economics notes chapters 15 backwards

7/30/2019 Economics Notes Chapters 15 Backwards

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Economics Notes:

Chapter 14 Monetary Policy:

14.1

More supply = Less Buyers therefore prices will decline = Less demand

moresupply and vice versa - greater supply, lower the interest rate= excess supply (pricedecreases) therefore less consumers and vice versa.

Supply volume of notes in circulation

Monetary policy supply of money and the interest rates (interlinked)

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Monetary policy is concerned with the changes in the supply of money and credit. Itrefers to the policy measures undertaken by the government or the central bank toinfluence the availability, cost and use of money and credit with the help of monetarytechniques to achieve specific objectives tool used to regulate money supply

Monetary policy aims at influencing the economic activity in the economy mainlythrough two major variables, i.e., (a) money or credit supply, and (b) the rate ofinterest.

The techniques; of monetary policy are the same as the techniques of credit controlat the disposal of the central bank. Various techniques of monetary policy, thus,

include bank rate, open market operations, variable cash reserve requirements,selective credit controls.

The monetary policy is defined as discretionary action undertaken by the authoritiesdesigned to influence (a) the supply of money, (b) cost of money or rate ofinterest and (c) the availability of money."

Monetary policy is not an end in itself, but a means to an end. It involves themanagement of money and credit for the furtherance of the general economic policyof the government to achieve the predetermined objectives.

Various objectives or goals of monetary policy are:

Neutrality of Money (change in supply affect nominal (no inflationadjusted) variables= prices, wages, exchange rates) not affect real

variables like employment, real GDP and real consumption. supply ofmoneywont affect things like employment, real GDP and realconsumption.

Price Stability

Economic growth
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Exchange Stability stable exchange rates

Full Employment(when everyone has employment)

Federal reserve system chapter 14

14.1

The Federal Reserve has several goals intended to promote a well-functioning economy:(1) price stability,(2) high employment,(3) economic growth,(4) financial market stability,(5) interest rate stability, and(6) foreign-exchange market stability.

Fluctuations in inflation can also arbitrarily redistribute income, as when lenders suffer losseswhen inflation is higher than expected. (1) price stability

In practice, the Feds goal of price stability means that it attempts to achieve low and stableinflation rather than zero inflation. With low and stable inflation, market prices efficiently allocateresources in the economy, so the economy is more productive and living standards are higher inthe long run.(1)

(2) high unemployment unemployment means GDP is below its potential level and causesfinancial distress and decreases self-esteem for workers who dont have jobs.

(2)- Aim is not necessarily for zero unemployment because there will be cyclical unemployment atsome stages. If there was zero unemployment, cyclical unemployment would be negative therebymaking the real GDP exceed the potential GDP tremendously.

(2)- The major aim is to keep the cyclical unemployment as close as possible to zero. The actual

unemployment rate needs to be in proportion with the natural rate of unemployment

(3) economic growth policymakers want stable economic growth because it allowshouseholds and firms to plan accurately and helps encourage long-run investment which inreturn produces and sustains growth. It is the only source for an increase in real incomes.

(3)economic growth will allow for greater savings for the purpose of investment funds as wellas business investment.

(3)-High employment facilitates economic growth. As a result, businesses are likely to be moreconfident that demand for their products will remain strong, and so will be willing to engage in thelong-term investment necessary for growth. In brief high employment produces economic growthand therefore increases the demand for products thus at the same time long-term investment

rises to produce economic growth. All this is because of high employment since more workers areemployed to produce more.

(3)With high unemployment, businesses have unused productive capacity and are much lesslikely to engage in long-term investment.

(3) - Stableeconomic growth - stable business environment - allows firms and households to planaccurately -encourages the long-term investment - sustain growth.


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(4) financial markets and institutions not efficient in matching savers and borrowers = loss ofresources

(4)Efficient flow of funds from savers to borrowers= Firms with the potential to producehigh-quality products and services cannot obtain the financing they need to design, develop, andmarket these products and services. Savers waste resources looking for satisfactory investments.

Commercial banks borrow from households and firms in the form of checking and savingsdeposits, while investment banks borrow primarily from other financial firms, such as otherinvestment banks, mutual funds, or hedge funds, which are similar to mutual funds but typicallyengage in more complex-and risky-investment strategies. (4)

14.2

The Fed aims to use its policy tools to achieve its monetary policy goals. Recall from Chapter 13

that the Fed's policy tools are open market operations, discount policy, and reserverequirements.

