ECON 102 Final Flashcards
Why measure economic growth with real GDP per capita rather than other measures (Nominal, Real GDP, etc.)?
- Separates growth in quantities of g+s produces from rising price levels.
- Isolates the economic changes’ effects on population’s standard of living
Why is the typical Chinese or Indian HH far poorer than Canadian although they have much higher economic growth rates?
Their population is enormous, thus their wealth must be divided b/w a growing large population, leaving each HH with less compared to a Canadian one.
Rule of 70
Number of Years for X real GDP per Capita to Double = 70/Annual Growth Rate
More accurate → Average Annual Growth = A(1+r)^t=B
How does employment websites new software impact unemployment rate over time?
Reduces frictional unemployment.
How does employment websites the encourage discouraged workers to start looking again impact unemployment rate over time?
EDITS NEED TO BE MADE: Initially increases labor force participation rate & unemployment rate. Assuming those individuals find jobs unemployment rate would decrease over time.
Microeconomics vs Macroeconomics
Microeconomics: analyzes the behavior & consequence of individual & firm action: consumer, producer or government action in individual markets. Issues such as what, where & how much to buy & produce, opportunity cost, single-market or demographic, gains in trade, efficient allocation of resources, supply & demand
Macroeconomics: analyzes the overall functioning/performance of an economy through variables that aggregate in nature. Issues of unemployment level, total number of jobs, currency value, policies preventing & understanding economic slumps, inflation, international macroeconomics, long-run economic growth
* Can draw on microeconomics but requires expanded frame of reference & additional set of tools
Classical Macroeconomics
Before Great Depression spurred economists to search how such things could happen, how to prevent them & how to measure them: economies are self-regulating through the “invisible hand”, government intervention would ineffective or worse
Keynesian Macroeconomics + Successes
A depressed economy is the result of inadequate spending & problems will be solved by the market forces, but only eventually in long run: but possible to reduce the pain & suffering by implementing Keynesian government policies → managing the economy is a government responsibility
* Monetary Policy: changing quantity of money to alter the key interest rate=cost of borrowing controlled by the central bank, which affects the overall level of spending
* Fiscal Policy: direct government involvement in the market by adopting appropriate tax policy through direct income tax or indirect gst tax to affect overall spending
Major catastrophes avoided
The Great Recession 2008-2009 tracking to do worse than the GD, interest rates slashed, shore up loans, aids, guarantees, increases in spending to sustain spending, opposite was done during the GD.
Why is Macroeconomics’ whole great than the sum of its parts?
The actions of individuals in an economy can compound upon one another leading to outcomes that magnify the actions of individuals. Analyzing micro behavior to solve macro issues is not sufficient.
Multiplier Effect: an initial action can cause an infinite loop of events
Paradox of Thrift: reducing expenditure could be rational for individuals but can lead to bad outcome for the economy, a self-fulfilling prophecy
* When families & firms are optimistic they spend more stimulating economy, leading to good times for all
Business Cycle + 4 Features
Natural up & down, recession & recovery, trend of economic activities, production of goods & services (GDP or industrial production), employment, etc., in which macroeconomics endeavors to regulate.
- Expansion or recovery economic activities shows sign of growth
- Recession or contraction economic activities shows sign of downfall, unagreed definition, either period of 2 consecutive quarters (many countries) or duration+amplitude+scope that is pronounced, pervasive & persistent decline (C.D Howe Institute)
- Peaks (local maximums, expansion→recession)
- Troughs (local minimums, recession→expansion)
X-axis=year/time, Y-axis=employment or production
Why is recession in business cycle bad?
Recession increases widespread job loss → unemployment, hard to find new jobs, standard of living reduce in households, rise in people living below the poverty line & those who lose their homes unable to afford the mortgage payments, firm’s profits fall, many small businesses fail too rapid and prolonged growth is also troublesome (Milton Friedman)
How are Recessions Compared?
Industrial production measured as a percentage of its level at the recession’s start
Long Run Economic Growth + Importance
Most important issue. Sustained rise in the quantity of goods & services the economy produces (potential), measures the speed & direction of growth per real GDP as it is a good measure of improvement of standard of living in the economy, direct effect.
* Recession: inability to maximize potential output, falling behind
Most important problem to sustain steady growth, if achieved increases income, production, import, standard of living, consumption possibilities (ex. Telephone: 1912=1/200 people, 2023=everybody).
Growth benefits (improves standards of living) & costs (negative externalities), distribution of income
Determines public’s sense of economic progress & key policy questions; country’s ability to bear & recover from future costs of govt programs, social security, health care
Price stability: overall level of prices is changing only slowly as a desirable goal
Growth Accounting
1 Year: A+interest rate*A = A(1+i)
2 Year: A(1+i)+(A(1+i))i = A(1+i)(1+i) = A(1+i)2
3 Year: A(1+i)3
or
%Change(y) = %A + %K + %L + %H = %Y - %L
Log Proof
Inflation in ST + LT + Problem + Calculated
A rise in the overall level of prices, explains why although wages increased living standard didn’t as cost of living increased as well.
In the short run: Tends to fall when the economy is booming inflation rises, when the economy is depressed+jobs are hard to find inflation tends to fall (ex. Prices fell during GD)
In the long run: overall price levels are mainly determined by changes in the money supply, total quantity of assets readily used to make purchases
Problem: discourages people from holding onto cash as it loses value over time if the overall price level is rising, g+s one can buy falls with a given amount of cash, extreme cases people stop holding cash altogether & turn to barter
Calculated by:
1. CPI Inflation
2. IPPI Inflation
3. GDP Deflator
Supply & Demand vs Inflation
Supply & demand can only explain why a particular g+s becomes more expensive relative to others g+s
Only inflation can explain why overall price levels have risen in spite that g+s production has become substantially cheaper & efficient
Deflation
A fall in the overall level of prices, a main concern of macroeconomics
Problem: holding onto cash becomes more attractive than investing as cash gains value of time as price level is falling which can deepen a recession, g+s that can be bought with given amount of cash increases over time
Views on Managing Trade Balance
Macroeconomic phenomena determined by decisions about investment spending & savings; high investment spending relative to savings run trade deficits & vice versa
* Old Dominant View: trade surplus is wanted as revenue is greater than expenses, with a store of gold+silver in case of crisis
* Now Dominant View: trade deficit is wanted as higher level of consumption = higher standard of living, stabilized & increasing consumption level in economy preferred
Greece Trade Balance
TBD
* 2000-2006: adopted euro earning foreign investments, savings & a healthy trade deficit, fueled rapid economic expansion
* Great Recession 2008-2009: investors lost confidence, trade deficit shrinks in comparison to GDP, severe recession, unemployment, forced to run a surplus
Trade Surplus vs Trade Deficit
Trade Surplus: value of the g+s bought from rest of world is smaller than the value of the g+s it sells abroad = value of g+s bought from foreigners is less than the value of g+s sold to them
x>m → Nx=x-m > 0
Trade Deficit: value of g+s bought from rest of world is larger than the value of g+s produced in country sold abroad= value of g+s bought from foreigners is more than the value of the g+s sold to them
x<m → Nx=x-m < 0
International (Im)balance
International Imbalance = Net Export Value (Nx) = Export (x) - Import (m)
Open Economy: economy that trades g+s with other countries due to comparative advantages
Export: value of the g+s sold to the foreign buyers altogether
Import: total value of the g+s purchased from the foreign seller
National Accounts
All countries calculate the National Income & Product Accounts following the flows of funds between sectors of the economy, the accuracy & reliability indicts the state of economic development.
Flow Variable & Quantity of Stock Variable
Flow Variable: have a time dimension per unit of time
* GDP, investment, demand, income, export, import
Quantity of Stock Variable: meaningfully measured at a point of time
* Capital, population, inventory, money in circulation
Gross Domestic Product (GDP)
(Y) Measures the size of economic activities within an economy for a time span of quarter or year
Definition: the total market value of all final g+s produced within the boundary of an economy in a specific period of time (usually a year)
* Goods & services purchased/produced outside of country not part of GDP, import revenue of g+s not included, export revenue from in country produced g+s included
* Final G+S: sold to the final user
* Intermediate G+S: inputs for production of final g+s
Measurement Methods
Every country will compare the calculations of all 3 methods to find discrepancies & make adjustments/corrections to around the same value
1. Value Added
2. Income Approach
3. Total Expenditure
Value Added Approach
Sum of Firm Payments for Factors of Production
Add the values of all final g+s produced in the economy. Intermediate g+s not included to not overestimate/double count as they’re values are aggregated in the final price.
Government collect info from every firm, find input resources & revenue to calculate intermediate cost
Equation:
Payments to the firm’s factors of production = sales value - intermediate g+s value
ex. $2+$(5-2)+$(10-5)+$(15-10)=15
Income Approach
Sum of income from Factors of Production
Total value of outputs in the economy is equal to total factor income earned by households from firms in the economy (factor payments) & income earned by federal government from production (non-factor payments); ideally if we add (gross) wages, rents, interests & profits that should add up to the value of g+s produced within the economy
* Don’t Include: inputs, used goods, financial assets, import spending, non market transactions, negative externality
Eqn: GDP = Wages + Interest + Rents + Dividends + Non-Factor Payments (indirect tax + capital depreciation)
Total Expenditure
Eqn: GDP= C + I + G + NX
g+s produced & bought within the economy (adjustments are required to factor in trade), by adding the expenditures on domestically produced final g+s in the economy
Consumption Expenditure (C)
* Households’ purchase of new goods & services
* Imputed rents for self-owned homes (value of owner-occupied housing)
* Newly built homes not included
Investment Expenditure (I)
Plants & Equipment, not inputs
Newly built residential & non-residential structures
Inventory adjustments: cost for storage for supply as safeguards
ex. Prod-100 Sold-90 Storage-20+10->30 = GDP+10
ex. Prod-100 Sold-110 Storage-20-10->10 = GDP-10
Government Expenditure (G):
Government purchase/borrowing of goods & services are included
Government transfer payments are not included as will be accounted for in consumer expenditure
Net Export (X-IM) = exports - imports, income leaked across national borders
Closed economy with a government that borrows 10bn has an income flow of 600bn, the government collects a lump sum tax of 20bn & transfers a fixed 10bn to the households. If the household sector saves a fixed 20% of their disposable income (income left net of tax & transfer), then what is the size of firm investment in this economy?
