UNIT 3: CHAPTERS 8, 10, 11 Chapter 8 Income is the most significant factor in determining levels of consumption and saving Consumption

on schedule is the relationship between consumption and disposable income Saving schedule is the relationship between savings and disposable income Break-even income is where all of disposable income is consumed, savings = 0 Dissavings occur when consumption is above disposable income Average propensity to consume APC=consumption/income Average propensity to save APS=savings/income Marginal propensities tell us how much is consumed/saved when income changes Marginal propensity to consume MPC=consumption/income Marginal propensity to save MPS=savings/income Marginal propensities always add up to one because the entire change in income is either consumed or saved since those are the only two options MPC+MPS=1 The slope of the consumption schedule graph is MPC The slope of the saving schedule graph is MPS Nonincome determinants of consumption and saving: Wealth (Wealth Effect) changing value of real assets (houses, land) changing value of financial assets (cash, savings accounts, stocks, bonds, pensions) households save to get more wealth, savings change more wealth: C up, S down Expectations expectations about price and income rising prices: C up, S down rising income: C up, S down Real Interest rates lower interests rates: more borrowing: C up, S down effects are not too large because the shift is towards products bought on credit and away from other products Household debt more debt: C up, S down Other Important Considerations Switch to real GDP, macro looks at consumption and savings relative to GDP instead of relative to DI Changes along schedules are just changes in amount consumed, actual shifts occur for nonincome determinants Schedule shifts occur by nonincome determinants, savings and consumption usually shift opposite one another

Taxation shifts both savings and consumption in the same direction because they are paid at the expense of both parts of DI

Determinants of Investment Spending Expected rate of return Real interest rate Invest up to the point where r = i (rate of return = real interest rate), thats when you have invested in everything where r > i Investment Demand Curve Shifters Acquisition, maintenance, and operating costs are similar to the cost of resources Business taxes, more shifts to the left Technology, more can shift curve to the right Stock of capital goods on hand, firms with excess production capacity shift curve left Expectations, optimism shifts curve to the right Instability of Investment Durability can lead to less optimistic firms keeping old equipment rather than upgrading Irregularity of innovation, innovation starts a wave of investment spending that decreases with time Variability of profits causes fluctuations in incentive to invest Variability of expectations can change with stock market prices, exchange rates, etc. Multiplier Effect Spending Multiplier=change in real GDPinitial change in spending=1/(1-MPC) =1/MPS Tax Multiplier= -MPC/MPS Economy supports continuous flow of expenditures, one persons expenditure is anothers income Changes in income will vary consumption and savings in the same direction Buying imports and paying taxes drains some of the consumption spending so multiplier effect is reduced

Chapter 10 Aggregate demand shows real GDP at any price level Slopes downward because: Real-balances effect higher prices erodes the value of savings, public is poorer Interest-rate effect higher price levels increase demand for money so interest rates rise Foreign purchases effect US prices rise relative to other countrys so more imports and less exports lead to a smaller GDP Determinants of aggregate demand (shifters) Consumer spending consumer wealth: wealth effect, financial and real assets consumer expectations: about income and prices household debt: more debt allows for more consumption taxes: less taxes allow for more consumption and savings Investment spending interest rates: not the same as interest-rate effect, comes from change in

money supply or something similar expected returns: how much a business thinks they can make expected future business conditions technology degree of excess capacity business taxes Government spending: more spending yields more demand Net export spending national income abroad: more national income abroad increases the aggregate demand because more imports sell exchange rates: dollar depreciation increases exports and decreases imports and thus aggregate demand shifts right