At times, the Fed encounters conflicts between its policy goals. For example, as we will discusslater in this chapter, the Fed can raise interest rates to reduce the inflation rate. But, as we saw inChapter 12, higher interest rates typically reduce household and firm spending, which may resultin slower growth and higher unemployment.

So, a policy that is intended to achieve one monetary policy goal, such as reducing inflation, mayhave an adverse effect on another policy goal, such as raising employment.

The two main monetary policy targets are the money supply and the interest rate. As we will see,the Fed typically uses the interest rate as its policy target.

Inflation is caused by the demand and supply of money. (macroeconomic) if the supply is moreand output produced is less the companies will want to make excessive profit and thereforeinflation rises and vice versa.

So people dont make excessive profits so they basically rise the interest rates in order to reducethe excessive supply of money. (when inflation rises or is high)

Inflation high = reduce the supply of money increase interest rates and vice versa when there isdeflation

If inflation is high, prices rise because of the demand and supply of goods. Demand is greatertherefore higher prices for greater profit (seller) but for the buyer itll be expensive. Inflation

increases due to profit incentive by seller. (microeconomics)

Interest rates decline qty. money dd. Increases central bank ; print more notes (increasemoney supply = to meet the demand)its a possibly to increase inflation; less demandfor money = less inflation

In a nutshell = higher interest rate less inflationary it is demand for money reducesinterest rate has gone up demand for money reduced supply of money will matchdemand of money less demand = less supply lower inflation and vice versa.


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Changes in variables other than the interest rate cause the demand curve to shift. The two most importantvariables that cause the money demand curve to shift are real GDP and the price level.

Real GDP increase = quantity of goods and services produced increase - An increase in real GDP meansthat the amount of buying and selling of goods and services will increase = produces employment,investment and greater demand/supply for money.

This additional buying and selling increases the demand for money as a medium of exchange, sothe quantity of money households and firms want to hold increases at each interest rate, shiftingthe money demand curve to the right. A decrease in real GDP decreases the quantity of moneydemanded at each interest rate, shifting the money demand curve to the left.

Real GDP Increase = More buying and selling of goods/services = Greater quantity demand formoney = Shifts the money demand curve shifts to right interest rates will rise- because of thispeople will hold more money esp. the consumers to earn greater interest whereas the banks willearn interestabove in brief

An increase in the price level increases the quantity of money demanded at each interest rate,shifting the money demand curve to the right. A decrease in the price level decreases the quantityof money demanded at each interest rate, shifting the money demand curve to the left.

(Real GDP increases more demand for goods/services demand curve shifts to right quantitydemanded for money will increase therefore this will increase price level leads to shift)above in brief

Increase in supply of money (shift in curve) decline in interest rates more supply of moneyless borrowers less interest rate due to less demand

For simplicity, we assume that the Federal Reserve is able to completely fix the moneysupply. Therefore, the money supply curve is a vertical line, and changes in the interestrate have no effect on the quantity of money supplied.

Just as with other markets, equilibrium in the money market occurs where the money

demand curve crosses the money supply curve.

To summarize: When the Fed increases the money supply, the short-term interestrate must fall until it reaches a level at which households and firms are willing tohold the additional money. Extra supply of money thats bought into the systemhas to be absorbed = people who will borrow/need money = provided you dropyour interests. excess supply money generated (e.g. in this case 900 950 = $50billion excess supply) in the banking system has to be used by someone ; supplyof money increased == interest rate will fall down

We discussed the loanable funds model of the interest rate. In that model, theequilibrium interest rate is determined by the demand and supply for loanable funds.

Loanable funds model is concerned with the long-term real rate of interest and moneymarket model is concerned with the short-term nominal rate of interest.

The long-term real rate of interest is the interest rate that is most relevant when savers considerpurchasing a long-term financial investment such as a corporate bond. It is also the rate ofinterest that is most relevant to firms that are borrowing to finance long-term investment projectssuch as new factories or office buildings, or to households that are taking out mortgage loans tobuy new homes.


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When conducting monetary policy, however, the short-term nominal interest rate is the most

relevant interest rate because it is the interest rate most affected by increases and decreases inthe money supply.

So, when the Fed takes actions to increase the short-term nominal interest rate, usually the long-

term real interest rate also increases.

When conducting monetary policy, however, the short-term nominal interest rate is the mostrelevant interest rate because it is the interest rate most affected by increases and decreases inthe money supply short term policy is accurate are dictated by demand and supply andtherefore it helps in predicting of what will happen in the long run.