GDP = C + I + G
I = GDP - C - G
C = Disposable Income - Savings
Disposable Income = GDP-Tax-Transfer
Savings = Percentage Saved * Disposable Income
G = Tax - Transfer + Borrowing
I = 600 - (600-20-10)*(1-0.2) - (10+10)
I = 600 - 472 - 20
I = 108
Circular Flow Diagram
- Interdependence between income & goods & services
Green = ‘real’ economy, flow of funds associated with production & sales of g+s
Blue = ‘financial’ economy, borrowing, lending & other flows of funds, indirect effect on production - Spending = Income = Value of factors of production = Output of firms = Spending
4 Buyers/Flows
* (1)Government Purchases of Goods & Services-education, defense (2)Transfer payments-social security, job insurance
* Households engage in consumer spending/consumption: purchasing goods & services through the goods & services market
* Firms: engage in investment spending-buying goods & services from each other, productive capital, machinery & construction of buildings
* Rest of the World: comes from net exports-imports, goods & services sold to residents of other countries
* * Financial Markets: provides financial instruments (loans, bonds) spent for investment. Government uses household savings that collect interests to borrow & invest, while firms compete
Nominal GDP vs Real GDP
Difference is in Real GDP prices are kept constant, in nominal GDP prices vary according to each year.
Nominal GDP: measuring GDP/aggregate output at current prices, overtime can overestimate or underestimate growth of economic activities as nominal GDP can increase even if output/quantities do not or even decrease due to price changes
Real GDP (Fixed Prices of Base Year): measured to make adjustment to price changes in nominal GDP, measures aggregate output/quantity produced in a year
Definition: total value of final goods & services produced in the economy during a given year, calculated using the prices of a selected base year
Growth Rate (g)
A(1+g)^t=B → g=(B/A)^1/10 - 1
Growth Rate vs Percent Change
Percent change represents the relative change in size between x across a time period. Growth rate represents the average amount of change per year or per month of x across a time period.
x could be Real, nominal GDP (per Capita), productivty, human capital per labor, etc.
Growth Rate: A(1+g)^t=B
Percent Change: (2-1)/1 * 100%
- Find Nominal GDP of 2007 & 2012
- Real GDP base year 2007 & 2017
- Growth rate of GDP base year 2007 & 2017
E: 2007(Q80, P40) –> 2017(Q100, P50)
P: 2007(Q90, P11) –> 2017(Q80, P10)
T: 2007(Q15, P90) –> 2017(Q20, P100)
Nominal GDP 2007 = 5540
Nominal GDP 2017 = 7800
Real GDP 2007 (base 2007) = 2007Q x 2007P = 5540
Real GDP 2017 (base 2007) = 2017Q x 2007P = 6680
Growth Rate (base 2007) = (6680/5540)^1/10 - 1 = 1.889%
Real GDP 2007 (base 2017) = 2007Q x 2017P = 6400
Real GDP 2017 (base 2017) = 2017Q x 2017P = 7800
Growth Rate (base 2017) = (7800/6400)^1/10 -1 = 1.998%
Chained Dollar Real GDP
In Chained Dollar Real GDP, the average real GDP growth between every pair of consecutive years are treated to be the growth rate.
Growth Rate (g) = (B/A)^1/t -1
Average Annual Growth Rate = (g1+g2)/2
Step 1: Find Real GDP of both years with both base years.
Step 2: Find average annual growth rate
Step 3: Choose a base year & calculate its nominal GDP
Step 4: Calculate real GDP for all years based on the growth rates
Real GDP per Capita + Purpose
(Y) Real GDP per Capita = Real GDP/Population, measure of an economy’s average aggregate output per person, those with high can afford its citizens to be healthy, education, in generally a good quality of life
* % in Real GDP per Capita =% in Real GDP - %Population
* %Z=%x-%y, Z=x/y
Real GDP/Population = Labor Productivity * Avg. Hour Per Worker * Proportion of Population that Work = Real GDP per Capita x Population = A * F(K, H, L)
* *Labor Productivity =Real GDP/Employed=Total Output/Workers or Hours Worked= y=Y/L=Af(KL,HL), output of the avg worker produces in an hour
* **Avg Hr **= Total HoursTotal Employment= hours avg. worker spends at the job
* EPR (Employment-population ratio) =EmploymentPopulation fraction of the population working
* Size of Population
Economic activities (defined by GDP) grow generally with the increase in population, therefore GDP doesn’t necessarily represent a better standard of living for the economy. Compare country to country. Only if GDP grows outpacing the growth rate of population, then at least improvement on average in the standard of living can be claimed
Should GDP be the meaning of life?
- No sufficient measure of human welfare, growth in real GDP per capita is no appropriate policy goal, although income is higher, will it be used to improve quality of life, useful summary of economic progress over time
- Richer countries on average have a higher life satisfaction
- Money matters less as you grow richer
- Middle-income nations seem more satisfied with their lives than richer nations, money isn’t everything
Disinflation vs Deflation
Disinflation: bringing down the level of inflation
- Difficult & costly when high inflation has become well established in economy as it requires a temporary but large increase in the unemployment rate
- Best to avoid high inflation in the first place, must respond forcefully to signs that inflation may be accelerating
Deflation: fall in overall price level or negative inflation
Increase in price level isn’t same as rate of change in price level. Worsens standard of living.
How to Monitor Inflation + Issues + Solution
- Compare all prices of each year
- Compare averages of all prices as observed in the market
Issues: not all goods are equally valuable/important or accurately represent the cost of living. Ex. 100% increase in housing prices is much more important than 100% increase in electric vehicles
Solution: Price Indexes
1. Consumer Price Index - inflation
2. Industrial Producer Price Index - inflation
3. GDP Deflator
Consumer Price Index + 3 Components
Changes in aggregate price level are measured by the cost of buying a particular market basket during different years.
Consumer Price Index (fixed Q): monitors cost of living based on consumer expenditure survey every 4 years representing average urban household’s typical consumption & monthly price surveys, differs country to country, poorer spend high proportion for food, Japan more fish less beef
* 3 components creating a price index: a market basket, a base year & normalization
CPI = (Cost of Market Basket in Given Year/Cost of Market Basket in Base Year)*100
Find CPi 2019, 2020, 2022, base year 2002
B: 2002(Q10, P5) –> 2020(Q8, P6) –> 2021(Q7, P8)
P: 2002(Q12, P20) –> 2020(Q3, P22) –> 2021(Q54, P24)
M 2002(Q2, P18) –> 2020(Q43, P23) –> 2021(Q34, P20)
CPI in 2019 = not possible, P Q needed for 2 consecutive years
CPI in 2020 = 370/326100 = 113.5
CPI in 2021 =408/326100 =125.15
Why Log CPI
Same rise in slope does not correlate to same inflation
CPI + IPPI Based Inflation Rate
Percent change in a price basket (Q)= (price index 2 - price index 1)/price index 1 * 100
- CPI is used to calculate official inflation rate estimate that adjusts transfer payments/tax brackets+bands yearly & private contracts (COLAs cost of living allowances), has more direct+immediate impact than GDP; transfer payments rise or fall when CPI rises or falls
- IPPI Based Inflation Rate: early indicator as primary commodity prices move faster than retail prices bought by consumers, changes/responds quick to inflationary or deflationary pressures than CPI & when they perceive a change in overall demand for their goods
Cost of Living + Market Basket
- Cost of Living: how much do we need to spend on a fixed consumption bundle =i=1nPiQi=P1Q1+P2Q2+… PnQn, Q held constant
- Market Basket: {Q1, Q2,… Qn}, Q held constant, hypothetical consumption bundle used to measure changes in overall price leve
Industrial Producer Price Index (IPPI)
Industrial Producer Price Index (IPPI): measures the cost of a typical basket of g+s bought by producers, used to measure inflation based on commodity prices of raw materials
GDP Deflator
Current weighted price index, ratio of nominal GDP & Real GDP for that year, measure to monitor economy wide price changes, broader list of items compared to market basket
=Nominal GDP for given year/Real GDP (P base) for the same year * 100
Relationship b/w change in CPI, IPPI & GDP Deflator
- All 2 price indexes fluctuate closely together
- PPI most volatile as it has less prices to incorporate into an average
- GDP deflator most stable as it has most prices to incorporate into an average
Goal of Macroeconomic Policy
Focuses mainly on mitigating high unemployment & high inflation, goals are low unemployment & price stability which can be in conflict, important to consider tradeoff as well as sources of each, their danger & length of time
Employment Rate + Working Age People + Labor Force + Labor Force Participation
Employment Rate: those who are employed full time or part time
=people employed/working age population*100
Working Age People: 15-64
Labor Force: =employed+unemployed sum people that either
* Has a parttime or fulltime job
* Person is not employed then looked for jobs within last 4 weeks
* Available for work, no disability
Labor Force Participation =labor forceworking age groupx100: percentage of working-age population in labor force
Unemployment Rate
Total number of people 15-60 actively looking, available but currently aren’t employed, very good indicator of economic changes that have impact on lives, imperfect indicator of labor market conditions, how easy or difficult it is to find a job in given state of the economy, contradictory to quit rate
* Without work, looking for work in past 4 weeks, and available/abled for work
* Maternity+paternity leave is still employed
* Temporary layoffs or waiting for new jobs are unemployed
* Monthly Labour Force Survey, interviewing random sample of 56,000 HH, ask if their employed or unemployed, scaled to total population
=number of unemployed/number people in labor force * 100
How is unemployment rate overstated & understated
UE Overstate True Level of UE difficulty: confident worker who has not accepted position is counted as unemployed & normal for job search
UE Understate the True Level of UE/Measure of Labour Underutilization: those who would like to work but aren’t working don’t get counted as unemployed Underestimation is worst than overestimation, doesn’t include
* Discouraged workers (searching within 1 year): people who have given up searching
* Marginally attached worker: stopped looking waiting for employment to begin, hopeful but waiting for recall, replies, new job in 5+ weeks
* Underemployment: work not to desired capacity.
