TEST REVIEW

MACRO UNIT-3

Unit #3 Key Graphs

QtyFood

Qty Shelter

. B

. A

. C

(100, 0)

(0,100)

(50,50)

(100, 0)

(0,100)

(50,50)

AS/AD ModelPPF

AS/AD Short Run Equilibrium• Output deviates only in short run when actual price

level deviates from expected price level

• In long run, wages & prices are not “sticky” and do not affect output (price level has no effect)– Prices/wages become flexible!

Why the AD curve is Downward Sloping

1. The Wealth Effect

2. The Interest Rate Effect

3. Exchange Rate Effect

Y = C + I + G + NX

Shifts in AD Curve• Shifts arise from changes in any of the 4 Determinants of AD

– Consumption– Investment– Government Purchases– Net Exports

AD = C + I + G + NX

AD1

AD2

AD2

PriceLevel

Real GDP = Y

Shifts in SRAS & LRAS Curve

• If PPF shifts => LRAS shifts.– Expected Price Level– Input Prices– Labor– Capital – Natural resources – Technology– Gov’t Incentives Changes in the other 5 variables

Shifts BOTH curves (LRAS & SRAS & PPF)

Shift ONLY SRAS => NOT LRAS

2 Ways to get back to full potential

Inflationary Gap

Contractionary Fiscal PolicyGov’t would raise income taxes => (C↓)Decrease Gov’t Spending (G↓ )

End result: AD shifts left, deficit falls

Classical Economics

At E1 actual price level is HIGHER than expected price level

Expected price level rises, => SRAS decreases

End result: SRAS shifts left

Recessionary Gap

Economy below full outputExpansionary Fiscal Policy

Gov’t would lower income taxes => (C↑) Increase Gov’t Spending (G↑)

End result: AD shifts right, debt rises

LRAS1PriceLevel

RealGDP

AD1

SRAS1

--------------------

P1

Y1 Y*

E1

Savers & Investors• Loanable Funds is where savers & investors meet

– Savers buy securities (bonds)– Investors borrow money

• Savers = Supply curve of loanable funds – Private savings = Firms & households savings– Public savings = government savings (it can be negative!)

– National Savings = Public & Private savings

• Investors = Demand curve for loanable funds– Business demands loans for investment (I in GDP)

Government Budget Deficit

Loanable Funds(in billions of dollars)

0

RealInterestRate

3. . . . and reduces the equilibriumquantity of loanable funds.

S2

2. . . . This raisesReal interest rate

Business Investmentcrowed out!

S1

D

$1,200

5%

$800

6% 1. A budget deficitDecreases supply ofLoanable fundsNational Savings ↓

Government Spending

• Social Security 22.0%• Medicare 14.0%• Medicaid 7.0%• Interest on Debt 6.0%• Defense Spending 18.0%• Homeland Security 1.0%• Education 2.0%• Other 26.0• Total 100.0%

43% of Budget

24% of Budget

THANK YOU!

Not Enough Workers?• The ratio of workers to retirees is falling

– This means less money coming in => more going out