Federal/central bank (Print currency-e.g. Bank of England, Reserve Bank of India Govt. Mint)banks under them are told to lend 90% of the deposit to the customers. The balance 10% is leftwith the federal/central bank.- not relevant for households

Fed uses monetary policy targets to affect economic variables such as real GDP or the pricelevel, that are closely related to the Fed's policy goals.

The Fed can use either the money supply or the interest rate as its monetary policy target.

The Fed has generally focused more on the interest rate than on the money supply.

There are many different interest rates in the economy. For purposes of monetary policy, the Fedhas targeted the interest rate known as the federalfundsrate.b/w banks interbank call rate

The federalfunds rate is the interest rate banks charge each other on loans in the federalfunds market. The loans in the federal funds market are usually very short term, often justovernight.

The federal funds rate is not set administratively by the Fed . Instead, the rate is determined by

the supply of reserves relative to the demand for them.

Fed can increase and decrease the supply of bank reserves through open marketoperations, it can set a target for the federal funds rate and usually come very close tohitting it.

Only banks can borrow or lend in the federal funds market.

However, changes in the federal funds rate usually result in changes in interest rates on othershort-term financial assets, such as Treasury bills, and changes in interest rates on long-termfinancial assets, such as corporate bonds and mortgages.

The effect of a change in the federal funds rate on longterm interest rates is usually smaller than

it is on short-term interest rates, and the effect may occur only after a lag in time.

14.3

Fed uses the federal funds rate as a monetarypolicy target because it has good control ofthe federal funds rate through open market operations (short term nominal interest rate)


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And because it believes that changesin the federal funds rate will ultimately affect economicvariables that are related to its monetary policy goals.

Recall that we calculate the real interest rate by subtracting the inflation rate from the nominalinterest rate.

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)

We will assume that the Fed is able to use open market operations to affect long-term realinterest rates. = depends on the ability to affect real interest rates such as real interest rates onmortgages and corporate bonds.

A nominal variable, such as a nominal interest rate, is one where the effects of inflation havenot been accounted for. Real interest rates are interest rates where inflation has beenaccounted for.

Changes in interest rates affect aggregate demand i.e. the total level of spending inthe economy

How Interest Rates Affect Aggregate Demand: Consumption, Investment, Net exports

Consumption = lower interest rates increased spending on durables

total cost of these goods to consumers is lower since interest payments on

loans are lower and conversely higher interest rates increase cost ofdurables households buy fewer of them

Consumption higher rate = save more and spend less and vice versa for

lower rate. This is concerning the interest rate.

Investment = firms finance spending on machinery, equipment andfactories by profits or borrowing

Investment= firms either borrow from banks or borrow from financialmarkets by issuing corporate bonfs

Investment= higher and lower interest on corporate bonds or bank loans

works the same way.

Investment= lower interest rates - increase in investment in stocks(compared to bonds) - stocks more attractive as an investment - increase

in stock prices - future profitability of investment projects (increased) -

firms issue more stocks and acquire funds - all due to increased demandand potential

Investment= spending by households on new homes when interest rateson mortgage loans rises/falls less/more homes will be purchased.

Net exports= value of $ rises (home currency) = (appreciates) exportswill be expensive in other countries (goods produced in USA will beexpensive) thereby making the imports cheaper (foreign currency) since the

home currencys ($) can purchase more of a currency as the rates have

declined.


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Net exports = interest rates rise in USA greater than other countries=investment in USA assets will be desirable as a result foreign investors will

demand for $s and will increase value of $ and therefore exports will bepricey and will fall and vice versa happens.

EFFECTS OF MONETARY POLICY ON REAL GDP AND PRICE LEVEL

INTEREST RATE INCREASE CONSUMPTION FALLS OUTPUT AND DEMAND DROP =THEREFORE GDP DROPS AND VICE VERSA.

AGGREGATE DEMAND in a has shifted from point A to B because the money supply has beenincreased which results into interest rates therefore shift in demand from A to B (expansionarymonetary policy) increasing supply of money and reduce interest rates = aggregate demandhas moved up it means aggregate supply has to match it up. Firms and companies will have toinvest more. Demand = Supply more investment therefore more employment that Is what hasled to increase in GDP and price level.

Contractionary policy = the aggregate demand shifts downwards and the price level decreasesso does the real GDP. In this case at point B it is the potential GDP and A is the actual/currentlevel. Real gdp and price levels fall.

