Chapter 9 Flashcards
different between aggregate demand curves and individual market curves?
these curves apply to the whole economy, rather than just to a single market
, the aggregate demand and aggregate supply model is very different from the microeconomic model of demand and supply in individual markets
why is aggregate demand curve downward sloping?
a fall in the price level increases the quantity of real GDP demanded.
Aggregate expenditure model
§A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant.
Aggregate expenditure (AE):
§The total amount of spending in the economy—the sum of consumption, planned investment, government purchases and net exports.
aggregate expenditure components
AE = C + I + G + NX
PLANNED investment
Macroeconomic equilibrium
Aggregate expenditure = GDP
If
Aggregate expenditure is equal to GDP then
total amount of expenditure = total amount of productoin
inventories are unchanged the economy is in macroeconomic equilibrium.
if
Aggregate expenditure is less than GDP
total amount of spending in the economy is less than the total amount of production
inventories rise
GDP and employment decrease.
Aggregate expenditure is greater than GDP
the total amount of spending in the economy is greater than the total amount of production
inventories fall
GDP and employment increase.
The five most important variables that determine the level of consumption are:
§Current disposable income
§ Household wealth
§ Expected future income
§ The price level
§ The interest rate
Consumption function:
§The relationship between consumption and disposable income.
Marginal propensity to consume (MPC):
§The slope of the consumption function—the change in consumption divided by the change in disposable income.
MPC
show consumption function
relationship between consumption and national income
§Disposable income = national income – net taxes
OR
§National income = GDP = disposable income + net taxes
little difference between national income and GDP
National income =
§consumption + saving + net taxes.
Change in national income
§change in consumption + change in saving + change in net taxes.
To simplify, we can assume that net taxes are always a constant amount, in which case the change in net taxes equals zero so that
change in Y = Change in C + change in S
Marginal propensity to save (MPS):
1 = MPC + MPS
The four most important variables that determine the level of planned investment are:
§Expectations of future profitability
§The interest rate
§Taxes
§Cash flow
government purchases does not include
transfer payments
The three most important variables that determine the level of net exports are:
§The price level in Australia relative to the price levels in other countries.
§The economic growth rate in Australia relative to the economic growth rates in other countries.
§The exchange rate: value of one currency in terms of another
When
a)Real interest rates increase.
how will this impact Aggregate expenditure?
consumers
more expensive to finance borrowing
consumers will save b/c they usually borrow to purchase consumer durables e.g. cars
- opportunity cost of spending increases as return to savings increase
When
a)Real interest rates increase.
how will this impact Aggregate expenditure?
firms
more expensive to finance borrowing
typically finance most of their investment through borrowing, hence an increase in the real interest rate will result in a decrease in investment spending
how will this affect aggregate expenditure
Two of Australia’s major trading partners, China and Japan, experience high economic growth relative to Australia
increase in net exports:
increased GDP in major trading partners such as China and Japan is reflected in increased demand for Australia’s resources.
the impact of each of the following changes on the components of aggregate expenditure (AE)
a)The business sector becomes pessimistic about future profits.
reduced investment
firms will not plan to increase productionI.
The expectations of firms are important because
investment spending is a smaller but more volatile component of AE.
45° line diagram can be used to
§illustrate macroeconomic equilibrium.
45° line measures real national income against
§planned real aggregate expenditure.
At points above the 45° line,
aggregate expenditures are greater than GDP
At points below the 45° degree line
§aggregate expenditures are less than GDP.
relationship between planned expenditure and GDP on 45 degree line
Changes in GDP have a much greater impact on
§consumption than on planned investment, government purchases or net exports.
The consumption function begins above zero because of
autonomous consumption.
Autonomous consumption
Consumption that is independent of income.
e.g. spending on necessities
Induced consumption:
Consumption that is determined by the level of income
increase in income –> increase in spending –> induced consumption
Macroeconomic equilibrium on the 45° line diagram
planned aggregate expenditure is equal to GDP
describe this graph
§macroeconomic equillibrium occurs where AE crosses the 45 degree line
§At points above the 45° line, planned aggregate expenditures are greater than GDP, unplanned fall in inventories, leading to an increase in production
.
At points below the 45° degree line, planned aggregate expenditures are less than GDP, firms will experience an unplanned increase in inventories, leading to a decrease in production
describe this graph
Macroeconomic equilibrium occurs where the AE line crosses the 45° line. In this case, that occurs at a GDP of $1000 billion.