Visibly Underemployed Workers: work fewer hours than wanted (ex. Part-Time, want Full-Time)
Invisibly Underemployed Workers: work in jobs that don’t use skills fully, substandard to human capital (ex. Low wage, disadvantages, Immigrant, doctors, lawyers)
How can Unemployment rate vary?
- Varies across regions (Atlantic vs Alberta), demographic groups (Young vs Old, Men vs Women), ethnicity (Black vs White), gender (Men vs Women in manufacturing vs service sector), macroeconomic conditions (commodity prices rising) & time/history (COVID)
- Overall unemployment rate low, jobs are hard to find for some groups
- On average, post-secondary educated have lower unemployment rates than highschool educated, especially during economic downturns
GDP Growth vs Unemployment Rate
Strong Negative Relationship GDP Growth vs UE: as economic growth increases, unemployment decreases, but growth must be very high for unemployment rate to fall
Jobless Recovery/Growth Recession: GDP growing below-avg rate & unemployment rising, typically following a deep recession
Job Loss recessions create lowers standard of living of many families
Natural Unemployment vs Actual Unemployment Rate
Natural Unemployment
Frictional Unemployment + Structural Unemployment = Unemployment present at peaks of business cycles
Continual job creation & destruction are features of modern economies, making naturally occurring unemployment inevitable.
Can be affected by government policies, changes over time.
Actual Unemployment Rate
Actual Unemployment = natural + cyclical
Frictional Unemployment
Voluntary, due to job search, lack of connection, constant churning in labor market, reduced through internet, exists even when D=S, no surplus of workers
* UE is mainly frictional: low UE→short avg. waiting period
* Limited amount may be good, more productive economy if workers take time to find well-matched jobs
Structural Unemployment + 4 Causes
Unemployment caused by structural change in the economy, more workers with a particular skill/wage than jobs available using that skill/wage, labor markets face constant changes, skill & wage mismatch as new technologies emerge & consumer’s tastes change, persistent surplus of labor even when economy is at peak.
* Mainly Structural: low UE, long avg. waiting time
* Unions: organization of workers that collectively bargain for better wages & benefits by threatening labor strikes, refusal to work, countered with lockouts, period in which union workers are unemployed hiring replacement workers, same results as minimum wage, wages pushed above minimum wage
* Minimum wage: government floor ensure people can earn enough income to afford a minimally adequate standard of living, irrelevant if below equilibrium wage, above equilibrium, binding minimum wage, leads to labor surplus S>D, takes work from workers willing to work for lower wages, more people working minimum wage than before minimum wage
* Efficiency wages: wages set above equilibrium to avoid moral hazard problem-incentivize better performance & address adverse selection problem-avoid quality problem/attract highly skilled
Higher wages pool more workers to that job, causing shortage
* Government policy side effects: employment insurance, emergency response benefit, reduces incentives to quickly find a new job
Cyclical Unemployment
Actual rate - natural rate of unemployment, government regulates using fiscal & monetary policy to bolster demand, arises from the downturns of the business cycle, enough capacity, not enough demand for output
* UE cyclical>frictional: high UE → jobless longer periods of time
Job Seekers>Jobs Available. What unemployment is most at work here.
structural or cyclical
3 Changed in Natural Rate of Unemployment
- Changes in Labor Force Characteristics: gender, age (ex. Women in the labor force incr., -25 decr., baby boom)
- Changes in Labor Market Institutions: Unions, temporary employment agencies, gig economy, technological change, skill mismatch
- Changes in Government Policies: jobless insurance, high minimum wage, job training programs, employment subsidies (financial incentive to accept job)
Inflation Rate
Rate of change/percent increase in overall prices per year level measured by price index
= (Price Index 2 - Price Index 1)/Price Index 1 * 100
How is Standard of Living Measured
Real Wage= Nominal Wage/ Current CPI
Real Income = Nominal Income/ Current CPI
Interest Rate + Real Interest Rate + Nominal Interest Rate
Interest Rate: return a lender receives for use of their funds for a year with consideration to inflation rate that would occur in that period of time
Nominal interest rate: stated interest rate actually paid for a loan.
Real interest rate: nominal interest rate minus the rate of inflation
r=i-r^e, Real Interest Rate (adjusted for inflation) = Nominal Interest Rate - Inflation Rate (Expected/Actual)
3 Costs of High Rates of Inflation
Shoe-Leather Costs - Increased Costs of Transactions - Wear & Tear of Running: money held in a wallet or bank during high inflation losses its purchasing power as prices rise. Avoiding holding money, moving funds into assets that will hold value,
* Unproductive employment of force with frequent transferring, larger bank branches
* Loss of real resources
Menu Costs: cost of changing a listed price, to avoid constantly changing prices they switch to a more stable currency or artificial unit/set prices relative to one another, this has been reduced with electronically changing prices online
* Unproductive employment of force: requires sending clerks/workers very often to change listed price with each item
* No longer listing prices, multiplied by a number on a chalkboard
Unit-of-Account Costs: costs of money as unreliable unit of measurements
Financial planning impossible
Reduces quality of economic decisions
* Less efficient use of resources from uncertainty
* Distorts measures of income & taxes collected
* Pay phantom gains in productive investments (an investor’s portfolio declines in value but they’re still required to pay capital gains taxes)
* Gain phantom losses (reduced tax bills) in unproductive investments
* Discourages long-term contracts & investments
Hyperinflation
Prices increase at or above 50% per month = 13,000% per year=1.5^t(1.5)
Winners & Losers from Inflation + Deflation
Unexpected Inflation: Actual Inflation doesn’t equal Expected Inflation, loan contract specifies a nominal interest rate, each party has expectation of future inflation, uncertainty discourages contracts, redistributes wealth arbitrarily
* A>E=Borrower Wins, returned less money/lower value than expected
* A<E=Lender Wins, receives more money/higher value than expected
Unexpected Deflation:
* A>E=Lender Wins, receives more money/higher value than expected
* A<E=Borrower Wins, returned less money/lower value than expected
How to Measure Long Run Economic Growth
Measured using real GDP per capita (Real GDP/Population), ability to produce steadily overtime, separates changes in quantity of g+s from prices & isolate its effect in the population.
Change in Level vs Change in Rate
Price level is different from rate of change of price level (inflation).
Economic Growth Equation
%Real GDP per Capita =%Labor Productivity + %Avg. Hours +%EPR
Putting more population to work might increase growth rate for a little, but will eventually follow the growth rate of the population
Aggregate Production Function
Most Important Driver of LREG is Productivity, variables cancel out leaving just total output from productivity
Aggregate Production Function: describes relationship b/w estimate contribution of different factors to production, labor productivity increases when these components increase
Y=AF(K,L,H)
Y: measures the real GDP
A: total factor productivity, usually technological progress, advances in technical/distributive means of production, most important driver of productivity
Not always flashy, post it notes, usually adopted by service firms
F: aggregate production function
Ex, Cobb-Douglas Production Function: y=A(KL)13(HL)23
K: physical capital in economy increases productivity (bike vs car): manufactured resources, non-financial, raw-materials, on hand money, buildings, tools, machineries, factories, roads, bridges & other structure production can take place
L: employment or amount of total labor hours used in production
H: human capital, skill + training, education & knowledge, potentially measured by the avg. years of schooling in the labor force or others, more important than physical capital
Labor Productivity Per Worker/GDP per Worker
y=YL=Af(KL,HL)shows/disentangles how overall productivity depends on quantities of K, H, A
* (Y/L) = real output (GDP) per worker
* (K/L) = real physical capital per worker
* (H/L) = human capital per worker
* A= total factor productivity
* Y =aggregate output, y=labor productivity
Growth Rate of Labor Productivity
Use log rules, log become %change:
%y=%A+13%(KL)+23%(HL) =%(Y/L)=%Y-%L
Constant Returns to Scale
If exponents add up to 1 = all inputs increased the same proportion, resulting output increases by same proportion, productivity increases
Positive Marginal Productivity of Factors + Diminsing Diminishing Marginal Productivity of Physical Capital/Human Capital
Positive Marginal Productivity of Factors (MPK/H): small increment increase in output due to smaller increase in size of 1 factor, while all others remain fixed, pervasive/not as effective as tech as every 1%=0.3% of productivity
Diminishing Marginal Productivity of Physical Capital: when the amount of human capital per worker & state of tech are fixed, each successive increase in the amount of physical capital per worker leads to smaller increase in output per worker, or productivity (200k vs 400k tractor not that big improvement, however 1k vs 200k is big), never reduces productivity just cost isn’t worth it when reaching a point
May disappear with human capital or tech improvement with it
Total Factor Productivity
A=Total Factor Productivity: amount of output that can be produced with a given amount of factor inputs
* Increased, economy can produce more output with the same quantity of physical capital, human capital & labor
* If inputs & aggregate production stay fixed, increases in total factor productivity are due to technological progress
* Shifts the aggregate production function upward
Growth rates differ from differences in ability to excel at…
- Savings & investment spending
- Education
- Research & development
Productivity Paradox
Disconnect between what looks like rapid technological progress & actual productivity, flashy technologies isn’t necessarily one of rapid progress, precut cardboard boxes had more of an impact
What shifts labor productivty graph up? Graph Axis?
