ECON Final Flashcards
Externalities vs Negative Externalities vs Positive Externalities
Externalities: cost or benefit that arises from production or consumption that falls on someone other than the producer or consumer.
Negative Externalities: cost imposed on 3rd party - punished
-Production: common costs that arise from production (clothing production –> pollution)
-Consumption: common costs that arise from consumption (speakers–>noise pollution)
Positive Externalities: benefit created for 3rd party - promoted
-Production: uncommon benefits that arise from production (honey production –> pollination)
-Consumption: common benefits that arise from consumption (education –> knowledge)
What is MSC = MC + MEC
MSC - Marginal Social Cost
Sum cost per unit of production for all of society = Social Supply Curve
EQ: MC+MEB
MC - Marginal Private Cost
Private cost per unit of production borne by producers = Private Supply Curve
EQ: MSC-MEC
MEC - Marginal External Cost
Social cost per unit of production borne by others = Vertical distance b/w MSC & MC curves
EQ: MSC-MC
Given:
PVT Cost Curve: P=6.25Q+75
SOC Cost Curve: P=37.5Q+75
Demand (MSB) Curve: P=-25Q+200
- Market EQM from PVT & SOC perspective?
- Calculate DWL of externality?
- How much tax to impose? Calculate Tax Revenue?
[Draw Graph to Support Calculations]
- PVT: Qe=4, Pe=100
SOC: Qe=2, Pe=150 - DWL=125
- Tax = MEC@SOC EQM= MSC-MC @SOC EQM = $62.5
Tax Revenue = Tax x Q =125
4 Ways to Eliminate DWL created by Negative Externality?
Eliminate DWL = Increase PKT cost to SOC EQM so firm bears all costs
- Taxes: gov set tax equal to MEC (MSC-MC) @ SOC EQM, Tax Revenue (Tax x Q)
- Emissions Charges: difficult to calculate, gov sets price per unit of pollution to discourage firm’s from creating social costs
- Cap-&-Trade: firms buy permits to produce an amount of pollution per period which can be traded
- Property Rights
- Coase Theorem: agreement that accurately reflects full costs –> efficient + no externalities
What curves does Negative vs Positive Externalities impact?
Negative Externalities: Cost/Supply Curves
Positive Externalities: Benefits/Demand Curves
Given:
PVT Benefit Curve: P=-0.667Q+20
SOC Benefit Curve: P=-1.733Q+51
Supply (MSC) Curve: P=1.33Q+5
- Market EQM from PVT & SOC perspective
- Calculate DWL?
- How much Subsidy to give? Calculate Government Loss?
- PVT: Qe=7.5, Pe=15
SOC: Qe=15, Pe=25 - DWL = 86.25
- Subsidy = MSB-MB @SOC EQM = $15
Gov Loss = Subsidy x Q = $225
What is Deadweight Loss in Externalities
Social cost at PVT market equilibrium
3 Ways to Eliminate DWL created by Positive Externality?
Eliminate DWL = Increase supply to SOC EQM so max benefit for society is reached
- Subsidy: gov given payment to producers to raise supply to SOC EQM
- .Voucher: subsidy given to students/consumers
- Copyright/Patent
What is MSB = MB + MEB
MSB - Marginal Social Benefit
Sum of benefit per unit of consumption for all of society = Social Benefit Curve
EQ: MB+MEB
MB - Marginal Private Benefit
Private benefit per unit of consumption = Private Benefit Curve
EQ: MSB-MEB
MEB - Marginal External Benefit
Social benefit per unit of consumption for society = Vertical different b/w PKT & SOC curves
EQ: MSB-MB
Short Run vs Long Run
Short Run: time frame where at least 1 factor remains fixed & decisions are easily reversible
Long Run: all factors are changing, irreversible decisions that can incur sunk (unrecoverable) costs
-Each plant has own unique cost curves
TP vs MP vs AP, Explain + Draw Graphs
Describing Output:
Total Production - total output produced in a given period
- Law of Diminishing Returns: fixed capital for infinitely increasing labour means output eventually increases decreasingly
- Inverse of TC (Total Cost)
