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ECON 4 th Quarter Notes by Yanyan Talusan and Jessie Cruz

Aggregate Demand

- the amounts of real domestic output (real GDP) which domestic consumers (C), businesses (I), governments (G), and foreign buyers collectively (NX) will desire to purchase at each possible price level

- difference between aggregate demand and quantity demand: QD is for household (only for one product), while AD is for all good in the economy, entire economy *aggregate means combined or compounded

AD CURVE

economy *aggregate means combined or compounded AD CURVE *we use price level instead of price since

*we use price level instead of price since we’re analyzing the entire GDP, so we’re using an average of the price of goods and services (not specific)

Components of Aggregate Demand

1. Consumption (C)

2. Investment (I)

3. Government Expenditure (G)

4. Net Export (NX)

Why is it sloping downward?

 

1.

interest-rate effect

 

-

as average price level rises (inflation), real interest rate begins to rise, thus increasing the cost of borrowing

-

firms postpone their investment and households postpone their consumption (because price increase causes people to not buy) until borrowing becomes more affordable

inflation – ↑IR – inflation premium – less investment and less consumption (components of G DP) – ↓GDP

and less consumption (components of G DP) – ↓GDP 2. wealth effect - as average price

2. wealth effect

- as average price level rises, value of assets like stocks, bonds, savings and cash on hand begins to fall

- higher prices reduce the quantity of output purchased

(GDP falls because PPP decreases and people buy less)

inflation – ↓PPP – less consumption (component of GDP) – ↓GDP

3.

foreign sector substitution effect (exchange rate effect)

- when average price of outputs increases, consumers naturally begin to look for similar items produced abroad

- thus, increasing imports of the economy (outflow of cash, more imports, means less net export causing lower GDP since imports are greater than exports)

*NX = (x – m) m>x – negative NX – ↓GDP

DETERMINANTS OF AD

* show shifts (determinants) and movement along the curve (the 3 effects)

1.

change in consumption

 

-

tax hike (shift to left) or tax cuts (shift to the right)

-

optimism about the future (right)

 

-

preferences regarding consumption (right)/saving (left) tradeoff

2.

change in investment

 

-

rate of interest (↑ IR, left / ↓ IR, right)

 

-

optimism (right)/pessimism (left)

-

expansion (right)

-

tax credit and tax incentives (both right)

 

3.

change in government expenditure

-

public goods spending (right)

-

taxes (increase causes left) and transfer payments (right)

4.

change in net export

 

-

foreign income (if economy of other countries strengthens, our country shifts to right for more exports)

-

exchange - rate (imports decrease when currency falls against foreign currency)

-

consumer taste (if it’s domestic then it shifts to the right)

 

GRAPHING

 

1.

congress abolished a 10- year old tax incentive (AD shifts to the left)

P AD 1 AD 2
P
AD 1
AD 2

Y

2. US exchange rate rises, based on US economy (AD shifts to the right)

P AD 2 AD 1
P
AD 2
AD 1

Y

3. a fall in the price level increases value of assets (movement along the AD curve)

P

AD increases value of assets (movement along the AD curve) P Y 4. government replace sales taxes

Y

4. government replace sales taxes to lower rate (AD shifts to the right)

P AD 2 AD 1
P
AD 2
AD 1

Y

5. domestic products become more popular abroad (AD shifts to the right)

P AD 2 AD 1
P
AD 2
AD 1

Y

6. a decrease in price level decreases real rate of interest (movement along the AD curve)

P AD
P
AD

Y

7. foreign trade partners economy crashes (AD shifts to the lef t)

P AD 1 AD 2
P
AD 1
AD 2

Y

8. inflation forecast possible increase in consumer goods (AD shifts to the left)

P AD 1 AD 2
P
AD 1
AD 2

Y

9. average price level decreased (movement along the AD curve)

P AD
P
AD

Y

10. government transfer payments decreased (AD shifts to the left)

P AD 1 AD 2
P
AD 1
AD 2

Y

Aggregate Supply

- the relationship between the average price level of all domestic output (GDP) and the level of domestic output production (AD is consumption)

- all market outputs in the economy

- difference between aggregate supply and quantity supply: QS is for one market only while AS is for all markets in the entire economy (similar to QD relationship with QD)