Human Capital & Total Production Factor/Technology Advancements. Y-axis=productivity X-axis=Capital per Labor
Growth in Real GDP per Capita & Productivity
%Real GDP per Capita = %Real GDP - %Pop = %Productivity + %Avg Hrs Worked + %EPR
%Productivity = %Total Output - Total Hrs Worked
Nominal + Real GDP relationship equation
%Nominal GDP = %Real GDP + %Price Changes
Nominal GDP = Real GDP * Price Changes
3 Types of Capital
Human Capital is largely provided by governments through public education
- Improvements in labour force generated by education, training, knowledge
Physical capital is mainly created through private investment spending
- Manufactured resources, buildings, machines
Financial Capital: funds from savings available for investment spending, from domestic or positive net capital inflow, flow of funds into the country from abroad
- Financial Asset (physical and financial): bonds, mutual funds, stocks, properties, businesses, confidence & dollar as hard currency makes people invest
- Bonds: confidence and dollar as hard currency makes people invest, promises to pay fixed amount whatever happens
- Stocks: give investors a share of future profits
Financial System
Set of markets & institutions that channels the funds of savers into productive investment spending, increases labor productivity as it allows firms to purchase physical capital. Where governments, firms & individuals trade promises to pay in the future
Savings-Investment Spending Identity
Savings & investment are always equal.
I & S in a Closed Economy with No Government
G=Nx=0
S=I
Y=C+I=C+S=HH consumption + savings/investment=income
S=I=Y-C=Income - HH Consumption
I & S in a Closed Economy with Government
Nx=0
Snational=I
Y=C+I+G=Aggregate Consumption(C+G)+ Snational(I)
I=S=Y-C-G=income after(-) spending
I=Snational=Spublic+Spvt
Spublic=T-TR-G
Spvt=Y-C-T+TR
Disposable Income
Y-T+TR
Budget Balance
Budget Balance=Spublic=Sgov
=Net Tax Revenue-Spending
=T-TR-G
- Income>Spending=budget surplus=positive
- Income=Spending=budget balanced=0
- Income<Spending=budget deficit=negative
I & S Open Economy with Government
Nx=NFI
Y=C+I+G+Nx
I+Nx=Y-C-G=Snational=I+X-M
Nx=Snational-Inational
NFI=Outflow of Funds - Inflow of Funds
=IDforeign-IFdomestic
=(SDforeign+SDdomestic)-(SDdomestic+SFdomestic)
=SDforeign-SFdomestic
=Snational-Inational
Inational=Snational-Nx
=SDdomestic+SFdomestic
Snational=I+Nx=SDdomestic+SDforeign
Nx=NFI
Savings allocated by accumulating physical capital (investing domestically) or acquiring foreign assets (investing abroad) = Funds that finance domestic investment come from domestic funds (national savings) and foreign funds (capital inflow=negative NFI)
NFI=Nx=Trade Balance
Net Foreign Investment = Outflow of Funds-Inflow of Funds
- Outflow of Funds: foreign investment funded by domestic savings
- Inflow of Funds: domestic investment funded by foreign savings
Trade Balance = Export - Import
- Positive O>I=E>I, Capital Outflow=Trade Surplus: more domestic investment in foreign countries, funds leaving country, funds lent to foreigners to use excess trade surplus amount
- Negative O<I=E<I, Capital Inflow=Trade Deficit: more foreign investment into country, funds entering country, funds borrowed from foreigners to make up trade deficit difference
Net Capital Inflow=Inflow-Outflow
Net Foreign Invesment=Outlfow-Inflow
Downsides of Open Economy
Higher national cost the more foreign capital inflow than investment spending financed by national savings
Interest on domestic savings is different from interest on a foreigner’s interest. Thus, dollar generated by national savings and dollar generated by foreign capital inflow are not equivalent.
Present Value + Calculation Process
Net Present Value: present value of current & future revenues - present value of current & future costs.
Best project to undertake is the one with the highest net present value
Face Value: amount lent, price of bond at the time is was issued -
Maturity (m): when amount lent/face value will be returned (30-100 years usually) - 1 yr
Coupon Value (C): feature of bond depending on the interest offered, bond yield - $5
Money Returned = Face Value + Coupons
Yield Rate = (Money Return-Face Value)/Face Value
Present Value: future return adjusting to inflation every year
Interest Rate (i): inflation’s affect on value/purchasing power of everything
There is an inverse relationship b/w the price of a bond & the nominal interest rate
1) Make timeline
2) Find present values of coupons of each year, maturity year with principle return, C/(1+i)+C/(1+i)^2+… + C/(1+i)^(m-1)+(C+F)/(1+i)^m
3) Sum up earnings & compare with initial cost. Gives max willing to pay. If it is greater than initial cost it is profitable.
1) Maturity 2 years, face value $100, coupons $6, interest rate changes to 7%, maximum price willing to pay for already issued bond?
2) Suppose a bond has a 5 year
maturity, $50 coupon, and a face value of $1000 which is the principal payment
that will be repaid after 5 years. If the other option for investment is to keep
your money into a savings account which carries a 10% interest (recently changed
after the bond was issued) then what is the maximum price for the bond you will
be willing to offer?
1) $98.19
2) $810
How much money save today to save up to $225 one year later, 10% interest rate
A(1+i)t=B → A=225/(1.1)1 = 204.55
Project A immediate $100, Project B costs $10 now and pays $115 a year from now, Project C immediate $119 costs $20 a year from now? Which project is more profitable?
C
A bond principle of $1000, maturity 7 years pays interest only during those years, given 2 years ago, the bond will pay interest for 5 more years, interest rate 6% when it was issued, 5% now. What is the max price willing to pay?
Coupon/Annual Interest Payment=6%*1000=$60 per year
Present Value at Today’s Market Equilibrium = 60/(1.05)+60/(1.05)2+60(1.05)3+60/(1.05)4+160/(1.05)5=$1043.30
Today willing to pay no more than $1043.30 or else spend $1043.30 or less on a new bond.
When determining the price of a preexisting bond, the interest rate used to calculate that price is the current market equilibrium interest rate, not the interest rate that was current when the bond was originally issued.
What is a zero percent financing loan?
When current market equilibrium interest rate is unchanged from when the bond was issued, the present value of the bond is equal to its face value, regardless of how many periods are left until it matures because r = i-tau=nominal interest-inflation rate = 6%-6%=0=no change in purchase power or value
Relation b/w Price of Bond vs Interest Rate + Price Bond vs Risk
Price of a bond goes up when market equilibrium interest falls. When price falls when market equilibrium interest rate goes up.
When the market interest rate on comparable bonds rises, the price of existing bonds falls. When market interest rate on comparable bonds falls, the price of existing bonds rises
High-risk bonds will sell at a lower price than a low-risk bond with the same maturity, face value, annual coupon payments. The lower price compensates the owner of the high-risk bond for the risk she faces of not being repaid in full
Stock Price + 3 Types of Calculation
Bond entitles the owner to interest payments, a share of stock entitles its owner to a share of the company’s profits (dividend) as a stock represents ownership of a portion of the company.
No time of maturity, goes on indefinitely
Stock Price=Dividend/(1+r)+Dividend/(1+r)2+Dividend(1+r)3+… , r=interest rate, no m
If company’s profits/dividends grow at a constant rate every year stock price
Stock Price=Dividend/(r-Growth Rate)
Highly variable dividends as profits vary year to year so stock prices are based on demand & supply
Loanable Funds Market + Graph
A hypothetical simplified market used to coordinate investors (Gov or Firms) & savers (HH), what makes S=I=Nominal Interest Rate, as there are so many different instruments to invest & borrow having their own markets with own D & S.
Hypothetical to estimate one singular interest rate (i) to calculate returns, works as all interest rates a linked together, usually nominal interest rate unadjusted for inflation.
D: projects of firm borrowers, firms with investment spending projects
S: savings of savers, savings of the households & the government
Price - price of borrowing x Quantity - quantity of loanable funds
Demand for Loanable Funds + Trend + Calculation
Borrowers (Firms+Gov) demand for loanable funds is a downward trend due to opportunity cost: As the interest rate (i) goes up, the higher the opportunity cost/attractiveness of investment spending, as putting money in a bank and earn interest on it is the highest-value alternative, as cost becomes greater than investment return calculated by present value, less loaning occurs. If interest rate gets lower, the greater the quantity of loanable funds demanded as cost is less than investment return or as putting money in a bank and earn interest on it as the highest-value alternative. As interest rate increases, less loaning occurs, .
- Money loses its value in the future, so use Present Value calculations to make sure that the future return adjusted to inflation is greater than the initial cost today (A=B/(1+i)).
Simple Words: Interest rate=cost of borrowing. The higher i=cost of borrowing, the less demand for loans. The lower i=cost of borrowing the more demand for loans.
Actual i = Nominal i - Inflation Rate
- Bigger Nominal i, bigger actual i, greater value of return to lenders = more costly for borrowers
- Smaller Nominal i, less actual i, smaller value of return to lenders = less costly for borrowers
Supply for Loanable Funds+Trend
Lenders (HH & Gov) supply of loanable funds is an upward trend due to opportunity cost: as interest rate increases it will become more attractive to save as return–>consumption is greater in the future than if spent now, the more people are willing to forgo current consumption and make a loan to a borrower.
