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Econ 103 Study Guide

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    Aggregate Expenditure: relationship showing (at a given price level) Real GDP. * Y=C+I+G+NX Consumption Function (C): A relationship between disposable income (income-tax) and consumption * C=a+b(Y-T) * a-autonomous spending * b-MPC * Y-Aggregate expenditure * T-net taxes (tY) * Marginal Propensity to Consume (MPC) * ? consumption/? disposable income * Marginal Propensity to Save (MPS) * ? savings/ ? DI * DI-MPC=Savings * MPS+MPC=1 * Determinants and Shifts in the Consumption Function * Net Wealth (assets-liabilities) * If Wealth up/consumption up * Price Level * If PL up/consumption down Interest Rate * If IR up/consumption down * Expectations Investment (I): new factories/equipment, inventories * autonomous (does not depend on DI) * Depends on interest rates. * If interest rates are high, investment is low Government: government purchases made with federal, state and local taxes AND transfer payments (if income is up, transfer payments are down) * Autonomous New Exports (NX): (exports-imports), autonomous * factors that shift net exports * Price Levels in US/ Abroad * If inflation is higher in US we import more – Ex. Down & Im up -NX down * Interest rates in US/Abroad If interest rates are higher in US- Ex Up. Im Down. NX Up. * Foreign income levels * If foreign income levels rise- Ex up. Im Down. NX up. * Exchange rate * If US dollar is worth more- Ex down. Im Up. NX up * Marginal Propensity to import * Y=C+I+G+(X-M) * M=mY * m= import rate Real GDP demanded: * Found when Aggregate Expenditure (Y)=Aggregate output * Intersection of consumption function and 45 degree line * 45 degree line is where spending = real gdp * Income expenditure model * Measures Real GDP on horizontal and Aggregate expenditure on vertical * If spending exceeds real GDP Aggregate expenditure line is above 45 degree line * Inventory reduction- prompt firms to produce more * Increases employment and consumer income * Leads to more spending * The increase in spending increases real gdp by more than the increase because the new intersection is much further up on 45degree line. * The increase in GDP can be found using the simple spending multiplier * If GDP exceeds Spending * Aggregate expenditure line is below 45 degree line * Spending falls short, unsold goods accumulate * Firms decrease production * Employment and income are reduced

    The Simple Spending Multiplier * In one of the components of the Aggregate expenditure shift the line upwards, then the new equilibrium level can be found by multiplying the simple spending multiplier by the ? a. e. * 1/1-MPC=Simple spending multiplier * EX. If spending=GDP demanded at 14, and the MPC=. 8… firms decide to increase their investment by . 1 the consumption function shifts up. The new equilibrium is now: * 1/. 2=5 (simple spending multiplier) * ? aggregate expenditure x 5 * . 1 x 5=. 5 * . 5+14 (original GDP demanded/equilibrium)) = 14. (new equilibrium) Aggregate Demand Curve *aggregate demand curve and aggregate expenditure line portray output from different perspectives. The expenditure line shows output at a given price level, GDP demanded is found when spending=income (real gdp). So a shift in the AE line also shifts the AD line. * At each price level there is a different GDP demanded. * A Higher Price Level REDUCES aggregate spending and GDP Demanded * Decreases real value of money- reduces consumption * Imports rise, exports fall * Higher interest rate reduces investments A Lower price INCREASES aggregate spending and GDP Demanded Aggregate Supply * Long Run Aggregate Supply (LRAC) * POTENTIAL OUTPUT * There are no surprises about price level. * Depends on Supply of resources, level of technology, production incentives * Can increase (beneficial supply shock) ie technology change * Aggregate demand crosses at lower price level, increases output * Can Decrease (adverse supply shock) natural disaster * Raises price level, reduces real GDP (Stagflation) * Short Run Aggregate Supply: Shows relationship btwn actual price level and GDP supplied. Expected Price Level is where SRAS and LRAS intersect * Actual Price Level is where Aggregate Demand and SRAS intersect * Price Level Higher than expected- EXPANSIONARY GAP * Short run output exceeds potential * Unemployment rate is less and natural rate * Price level is higher than expected * Real wages are less than expected * Next round of hiring wages will increase. * SRAS will shift back to LRAS with new higher price level at Long Run Equilibrium * Price Level is Lower than expected- RECESSIONARY GAP * Production is less than potential Unemployment rate is higher than natural rate * Price levels are lower than expected * Real wages are higher than expected * Next round wages will be lowered- lowering costs and closing gap * SRAS will shift rightward until it reaches LRAS at new lower PL. * Natural unemployment: unemployment rate when economy produces at full output * Frictional+Structural+Seasonal=natural unemployment rate (4-6%) * Cyclical unemployment rate is not counted Fiscal Policy: Changes in Government Purchases/ Net Taxes.