SHORT RUN VS LONG RUN AGGREGATE SUPPLY

Short Run

Long Run

fixed cost (graph is upward sloping)

variability, future, long term (vertical)

SRAS is upward sloping and P and Y are directly proportional

LRAS is vertical

prices of input (of factors of production) are still not adjusted to the prices of output (finished goods/services)

price of input is already adjusted to the prices of output

economy is not yet operating in its maximum potential, max labor, max output, economy makes more and more

economy is operating at its maximum potential or full employment

Sticky Wage Theory THEORIES

Sticky Wage Theory

THEORIES

Sticky Wage Theory THEORIES

- nominal wage is sticky (constant/not changing) in the short- run because of contracts and expected price level

- if the nominal wage is lower than actual price level of output, production is more profitable (cheaper labor) thus increasing employment and AS

- if the nominal wage is greater than actual price level, firms cut down employment thus decreasing AS

- lower production at lower price

Sticky Price Theory

- real GDP is directly proportional to price

- many price is sticky in the short - run because of menu cost or the cost of changing prices

- firms set sticky prices to their outputs based on the expec ted price level

- if price level increases, firms with menu costs wait to adjust their low price set, demand for output increases therefore increasing AS and employment

Misperceptions Theory

- firms may confuse increasing price level as an increase of their output’s price

- firms see it profitable, so production and employment increase therefore increasing AS

- firms see decreasing price level as a challenge, so it cuts down production and employment

IN CONCLUSION

so it cuts down production and employment IN CONCLUSION Y = output Y N = expected

Y = output

Y N = expected output (natural rate of output)

P = price level

P E = expected price level

P E = P in the long run

P E = expected price level P E = P in the long run * in

* in the long run, sticky wages, prices and misperception will be corrected; economy will be in full employment

DETERMINANTS OF SRAS

economy will be in full employment DETERMINANTS OF SRAS 1. input price   - if input

1.

input price

 

-

if input price falls, SRAS increases

 

-

if input price increases, SRAS decreases

2.

tax policy
tax policy

-

if supply- side taxes are lowered, SRAS increases

-

if supply- side taxes are increased, SRAS decreases

3.

deregulation

 

-

regulation of industries cant restrict and decrease SRAS

-

less regulations can increase SRAS

 

-

ex. straw ban

 

4.

political and environmental phenomena

 

-

wars and natural disasters can decrease SRAS

-

political stability can increase SRAS

 

DETERMINANTS OF LRAS

 

1.

availability of resources

 

-

a larger labor force (increase on population), larger stock of capital (machines, funding, investments), more widely available natural resources (discovery of new resources) can increase the level of full employment

2.

technology and productivity

 

-

better technology raises the productivity of both capital and labor

-

a more trained and educated population increases productivity and LRAS over time (like K- 12)

3.

policy incentives

 

-

if policy provides incentives to quickly find a job, full employment real GDP rises

-

if government gives tax incentives to invest in capita l and technology, full employment increases

GRAPHING

* when you graph, you need to draw both LRAS and SRAS

1. price of factors of production decrease: input price (SRAS shifts to the right)

P

LRA S SRAS 1 SRAS 2
LRA S
SRAS 1
SRAS 2

Y

2. actual price level increased than expected price level:

sticky price theory (movement along the SRAS curve)

P

LRAS SRAS Y
LRAS
SRAS
Y

3. government removes subsidies from local production:

policy incentives (LRAS shifts to the left)

production: policy incentives (LRAS shifts to the left) 4. unexpected hikes in the price of natural

4. unexpected hikes in the price of natural resources:

input price (SRAS shifts to the left)

P

LRA S SRAS 2 SRAS 1 Y
LRA S
SRAS 2
SRAS 1
Y

5. an improved education and training of population:

technology and productivity (LRAS shifts to the right)

P

LRAS 1 LRAS 2 SRAS Y
LRAS 1
LRAS 2
SRAS
Y

6. discovery of new natural resources: availability of resources (LRAS shifts to the right)

P

LRAS 1 LRAS 2 SRAS Y
LRAS 1
LRAS 2
SRAS
Y

7. stricter regulation to industries: deregulation (SRAS shifts to the left)