Marginal Production - change in total product that results from a one-unit increase in the quantity of labour employed
EQ: TP2-TP1 + Midpoint
- Inverse to (MC) Marginal Cost
Average Product - Output per unit of labour
EQ: TP/Q of Labour
- As long as MP>AP=AP rises
MP<AP=AP fall
AP max when MP=AP
- Inverse of (AVC) Average Variable Cost
Explain + Draw Total Cost
Total Cost = TFC +TVC = cost of all resources used
- Law of Diminishing returns, less & less product being produced for an infinitely growing labor means cost eventually increases increasingly
- Inverse of TP curve
Total Fixed Cost = TC @Q=0
- Cost of firm’s fixed inputs, does not change with output
- Shifts TVC up to become TP
Total Variable Cost = Q of Laborers x Wage/Income/Pay Rate
- Cost of firm’s variable inputs, changes with output
- Gives TC its shape
- Inverse to TP
MC + ATC + AFC + AVC
Marginal Cost = increase in total cost that results from a one-unit increase in total product
- MC Inverse relationship with marginal production MP
- MC will hit AVC & ATC at their mins
Average Total Cost = total cost per unit of output = AFC + AVC = TC/TP
Average Fixed Cost = total fixed cost per unit of output = TFC/TP = ATC-AVC
- Approaches 0 as fixed constant cost/infinitely growing output
Average Variable Cost = total variable cost per unit of output = TVC/TP = ATC-AVC
- Minimum hits MC faster than ATC as AFC consistently falls slowing ATC’s ability to increase at the same rate as AVC
2 Factors that Shifts Cost Curves + Draw
- Technology: increased productivity
- Low Output: Capital>Labor = AFC high. + VC low = ATC shift up, TP decreaes
- High Output: Capital<Labor = FC fixed VC increase = ATC shift down, TP increasingly increasing - Price of Factors of Production = ATC shifts up
- TFC Fixed Cost Rise = TP + AFC shifts up (VCs + MC stays same)
- TVC Variable Cost Increasingly Increasing = AVC TC MC ATC shifts up
Draw + Explain Long Run Average Cost Curve LRAC
Long Run Average Cost Curve (LRAC): shows us which plant gives us lowest/minimises ATC for each output level
Ex. At 15 sweaters a day cost is around $7 each on
ATC2. Least-cost way of producing 15 sweaters is
use 2 knitting machines
The larger the plant, the greater the output when ATC is at a minimum = great output incurs relatively lower cost the larger the plant
Diminishing MP of Capital & Labour Returns: as TP rises at a decreasing rate as labour increases with a fixed capital
Economies of Scale/LRAC increasing: features of a firm’s technology that lead to falling long-run average as output increases
Diseconomies of Scale/LRAC decreasing: features of a firm’s technology that lead to rising long-run average as output increases
Constant Returns to Scale/LRAC constant: features of a firm’s technology that lead to constant long-run average as output increases
Minimum Efficient Scale/LRAC minimum: smallest quantity of output at which the long-run average cost reaches its lowest point
Perfect Competition - MKT + PKT Demand + TR Graphs
A market in which
- Many firms sell identical products, perfect substitutes, to many buyers
- No restrictions to entry into the industry
- Established firms have no advantages over new ones
- Sellers & buyers are well informed about prices
MKT is price maker, firms are price taker.
MKT Graph shows:
- Demand is not perfectly elastic as substitute goods exist in the mkt
PKT Graph shows:
- Each firm’s output is a perfect substitute
TR Graph shows:
- TR is linear
- MR=P
How to Find Maximizing Output P & Q?
MC = MR
or
TR-TC max difference
In the short run:
- How to Determine of Maximizing Output is Economic Loss or Profit
- How much Economic Loss or Profit
Draw graphs
- P>ATC = Economic Profit
P=ATC = Breakeven Point
P<ATC = Economic Loss - PQ-ATCQ = Economic Loss/Profit
- What is Profit In the Long Run?