Real gdp > potential gdp = inflation = excessive demand which supply cannot meet thereforeprices rise (contractionary policy)the prices will drop therefore leading to price stability

GOALS: PRICE STABILITY & HIGH EMPLOYMENT IN THE SHORT RUN AFFECTS PRICELEVEL AND THE REAL GDP.

In the basic version of the model, we assume that there is no economic growth, so the long-runaggregate supply curve does not shift.

CAN CENTRAL BANKS ELIMINATE RECESSIONS IN A COUNTRY?

Central bank can reduce the length of recession but not eliminate them. If to be successful =sharp in understanding demand and supply of money and play with interest rates to control theeconomy.

It only reacts to the situation and dont know demand and supply of lending by consumers.


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14.4

Interest rate increase/decrease has an inverse relation with price, GDP and aggregate Demand

Equilibrium = aggregate demand equals the aggregate supply

Pessimistic future cut consumption less output

Potential vs actual consumption = figure 14.9 potential GDP (produced and sold aggregate0 is

14.4. if the fed does not intervene without policy it will be at 14.3. With policy = government has intervened and without policy = government hasnt intervened in

the short run. The aggregate demand 1 is basically the normal one at point B. Point C is potentialGDP - expectation

Short run = without policy = actual consumption is at B govt. doesnt do much about policy. Thisis before the new policy.

Trouble is matching inflation and increasing demand inflation low and employment 100% =target of the govt.

Interest rates drop = inflation rises

14.5

Interest rates drop = inflation rises

Remember that the Fed controls the money supply, but it does not control money demand.Money demand is determined by decisions of households and firms. (Cant get into consumerhead- therefore no control)

Chapter 15 Fiscal Policy:

15.1

"To promote maximum employment, production, and purchasing power."

Also make changes in taxes and government purchases to achieve macroeconomicpolicy objectives, such as high employment, price stability, and high rates of economicgrowth.

Changes in taxes and govt. spending that are intended to achieve macroeconomic policyobjectives (above 3 objects) are called fiscal policy.

Collect sufficient money in terms of taxation (direct/indirect) that money is spent ingovt. spending

Automatic stabilizers: the ones which happen without govt. intervention as they go along

with the business cycle change spending or taxes and discretionary fiscal policy =when govt. changes spending or taxes - - discretion: hands of individual (govt. actions)

in this context to increase spending

In addition to purchases, there are three other categories of government expenditures:interest on the national debt, grants to state and local governments, and transferpayments


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Interest on national debts expenditure when govt. are in deficit and pay loans andalong with that an interest

Grants to govt. = aids

Transfer payments = unemployment insurance, social security, medical care etc.

15.2 + 15.3

Because changes in government purchases and taxes lead to changes in aggregatedemand, they can affect the level of real GDP, employment, and the price level. Whenthe economy is in a recession, increases in government purchases or decreases intaxes will increase aggregate demand.

As we saw in Chapter 12, the inflation rate may increase when real GDP is beyondpotential GDP. Decreasing government purchases or raising taxes can slow the growthof aggregate demand and reduce the inflation rate.

The inflation rate may increase when real GDP is beyond potential GDP. Decreasinggovernment purchases or raising taxes can slow the growth of aggregate demand andreduce the inflation rate.

Real GDP inflation adjusted prices

LRAS Long run aggregate supply


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FIGURE 15.6 = economy began at A economy has a potential to go to C in case thegovt. uses expansionary policy and thats where the SRAS, LRAS and AD curve allinteract together (use expansionary policy). At point Bdont use expansionary policy the equilibrium will be B which is below the potential GDP which is point C. real gdpindicating potential gdp missed the target of reaching the potential GDP despite

favourable conditions. (C- Potential GDP SRAS + LRAS + DEMAND real GDPconsidered if it goes to that point) AT B short run supply (15.3) = expansionary fiscalpolicy

-

EQUILIBRIUM = DEMAND AND SUPPLY INTERSECTION

15.4

Multiplier effect = govt. uses discretionary fiscal policy measure chain reactions

Effects of change in tax rates higher the taxes lower/poorer the multiplier effecttherefore effect wont be large affects their disposable incomes

When the government increase expenditure = aggregate demand rises increase inconsumer spending

Figure 15.10 = the govt. tries to raise consumption = shift from a c indicates that at c =lras, sras and dd. All interact with each other

15.5

Timing of fiscal and monetary policy matters because in the case the economy hasused contractionary fiscal policy in an economy thats moved into recession will makethe effects worse and whereas if the economy has come out of recession and usingexpansionary fiscal policy means the inflation rise. Thereby causing more harm thangood.