Actual i = Nominal i - Inflation Rate
- Bigger Nominal i, bigger actual i, greater value of return/earnings to lenders= more costly for borrowers
- Smaller Nominal i, less actual i, smaller value of return/earnings to lenders = less costly for borrowers
Equilibrium Interest Rate + What it Ensure + Draw Graph
Interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded.
- Right Investments Get Made: Investment spending projects that are financed have higher payoffs than those that do not get financed
- Right People do the Saving & Lending: The savers who actually lend funds are willing to lend for lower interest rates than those who do not
Interest rate above equilibrium, profitable for lenders, but projects unaccepted by borrowers (Funded+Unaccepted).
Below Equilibrium, profitable for projects of borrowers, but unfunded by lenders. (Unfunded+Accepted)
2 Causes of Shifts of Demand for Loanable Funds + Sketch
Changes in perceived business profitability and/or opportunities: increase or decrease amount of desired spending at any given interest rate. (ex. Fracking, technological advancement)
- As demand for loanable funds rises, (i) equilibrium rises as borrowers are willing to borrow more & supply/investment increases/shifts up+right in economy
- As demand for loanable funds falls, (i) equilibrium rises falls borrowers are willing to borrow less & supply/investment decreases/shifts down+left in economy
Changes in government policy that affects investment decisions decentivize & incentivize certain sectors:
- Tax Credit (allows certain sectors to pay less tax): promotes investment making it more attractive/less expensive to undertake → As more investment projects are undertaken at any level of interest, … shifts demand curve up+right…
- Subsidy for investment (Ex. Clean energy technology has been incentivised by government)
Shifts of the Supply of Loanable Funds + Sketch
Changes in private savings behavior
- Recessions encourages households to save more, increasing loans, leads to fall → curve shifts right
- Expansion encourages households consumption, decreasing loans → curve shifts left, fall in i
Changes in budget surplus:
- Budget Surplus=Saver: (T-TR)-G>0 → (T-TR)>G, SPub>0, spending less than savings → savings used to finance investment spending, shift right
- Budget Deficit=Borrower: (T-TR)-G<0 → (T-TR)<G, SPub<0, spending more than savings, takes funds from market → less supply of funds to borrow from, reduction in national savings, shift left, rise in i
Effects of reduction of supply of loanable funds
Reduction of supply of loanable funds leads to rise in interest rate tells us an increasing persistent government budget deficits are a concern, businesses and households will cutback on investment spending → balancing budget is top priority
Crowding Out
Crowding Out: negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates
In a recession crowding out may not occur, government spending can lead to higher incomes→ increased savings→ gov borrowing without increasing interest rate
Global Loanable Funds Market
Global Loanable Funds Market: international capital flows are so large that they had the effect of completely equalizing interest rates across countries
- Most of the time, capital flows from countries where i is relatively low to countries where i is relatively high, resulting in raising i where it was low and reducing i where they were high
- Assumption world if frictionless, ceteris paribus to describe how nominal interest rate changes between countries, however investing abroad is not frictionless as risk is involved (political volatility & currency exchange)
Factors Driving Flow of Funds b/w Markets
Factors driving flow of funds b/w markets: interest rate differential, risk status, (currency) exchange rate
Ex. High world interest rate causes capital outflow, low world interest rate causes capital inflow from Canada to rest of the world
Explain + Show Graphically how US high interest & UK low interest equalizes
1) Savers/Lenders want higher returns/interest rate → borrowers in UK compete with US in US → capital inflow increases quantity of loanable funds supplied to US → pushes US interest down/downward pressure
- Reduces supply quantity of loanable funds supplied to UK → pushing interest rate up in UK → continues until gap between interest rates is eliminated
2) Borrowers/Firms want lower interest rate, thus borrowers in US compete with UK in UK → capital outflow increases demand of loanable funds in UK → pushes UK interest up/upward pressure
- Reduces demand quantity of loanable funds supplied to US → pushing interest down in US → continues until gap between interest rates is eliminated
3) US borrowers face competition, demand increases, supply decreases → excess demand
- Supply quantity of loanable funds in US exceeds demand in US, excess exported in the form of capital outflow to UK
UK lenders face competition so demand decreases, supply increases → excess supply
- Quantity of demanded loanable funds in UK exceeds supply quantity in UK, gap filled by imported funds=capital inflow from US
Excess demand & supply of both countries cancel out
See notes.
Comparative Advantage in Global Funds Market
Comparative Advantage: Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in the absence of such flows to earn more profit.
Fisher Effect/Equation + Sketch effect of 10% Expected Inflation
r = i - tau
real interest=nominal interest-inflation rate
Fisher Effect: expected real interest rate is unaffected by changes in expected future inflation, only nominal interest rate.
1) Interest rate/equilibrium in loanable funds market corresponds to the fluctuations of the expected inflation. Thus lenders and borrowers base decisions on expected real interest rate as true cost of borrowing and true pay off of lending is real interest rate )ex. Zero-Interest Loan: 0=10%-10%)
- The nominal interest rate is the accounting interest rate – the percentage by which the amount of dollars (or other currency) owed by a borrower to a lender grows over time, while the real interest rate is the percentage by which the real purchasing power of the loan grows over time. In other words, the real interest rate is the nominal interest rate adjusted for the effect of inflation on the purchasing power of the outstanding loan.
2) Change in expected inflation shifts equally both demand & supply of loanable funds simultaneously=shifts in demand and supply curves changes the interest rate; leads to a new nominal interest rate in loanable funds market,
- equilibrium quantity doesn’t change
Why is Nominal Interest Rate used & Significance
Nominal interest rate used rather than real interest rate because no one knows future inflation rate when making a deal. Expected inflation rate is held fixed based on recent experience, only nominal is dynamic
Significance: our expectation of inflation shifts with the economy, unions base wage negotiations on expected tau
Role of Government
Role of the government in current modern economies is huge, 50% spending, changing this causes
- Affects to flow of income: funds flow into G (taxes & borrowing) & funds flow out (G purchases of g+s & transfers to HHs)
- Affects to aggregate demand
Tool To Maintain Economy:
Fiscal Policy: changes in taxes & G spending to stabilize the economy by shifting aggregate demand curve (AD)
Fiscal Policy: goal+drivers+types+sketch
Goal: to shift aggregate demand curve to close recessionary or inflationary gap
Drivers:
- DeltaC Disposable Income=total income-taxes+government transfers, T & TR government can alter. Fall/Rise in disposable income leads to a Fall/Rise in consumer spending, shifting aggregate demand
- Delta C+I Incentive to Spend on Investment Goods by changing rules that determine how much a business owes, shifting aggregate demand
Types
- Direct Influence is changing G, changing demand in economy
Indirect Influence is changing t or - TR, changing disposable income→ spending → demand
1) Expansionary FP when economy is in Recessionary Gap:
* Delta G spending of g+s rise,
* Delta C Tax fall, Transfer Revenue rise more pension plans+social assistance
* Delta I Tax breaks, incentives, subsidies
2) Contractionary FP when economy is in inflationary gap:
* Delta G Spending of g+s fall
* Delta C Tax rise, Transfer Revenue fall, Less pension plans+social assistance
* Delta I Tax hikes, disincentives, fines/fees
3 Criticisms of Fiscal Policy + Wrong With Criticisms
Although criticism in safe/ordinary economic conditions, appropriate for when the economy is depressed. In fiscal policy, timing is crucial
Extent of expansionary fiscal policy effectiveness depends upon circumstances. Naturally economy will balance, could overdo things, causing inflation or recession.
1) Government spending always crowds out private spending (Wrong): aggregate output/demand/expenditure is fixed, increasing G spending, all other factors will decrease (more taxes), total spending will not increase. Upping G spending would tax the struggling households even more.
- Wrong in Principle: In reality, during recessionary gap (unemployed resources, output below potential), puts unemployed resources to work, generates higher spending & higher income (starts a multiplier effect). Only crowds out private spending when economy is operating at full employment
2) Government borrowing always crowds out private investment spending (Valid under some, but not all circumstances,): government borrowing funds that would have been used for private investment spending, crowding them out
- Wrong: if the economy isn’t depressed, incr. government borrowing → demand for loanable funds can raise interest rates & crowd out private investment. If economy is depressed (less than full employment), fiscal expansion raises incomes, increasing savings at any given interest rate, allows government to borrow without driving up interest rates
- In deep recession, lots of unutilized resources, government bring back capacity, generates more income, household increase in disposable income
3) Government budget deficits reduce private spending (Raises important issues, isn’t a good argument, Ricardian equivalence): expansionary fiscal policy leads to larger budget deficit greater debt which will require a raise of taxes to pay off, and in anticipation of this consumers will cut spending today to save money Ricardian Equivalence. Implies policy will have no effect because far-sighted consumers will undo any attempts at expansion or contraction by government
- Wrong: doubtful consumers behave with such foresight & budgeting discipline, cutting back will be gradual extended period to save over time to pay future tax bill nor is policy completely ineffective. Government spending will be concentrated in the near future, consumer cuts will be much in comparison, and will bring unused resources into the economy fast enough.