    Shifts AD. Major Sources of Gov’t Revenue: * Individual tax income (45%)-Progressive (the more you earn, the more you pay) * SS/ Medicare Tax (35%)- Payroll taxes. Gov’t collects from employees and employers * Corporate income tax (paid by shareholders-lower dividend. Workers-lower wages. Consumers-higher prices) Most $$ Goes to Social Security, followed by defense (medicare & medicad) * SS is a Transfer (pay-as-you-go) Payment Automatic stabilizers: features of government spending which reduce fluctuations in GDP

    Government purchases: * Change in government purchases which effect the consumption function directly, by shifting it up or down. * The increase in the consumption function is multiplied with the Simply Spending multiplier to get the New Level in GDP Demanded (? Aggregate Demand) * ? AD = ? G x (1/1-MPC) Net Taxes: * Changes in net taxes also shift the consumption function, but not as directly: * A decrease in Net Taxes INCREASE Disposable income * Households save some of the tax cut Consumption Spending rises by the decrease in net taxes multiplied by the MPC and then again by the simple spending multiplier, it is reduced to the Simple Tax Multiplier: * ? AD= ? NT x –MPC/1-MPC * An increase in Net Taxes Decreases DI Government spending to fight Recessionary Gap * Expansionary fiscal Policy * Increases Aggregate Demand By Demand Shortfall (? AD) * Increase Government Spending * Decrease Taxes Government spending to Close Expansionary Gap * Contractionary Fiscal Policy * Reduces Aggregate Demand by Excess Demand (? AD) Decrease in government spending * Increase in Net Taxes EX: Demand Shortfall of 8m. MPC=. 8 Increasing Government Spending: ?AD=? Gx(1/1-MPC) 8=? G*(1/. 2) 8=? G*5 8/5=? G ?G=1. 6 The Government must increase spending by 1. 6m Increasing Net Taxes: ?AD=? NT*(-MPC/1-MPC) 8=? NT*(-. 8/. 2) 8=? NT*-4 ?NT=-2 (because MPC is . 8, decreasing Net Taxes by 2m will result in a 1. 6m increase in consumption) Classical Economists Believe: * Economic crises are caused by external shocks * Free markets are the best way to achieve prosperity * Economy is self-correcting, no gov’t intervention The government should avoid running a deficit * Believed that if prices were too high, the SRAS would fall until equilibrium Keynesian Economists Believe: * The government should stimulate AD * Lowering interest rates may not be enough to invest all that has been saved * Only discretionary fiscal policies can drive economy from recession to potential output Before 1930’s policy was shaped by Classical Economists, dominant policy was Balanced Budget. Natural market forces (flexible wages, interest rates and prices would move economy towards potential GDP.

    In 36’ (Great Depression) JM Keynes published General theory of Employ. Interest & $$ which sparked Keynesian Revolution. These policies were developed as a response to high unemployment. Increase AD to boost output. Employment Act 46’ assigned Fed responsibility for promoting full employment 60’s- golden age of fiscal policy. Kennedy proposed fed. Budget deficit to close recessionary gap. Next president, Johnson, cut income taxes. Seemed to work wonders. By 70’s- stagflation, higher inflation and higher unemployment from decrease in AS (crop failure and higher oil prices).

    Fiscal policies are ill suited to cure stagflation bc and increase of AD increases inflation or decrease in AD increases unemployment. After supply-side tax cuts in 80’s government spending grew faster than tax revenue. The tax cuts on supply side with simulative effects of deficit spending on AD contributed to longest expansion. Gov’t backed off of discretionary fiscal policy until 2001. Tax cuts and new spending increased to 04, adding new jobs. Economy turned down in 07, unemployment rose after financial crisis in 08-09. Jobs have begun coming back in 10’, but unemployment rate is still low.

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