Chapter 12 ad and as

12.1 = AGGREGATE DEMAND

Aggregate demand - level of planned aggregate expenditure in t he economycomprises of C + I + G + NX = in this case all factors are constant and price isnt

Decline in price = Rise in C + I + NX (Why AD is downward sloping?)

Rely more on monetary makers take actions within it to curtail the bad effects of thebusiness cycle reduce cyclical unemployment

Interest rate and money supply

A rule or formula that a central bank uses to set interest rates in response to changingeconomic conditions.

Aggregate supply = the total quantity of goods and services that firms are willing tosupply.

Goal of central bank (monetary policy) = price stability lower inflation

Interest rate and inflation rate = directly proportional increase interest rate to curtaildemand and vice versa

Monetary policy rule = central bank response to changes


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Certain goals will contradict with inflation goals and thereby causing problems

Short term nominal interests will affect long term real interest rates

Nominal interest = In finance and economics nominal interest rate or nominal rate ofinterest refers to the rate of interest before adjustment for inflation

Real interest = adjusted for inflation actual worth of the money in the real world realworld example

A higher real interest rate also increases the exchange rate between the U.S. dollar and foreigncurrencies, which reduces net exports.

Because aggregate expenditure and real GDP decrease as the real interest rate increases, thereis a negative relationship between the real interest rate and the quantity of real GDP demandedby households and firms.

A curve that shows the relationship between aggregate expenditure on goods and servicesby households and firms and the inflation rate.

Aggregate demand curve downward sloping = WEALTH EFFECT, INTEREST RATE EFFECT,INTERNATIONAL TRADE EFFECT (SEE REFERENCE)

EXTRA: Chapter 9 IS/MP Below

Chapter 9 IS MP = EXTRAAA

The ISMPmodel is a macroeconomic model that analyzes the determinants ofreal GDP, theinflation rate, and the real interest rate in the short run.

What determines = real GDP, inflation rate and real interest rate in the short run


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The ISMPmodel explains the main reasons real GDP fluctuates and to allow us to understandthe key aspects of monetary policy and fiscal policy reasons of real GDP fluctuation and alsostudy of fiscal and monetary policies

IS = Aggregate supply

MP = Monetary policy change in interest rates

12.2a = measure of x axis represents output simply

Y axis = real interest rate

Output gap = difference b/w output from one point to another output

A and B a change in monetary policy and real interest rate results in quick change in ADcurvettherefore output gets reduced in both the curves.

In deriving the ADcurve, we assumed that the IScurve would remain constant. Anything thatcauses the IScurve to shift to the right will cause the ADcurve to shift to the right, and anythingthat causes the IScurve to shift to the left will cause the ADcurve to shift to the left.


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Aggregate demand - level of planned aggregate expenditure in t he economy

Rely more on monetary makers take actions within it to curtail the bad effects of thebusiness cycle reduce cyclical unemployment

Interest rate and money supply


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SHIFTS IN AD CURVE =

If any other variable other than price changes then its a shift in the curve

A change in the monetary policy rule will also cause the ADcurve to shift.

There are two key components of the monetary policy rule: the inflation target and the sensitivityof the real interest rate to the inflation rate.


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SHIFTS IN AD CURVE =

autonomous consumption = An expenditure that doesnt depend on the level of GDP

Certain bills and expenses are deemed to be autonomous (or independent), such as electricity,food and rent, because these expenses cannot ever be entirely eliminated whether you have

money or not. Even in the worst-case financial scenario, you would still need to eat and have aplace to live. If a consumer's income were to disappear for a time, he or she would have to dipinto savings or increase debt in order to pay these expenses, which is also known as being in a"dissaving mode". = Autonomous consumption

Changes in autonomous consumption, investment, and government purchasesof goodsand services, changes in taxes and transfer payments, and changes in net exports. =Factors

Factors in brief = change on govt. policies change in expectations of households andfirms changes in foreign variables

Factors = monetary policy change interest rates consumption and investment willchange leads to a shift in curve (govt. policies)

Factors= fiscal policy means changes in federal taxes and purchases shift the curve(govt. policies)

Govt. policies change in household expectations and firms change in foreign variables

Govt. policies= monetary and fiscal policymonetary: reduce interest rates lower borrowingcosts higher consumption and investment spending shifts curve to right

Continued = fiscal policy is changes in federal taxes and purchases to achieve macroeconomicpolicy objectives = high employment, price stability and high rates of economic growth

