macroeconomics final exam study notes.docx

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Maxine Darnell

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Econ1020 - Macroeconomics The aggregate expenditure model: A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant. Macroeconomic equilibrium: AE = GDP Consumption expenditure – The five most important variables that determine the level of consumption are: 1. Household wealth 2. Current Disposable Income 3. Expected future income 4. The price level 5. The interest rate The Consumption Function Slope = Marginal propensity to consume Y axis = Real Consumption Spending, X axis = Real Disposable Income MPC  The amount by which consumption spending increases when disposable income increases. MPC = ∆C / ∆Y Consumption and National Income Disposable Income YD = National Income – net taxes OR National Income Y = GDP = YD + net taxes Income, Consumption and Saving National Income = consumption + saving + taxes Y = C+S+T Change in National Income = change in consumption + change in saving + change in taxes ∆Y = ∆C+∆S+∆T If ∆T = 0  ∆Y = ∆C+∆S Marginal Propensity to Save: The change in saving divided by the change in income. 1 = ∆Y/∆Y = ∆C/∆Y + ∆S/∆Y OR 1 = MPC + MPS, MPS = 1 – MPC The four most important variables that determine the level of planned investment are: 1. Expectations of future profitability 2. The interest rate  borrowing 3. Taxes ( a decrease will increase investment spending) 4. Cash flow  profits pg. 1 Econ1020 - Macroeconomics The three most important variables that determine the level of net exports are: 1. The price level in Australia relative to the price level in other countries 2. The growth rate of GDP in Australia relative to the growth rates of GDP in other countries 3. The exchange rate between the dollar and other countries Graphing macroeconomic equilibrium The 45 degree line: - Shows all points equi-distant from both axes - All points of macroeconomic equilibrium must lie along the 45 degree line - At points above the 45 degree line, aggregate expenditures are greater than GDP - At points below the 45 degree line “ lower Consumption function and AE function The consumption function intersects the vertical axis at a point above zero due to autonomous consumption  Autonomous consumption: - Consumption that is independent of income  Induced consumption - Consumption that is determined by the level of income The Multiplier Effect Autonomous expenditure:  Expenditure that does not depend on GDP Multiplier:  The increase in equilibrium real GDP divided by the increase in autonomous expenditure Multiplier effect:  The process by which an increase in autonomous expenditure leads to a larger increase in real GDP A formula for the Multiplier Multiplier = Change in equilibrium real GDP/ Change in autonomous expenditure Multiplier = 1/1-MPC = 1/MPS pg. 2 Econ1020 - Macroeconomics The Multiplier Effect  The multiplier effect occurs both when autonomous expenditure increases and when it decreases.  The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it otherwise would be.  The larger the MPC, the larger the value of the multiplier  Out formula for the multiplier is very simplified, but serves to illustrate the process Changes in the price level  An increase or decrease in aggregate expenditure will affect not only real GDP, but also the price level  An inverse relationship exists between changes in the price level and changes in aggregate expenditure - Increases in the price level cause aggregate expenditure to fall - Decreases in the price level cause aggregate expenditure to rise Aggregate demand curve  A curve showing the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.  Changes in the price level shift the AE curve and move us ALONG the AD curve Topic 5 Aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level. The Aggregate demand curve:  Downward sloping curve  Shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government. The aggregate demand curve slopes downwards for three reasons: 1. The wealth effect 2. The interest rate effect 3. The international-trade effect The variables that shift the aggregate demand curve are: 1. Changes in government/central bank policies 2. Changes in expectations of households or firms 3. Changes in foreign variables pg. 3 Econ1020 - Macroeconomics Aggregate supply – The long run aggregate supply curve LRAS:  Shows the relationship in the long-run between the price level and the quantity of real GDP supplied  Vertical line at potential GDP - Full employment GDP - Natural rate of Unemployment  Shows that in the long-run increases in the price level do not affect the level of real GDP Long run aggregate supply – Shifts in the LRAS curve occur because potential GDP increases over time Increases in GDP are due to: 1. An increase in resources 2. An increase in capital stock 3. New technology Short-run aggregate supply  SRAS shows the relationship in the short-run between the price level and the quantity of real GDP supplied by firms - Is upward sloping, showing that in the short-run firms will produce more in response to higher prices  A given aggregate supply curve holds constant the following factors: - The supply of resources - The state of technology - The efficiency of production Points to note:  The slope of the SRAS depends on how much costs increase as output increases  If an increase in output results in sharp increases in per-unit production costs, then the SRAS curve will be quite steep  If an increase in output results in modest increases in per-unit production costs, then the SRAS curve will be quite flat. Explanations of the SRAS curve  Economists disagree over the shape of the SRAS curve, however, we can generally say that as output increases , the pressure on resources causes the SRAS curve to get steeper and steeper - Sticky nominal wages - Sticky prices - Menu costs (costs of changing prices) pg. 4 Econ1020 - Macroeconomics Variables that shift the SRAS curve: 1. Expected changes in the future price level 2. Adjustments of workers and firms to errors in past expectations about the price level 3. Unexpected changes in the price of an important natural resource such as oil. Variables that shift the SRAS and LRAS curves: 1. Increases in the labour force and/or in the capital stock, and/or in resources 2. Technological change A dynamic AD/AS model Three changes to the basic model: 1. Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right. 2. During most years the aggregate demand curve will be shifting to the right. 3. Except during periods when workers and firms expect high rates of inflation, the short run aggregate supply curve will be shifting to the right. Macroeconomics schools of thought  Keynesian revolution: - The name given to the widespread acceptance during the 1930s and 40s of John Maynard Keynes’s macroeconomic model.  Alternative models to Keynes: 1. The monetarist model 2. The new classical model 3. The real business cycle model The Monetarist model  Monetary growth rule: - A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions.  Monetarism: - The macroeconomic theories of Milton Friedman and his followers; particularly the idea that the quantity of money should be increased at a constant rate. The New classical model  New classical economics: - The macroeconomic theories of Robert Lucas and others - The idea that workers and firms have rational expectations - Will anticipate effects of any stabilisation policy pg. 5 Econ1020 - Macroeconomics The real business cycle model  Real business cycle model: - Focuses on real, rather than monetary, causes of the business cycle - Business cycle fluctuations are an efficient response to productivity changes - Source of fluctuations found in the supply side of the economy Notes on fiscal policy – topic 10  Fiscal policy involves changes in taxes and government purchases to achieve important macroeconomic policy goals.  The government can affect the levels of both aggregate demand and aggregate supply through fiscal policy. Learning objectives Define Fiscal Policy: Changes in federal taxes, transfer payments and purchases that are intended to achieve macroeconomic policy objectives, such as full employment, price stability, and sustainable economic growth. Explain how fiscal policy affects aggregate demand:  An increase in government purchases will increase aggregate demand (AD) directly.  An increase in transfer payments or a reduction in taxes has an indirect effect on AD through the effect on disposable income – this is appropriate when the economy is in equilibrium below full-employment, e.g. a recession. Contractionary Fiscal Policy  CFP involves decreasing government purchases and/or increasing taxes  A decrease in government purchases/increase in taxes will reduce the rate of increase in aggregate demand, to reduce the inflation – this is appropriate when the economy is above full-employment equilibrium and the inflation rate is high.  An initial increase in autonomous (i.e. discretionary) government spending, such as building new railway lines, may increase AD by an amount that is more than the initial amount of new spending. pg. 6 Econ1020 - Macroeconomics Explain how the multiplier process works with respect to fiscal policy:  Government purchase multiplier Change in equilibrium real GDP/ change in government purchases Discuss the limitations of fiscal policy: There are two main problems associated with the effectiveness of using fiscal policy to stabilize the economy:  Time lags: The time lag of fiscal policy typically is longer than monetary policy  Recognition lag: the time it takes policy makers to ascertain there is a problem to be addressed.  Legislative lag: the time it takes to have policy approved by both Houses of Federal Parliament.  Implementation lag: the time it takes to implement the policy, and for the policy to take effects.  Crowding out: A decline in private expenditures as a result of an increase in government purchases. An increase in government purchases diverts financial and real resources away from the private sector. Financial crowing out: To finance a budget deficit, the government may need to sell more bonds and securities, pushing up interest rates. Higher interest rates will reduce private investment spending and consumption spending. Higher inter
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