If GDP is less than $1000 billion, the corresponding point on the AE line is above the 45° line, planned aggregate expenditure is greater than total production, firms will experience an unplanned decrease in inventories –> increase in production–> GDP will increase.
If GDP is greater than $1000 billion, the corresponding point on the AE line is below the 45° line, planned aggregate expenditure is less than total production, firms will experience an unplanned increase in inventories –> decrease in production–> GDP will decrease
When GDP falls to $1000 billion inventories will stop rising and the economy will be in macroeconomic equilibrium.
Macroeconomic equilibrium can occur
at any point on the 45° line.
It is ideal to have equilibrium occur at
potential GDP.
If there is insufficient aggregate spending, equilibrium will occur
§below potential GDP: the economy will be in a contraction or recession.
showing a recession on the 45 degree line
describe this graph
When the aggregate expenditure line intersects the 45° line at a level of GDP below potential GDP, the economy is in recession.
potential GDP is $1000 billion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $980 billion, where the AE line intersects the 45° line.
macroeconomic equilibrium will occur when real GDP is $980 billion. Because this is 2 per cent below the potential level of GDP of $1000 billion, many firms will be operating below their normal capacity and the unemployment rate will be above the natural rate of unemployment. The economy will remain at this level of real GDP until there is an increase in one or more of the components of aggregate expenditure.
describe this graph
potential GDP is $1000 billion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $980 billion, where the AE line intersects the 45° line.
what does this mean?
some firms will be operating below their normal capacity and unemployment will be above the natural rate of unemployment.
describe this graph
How can we measure shortfall in planned aggregate expenditure
The shortfall in planned aggregate expenditure is exactly equal to the unplanned increase in inventories that would occur if the economy were initially at a level of GDP of $1000 billion.
The unplanned increase in inventories measures the amount by which current planned aggregate expenditure is too low for the current level of production to be the equilibrium level.
The important role of inventories
Whenever aggregate expenditure is less than real GDP, firms will experience unplanned increases in inventories.
When the economy is experiencing a contraction or recession the shortfall in aggregate expenditure is equal to the unplanned increase in inventories
find the unplanned change in inventories and what effect this will have on the GDP
The multiplier effect
Autonomous expenditure:
Expenditure that does not depend on the level of GDP
An increase in autonomous expenditure will shift the aggregate expenditure function upwards and a decrease in autonomous expenditure will shift the aggregate expenditure function downwards
The multiplier effect
induced expenditure:
Expenditure that depends the level of GDP.
however, real GDP increases (axis) and aggregate spending increases, the economy will move up along the aggregate expenditure function.
The multiplier effect
multiplier and multiplier effect
- *§Multiplier:** The increase in equilibrium real GDP divided by the increase in autonomous expenditure.
- *§Multiplier effect:** The process by which an increase in autonomous expenditure leads to a larger increase in real GDP/national income
e.g. spend 10m on equipment –> becomes someone else’s income –> spends on goods and services –> national income increases –> received by owners and employees –> they spend–> process of increasing production, income and consumption will continue.
describe
The economy begins at point A, at which equilibrium real GDP is $960 billion.
A $10 billion increase in planned investment shifts up aggregate expenditure from AE1 to AE2.
The new equilibrium is at point B, where real GDP is $1000 billion, which is potential GDP. Because of the multiplier effect, a $10 billion increase in investment results in a $40 billion increase in equilibrium real GDP.
Multiplier formula
1/1-MPC
The multiplier effect occurs when
autonomous expenditure increases or decreases
The multiplier effect makes the economy more sensitive to
changes in autonomous expenditure than it would otherwise be.
Because an initial decline in investment spending sets off a series of declines in production, income and consumptoin
what effect does the MPC have on the multiplier?
1.The larger the MPC, the larger the value of the multiplier.
B/c you are spending more
The formula for the multiplier is over-simplified because
it ignores the effect that an increasing GDP can have on imports, inflation and interest rates.
The paradox of thrift?
§John Maynard Keynes argued that if many households simultaneously increase saving and reduce spending, aggregate expenditure may fall, leading to a contraction or recession.
- The lower incomes during the contraction or recession might mean that total saving does not increase
-paradox of thrift because what appears to be something favourable to the long- run performance of the economy might be counterproductive in the short run.
why are economists sceptical of the paradox of thrift?
─Increases in saving increase the supply of loanable funds, lowering the real interest rate and increasing investment.
─Increases in investment increase aggregate expenditure, output and employment.
─The global financial crisis (2007-08) demonstrated how a shortage of loanable funds contributed to severe recessions.