Fiscal policy = govt. purchases are part of aggregate demand an increase/decrease in this

variable will lead to shifts accordingly and the same for personal income taxesincrease/decreases spendable/disposable income available to households and as well businesstaxes in brief = govt. purchases personal income taxes business taxes = disposable income end of govt. policies interest rates/govt. purchases and personal income/bus taxes asa whole

Changes in expectations of households and firms = if households more optimistic aboutfuture incomes they are likely to increase their current consumption leading to shift to theright and vice versa for pessimistic. The same logic applies to firms who are optimistic orpessimistic about the future profitability of investment spending (firms expectations) leadsto rise in investment spending

Changes in foreign variables =an increase in net exports at every price level = shifts

aggregate demand curve to the right and if real GDP grows more slowly than in othercountries or if value of dollar falls against other countries (DROP IN HOME CURRENCYVS. FOREIGN CURRENCY) leads to shift in the demand curve


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12.2 = AGGREGATE SUPPLY

Definition = Effect of changes in price level on quantity of goods and services that firmsare willing and able to supply.


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As aggregate expenditure (demand) rises the real GDP rises up therefore causingcapacity constraints as a result firms raise prices leading to a shift in inflation accordingto the graph and the output gap is lesser than before

Demand shock difference between real and potential GDP = capacity constraintsleads to rise in inflation rate

Supplyshock price of a key input rises leads to an increase in inflation rate


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SHIFTS IN THE AGGREGATE SUPPLY

Increase in labor force and capital stock = if there are more workers and physicalcapital supply more output at every price level and shifts to rightcosts ofproduction at every level of output

Technological change = increase in productivity as a result more output with sameamount of labor and machinery reduces cost of production and more output at everyprice and shifts to the right.costs of production at every level of output

Expected changes in future price level = if price levels rise then workers and firms willtry to adjust their wages and prices accordingly. In final if workers and firms expect pricelevel to increase by a certain %, the SRAS curve will shift by an equivalent amount(inflationary expectations)

Adjustments of workers and firms to errors in past expectations about the pricelevel = wrong predictions therefore leads to compensate for those errors if price levelhigher than expected shifts to the left and vice versa (inflationary expectations)

Unexpected changes in the price of an important natural resource = if naturalresource price rises therefore the costs of production will rise for these firs and it leadsto firms facing rising costs and they will supply same level of output at higher pricethereby shifting to the left. It is a supply shock which is caused by an unexpectedincrease/decrease in the price of an imp. Natural resource or in other words an

unexpected event that causes the short-run aggregate supply curve to shift


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LRAS =LONG RUN AGGRGATE SUPPLY CURVE (potential GDP or fullemployment GDP in the Long run)

The level of real GDP is determined by = number of workers, the capital stock(factories, office buildings, machinery and equipment plus the technology) these arethe determinants

Changes in price level dont affect no. of workers, capital stock, machinery andequipment or technology in the long run = therefore changes in price level dontaffect the level of real GDP but factors other than price which are mentioned above willlead to the shifts.

Shifts occur because = the potential real GDP increases each year as the number ofworkers, capital stock, machinery and equipment and technology increase.

BOTTOMLINE = IN THE LONG RUN CHANGES IN PRICE LEVEL DONT AFFECTTHE LEVEL OF REAL GDP AND LEVEL OF GDP IN LONG RUN = POTENTIALGDP/FULL-EMPLOYMENT GDP

SUPPLY SHOCK IN DETAIL BY GRAPHS (details later12.3)


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SRAS AND AD CURVES (12.1+12.2)

SRAS

Price increases = quantity of goods and services firms are willing to supply willincrease

As prices of goods and services rise price of inputs workers + resources risemore slowly and then profits rise when the revenue gained from sellng is greaterthan the costs faced by firms

AD: WHY IS IT DOWNWARD SLOPING?

Wealth effect: How a change in the price level affects consumption; when the pricelevel rises accordingly the real value of household wealth declines and so will

consumption and vice versa when the price level falls down. Impact of the price levelon consumption = wealth effect

Interest rate effect: How a change in the price level affects investment; higher pricemeans households and firms need more money to finance buying and selling andtherefore borrowing and selling financial assets and withdrawals from banks are at itspeak. The bottom line is:A higher interest rate on the bottom line means greater costof borrowing for firms and households and therefore less borrowing as a resultconsumption will decline and the opposite holds true. Esp. for firms

International trade effect: How a change in the price level affects net exports; lowprices in home country means net exports rise and vice versa when prices are high. Itsthe impact of the price level on net exports is known as international trade effect


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12.3: Macroeconomic Equilibrium in the Short and LongRun

SUPPLY SHOCK

Supply Shock = in the short run increase in natural resource price shifts supply toleft to a lower real GDP and a higher price level and this leads to inflation andrecession due to less output it is stagflation in this case.

