public, and foreign sector collectively desire to purchase
• The relationship between the price level and the level of Real GDP is inverse
• Aggregate Demand Curve

• Three Reasons AD is downward sloping
• Real-Balances Effect:
• When the price level is high, households and businesses cannot afford to purchase as much output
• When the price level is low, households and businesses can afford to purchase more output
• Interest-Rate Effect:
• A higher price level increases the interest rate which tends to discourage investment
• A lower price level decreases the interest rate which tends to encourage investment
• Foreign Purchases Effect
• A higher price level increases the demand for relatively cheaper imports
• A lower price level increases the foreign demand for relatively cheaper U.S. exports
• Shifts in Aggregate Demand (AD)
• There are two parts to a shift in AD:
• A change in C, Ig, G, and/or Xn
• A multiplier effect that produces a greater change than the original change in the 4 components
• Increases in AD = AD →
• Decreases in AD = AD ←
• Consumption
• Household spending is affected by:
• Consumer wealth
• More wealth = more spending (AD shifts →)
• Less wealth = less spending (AD shifts ←)
• Consumer expectations
• Positive expectations = more spending (AD shifts →)
• Negative expectations = less spending (AD shifts ←)
• Household Indebtedness
• Less debt = more spending (AD shifts →)
• More debt = less spending (AD shifts ←)
• Taxes
• Less taxes = more spending (AD shifts →)
• More taxes = less spending (AD shifts ←)
• Gross Private Investment
• Investment spending is sensitive to:
• The Real Interest Rate
• Lower Real Interest Rate = more investment (AD →)
• Higher Real Interest Rate = less investment (AD ←)
• Expected Returns
• Higher Expected Returns = more investment (AD →)
• Lower Expected Returns = less investment (AD ←)
• Expected Returns are influenced by
• Expectations of future profitability
• Technology
• Degree of Excess Capacity (Existing Stock of Capital)
• Business Taxes
• Government Spending
• More government spending (AD →)
• Less government spending (AD ←)
• Net Exports
• Net Exports are sensitive to:
• Exchange Rates (International value of $)
• Strong $ = more imports and fewer exports (AD ←)
• Weak $ = fewer imports and more exports (AD →)
• Relative Income
• Strong Foreign Economies = more exports (AD →)
• Weak Foreign Economies = less exports  (AD ←)
• Aggregate Supply
• The level of Real GDP (GDPR) that firms will produce at each Price Level (PL)
• Long-Run v. Short-Run
• Long-Run
• Period of time where input prices are completely flexible and adjust to changes in the price level
• In the long-run, the level of Real GDP supplied is independent of the price level
• Short-Run
• Period of time where input prices are sticky and do not adjust to changes in the price level
• In the short-run, the level of Real GDP supplied is directly related to the price level
• The Long-Run Aggregate Supply (LRAS)
• The Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to PPC)
• LRAS is vertical at the economy's level of full employment
• Changes in SRAS
• An increase in SRAS is seen as a shift to the right. SRAS →
• A decrease in SRAS is seen as a shift to the left. SRAS ←
• The key to understanding shifts in SRAS is per unit cost of production
• Per-unit production cost = total inpurt cost / total output
• Determinants of SRAS (all of the following affect unit production cost)
• Input Prices
• Productivity
• Legal-Institutional Environment
• Input Prices
• Increases in Resource Prices = SRAS ←
• Decreases in Resource Prices = SRAS →
• Productivity
• Productivity = total output / total inputs
• More productivity = lower unit production cost = SRAS →
• Lower productivity = higher unit production cost = SRAS ←
• Legal-Institutional Environment
• Ranges/Shapes/Views of A.S.

• The followers of the Keynesian view believe in a horizontal AS curve, because when the economy is below full employment, AD shifts outward.
• Whenever that happens, increase in Real GDP
• Employment drops, but price level is constant
• That means that demand creates its own supply
• Classical Range (Vertical)
• In the long run, the AS curve is vertical, because the only effects of an increase in AD is when we're already at full employment
• Thus, you have an increase in the price level, and supply creates its own demand (Say's Law)
• Intermediate Range


• AS is between the Classical and the Keynesian range
• When this occurs, as AS shifts outward, price level and Real GDP increases
• CLASSICAL vs. KEYNESIAN DEBATE

• The AS/AD Model
 
• The equilibrium of AS and AD determines current output (GDPR) and the price level (PL)
• 
• Full Employment
 
• Full Employment Equilibrium exists where AD intersects SRAS and LRAS at the same point
• 
• Recessionary Gap
 
• A recessionary gap exists when equilibrium occurs below full employment output
• 
• Inflationary Gap
 
• An inflationary gap exists when equilibrium occurs beyond full employment output
• 
• Changes (Δ) in AD
• Δ Consumption (C)
• C up, AD right, GDPR up, PL up, u% down, π% up
• C down, AD left, GDPR down, PL down, u% up, π% down
• Δ Gross Private Investment (Ig)
• Ig up, AD right, GDPR up, PL up, u% down, π% up
• Ig down, AD left, GDPR down, PL down, u% up, π% down
• Δ Government Spending (G)
• G up, AD right, GDPR up, PL up, u% down, π% up
• G down, AD left, GDPR down, PL down, u% up, π% down
• Δ Net Exports (Xn)
• Xn up, AD right, GDPR up, PL up, u% down, π% up
• Xn down, AD left, GDPR down, PL down, u% up, π% down
• Increase in AD