P

LRA S SRAS 2 SRAS 1 Y
LRA S
SRAS 2
SRAS 1
Y

8. abolishment of tax burden of producers: tax policy (SRAS shifts to the right)

P

LRA S SRAS 1 SRAS 2
LRA S
SRAS 1
SRAS 2

Y

9. discovery of improved and optimal technology:

technology and productivity (LRAS shifts to the right)

P

LRAS 1 LRAS 2 SRAS Y
LRAS 1
LRAS 2
SRAS
Y

10. increase in labor force: availability of resources (LRAS shif ts to the right)

P

LRAS 1 LRAS 2 SRAS Y
LRAS 1
LRAS 2
SRAS
Y

Macroeconomic Equilibrium

* intersection – perfect situation

- the quantity of real output demanded is equal to the quantity of real output supplied

- macroeconomic equilibrium is at the intersection of AD, SRAS and LRAS

P LRAS SRAS Why is it perfect? there is no inflation, price is stable -
P
LRAS
SRAS
Why is it perfect?
there is no inflation,
price is stable
-
P
-
1
producing to maximum
capacity, maximum
output
AD
-
full employment
Y
Y
1
INCREASE IN AD
P
LRAS
SRAS
P
2
P
1
AD 2
AD 1
Y
Y 1
Y 2

- price ↑ (demand- pull inflation) ; GDP ↑

- unemployment ↓ (right of LRAS which is full employment, so unemployment decreases because employment is operating at beyond full employment level)

DECREASE IN AD

P 1

P 2

P LRAS SRAS AD 1 AD 2
P LRAS
SRAS
AD 1
AD 2
level) DECREASE IN AD P 1 P 2 P LRAS SRAS AD 1 AD 2 Y

Y

Y 2 Y 1

- price ↓ (deflation); GDP ↓

- unemployment ↑ (cyclical unemployment, left of LRAS which is full employment)

- this shows recession

DECREASE IN SRAS

P 2

P 1

P LRAS SRAS 2 SRAS 1 AD
P LRAS
SRAS 2
SRAS 1
AD
DECREASE IN SRAS P 2 P 1 P LRAS SRAS 2 SRAS 1 AD Y Y

Y

Y 2 Y 1

- price ↑ (cost- push inflation); GDP ↓

- unemployment ↑ (left of LRAS which is full employment)

- this shows stagflation, a combination of inflation, people with no jobs and low output

INCREASE IN SRAS

P 1

P 2

P LRAS SRAS 1 SRAS 2 AD
P LRAS
SRAS 1
SRAS 2
AD
output INCREASE IN SRAS P 1 P 2 P LRAS SRAS 1 SRAS 2 AD Y

Y

Y 1 Y 2

- price ↓ ; GDP ↑

- unemployment ↓ (right of LRAS which is full employment, so unemployment decreases because employment is operating at beyond full employment level)

- this shows expansion

EXAMPLES

1. Widespread optimism among consumers of an impending expansion.

P 2

P 1

P LRAS SRAS AD 2 AD 1 Y Y 1 Y 2
P LRAS
SRAS
AD 2
AD 1
Y
Y 1
Y 2

AD increase

2. A new national tax on producers based on value added.

P 2

P 1

P LRAS SRAS 2 SRAS 1 AD
P LRAS
SRAS 2
SRAS 1
AD
based on value added. P 2 P 1 P LRAS SRAS 2 SRAS 1 AD Y

Y

Y 2 Y 1

SRAS decrease

3. An increase in interest rate

P 1

P 2

P LRAS SRAS AD 1 AD 2
P LRAS
SRAS
AD 1
AD 2
increase in interest rate P 1 P 2 P LRAS SRAS AD 1 AD 2 Y

Y

Y 2 Y 1

AD decrease

4. A major increasing in spending for education

P 2

P 1

P LRAS SRAS AD 2 AD 1 Y Y 1 Y 2
P LRAS
SRAS
AD 2
AD 1
Y
Y 1
Y 2

AD increase

5. The general expectation of coming rapid inflation

AD increase or AD decrease

P LRAS SRAS P 2 P 1 P 1 P 2 AD 2 AD 1
P LRAS
SRAS
P 2
P 1
P 1
P 2
AD 2
AD 1
Y
Y 1
Y 2
P LRAS SRAS AD 1 AD 2
P LRAS
SRAS
AD 1
AD 2
P 1 P 2 AD 2 AD 1 Y Y 1 Y 2 P LRAS SRAS