Economists continue to debate the short-run effects of an increase in saving
what is the equilibrium level of real GDP?
when real GDP equals $12 000 billion
a)What is the MPC?
Suppose government purchases increase by $500 billion. What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer.
multiplier = 1/1-MPC
=4
–The change in equilibrium GDP is equal to the change in government expenditure multiplied by 4.
–Change in equilibrium GDP = $500 x 4 = $2000 billion.
–Therefore the new level of equilibrium GDP = $12 000 billion + $2000 billion = $14 000 billion.
An increase or decrease in aggregate expenditure will affect
real GDP and price level
describe the inverse relationship that exists between changes in the price level and changes in aggregate expenditure
Consumption:
1.Increases in the price level decrease consumption by decreasing real wealth, causing aggregate expenditure to fall; a falling price has the reverse result.
describe the inverse relationship that exists between changes in the price level and changes in aggregate expenditure
net exports
price level in Australia rises relative to the price levels in other countries, Australian export income will fall in real terms making exports less attractive to produce, and foreign imports will become relatively less expensive, causing net exports to fall. A falling price level in Australia has the reverse effect.
describe the inverse relationship that exists between changes in the price level and changes in aggregate expenditure
investment
2.If prices rise, individuals and firms will need to borrow to spend more –> the central bank (RBA) does not increase the availability of funds —> increase interest rates –> increases cost of borrowing –> reducing investment spending, households borrow less to buy new houses and consumer durables a falling price has the reverse result.
what effect that decrease in price level have on real GDP
a decrease in the price level results in rising consumption, planned investment and net exports and causes the aggregate expenditure line to shift up from AE1 to AE2. As a result, equilibrium real GDP increases from $1000 billion to $1020 billion.
What happens to AE when there is an increase in price level
an increase in the price level results in declining consumption, planned investment and net exports and causes the aggregate expenditure line to shift down form AE1 to AE2. As a result, equilibrium real GDP declines from $1000 billion to $980 billion.
Aggregate demand (AD) curve:
The aggregate demand curve shows the relationship between the price level and the level of planned aggregate expenditure in the economy.
When the price level is 97, real GDP is $1020 billion. An increase in the price level to 100 causes consumption, investment and net exports to fall, which reduces real GDP to $1000 billion
Singapore’s economy during the GFC
Singapore’s economy experiencing growth
what are inventories
good produced but not sold yet
Changes in inventories are included as part of
investment spending along with spending on machinery, equipment, office buildings and factories.
We assume that businesses always spend the amount they planned on machinery and office buildings, but the amount businesses plan to spend on inventories
may be different from the amount they actually spend because changes in inventories depend on sales of goods - firm cannot forecast accurately
Random House Australia may print 20 000 copies of the latest John Grisham novel expecting to sell them all. If Random House Australia does sell all 20 000 its inventories will be unchanged, but if it sells only 15 000 it will have
n unplanned increase in inventories of 5000 books.
actual investment spending will be greater than planned investment spending when there
actual investment spending will be more than planned investment spending when there is an unplanned increase in inventories.
Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories.
actual investment will equal planned investment only when there is no unplanned change in inventories.
When aggregate expenditure is greater than GDP the total amount of spending in the economy is greater than the total amount of production,
what happens to businesses and their inventory
businesses will sell more goods and services than they had expected.
For example, the manager of a Harvey Norman store might like to keep 50 refrigerators in stock to give customers the opportunity to see a variety of different sizes and models. If sales are unexpectedly high the store may end up with only 20 refrigerators. In that case the store will have an unplanned decrease in inventories: its inventory of refrigerators has declined by 30.
How will the store manager react when more refrigerators are sold than expected?
how will this affect GDP and employment?
The manager is likely to order more refrigerators.
If other stores selling refrigerators are experiencing similar sales increases and are also increasing their orders, then refrigerator manufacturers will significantly increase their production
. These manufacturers may also increase the number of workers they hire.
If the increase in sales is affecting not just refrigerators but also other goods and services, then GDP and total employment will begin to increase
that aggregate expenditure is less than GDP, many businesses
many businesses will sell fewer goods and services than they had expected, so their inventories will increase
that aggregate expenditure is less than GDP, many businesses will sell fewer goods and services than they had expected, so their inventories will increase
give an example
the manager of the Harvey Norman store who wants 50 refrigerators in stock may find that because of slow sales the store has 75 refrigerators, so the store manager will cut back on orders for new refrigerators.
If other stores also cut back on their orders regrigerator producers will reduce production and lay off workers.
If the decrease in sales is affecting not just refrigerators but also many other goods and services, GDP and total employment will begin to decrease.