Plus in addition to that in the long run because of the stagflation which leads toincrease in inflation as well as unemployment means workers accept lower wages

and firms will accept lower prices. It leads to a shift in supply from the recessionpoint when it shifted to the left in short run to the equilibrium when potential GDPis at original price level = Supply shock

Alternative to deal with the above is to use monetary and fiscal policy to shift ADto the right whereas above dealt with the AS only!


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EXPANSION

SHORT RUN of an increase in AD and adjustment back to potential GDP in thelong run: Firms are more optimistic about future profitability of investment thereforeincrease in investment shifts AD to the right and will be above potential real GDP. Firmsin here are operating beyond their normal level of capacity and some workers areemployed. In this case from AD1 to AD2 is the shift in demand. BOTTOM LINE = AD1to AD2 is the short run equilibrium Therefore workers and firms adjust o higher

price levels workers demand higher wages = firms will charge higher pricesinflation rate rises in brief higher inflation, increased real GDP and lowerunemployment rate inflation rate rises leads to AS curve shifts and point C is theequilibrium where real GDP = potential GDP. Therefore NO OUTPUT GAP!!!! A =OLD EQUILIBIRUM AND C = NEW EQUILIBRIUM at C = higher inflation nochange in unemployment

Adjustment back to potential GDP in the long run = also known as automaticmechanism because it occurs without government interference and also an alternative isto use both policies to shift AD curve to right in order to restore potential GDP morequickly.


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RECESSION

SHORT RUN of an increase in AD and adjustment back to potential GDP in the

long run: Firms are more optimistic about future profitability of investment thereforeincrease in investment shifts AD to the right and will be above potential real GDP. Firmsin here are operating beyond their normal level of capacity and some workers areemployed. In this case from AD1 to AD2 is the shift in demand. BOTTOM LINE = AD1to AD2 is the short run equilibrium Therefore workers and firms adjust o LOWERprice levels workers demand LOWER wages = firms will charge LOWER pricesinflation rate FALLS in brief LOWER inflation, LOWERED real GDP and HIGHERunemployment rate inflation rate FALLS leads to AS curve shifts and point C isthe equilibrium where real GDP = potential GDP. Therefore NO OUTPUT GAP!!!!A = OLD EQUILIBIRUM AND C = NEW EQUILIBRIUM at C = higher inflation nochange in unemployment

In this case it is a decline in investment (RECESSION) that causes the shifts indemand curves - IMPORTANT CONSLCUSION = DECLINE IN AGGREGATEDEMAND = IN SHORT RUN: RECESSION AND IN LONG RUN = DECLINE IN PRICELEVEL

THE OPPOSITE HOLDS TRUE FOR A RISE IN INVESTMENT I.E. EXPANSION

Chapter 11 Output and expenditure in the short run:

11.1

In this case it is talking about the aggregate expenditure which is C+I+G+NX and itis equated to real GDP in the short run thereby price level is constant in the short

run. The level of GDP is determined by aggregate expenditure.

AE = C + I + G + NX

C = Spending by households on goods and services

I = planned spending by firms on capital goods and households on newhomes and in this case it is assumed planned equals the actual spending forcapital goods but not for inventories.

I = Changes in inventories are a part of investment since there is a difference

between planned and actual inventory spending. In terms of business plan tospend.

G = It is the spending by the governments: (local/state/federal)

NX = exports imports (trade balance)


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Therefore actual investment = planned investment when there is nounplanned change in inventories in this case we are referring to amacroeconomic equilibrium.

Macroeconomic equilibrium in this case is when the aggregate expenditure =GDP that is total spending = total production and in this case economicgrowth is zilch. Things go as per plan.

When aggregate expenditure> GDP the spending is greater than productionand selling more goods/services than expected and vice versa when GDP isgreater.

In the fridge example if the opening stock is at 50 and the closing stock is at20. This indicates to us that sales are high and therefore an unplanned changein inventories since inventory drops by 30 units. Therefore there will be moreordering of fridges which will increase production and therefore an increasein number of workers to hire if it affects all the sectors in the economy such as

appliances, furniture, transportation etc.

The above situation reflects to us when Aggregate Expenditure >GDP and GDP and employment rise and inventories fall down and

vice versa when aggregate expenditure < GDP.