• Decrease in AD

• Changes (Δ) in SRAS
• Δ Input Prices
• Input Prices down, SRAS right, GDPR up & PL down, u% down & π% down
• Input Pries up, SRAS left, GDPR down & PL up, u% up & π% up
• Δ Productivity
• Productivity up, SRAS right, GDPR up & PL down, u% down & π% down
• Productivity down, SRAS left, GDPR down & PL up, u% up & π% up
• Δ Legal-Institutional Environment
• Deregulation, SRAS right, GDPR up & PL down, u% down & π% down 
• Regulation, SRAS left, GDPR down & PL up, u% up & π% up
• Increase in SRAS

• Decrease in SRAS

• Long-Run Aggregate Supply
• Measuring potential output
 
• We're assessing if all our resources are used efficiently
• 
• Shifts in LRAS
• Technology
• Economic Growth
• Capital
• Entrepreneurship
• More resources available
• What is investment?
• Money spent or expenditures on:
• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• New homes
• Inventories (goods sold by producers)
• Expected Rates of Return
• How does business make investment decisions?
• Cost/Benefit Analysis
• How does business determine the benefits?
• Expected rate of return
• How does business count the cost?
• Interest costs
• How does business determine the amount of investment they under take?
• Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest
• Real (r%) v. Nominal (i%)
• What's the difference?
• Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto
• How do you compute the real interest rate (r%)?
• r% = i% - π%
• What then, determines the cost of an investment decision?
• The real interest rate (r%)
• Investment Demand Curve (ID)
• What is the shape of the Investment Demand Curve?
• Downward sloping
• Why?
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
• Conversely, there are few investments that yield high rates of return, and many that yield low rates of return.
• The Investment Demand Curve
• Changes in r% cause changes in Ig. Factors other than r% may shift the entire ID curve.
• Shifts in Investment Demand (ID)
• Cost of Production
• Business Taxes
• Technological Change
• Stock of Capital
• Expectations
• Consumption & Saving / Disposable Income (DI)
• Income after taxes or net income
• 2 Choices
• With disposable income, households can either
• Consume (spend money on goods and services)
• Save (not spend money on goods and services)
• Consumption
• Household spending
• The ability to consume is constrained by
• The amount of disposable income
• The propensity to save
• Do households consume if DI = 0?
• Autonomous consumption
• Dissaving
• Saving
• Household NOT spending
• The ability to save is constrained by
• The amount of disposable income
• The propensity to consume
• Do households save if DI = 0?
• No
• APC & APS
• APS = average propensity to save
• APC = average propensity to consume
• APC + APS = 1
• 1 - APC = APCS
• 1 - APS = APC
• APC > 1 : Dissaving
• -APS : Dissaving
• MPC & MPS
• Marginal propensity to consume
• Δ in C / Δ in DI
• % of every extra dollar earned that is spent
• Marginal propensity to save
• Δ in S / Δ in DI
• % of every dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC
• Determinants of C & S
• Wealth
• Expectations
• Household Debt
• Taxes
• MPC
• The fraction of any change in DI that is consumed
• MPS
• The fraction of any change in DI that is saved
• The Spending Multiplier Effect
• An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or Aggregate Demand (AD)
• Multiplier = Δ in AD / Δ in Spending
• Why does this happen?
• Expenditures and income flow continuously which sets off a spending increase in the economy.
• Calculating the Spending Multiplier
• The spending multiplier can be calculated from the MPC or the MPS.
• Multiplier = 1/1-MPC or 1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease
• Calculating the Tax Multiplier
• When the government taxes, the multiplier works in reverse
• Why?
• Because now money is leaving the circular flow
• Tax Multiplier (note: it's negative)
• = -MPC/1-MPC or -MPC/MPS
• If there is a tax-CUT, then the multiplier is (+), because there is now more money in the circular flow
• MPS, MPC, & Multipliers
• Step 1: Calculate the MPC and MPS
• Step 2: Determine which multiplier to use, and whether it's (+) or (-)
• Step 3: Calculate the spending and/or tax multiplier
• Step 4: Calculate the change in AD
• For a better understanding of calculating the MPC, MPS, and the multiplier, I recommend you to watch this video:

• Fiscal Policy
• Expansionary and Contractionary policy
• Deficits and Surpluses
• Built-in Stability
• Changes in the expenditures or tax revenues of the federal government
• 2 tools of fiscal policy:
• Taxes - government can increase or decrease taxes
• Spending - government can increase or decrease spending
• Fiscal policy is enacted to promote our nation's economic goals: full employment, price stability, economic growth
• Deficits, Surpluses, and Debt
• Balanced Budget
• Revenues = Expenditures
• Budget Deficit
• Revenues < Expenditures
• Budget Surplus
• Revenues > Expenditures
• Government Debt
• Sum of all deficits - Sum of all surpluses
• Government must borrow money when it runs a budget deficit
• Government borrows from
• Individuals
• Corporations
• Financial institutions
• Foreign entities or foreign governments
• Fiscal Policy Two Options
• Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit (when in a recession)
• Contractionary fiscal policy - think surplus (going through an inflationary period)
• Non-Discretionary Fiscal Policy (no action)
• Discretionary v. Automatic Fiscal Policies
• Discretionary
• Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
• Automatic
• Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.
• Contractionary v. Expansionary Fiscal Policy
• Contractionary fiscal policy - policy designed to decrease aggregate demand
• Strategy for controlling inflation
• Expansionary fiscal policy - policy designed to increase aggregate demand
• Strategy for increasing GDP, combatting a recession, and reducing unemployment
• Expansionary Fiscal Policy
• Recession is countered with expansionary policy
• Increase government spending
• Decrease taxes
• If recession, then increased government spending, and AD shifts right
• Contractionary Fiscal Policy
• Inflation is countered with contractionary policy
• Decrease government spending
• Increase taxes
• Progressive Tax System
• Average tax rate (tax - revenue/GDP) rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP
• The more progressive the tax system, the greater the economy's built-in stability.