Aggregate supply shows real domestic output at any price level Differs long term versus short term Long run aggregate supply (LRAS) vertical at full potential nominal wages change with the price level so real wages stay constant Short run aggregate supply (SRAS) increases in price level increase real profits temporarily causing more output upsloping and concave up Per unit production cost=total input cost/units of output Determinants of aggregate supply (shifters) Change in input prices domestic resource prices: increasing wages or price of land and capital inputs shifts curve left prices of imported resources: added supplies, domestic or imported, reduce per unit production costs so lower prices of imports shift curve right market power: ability to raise prices leads to less supply Change in productivity: Productivity=total outputs/total inputs increase in productivity decreases per unit cost Change in legal-institutional environment business taxes and subsidies: changes the cost of production government regulations: costs money to comply with regulations Demand-Pull Inflation Aggregate demand shifts right Equilibrium price increases Multiplier effect is lessened because prices rise, smaller quantity demanded than would have been at the original price with the new demand curve Decrease in AD Deflation rarely occurs, instead there is disinflation (lower inflation rate) Real output accounts for most of the decline in AD Prices cannot go down easily Fear of price wars: could drive price so low that they lose profit, choose to cut production and workers instead Menu costs: additional costs of lowering prices such as determining the value of lowering prices, repricing inventory, printing and mailing new catalogs, and communicating new prices to consumers derived name from cost of printing new menus for price changes in restaurants Wage contracts: a cut in prices would only be profitable if wages were also cut, hard to cut wages because of contracts Morale, effort, and productivity: efficiency wages maximize worker productivity, cuts in wages might discourage workers from being efficient Minimum wage: firms cant cut wages if they already only pay minimum wage Cost-push inflation Cost of resources or fewer resources drives up price Increase in AS while maintaining full employment and stable prices

both AD and AS shift right, equilibrium price level stays fairly constant and GDP increases

Chapter 11 Expansionary fiscal policy (creates budget deficit) use to stimulate economy Increased government spending: shifts AD to the right, continues shifting right because of the multiplier effect Tax reductions: will increase consumption and saving (so need a larger tax cut to get same effect as from government spending), shifts AD to the right initially and through multiplier effect Combined government spending increase and tax reductions: need to cut taxes less and spend less Contractionary fiscal policy (creates budget surplus) use to control high inflation Decreased government spending: tries to shift AD left through initial and multiplier effect, harder to push prices down than to raise prices, can only slow rising prices, is not meant to lower prices Increased taxes: shifts AD left through initial and multiplier effect Combined government spending decrease and tax increases Automatic stabilizers: increase deficit in recession, increase surplus in expansion Taxes increase during expansion because people have more income and spend more, helps to restrain growth Standardized (full-employment) budget removes the effect of automatic stabilizers to assess fiscal policy compares actual expenditures to the theoretical if economy had yielded full employment GDP Fiscal Policy problems, criticisms, and complications Problems of timing recognition lag: time to recognize that recession or inflation is occurring administrative lag: time between recognition and action taken by government operational lag: time between fiscal action and effects from it Political considerations people who want to get reelected may propose an inappropriate policy to get votes Future policy reversals policies may not work if people expect the policies will be reversed ex. taxes are lower and people save a large portion of money for the future expected raise rather than spending it Offsetting state and local finance state and local fiscal policy often is pro-cyclical (works to worsen inflation or recession) Crowding-Out Effect expansionary policy may increase interest rate and reduce private spending government borrowing can increase rates, cutting off some investment spending and some consumption spending that depends on interest (cars and other purchases on credit) Public Debt: total accumulation of deficits minus surpluses that the Federal

government has incurred over time Ownership U.S. securities: Treasury bills (short-term) Treasury notes (medium-term) Treasury bonds (long-term) U.S. saving bonds (long-term, nonmarketable) Americans hold of their own debt Debt and GDP easier for a nation with a high GDP to incur a lot of debt, should look at debt relative to GDP International Comparisons Many countries also have high debt as a percentage of GDP Interest Charges The interest on loans is the biggest cost of having debt 4th largest item in Federal budget (behind income security, national defense, and health) False Concerns Bankruptcy: large debt does not threaten to bankrupt the government Refinancing: sell new bonds to pay off old bonds Taxation: can increase taxes if necessary to finance debt payments Burdening future generations Since most public debt is owed to Americans, only the owed to foreigners will negatively impact U.S. purchasing power Real Concerns Income Distribution Distribution of debt ownership is concentrated among the wealthy Interest payment (mostly to the wealthy) on debt increases income inequality Taxes are only slightly progressive Thus, income is essentially transferred from the poor to the rich Incentives Need to finance debt interest payments through taxes Raising taxes to repay debt would lower incentives to invest, innovate, work, and bear risk Large public debt thus indirectly dampens growth of economy Foreign-Owned Public Debt This external public debt the payment of interest to foreigners allows them to purchase some of our output Crowding-Out Effect Continual refinancing leads to higher interest rates Higher interest rates cause less investment spending Thus, future generations could inherit an economy with a smaller production capacity and lower standard of living Offsetting the burden on future generations: Public investments: more public goods increase economys

future production capacity Public-private complementaries: public investments could increase private investment by increasing expected return ex. new Federal building encourages private investment in the form of nearby shops, restaurants, offices, etc.