Y

Y 2 Y 1

6. The complete disintegration of OPEC, causing oil prices to fall by one - half.

P 1

P 2

P LRAS SRAS 1 SRAS 2 AD
P LRAS
SRAS 1
SRAS 2
AD
to fall by one - half. P 1 P 2 P LRAS SRAS 1 SRAS 2

Y

Y 1 Y 2

SRAS increase

7. Value of currency falls P LRAS SRAS P 2 P 1 AD 2 AD
7. Value of currency falls
P LRAS
SRAS
P 2
P 1
AD 2
AD 1
Y
Y 1
Y 2

AD increase

8. A 15 percent across- the - board increase in personal income tax rates.

P 1

P 2

P LRAS SRAS AD 1 AD 2
P LRAS
SRAS
AD 1
AD 2
income tax rates. P 1 P 2 P LRAS SRAS AD 1 AD 2 Y Y

Y

Y 2 Y 1

AD decrease

9. An increase in exports that exceeds an increase in imports

P 2

P 1

P LRAS SRAS AD 2 AD 1 Y Y 1 Y 2
P LRAS
SRAS
AD 2
AD 1
Y
Y 1
Y 2

AD increase

10. Increased spending on war preparations

P LRAS SRAS P 2 P 1 AD 2 AD 1 Y Y 1 Y
P LRAS
SRAS
P 2
P 1
AD 2
AD 1
Y
Y 1
Y 2
Fiscal Policy

AD increase

- it refers to deliberate changes in the government spending and net tax collection to affect economic output, unemployment and the price level

- i t is designed to manipulate AD to 'fix' economy

o there will always be a doubt since it is risky and it doesn’t ensure that it will ‘fix’ the economy)

- government spending and taxes are adjusted by the government to fix the economy

Classical Economics

Modern Economics

it believes that the economy will soon correct itself in the long run

it believes that the economy will should have stimuli for growth

government should not intervene with the workings of the economy

government should intervene through spending and taxation

Laissez Faire” – “let it be”, “leave alone” à leave the economy alone

“ in the long run, we are all dead” - if you leave the economy alone for too long, we will die as struggle continues

founded by Adam Smith

founded by John Maynard Keynes

EXPANSIONARY FISCAL POLICY

- shifts AD to the right to increase gross domestic product and reduce unemployment

o

increase government spending

o

lowering taxes

o

increasing aggregate demand

* government spending increase is better than taxation decrease because it is not guaranteed that the money gained by consumers from not paying taxes will be spent

immediately

Recessionary Gap

- the amount in which full employment GDP exceeds current macroequilibrium GDP

- GDP which is operating below economy's maximum potential

- potential GDP > actual GDP P LRAS SRAS P 1 P 2 AD 1
- potential GDP > actual GDP
P LRAS
SRAS
P 1
P 2
AD 1
AD 2
Y

Y 2 Y 1

needs expansionary fiscal policy to stimulate

economic growth or shift AD back to the right

*you implement this type of policy when there is a decrease in demand so that it can increase again

CONTRACTIONARY FISCAL POLICY

- shifts AD to the left in order to control inflation

o

decrease government spending

o

increasing taxes

o

decreasing aggregate demand

Inflationary Gap

- the amount in which current macroequilibrium GDP exceeds full employment GDP which is characterized by inflation

- potential GDP < actual GDP P LRAS SRAS P 2 P 1 AD 2
- potential GDP < actual GDP
P LRAS
SRAS
P 2
P 1
AD 2
AD 1
Y
Y 1
Y 2

must be corrected due to

bad inflation, must be

slowed down with contractionary fiscal policy to shift AD back to the left

*the government doesn’t usually implement this since it is a hard sell, lowers GDP, decreases government spending and demand, increases taxes

EXAMPLES

W hich fiscal policy would be implemented in these economic situations?