Cautionary Note for Fiscal Policy
Governments that try too hard to stabilize the economy can end up making the economy less stable due to time lags b/w when policy is decided, when it is implemented → attempts to increase spending take to long to get going, economy has already recovered on its own, turning from recessionary to inflationary gap when expansionary fiscal policy takes effect making things worse
- Gov. had to realize recessionary gap exists through collection + analysis of economic data, takes months, hard to pinpoint exactly when economic events occured
- Gov. has to develop spending plan taking months, particularly if politicians take time debating and passing legislation
- Takes time to spend money, big projects follow small project like construction, causing some to wait
Taxes
Taxes: required payments to government, collected at
- National/federal level: income tax on personal income & corporate profits, social insurance taxes
- Provincial/territorial level & Local/municipal level: mix of sales, property, income taxes & fees of various kinds
Government Spending
1) Direct Purchases of G+S (G expenditure approach): range from diagnostic equipment for hospitals, salaries for public school teachers, civil servants
2) Transfer Payments (C in expenditure approach as not final g+s): payments to HHs for which no g+s is provided in return
- Public Pension Plans: guaranteed income to older, disabled, surviving spouses or dependent children of deceased or retired beneficiary Canadians
- Other Social Assistance Payments: help HHs maintain an acceptable level of earnings
Social Insurance
Social Insurance: government programs intended to protect families against economic hardships including payments form public pension plans (CPP/QPP, GIS, OAS), general welfare & family allowance payments, smaller programs (veterans’ benefits, motor vehicle accident compensation payments, legal aid, daycare subsidies)
- Largely paid for with special dedicated taxes on wages
What drives the business cycle?
Business cycle is driven by ups in downs by export or investment spending, and multiplier effects
Multiplier Effect
Informal Definition: an initial change (rise or fall) is followed by multiple rounds of increases/decreases in aggregate output (income & expenditure), so it is used to measure the total effect of any such initial change in aggregate expenditure in the economy MPC is used
Formal Definition: ratio of total change in real GDP caused by an autonomous change in aggregate expenditure to the size of that autonomous change
- Ex. Spain additional car export causes rising output & income leads to more consumer spending leading to more income gains & so on
Equation: Multiplier=1/(1-MPC) =1/MPS= (1+MPC+MPC^2+MPC^3+…)=AY/AAE_0, there is an eventual limit to multiplier effect leading to a fixed amount increase in aggregate income determined by MPC & MPS as each stage, rise in disposable income leaks out because it is saved
Derive Multiplier
1) Sub in C=AC+MPC x YD into AEPlanned:
AEPlanned=C+IPlanned=AC+MPCYD+IPlanned
2) Since YD=Y & income-expenditure equilibrium Y=Y=AEPlanned: Y=AC+MPC x Y+IPlanned
3) Subtract MPCY from both sides: Y-(MPC x Y)=AC+(MPC x Y-MPCY)+IPlanned
Y*(1-MPC)=AC+IPlanned
4) Divide both sides by 1-MPC:
y*=AC+IPlanned1-MPC
5) Let AC=C so C+IPlanned=AE0: 1/(1-MPC) x AE0
Multiplier=1/(1-MPC)
Model Assumption for Income-Expenditure Model
1) Producers are willing to supply additional output at a fixed price: without driving up overall prices with additional spending from C+I, so Aggregate expenditure=Aggregate output=Aggregate Income (fine in short run, not long run) Nominal=Real GDP
2) Interest rate is fixed → determines borrowing & investment, we take it as given
3) No government spending and no taxes, Y = C + I
4) Closed economy (X = M = O → Nx=0)
5) y0=y=Disposable Income= GDP = y - (T-TR), T=TR=0
MPC & MPS
MPC - Marginal Propensity to Consume: increase in consumer spending b/w 0-1 when disposable income rises by $1, as only a portion of it is spent
* MPC=Delta consumer spending/Delta disposable income
* Disposable Income=consumer spending + savings = Y-T+TR
MPS - Marginal Propensity to Save: proportion of an additional dollar saved or not spent on consumption purposes
- MPS=1-MPC,
Multipliers Total Effect on Real GDP
Y= (1+MPC+MPC2+MPC3)Delta AE_0 = 1/(1-MPC)Delta AE_0
Autonomous Change in Aggregate Expenditure = Delta AE_0
Autonomous Change in Aggregate Expenditure: initial rise/fall in aggregate expenditure at a given level of real GDP, autonomous as it is self-governing, the cause not after effect of chain reaction. Triggered by a change up & above the initial real GDP
MPC + MPS Effect on Multiplier
- High MPC & Low MPS = more spending + less saving = high multiplier = bigger expansion = GDP growth
- Low MPC & High MPS = less spending more saving = low multiplier = smaller expansion = GDP fall
Driver of MPC
Consumer spending accounting for 60% of toal spending of g+s
Individual Consumer Spending vs Aggregate Consumer Spending
An equation showing how an individual household’s consumer spending varies by household’s disposable income (the greatest determinant) C=ac+MPCyd
- Upward Positive Trend: higher disposable income, higher consumption spending
- yd= individual household current disposable income
- ac = Autonomous Consumer Spending: spending if HH had 0 disposable income, always greater than 0 by borrowing or using savings. Constant term, intercept, y when x=0, or plug in a point in y=mx+b after finding slope
- c= individual HH consumer
- MPC =c/yd=y/x= Marginal Propensity to Consume: how spending rises if current disposable income rises by $1
slope, rise/run, can be determined with any given 2 points= A(yd1,c1), B(yd2,c2)
c=MPC*yd
- Y-axis consumption spending, x-axis disposable income
- Each dot is a household at different income and consumption spending
- Below line, is HH saving, above line is HH spending savings
Shifts in Aggregate Consumption Function
Shifts of the Aggregate Consumption Function: when factors other than disposable income change, aggregate consumption shifts at any level of current disposable income by 2 principle causes:
1) Changes in expected future disposable income (ex. Getting a first job, income → consumption will increase or losing job, income→consumption will decrease)
* Puzzle: why does a higher income economy doesn’t necessarily mean more savings?
* Permanent Income Hypothesis (Milton Friedman): consumer spending depends mainly on income people expect to have over the long term rather than on their current income due to systematic difference b/w current disposable & expected disposable income in individual households that creates upward trend b/w current income & savings rate
* Low income often due to unusual bad year (laid off, will find job soon), expecting higher future income → low or negative savings, more spending
* High income often due to unusual good year (investments that did well) expecting lower future income → high + more savings, less spending
* When economy grows, current & expected incomes rise leading to higher savings→ weaker relationship b/w current income & saving
2)Changes in aggregate wealth: those with more wealth, even if all have identical income, will spend more
* Life Cycle Hypothesis: consumers plan their spending over a lifetime not just in response to disposable income, want a consistent smooth sustained consumption level (standard of living)
* Eventually people’s wealth levels off/retire without income. So to prepare they build up wealth, saving income + investing=build up in assets (wealth=value of assets) to maintain a certain living standard.
* Thus, rise in aggregate wealth (Boom in stock or housing market)→ higher consumption spending in economy, vice versa
* Bank Scam: offering loans to anybody not able to return loans while housing market is rising, led to crisis
* Borrowing: buy house now, house will go up in value, earn money in future
Calculate Aggregate Function:
Aggregate Spending: $21750–>$40750, when current disposable income for all HH went up $0 –> $10000
C=3000+0.633^YD
Aggregate Consumption Function
Aggregate Consumption Function: C=AC+MPCYD derived by aggregating individual consumption spending decisions, relationship b/w aggregate current disposable income & aggregate consumer spending. Add intercepts + difference of sum of all consumer spending in an interval divided by add up all disposable income earned in same interval
* YD= aggregate current disposable income/disposable income (Sum of all HH ac=y-intercepts)
* AC aggregate autonomous consumer spending, a constant used to represent a situation where the HH has no income, even when disposable income is 0, C>0
* MPC=CYD, captures the amount by which the expenditure increase in response to a $1 increase in income (Sum difference of all HH consumption divided by sum difference in all disposable income)
Factors that Causes Changes in Planned Investment Spending
Planned Investment Spending: the investment spending that businesses plan or intend to undertake during a given period depends on
1) Interest Rate: downward relationship, higher interest rate the lower the planned investment spending (IPlanned), vice versa, from comparison b/w rate of return & market interest rate (Construction, housing loans)
* Fall in interest rate (cost of borrowing)→ projects/investments are more likely to be carried out as they are less costly, rate of return higher than cost to borrow, more profitable
* Rise in interest rate (cost of borrowing) → projects/investments are less likely to be carried out as they are too costly, rate of return lower than cost to borrow, less profitable
* Retained Earnings: past profits used to finance investment spending, doesn’t make trade off/opportunity cost any better (ex.Funds invested in machinery vs lending to collect interest)
2) Expected Future Real GDP + Production Capacity: firms incr/decr investment to build up stock capital, increase production output, depending on sales growth/demand for their product dictated by expected future real GDP, high levels of IPlanned occur when expected sales grow rapidly and excess production capacity will be used up
* Expected Future Real GDP (Accelerator Principle): positive effect on investment spending: higher expected future GDP higher investment spending. If firms will undertake more investment spending when they expect their sales to grow. Firms will engage in lower investment spending only to replace existing capital that wears out or rendered obsolete by new technologies if sales are not expected to grow.
* Current Level of Production Capacity: negative effect on investment spending: the higher the current capacity the lower the investment spending. If a firm has more capacity than needed to meet current production needs, they won’t undertake investment spending until sales catch up to excess capacity. If a firm has less capacity than required, they will undertake investment spending.
Factors that Causes Changes in Unplanned Investment Spending
Unplanned Investment Spending: investment spending, positive or negative that occurred but was unplanned
Inventory Investment/Spending (New-Old): value change of total inventories from unexpected fluctuations in sales held in economy during a given period of time, can hold more or less than intended
* Inventories: stocks of goods & inputs held to satisfy future sales needs, keep a steady supply (cushion/safety against chain/supply disruption) & to quickly satisfy buyers instead of keeping them waiting to be manufactured (8.5% of GDP).