MACROECONOMIC EQUILIBRIUM: AGGREGATE EXPENDITURE= GDP no change in inventories

11.2

The factors behind consumption are:o disposable income,o household wealth (assets liabilities),o price level ando Interest rate levels in real termso taking into account inflation - interest rate and price levelo Plus expected future income.

Consumption function is the relationship b/w disposable income andconsumption.

Marginal propensity to consume

change in consumption/ change indisposable income

Marginal propensity tosave change in saving/ change in disposable income

The consumption function gradient is the MPC which determines how muchspending/consumption happens when income changes.


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Another model of consumption function with the exception being thatdisposable income at x axis is replaced by the real GDP or real national income. relation b/w consumption and national income

Disposable income = national income net taxes

income , consumption and savings = national income change inconsumption + change in savings + change in taxes - Y= C+S+T

Continued from above = change in income equates to = change in consumption +change in savings and taxes are removed since they are assumed zero and areconstant.

Marginal propensity to save + marginal propensityto consumer always haveto equal 1 when taxes are constant. Since change in consumption and savings aredivided by disposable income and the same for national income above

Planned investment determinants:o future profitability or expectations about future profits,o cash flow,o interest rate ando Taxes.

Net exports determinants :

o Exchange rateo Growth rate compared to other countrieso Price level compared to other countries

11.3 + 11.4+ 11.5need help upon on understanding graphs

45 degrees line is where aggregate expenditure equals to real GDP known asmacroeconomic equilibrium

The iteration of chart is of consumption function with AE on x axis and real GDPon the y axis

Macroeconomic equilibrium is when C+I+G+NX = AE bottles sold equals theGDP (real) bottles produced and also where Y=AE AND AE line equal is theequilibrium real GDP/macroeconomic equilibrium

Above 45 degrees line= planned expenditure > GDP decrease ininventories and vice versa when below 45 degrees line

Changes in GDP have great impact on consumption than plannedinvestment, govt. purchases and net exports since they are assumed to

be constant

Variables that determine investment, purchases and exports remainconstant

The AE line represents expenditure in aggregate.


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GDP = AE is the grey line which is Y = AE

How does a decrease in government spending affect the aggregate expenditure line?A) It shifts the aggregate expenditure line upward.B) It shifts the aggregate expenditure line downwards

C) It increases the slope of the aggregate expenditure line.D) It decreases the slope of the aggregate expenditure line


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If the U.S. economy is currently at point N, which of the following could cause it to move topoint K?A) Households expect future income to decline.B) Household wealth rises.C) The firm's cash flow rises as profits rise.D) Government expenditures increase.

If the U.S. economy is currently at point K, which of the following could cause it to move to

point N?A) The price level in the United States rises relative to the price level in other countries.B) Congress passes investment tax incentives.C) The interest rate rises.D) Household wealth declines.

Suppose that the level of GDP associated with point N is potential GDP. If the U.S. economy iscurrently at point K,A) firms are operating above capacity.B) the economy is at full employment.C) the economy is in recession.D) the level of unemployment is equal to the natural rate.


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Suppose that investment spending increases by $10 million, shifting up the aggregateexpenditure line and GDP increases from GDP1 to GDP2. If the MPC is 0.9, then what is the

change in GDP?A) $9 millionB) $10 million

C) $90 millionD) $100 million

Suppose that government spending increases, shifting up the aggregate expenditure line. GDPincreases from GDP1 to GDP2, and this amount is $400 billion. If the MPC is 0.75, then what is

the distance between Nand L or by how much did government spending change?A) $10 billionB) $100 billionC) $200 billionD) $300 billion


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Potential GDP equals $100 billion. The economy is currently producing GDP1 which is equal to

$90 billion. If the MPC is 0.8, then how much must autonomous spending change for theeconomy to move to potential GDP?A) -$18 billionB) -$2 billionC) $2 billionD) $18 billion

100-90 = 10 *0.8 = 8

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If an increase in investment spending of $50 million results in a $400 million increase inequilibrium real GDP, thenA) the multiplier is 0.125.B) the multiplier is 3.5.C) the multiplier is 8.400/50change in real gdp/change in investment spendingD) the multiplier is 50.

If an increase in autonomous consumption spending of $10 million results in a $50 millionincrease in equilibrium real GDP, thenA) the MPC is 0.5.B) the MPC is 0.75.C) the MPC is 0.8.D) the MPC is 0.9.


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economics notes chapters 15 backwards

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