- Process that occurs when mkt starts with Profit>0 & Profit<0
Draw Graphs
- Profit = 0, break even point
- Profit>0 = Economic Profit –> Firms enter MKT –> S rise P lowers –> MR=P lowers < ATC –> until P=ATC –> Profit = 0
Profit<0 = Economic Loss –> Firms exit MKT –> S falls P rises –> MR=P rises >ATC –> until P=ATC –> Profit = 0
What is the Temporary Shutdown Point + What is the Economic Loss + Draw Supply Curve
Shutdown Point (AVC = P): when firm is indifferent b/w producing & shutting down temporarily
- Economic Loss = TFC
Economic Loss = TFC + Q(AVC-P) = PQ-ATCQ
Firm supplies shutdown Q or nothing
2 Factors that Shift Demand + Process that Ensues [Draw Graphs]
- Preference (Taste) Rises:
D rises → Pmkt rises → πFirm rises incurring economic profit π>0
Firms enter → S rises → Pmkt falls → QFirm falls
Continues until π=0
Number of firms =Qmkt/QFirm increase
- Technological Advances Lowers Production Cost:
- First firms use it to make economic profit, as more firms begin to use S rises + P falls = MC + ATC shift downwards
- Old-technology firms incur economic losses → some exit market or switch to new technology → new long-run eqm as all firms use new technology
Pmkt rises → QFirm rises until Pmkt=ATCMIN, π=0, all firms use new technology
Long Run Market Supply Curve
As output changes…
Decreasing Cost Industry (External Economies) cost of production decreases, P & D decrease
Constant Cost Industry cost of production constant, P & D constant
Increasing Cost Industry (External Diseconomies) cost of production increases, P & D increase
Monopoly
No close substitutes = no competition
Barriers to entering the market: protects firm from potential competitors
3 Types of Barriers to Entry in a Monopoly Market
- Natural creates a Natural Monopoly: market where economies of scale enable one firm to supply large quantity/the entire market at the lowest possible cost with larger plants, having scope, control & factors of production
See graph: LRAC meets market demand at lower price & cost - Ownership: firm owns a significant portion of a key resource
Ex. De Beers owns 90% of the world’s diamonds - Legal barriers create Legal Monopoly: market where competition & entry are restricted by the granting of law
Public Franchise: Canada Mail
License: driver’s license
Patent: copyright
2 Price Setting Strategies for Monopolies
- Single-Price Monopoly: firm sells goods & services at same price for all customers
- Price Discrimination: firm sells different units of good or service for different prices for different customers
In a Single-Price Monopoly
- How to find max output P & Q
- How much economic profit/loss?
Draw Graphs
- Q=MR=MC, P=D @Q
- Profit=PQ-ATCQ
When is Demand elastic, unit elastic & inelastic? [Draw graphs]
Elastic: e>1, MR>0, TR rises
Unit elastic: e=1, MR=0, TR constant
Inelastic: e<1, MR<0, TR falls
Perfectly Competitive vs Single-Price Monopoly in terms of Long Run Profit & maximizing P & Q
How to Calculate Monopoly Gain + DWL [Draw Graph]
Perfect Competition: profit=0 in long run as firms freely enter & exit market, P=MR=MC Q=MR=MC
Single-Price Monopoly: profit>0 in long run as monopoly has no competitors & can temporarily shutdown or exit if it starts incurring economic loss
Rent Seeking & How Much to Transfer [Graph]
Pursuit of wealth by capturing economic rent - any surplus (producer, consumer, economic profit, etc.)