* Positive: producing too much, unexpected increase in the value of inventory (incr. Inventory from unexpected sales) → slowing economy as sales lower than forecast ($8000 prepped for expected $8000 sales, however only $7000 sold, Inventory Investment=Planned -Actual =10-5=+5)
* Negative: producing not enough, unexpected fall in value of inventory (unexpected sales, spoilage) → growing economy as sales greater than forecast
(Inventory Investment=Planned -Actual =10-15=-5)
Actual Investment
I=Iplanned+Iunplanned
Income Expenditure Model + Assumptions
Income-Expenditure Model: as income increases, planned expenditure increases as well, consequently seen in AD model, shown numerically, graphically & algebraically
* No Government + Closed Economy
* Prices aren’t fixed
GDP=C+I= YD=AEPlanned+IUnplanned, C=AC+MPC*YD, IPlanned fixed=Y-AEplanned
Planned Aggregate Expenditure/Consumer Spending
AEPlanned=C+IPlanned: total amount of planned expenditure in the economy, as households don’t take unintended actions. AEPlanned depends on GDP: Higher GDP → higher disposable income → higher consumer spending → higher planned aggregate expenditure → higher GDP… multiplier effect, vice versa.
Income Expenditure Equilibrium + Draw Graph
Income-Expenditure Equilibrium: Y=AEPlanned, IUnplanned=0, no unplanned inventory investment, firms don’t have an incentive to change output, any point on the Keynesian Cross (45 degree) is the equilibrium. AEPlanned differs from Y when IUnplanned=0
* Firm’s will adjust output/production to eliminate unanticipated changes in inventory & reach equilibrium
* Since GDP=AEPlanned+IUnplanned IUnplanned=Y-AEPlanned
* Below equilibrium AEPlanned>Y, underproduction as IUnplanned=-ve, underestimate
* Firms incr. production → GDP incr.
* Above equilibrium AEPlanned<Y, overproduction as IUnplanned=+ve, overestimate
* Firms decr. production → GDP decr.
* Y*= Income-Expenditure Equilibrium GDP
* Else where there is disequilibrium, mismatch b/w how much economy wants to spend & how much has been produced
Shifts of Planned Aggregate Expenditure + Draw
Y1Y2 AEplanned = C + Iplanned
1) Change of Aggregate Consumption Function (C): change expected future disposable income and/or in aggregate wealth, leads to
Autonomous Change in Planned Aggregate Expenditure (AE0): change in desired level of spending of whole economy at any given level of real GDP
Rise in income expenditure equilibrium greater than AE0 due to multiplier effect=Delta Y/DeltaAEPlanned → Y=Multiplier*AE_0
Process In Depth: (X→E1)AE0 incr. Gap b/w AEPlanned & Y→Production rises → GDP rises (Y1→Y2) → Disposable income rises → C rises → Real GDP rises → YD again loop… Vice versa as well
2) Change in Investment Spending (IPlanned): change in interest rate, expected future GDP, production capacity, inventory investment from unexpected fluctuations in sales
Autonomous Change in Aggregate Expenditure
Autonomous Change in Planned Aggregate Expenditure (AE0): change in desired level of spending of whole economy at any given level of real GDP
=DeltaY*/Delta AEPlanned
3 Ways of how open economy influences Aggregate Expenditure
1) Export=Income=Spending=AE0
2) Multiplier effect weaker/lower depending on Marginal Propensity to Import (MPI) as C=ImportGDP domestic
Algebraic:
AEp=C+Ip+(X-M)
* Export: x=x0, fixed, depends on foreign GDP, not ours
* Import: M=my, 0<m<1, fixed proportion to our GDP, depends on our income
AEp=AC+MPC*yd+Ip+x0-my
AEp=(AC+Ip+x0)+(MPC-m)y
Multiplier = (MPC-m) = weaker
3) Creates interdependence among national economies Exports=Imports, spill over of recessions or expansions, international business cycles
Generally, closed economy has higher income-expenditure equilibrium
Aggregate Demand Curve + Why is it downward sloping
Based on the income-expenditure model shows change in AEplanned curve, shows how much aggregate output demanded (real GDP) by HH, firms, gov, rest of world, at any given aggregate price level (GDP Deflator)
Downward sloping relationship: higher the aggregate price level reduces quantity of aggregate output demanded, lower aggregate price level increases quantity of aggregate output demanded
1) Wealth Effect: the effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers’ assets
* an increase in aggregate price level reduces the purchasing power of many assets, causing a scaling back in aggregate consumption plans, aggregate demand falls (ex.25% rise in GDP deflator = $5,000 in the bank → becomes $4000)
* P rise, PP fall, C fall
* A decrease in aggregate price level increases the purchasing power of many assets, causing a scaling up in aggregate consumption plans, aggregate demand rises (ex.25% fall in GDP deflator = $5,000 in the bank → becomes $6,666)
* Downward shift of the AEplanned
2) Interest Rate Effect: a rise in the aggregate price level depresses investment and consumer spending through its effect on the purchasing power of money holdings
* Money is held to reduce the cost & inconvenience of making transactions. An increase in aggregate price level reduces purchasing power of a given amount of money holdings. This results in less supply and high demand of loanable funds as more borrowing or selling of loans occurs to increase money holdings and less money is saved in bank accounts, driving up interest rates.
* Rise in interest rate reduces investment spending as cost of borrowing is higher, and reduces consumer spending as money is saved.
* P rise, Hold money fall, buy today rise, savings fall, interest rate rise to attract people to save, cost of borrowing rise, investment fall, consumption fall
* Downward shift of the AEplanned
Not law of demand as the AD curve considers a simultaneous change in the prices of all final goods & services, the basket of g+s is irrelevant. Law of demand hinges on how specific prices don’t change and the variety of the basket
Aggregate Demand vs Income-Expenditure Model
Aggregate expenditure at any given aggregate price level is derived from the Income-Expenditure model that no longer has fixed planned aggregate spending (C+I=y), prices are not fixed. Shifts in the Income-Expenditure Model caused by changes in the aggregate price level derive the AD curve.
* Income-expenditure equilibrium: planned aggregate expenditure crosses the 45 degree line (keynesian cross)
* When aggregate price level changes, the income-expenditure model shifts:
* Ex. A fall in aggregate price level causes AEplanned curve to shift up
* Fall in aggregate price level causes an upward shift of the Income-Expenditure Model and a rise in real GDP → downward trend of AD curve
5 Factors that Shift Aggregate Demand
1) Changes in expectations of the future: Optimistic aggregate spending rises, pessimistic aggregate spending decreases due to a decrease in autonomous consumption & investment
* Delta C: consumer spending is based on income they expect to have in the future (ex. Expected income → planned consumption rises→aggregate consumption/expenditure/output shifts up).
* Delta Iplanned: firm investment spending is based on sales they expect to make in the future
2) Changes in wealth Delta C: independent of changes in price index, real prices of assets rise/fall → purchasing power rise/fall → aggregate expenditure rise/fall
* Ex. Housing bubble, everybody buying homes, banks making loans to people uncredited worthy, banks have no risk will sell, aggregate spending rises. When it burst, price levels of assets fell, aggregate spending fell.
3) Size of the existing stock of physical capital Iplanned: investment spending depends on how much physical capital they have small/large & the more/less they need
* Ex. China, real estate ghost towns as borrowing was too easy, there isn’t much demand, too much stock of physical capital, massive drop in investment in the sector, aggregate spending falls as price levels fall.
4) Fiscal policy: use of government spending or tax policy to stabilize the economy through contractionary & expansionary aims. Governments are 50% of World GDP, a huge share in the modern economy, what they do has a huge influence on the economy. Given this role, they can shift aggregate demand by changing household and firms decisions, indirectly influence
* Increasing aggregate demand → expansionary fiscal policy, (1)direct-buy more stuff G, (2)indirect-transfer more disposable income to up consumption spending TR, (3)reducing tax more disposable income to spend T (sales, federal, provincial), combination of 3
* Decreasing aggregate demand → contractionary fiscal policy - opposite of the combination of 3 (1)direct-buy less G (2)indirect-transfer less disposable income to lower consumption spending TR (3)increasing tax to reduce disposable income to spend T
5) Monetary Policy: use of changes in the quantity of money or the interest rate to stabilize the economy, contractionary and expansionary
* Increasing aggregate demand → expansionary monetary policy
* Expansionary -
* Increasing quantity of money in circulation→ firms+HH have more money willing to be lent out, drives interest rate down
* Decrease interest rate→make money cheaper→will borrow more→ more investment spending → increases AD
* Decreasing aggregate demand → Contractionary monetary policy - increase interest rate, money expensive, will borrow less, less investments, more savings
* Decrease quantity of money in circulation→ firms+HH have less money willing to be lent out, drives interest rate up
* Increase interest rate→make money more valuable→will borrow less→ less investment spending → decreases AD
Aggregate Supply
Shows as aggregate price level (GDP deflator) rises aggregate output supplied (real GDP) rises, a fall of aggregate price level causes a fall in aggregate output supplied due to the greater than or less than cost of producing that unit of output.
* Short Run Aggregate Supply Curve
* Long Run Aggregate Supply Curve
SRAS vs LRAS
Short Run AS Curve (SRAS): no change in technology & input prices don’t change, Sticky prices, takes times for prices to change due to shocks in economy, slower to change.
- Potential Aggregate output different from Aggregate Output; Below Potential or Above Potential, shifts until the point where LRAS and SRAS intercept is at the Potential Aggregate Output
* Wages are the stickiest/most inflexible/fixed: any worker compensation, health care, retirement benefits, addition to earnings, because nominal wage=sticky wages is often determined by contract signed long before or informal agreements. Firms will only reduce wages if the downturn has been long or severe for fear of generating worker resentment or raise wages until at risk of losing workers to competitors during good economic times to not encourage workers to routinely demand higher wages.