Only when aggregate expenditure equals GDP will firms
sell what they expected to sell. In that case their inventories will be unchanged and they will not have an incentive to increase or decrease production.
The economy will be in macroeconomic equilibrium.
If economists forecast that aggregate expenditure will decline in the future, that is equivalent to forecasting that
GDP will decline and that the economy will enter a contraction or recession.
increasing and decreasing GDP
When GDP is increasing, so are wages, profits and job opportunities.
Declining GDP can lead to declining wages (or slower wage growth) and will cause profits to fall and unemployment to rise.
what happens when economists
forecast that aggregate expenditure is likely to decline and that the economy is headed for a contraction or recession
the federal government and the Reserve Bank of Australia may implement macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into a contraction or recession.
Disposable income
income households have after they have paid personal income tax and received government transfer payments, such as social security payments.
how does current disposable income influence consumption?
increase in current disposable income –> increase in consumption
vice versa
A household’s wealth
A household’s wealth is the value of its assets minus the value of its liabilities.
distinguish between asset and liability
An asset is anything of value owned by a person or a firm: house, shares, bonds, bank deposits
liability is anything owed by a person or a firm: loans owed
household wealth on consumptoin
increase in household wealth –> increase in consumptoin
how can changes in price level affect consumption
Changes in the price level affect consumption mainly through their effect on household wealth. An increase in the price level will result in a decrease in the real value of household wealth –> decrease consumption
For example, if you have $2000 in a bank account, the higher the price level the fewer goods and services you can buy with your money.
If the price level falls, the real value of your $2000 increases. Conversely, if the price level falls (which is a rare occurrence in Australian history) your consumption will increase.
discuss how interest rate may affect consumption
- When the real interest rate is high, the reward for saving is increased and households are likely to save more and spend less.
- reduce expenditure on durable goods b/c financning on borrowers becomes expensive
However, many households are net lenders and therefore as the real interest rate rises their wealth increases, which may lead to increased consumer spending.
what does it mean if MPC = 0.9
households spent 90 per cent of the increase in their disposable income.
also use the MPC to tell us how much consumption will change as income changes.
Change in consumption = change in disposable income × MPC
rearranging formula
difference between national and disposable income
net taxes included in national income
MPC is calculated by change in consumption/ change in income (national or disposable)
national and disposable income differ by constant amount so we can use national income to graph the consumption function
MPC calculated using either the change in national income or the change in disposable income and always get the same value.
how does Expectations of future profitability influence planned investment?
optimistic that demand for product will increase: purchase equipment
Pessimistic: demand for pdouct will decrease due to uncertain conditions –> postpone purchase
how do taxes influence investment spending?
higher company income tax –> decrease the after-tax profitability of investment spending.
Investment tax incentives also increase investment spending. deduct proportion of goods on new investment goods from annual profit
how does cash flow influence firms’ investment spending?
many firms use own funds for investment spending
-more profitable –> more cash flow –> greater its ability to finance investment
how can The economic growth rate in Australia relative to the economic growth rates in other countries
influence net exports?
Domestic GDP increases –> household incomes rise –> purchase more goods and services including imports –> reduces net exports
GDP and income in other economies increase –> purchase more exports (particularly commodities)–> increases net exports
how the exchange rate influence net exports
prices received for primary products fall and export income falls
increase in the value of the dollar will reduce export income and increase imports, so net exports will fall.
all points on the 45 degree line
planned aggregate expenditure =GDP
all points of macroeconomic equilibrium must lie along the 45° line.
what happens if real GDP were only 800b?
planned aggregate expenditure will be greater than $800 billion at this level of real GDP.
- Whenever total spending is greater than total production firms’ inventories will fall. The fall in inventories is equal to the vertical distance between the AE line, which shows the level of total spending, and the 45° line, which shows the $800 billion of total production. Unplanned declines in inventories lead firms to increase their production.
- As real GDP increases from $800 billion, so will total income and therefore consumption.
- The economy will move up the AE line as consumption increases.
- The gap between total spending and total production will fall, but as long as the AE line is above the 45° line inventories will continue to decline and firms will continue to expand production.
- When real GDP rises to $1000 billion inventories stop falling and the economy will be in macroeconomic equilibrium.
at potential GDP, economies will be operating at
their normal level of capacity and the economy will be at the natural rate of unemployment.
describe the inverse relationship that exists between changes in the price level and changes in aggregate expenditure
when interest rate is higher? who does it benefit? why?
people with savings have their wealth increased when interest rates are higher and will increase their consumption spending.