- Buy a monopoly transfer rent to creator: ATC rises = P to breakeven point, no economic profit & massive DWL
- Create Monopoly: get law on you side, political policies
Price Discrimination & Perfect Price Discrimination [Draw Graphs]
Price Discrimination: Monopoly’s practice of selling different units of a good or service for different prices in the goal of converting all consumer surplus into economic profit by:
1. Identifying & separating different buyer types by discrimination among groups of buyers & units of good
2. Sell a product that cannot be resold
Perfect Price Discrimination: D=MR=P
1. Firm sells each unit of output for highest price each customer is willing to pay so no consumer surplus left
2. Greater economic profit than Single Price Monopoly leads to inefficient rent seeking
Price Ceiling vs Price Floor
Price Ceiling: a regulation that makes illegal to charge above a maximum price
Ex. In housing market = Rent Ceiling
Price Floor: regulation that makes it illegal to trade lower than minimum price
Ex. In labor market = Wage Floor
Minimum Wage + When is it Efficient + Inefficiency + Unfair
Wage Floor
-Ineffective: below equilibrium, market will operate at legal equilibrium
-Effective: above equilibrium, market consequences
Inefficiency - Unemployment:
- Effective min wage is set above equilibrium → QS>QD quantity of labor supplied by workers exceeds the quantity demanded by employers
- Quantity of labor decreases
- Surplus of labor/workers → unemployment (inefficient outcome)
- Less workers are hired than within an unregulated labor market
- Marginal social cost of labor to workers (leisure forgone)>Marginal social benefit from labor (value of goods produced)
- Full Loss Increases: DWL rises + Potential loss from increased job search increases → decreasing workers’ & firms’ surplus
Minimum Wage isn’t Fair:
- Increases the unemployment of rate of low-skilled younger workers as they lack job experience & wages have increased
- Government needs to create more job opportunities
Rent Ceiling + When is it Efficient + Inefficiency + Unfair
Rent Ceiling (R): price ceiling in the housing market
Ineffective above market equilibrium, market will operate at equilibrium legally
Effective below market equilibrium, market consequences
Legal price cannot eliminate the shortage other mechanisms operate:
- Increase in potential loss from search activity: time spent looking for someone with whom to do business, costly,
- Black markets: illegal market that operates alongside a legal market where a price ceiling or other restriction is imposed. Illegal arrangements are made between renters & landlords at rents above the rent ceiling or unregulated market
Inefficiency of Rent Ceiling = Shortage
- Marginal Social Benefit>Marginal Social Cost = QD>QS=shortage
- Deadweight loss arises, producer surplus & consumer surplus shrinks
- Increase in potential loss from increased search activity
Rent Ceilings are Unfair
- Blocks voluntary exchange, generally does not benefit the poor as wealthy offer the highest profit
- Rent ceiling decreases quantity of housing & scarce housing is unfairly allocated by Lottery (the lucky)
First-come first-served (to those with greatest foresight & get their names on the list first)
Discrimination (housing to friends, family members, selected race, sex or political status)
Rent Ceiling + Min Wage Long - Draw Graph
1. Formulate 4 equations
2. Effective or Ineffective
3. At Rceil or Wmin=# What is QD & QS. Surplus or Shortage → effect?Unemployment of people or hours
4. DWL
5. Potential loss of search activity
6. Consumer & Producer Surplus
7. Is it fair?
- Isolate for Q or P
- Equilibrium Qe Pe, Rent Ceiling/Min Wage efficient or inefficient above or below equilibrium
- Sub in Rceil or Wmin in Q equations. Depending on which is greater QD or Qs, surplus or shortage, find difference
- Area of arrow point triangle from Qs to Qe
- Rectangle between CS & PS
- Area of top and bottom triangles
- Blocks voluntary exchange, generally does not benefit the poor as wealthy offer the highest profit
Rent ceiling decreases quantity of housing & scarce housing is unfairly allocated by Lottery, First-come first-served, discrimination
Minimum Wage isn’t Fair
Increases the unemployment of rate of low-skilled younger workers as they lack job experience & wages have increased
Government needs to create more job opportunities
Government Actions
- Price Cap/Rent Ceiling
- Price Floor/Min Wage
- Tax
- Production Quotas + Subsidies
Tax + Tax Revenue + Tax Incidence
Taxes: fee added onto price
Direct: income tax
Indirect: GST, goods & services
Tax Revenue: tax x QS
Tax Incidence: division of tax between sellers & buyers, how much for who as government places tax on sellers who in turn pass tax on buyers
-Buyer Tax Paid=Additional price paid by buyers=original price-price after tax
- Seller Tax Paid=Tax Imposed-Buyer Tax Paid