1.

government exceed the target import quota

à

expansionary fiscal policy

 

-

more imports = lower GDP

-

needs this policy to shift AD to the right

2.

household prefers to consume than to save

à

contractionary fiscal policy

 

-

increase in demand = increase in price = inflation

-

needs this policy to correct inflation (shift AD left)

3.

peso falls against dollar

à

contractionary fiscal policy

 

-

increase in exchange rate = increase in price = inflation

-

needs this policy to correct inflation (shift AD left)

4.

interest rate increased

à

expansionary fiscal policy

 

-

increase in interest rate = decrease in demand

-

needs this policy to shift AD to the right

5.

government cuts down budget appropriation

à

expansionary fiscal policy

 

- lesser budget appropriation = decreased gov. spending

- needs this policy to increase government spending

THE MULTIPLIER EFFECT

- a change in spending and tax creates a larger change in GDP for each money used for consumption generates more goods and services *higher multiplier effect = increase in GDP ex. if your classmate gives you 100 pesos, let’s say you consume 80 pesos and save 20 pesos

Marginal Propensity to Consume (MPC)

Marginal Propensity to Save (MPS)

the change in consumption caused by a change in income

the change in saving caused by a change in income

MPC = c onsumption ÷ income à 80/100 = 0.8

MPS = saving ÷ income à 20/100 = 0.2

MPC + MPS = 1 (always equal to 1 because every dollar not spent is saved)

SPENDING MULTIPLIER

- ways to calculate the newly generated GDP caused by the spending in the economy

- used for government expenditures (expansionary fiscal policy)

Spending Multiplier

New GDP

1/MPS or 1/(1- MPC)

(initial spending by the government) (spending multiplier)

Example
Example

Suppose the government spent $100million for building new roads and bridges with the MPC of 0.50, how much additional GDP will be created by the spending?

new GDP = (initial spending by gov. ) (spending multiplier)

= (100 million) (1/1- 0.5) à $200 million

TAX MULTIPLIER

- government can induce additional GDP by changing taxes and transfers

- used when the government changes tax or transfers (the cash the government gives) *changes GDP because household has additional income with transfers, which would increase GDP, but increase in taxes will decrease G DP

Tax Multiplier

New GDP

(MPC) (spending

(change in tax) (tax multiplier)

multiplier)

Example
Example

The MPC is 0.90 and the government transfers back tax revenue to consumers by sending each taxpayer a $200

check. How much additional GDP is made because of this? new GD P = (change in tax) (tax multiplier)

= (change in tax) (MPC) (spending multiplier)

= (200) (0.90) (1/0.10) = $1800

BALANCED MULTIPLIER

- the government both collects and spends tax revenue

- if the dollars spent is equal to the dollars collected then the budget is balanced (government spent = government collected)

Balanced Multiplier

(spending) (1)

Example
Example

The government wants to spend $100 on a federal program and pay for it by collecting $100 in additional taxes. If the MPC = 0.90, how much is the increase in new GDP?

Spending

Taxes

initial spending by the government) (spending multiplier)

(change in tax) (tax multiplier) = (100) (0.90) (1/1- 0.90)

= (100) (1/1- 0.90)

= - $900 (decreased

= $1000

because increase in tax)

new GDP =

$100

 

(because 1000 was given, 900 create d was taken)

GENERAL PRACTICE

1. Government spent P80M

à spending multiplier

MPC

Multiplier

Additional GDP

0.90

10

P800M

0.80

5

P400M

0.75

4

P320M

0.50

2

P160M

2. If the MPC is 0.50…

spends $100

gives back $100

spending multiplier = 2

tax multiplier = 1

new GDP = $200

new GDP = $100

shows how government spending is better than government transfers since it has a higher GDP (ex. Build, Build, Build program)

3. Government decreased ta x by P25M

MPS

MPC

Tax Multiplier

Additional GDP

0.10

0.90

9

P225M

0.20

0.80

4

P100M

0.25

0.75

3

P75M

0.50

0.50

1

P25M

4. Government spent P25M

MPS

MPC

Spending Multiplier

Additional GDP

0.10

0.90

10

P250M

0.20

0.80

5

P125M

0.25

0.75

4

P100M

0.50

0.50

2

P50M

*shows how the additional GDP is higher when you spend rather than decreasing taxes ( example #3)

5. Assume Germany raises taxes on its citizens by €200B.

Assume that Germans save 25% of the change in their disposable income. Calculate the effect of the €200B change in taxes on the German economy. taxes = (initial spending by the government) (spending multiplier)