Long Run AS Curve (LRAS): technological improvement is a possibility and all, both output & input prices are flexible; long enough for input prices/wages to adjust to changes in price index. Aggregate price level has no effect on the quantity of aggregate output supplied as prices and costs adjust proportionally the same, changes in aggregate price level, composed of prices of final g+s, will be accompanied by equal proportional changes in all input prices, including nominal wages
SRAS Upward Slope + Draw MC Curve
Upward Slope driven by nominal sticky wages/prices & profit per unit of output, as some production costs are fixed in the short run, a change in aggregate price levels leads to a change in producers’ profit per unit of output → change in the profit-maximizing level of aggregate output supplied
Perfectly Competitive Firms: Price takers, can’t influence price, operate where their MC Marginal Cost curve is at or above the AVC Average Variable Cost Curve, s
If aggregate prices decreases, profit per unit of output decreases and input prices are fixed → reduces per unit profit → reduces supply in short run
To limit decline in per unit profit costs need to be cut → land, capital, technology, wages are fixed in short-run only option is to decrease the level of labor
Law of Diminishing Marginal Productivity: marginal product of labor declines as the number of workers employed rises, implying layoffs raise marginal productivity of labor lowers production costs & increases profit
Costs greater than price → labor level falls, marginal productivity rise, marginal cost fall, per unit profit rise at the new price, output/supply falls to mitigate drop in profit per unit
If aggregate prices rise, higher price for final g+s, profit per unit rises as production costs are fixed and price of unit rises → output increases as more profitable
Imperfectly Competitive Firms: Price makers, they decide price when they they have market power
Rise in demand → output increases at any given price → with pricing power will choose to increase price + output to increase profit per unit of output
Fall in demand → limit fall in sales by cutting prices + lowering output
4 Factors that Shift SRAS Curve
Per Unit Profit of Output drives firm’s decisions, greater more, less less which changes depending on cost of production: increase cost → profit falls →production fall → output fall, vice versa
1) Changes in Commodity Prices while output prices do not change: are not final goods, hence not included in aggregate price level, are a significant cost of production having large impacts, volatile due to industry-specific shocks to supply
* Commodity: standardized input bought & sold in bulk quantities (refined inputs aluminum, iron, oil, nickel, potash, copper)
2) Change in Nominal Wage: enough time passed for contracts for informal agreements to be renegotiated,
* Ex. Healthcare insurance, Minimum wages for addressing sticky wages, increased cost of production, profit decr.–> aggregate output shift left.
* Knock-On Effect: surge in oil prices commodity price raised overall consumer prices → nominal wages with cost-of-living-allowances
3) Changes in Productivity: ex. Barcode scanners,
* P: less stuff to produce the same amount = improvement in productivity → less cost per output → increase in aggregate supply
4) Change in Regulation: ex.Filing more reports, forms
* R: fall of productivity from inefficient use of time → higher cost of production → reducing production → shift in aggregate output
LRAS Vertical Graph
Vertical graph: firms makes adjustments, need to reduce labor is no longer a problem, no relationship, same output is produced at all price levels,
Potential output reached
Horizontal Intercept = economy’s Potential Output: the level of real GDP the economy would produce if all prices were perfectly flexible, not maximum level of output, output when all factors of production are effectively & fully utilized. In reality, output is always above or below gravitating towards/fluctuating around it.
Other names: full employment level, long-run equilibrium level of output, natural rate level of output. Determined by the production capacity using production function: labor force, capital stock, resources, technological improvement, and Long-Run Economic Growth factors
2 States of SRAS LRAS curves + Draw Graphs
Always in 1 of 2 states, both curves simultaneously if they cross (Aggregate Output=Potential Output) or SRAS shifting over time until they intersect
* GDP>Potential Output → low profits low unemployment, need for workers, rise in bargaining power for wage → rise in nominal wages → production cost rise → supply decreases to Potential Output
* GDP<Potential Output—> high profits high unemployment, too many workers, fall in bargaining power for wage → fall in nominal wages → production cost falls → supply increases to Potential Output
Short-Run Macroeconomic Equilibrium (ESR) + Draw Graph
Short-Run Macroeconomic Equilibrium (ESR): intersection at which AD & SRAS curves intersect, quantity of aggregate output supplied is equal to the quantity demanded by HH, firms, government & rest of the world
* P_E Short-Run Equilibrium Aggregate Price Level
* Y_E Short-Run Equilibrium Aggregate Output
* If aggregate price level is above E, SRAS>AD → aggregate price level will fall to E
* If aggregate price level is below E, SRAS<AD → aggregate price level will rise to E
* Shift of equilibrium points out the level of inflation in the economy (tau)
*
Demand Shock + Negative & Positive + Draw Graph
Demand Shock/Shifts of Aggregate Demand (AD) Curve: an event causes AD curve to shift, while aggregate supply stays fixed, caused by factors listed above changes in expectations, wealth, effect of the size of existing stock of physical capital, use of fiscal or monetary policy. Aggregate output and price levels move in same direction
Positive Demand Shock: aggregate demand increases (AD shift right), short-run price levels and output rise, higher equilibrium, upward movement along SRAS curve ex. an expansionary fiscal policy shifts the AD curve to the right (see factors that shift demand above), solved the Great Depression
Negative Demand Shock: aggregate demand decreases (AD shift left), short-run price levels & output fall, lower equilibrium, downward movement along SRAS curve ex. Recession abroad cause a negative demand shock → fall in export, Contractionary fiscal policy, less spending, less demand, Monetary make spending more costly, buying less, less demand (investment spending is particularly sensitive)
Supply Shock + Negative & Positive + Draw Graph
Supply Shock/Shifts of Aggregate Supply (SRAS) Curve: an event causes the SRAS curve to shift, changes in costs of production causes profit to change (see factors listed above; change in commodity prices, nominal wage, tech/productivity), aggregate output & aggregate price level move in opposite directions. Harder for government to shift.
Positive Supply Shock (favourable): an event causing per unit profit to increase for the given price level that reduces production cost & increases quantity supplied at any given price level (SRAS right shift) → short-run price levels fall & output rises, downward movement along AD curve
* Technological improvement, internet 1995-2000
* Declining inflation + full employment, optimism
Negative Supply Shock: an event causing the per unit profit to decrease that raises production costs & reduces the quantity producers are willing to supply at any given aggregate level (SRAS left shift) → short-run price levels rise & output falls, upward movement along AD curve
* Increase in oil prices 1973 & 1979, drives permanent rise in cost, reduces supply
* Stagflation (stagnation+inflation): inflation/rising aggregate price levels & falling aggregate output leads to rising unemployment, purchasing power squeezed by rising prices, pessimism
Long- Macroeconomic Equilibrium (ELR) + Draw Graph
Long- Macroeconomic Equilibrium (ELR), when the short-run macroeconomic equilibrium is on the long-run aggregate supply curve. All 3 curves must agree AD, SRAS and LRAS. Long Run the economy is self-correcting, Output is unaffected, Price Levels are affected in Long-Run
* P_E Long-Run Equilibrium Aggregate Price Level
* Y_P Potential Output = Long-Run Equilibrium Aggregate Output
Output Gap + Draw Graph
Output Gap: percentage difference b/w actual aggregate output (Short-Run) & potential output (Long-Run)
=(Actual Aggregate Output-Potential Aggregate Output)/Potential Aggregate Output x100, always tends to 0, the YP
- (-ve) Recessionary Gap: YE<YP aggregate output is below potential output, high unemployment, nominal wages + sticky prices fall, moving back to YP
- (+ve) Inflationary Gap: YE>YP aggregate output is above potential output, nominal wages + sticky prices rise, moving back to YP
Negative Demand Shock (Recession) SR vs LR Effects + Draw Graph
E1 (LR): all 3 agree at one point, long-run aggregate supply curve Y1=YP
E2 (SR): AD falls (left) → fall in P2 and Y2 as suddenly the economy doesn’t want to buy→produce as much as E1 → below potential output and recessionary gap created (high unemployment, no need for so many workers for little demand or production)
In the long run, even if the government does nothing, naturally SRAS will increase, as high unemployment=bargaining power for wage decreases, nominal wages fall=downward pressures on prices, production costs decrease, upward push on SRAS to increase output as profit per unit rises until…
E3 (LR): will return to equilibrium of all 3, long-run macroeconomic equilibrium, Y3=YP, lower aggregate price level P3<PE
Positive Demand Shock SR vs LR Effects (Inflation) + Draw Graph
E1 (LR): all 3 agree at one point, long-run aggregate supply curve Y1=YP
E2 (SR): AD increases (right shift), suddenly the economy wants to buy→produce more than E1, P2 & Y2 rises above potential output and inflationary gap created (low unemployment to produce higher level of aggregate output)
In the long run, even if the government does nothing, naturally SRAS will decrease, more firm competition, higher bargaining power for wages, upward pressures on wages, production costs increase, downward left push on SRAS decreasing output until..
E3 (LR): will return to equilibrium of all 3, long-run macroeconomic equilibrium, Y3=YP, higher aggregate price level P3>PE
Difference b/w Negative Demand & Supply Shocks
Recessions are mainly caused by demand shocks, negative supply shocks tend to be more severe stagflation=inflation+falling output as macroeconomic policies have a harder time dealing with supply shocks. Biggest from Oil conflicts.
How to Calculate Y*?
Y*: GDP=AEp=YD
AEp = C + Iplanned = AC + MPC*YD+Iplanned
Set GDP=AC+MPC*GDP+Iplanned & isolate for GDP
Draw AEp Graph (income expenditure model) + IE vs AD graphs
See mindmap