Buyers Pay Tax: price rises by the full amount of the tax
Buyers and Sellers Share: price rises by a lesser amount than the tax
Sellers Pay Tax: price doesn’t rise at all
Tax Imposed on Seller vs Buyer
Tax Imposed on Seller: supply line shifts left, decreases in supply, price incr. for same quantity
- S+tax=supplies+tax
Tax Imposed on Buyer: demand line shifts left, demand decreases, price willing to pay decreases for same quantity
- D-tax=price-tax
Tax Incidence stays the same no matter imposed on seller or buyer
Tax Incidence & Elasticity of Demand vs Supply + Draw Graphs
Tax incidence depends on elasticities of demand & supply, the steeper the line for D (more inelastic demand) or the more flat the line for S (more elastic supply) the more tax paid by buyers
Perfectly inelastic demand: buyers pay the entire tax, they have must buy good no matter the price
Perfectly elastic demand: sellers pay entire tax, very competitive market so seller must pay all the tax
Perfectly inelastic supply: sellers pay entire tax, must sell quantity of resources already made
Perfectly elastic supply: buyers pay entire tax, supply of resources malleable no rush to sell everything
Intervention in Markets for Farm Products
Production Quota: upper limit to the quantity of a good that maybe produced (rent ceiling)
- Inefficient Set Below Equilibrium:
Marginal social benefit=market price increases
Marginal social cost has decreased
Production is inefficient & producers have an incentive to cheat
Subsidy: payment made by government to a produce (opposite of tax) causes overproduction loss for society
- Inefficient Overproduction: marginal social benefit = market demand price decreases. Marginal social cost increases, exceeding marginal social benefit
Imports + Exports + Driver
Imports: g+s bought from other countries
Exports: g+s sold to other countries
National Comparative Advantage: ability of a nation to produce or perform g+s at a lower opportunity cost than any other nation
Import Question - Draw Graph
1. How much Canadians produce, consume how much should be imported
- Who are losers & winners = compares before & after consumer vs producer surplus
- Is the country losing or gaining = compare total surplus, by how much?
Imported good lowers in price.
- QD-QS
- Area of CS Top Triangle, PS Bottom Triangle
- CSAT-CSBT vs PSAT-PSBT
- (TSAT=CSAT+PSAT)-(TSBT=CSBT+PSBT)
Import Tariff - Draw Graph
- Suppose Tariff=#, How much produced domestically (QS), consumed (QD)
- Total Price After Tariff rest of world (ROW)
- After Tariff Import Quantity
- Total Tariff Revenue
- Losers & Winners Consumers, Producers, Society
- DWL = Loss From Tariff
- Ranking 3 types of trade by most beneficial to society
Import Tariff: Pw rises, tax on imported good to promote domestic producers and earn government revenue
- Produced domestically Qs, Consumed domestically QD
- WP+Tariff
- QD-Qs
- Tariff x QAT
- CSAT+ PSAT + TR
- Compare CSAT-CSBT & PSAT-CSBT, TSAT-TSBT
- Canadian consumers lose (higher P lower Q bought), Canadian producers gain (cost of producing lower than P so more shirts produced), Society loses from arising deadweight loss (production costs increased and decreased imports) - TSFree Trade-TSAT
- Free trade, tariff, domestic
Import Quota - Draw Graph
- Supply Source, domestic or ROW
- Domestic Supply
- Profit for importer
- DWL
- Winners & Losers Consumer, Producer, Society
Import Quota: maximum quantity units that can be imported in a given period
- If PDom<Pw($5), supply will come from domestic → QS stays same
If PDom > Pw($5), supply will come from domestic & ROW for Quota# unit → QS=___+Quota#
- Qe-1
- Area of small square
- Area of 2 small triangles
- Compare CSAQ-CSBQ & PSAQ-PSBQ, (TSAQ=CS+PS+Importer Profit)-TSBQ(=CS+PS)
- Canadian consumers lose (higher P lower Q bought), Canadian producers gain (cost of producing lower than P so more shirts produced), Society loses from arising deadweight loss (production costs increased and decreased imports)
Export Question = Draw Graph
- How much Canadians will produce, consume and exported
- CS, PS, TS no Trade
- Winners & Losers Consumer, Producer Society
Increases price of an exported good.
- QS(produced)-QD(consumed)
- Area of CS top triangle, PS bottom triangle, TS(CS+PS)
- Compare CSAT-CSBAT vs PSAT-PSBAT
- Producers gain (higher P for same Q=more revenue), Consumers lose (more expensive)
Overall Societal Gain = TS Free Trade - TS No Trade
Export Restrictions
Subsidy: payment by government for a domestic producer of an exported good, production cost decreases so domestic supply increases → domestic over production, international underproduction creating DWL
Others: health, safety restrictions
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
=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: an increase in GDP deflator (prices) reduces equilibrium GDP, 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.