= (200 billion)(0.75)(1/0.25)

new GDP =

-€600 billion

(decreased)

6. Assume the Japanese spend 4/5 of their disposable income. Furthermore, assume that the Japanese government increases its spending by ¥50 trillion and in order to maintain a balanced budget simultaneously increases taxes by ¥40 trillion. How much additional GDP will be added in the Japanese economy?

balanced = (spending)(1)

Spending

   

Taxes

spending = (initial spending by the government) (spending multiplier)

taxes = (change in tax) (tax multiplier)

=

(40 trillion) (0.80)

= (50 trillion) (1/1- 0.80)

(1/1-

0.80)

= ¥250 trillion

 

=

- ¥160 trillion

new GDP =

¥90 trillion

 

Money

- i t refers to anything that is used to facilitate the exchange of goods between buyers and sellers

- today’s paper and coin money are called fiat money because it has no intrinsic value

- the government assures us that it performs 3 general functions

o

medium of exchange

o

unit of account (standardized, with fixed value)

o

store of value

FINANCIAL ASSETS

- it refers to investment in the form of financial capital which households and firms use as a place for their money

Stocks
Stocks

- a share of stock represents a claim on the ownership of the firm

- firms that wish to raise money can issue or sell stocks of their company

- stocks are purchasable and the value of stocks changes

Bonds
Bonds

- a bond is a certificate of indebtedness

- when firms want to raise money, they can issue a corporate bond that promises the buyer of the borrowed amount, interest rate and repayment date *like a certificate for safekeeping money *investing in stocks is better than buying bonds since there is profit in investing stocks while bonds stay as is

SUPPLY OF MONEY

- flow of money in the economy which is being measured by its liquidity

- it refers to how an asset can be easily converted to cash and be used in economic transaction

M1
M1

1. (most liquid)

cash + coins + checking deposits + travelers check

2.

M1 + savings deposits + small time deposits (less than $100,000) + money market deposits + mutual funds

M2
M2

3.

M2 + large time deposits (over $100,000) *they are called large time since a bank needs to regulate

money supply first to avoid a bank run (bankruptcy is for companies)

M3
M3

(least liquid)

DEMAND FOR MONEY

- demand for money is inversely proportional with the nominal interest rate

- downward sloping graph P interest rate or cost of borrowing money deman d
- downward sloping graph
P
interest rate
or cost of
borrowing
money deman d
P interest rate or cost of borrowing money deman d quantity of money per period Monetary

quantity of money per period

Monetary Policy

- this is the task of the Bangko Sentral ng Pilipinas or the central bank

- it is a structured process of the increase and decrease of the money supply in order to move the economy in full employment and stabilize prices

- in the stock market

- money supply is adjusted to correct situations, like if

o

gainers: companies with stocks that increased

there is inflation, money supply is decreased

o

losers: companies with stocks that decreased t

 

TOOLS IN MONETARY POLICY

1.

Open Market Operation

 

-

buying and selling of government bonds

-

m ↑ government buys bonds

 

-

m ↓ government sell bonds

2.

Reserve Requirement

 

-

selling the supply of money that should stay in the banks

-

m ↑ low reserve requirement (money can now circulate in the economy)

-

m ↓ high reserve requirement (money is reserved in the bank)

3.

Discount Rate

 

-

the interest rate charged by the Federal Reserve to the banks for lending money

-

m ↑ discount rate goes down

 

-

m ↓ discount rate goes up

 

EXPANSIONARY MONETARY POLICY

-

increase in money supply and decrease in interest rate to solve low GDP and high unemployment

o

buying back government bonds

o

lowering reserve requirements

o

decreasing discount rates

- in a

Recessionary Gap

– low real GDP and high

unemployment, AD must shift to the right à we need more money supply for more consumption, investments and more = expansion monetary policy *where the Philippines is right now

CONTRACTIONARY MONETARY POLICY

- decrease in money supply and increase in interest rate to solve inflation

o

selling government bonds

o

increasing reserve requirements

o

increasing discount rates

- in an

Inflationary Gap

– inflation, AD must shift to the

left à we need less money supply to target inflation = contractionary monetary poli cy