Note on the Final Exam
STUDENT STUMBLING BLOCKS:
The following list is a summary from each lecture regarding the most difficult
content/material. Please review it. If you have any questions, please feel free to ask me.
Lecture 5 and Lecture 6 (up to slide #18)
Lecture 5 and 6 are very important, it explains the basic aggregate expenditure model, please
review all of the slides and examples, you must understand:
1. AE = Y derive the short-run equilibrium level of output
a) AE = C + I (in the private, closed economy)
b) Y is measure by real GDP
c) It is the point where the 45 degree line intercepts AE Function.
2. The Consumption Function C = C0 + cY, which is a relationship between aggregate
consumption spending and real income (measure by real GDP) and C0 is the autonomous
expenditure, c is the marginal propensity to consume.
3. The Saving function S = Y – C and S = S0 + sY, s is the marginal propensity to save and c +
s = 1.
4. The Investment function I = I g gross investment spending is not a function of real GDP, it is
determined by investment demand. Investment demand and real interest rate is negatively
Note: Review Lyryx Lab 5
5. AE = C + I = C0 + cY + Ig = (C0 + Ig) + cY, note that, AE function is also a linear function, it
relates the aggregate spending with real output (measured by real GDP), the intercept of the
AE function is given by (C0 + Ig), which is also called autonomous expenditure; the slope of
the AE function is given by c, the marginal propensity to consume.
6. The equilibrium output is that output which creates total spending just sufficient to produce
that output (Y = AE)
a) Saving equals planned investment (S = I)
b) No unplanned changes in inventories c) AE = Y, Ye = (C0 + Ig)/(1-c); equilibrium output is equal to autonomous expenditure
divided by (1 – MPC)
7. The Multiplier
a) Multiplier = 1/(1-MPC) = 1/MPS
b) Multiplier = change in equilibrium output/change in autonomous expenditure
c) Multiplier = ΔYe/ΔAE
Note: Review questions on Slide 17 and 18. Lyryx lab 6 Question 1 and 2. Additional
MC questions posted on blackboard under Connect quizzes.
Lecture 7 is built on Lecture 5 and 6. By adding the government sector, we add government
spending (G) and taxes (T) into the AE equation.
1. Adding government spending (G) is easy. G is an autonomous term, AE = C + I + G,
G shift AE up and increases equilibrium GDP.
2. Adding tax (T) is tricky. Tax doesn’t affect AE directly, taxes reduces disposable
income and affect consumption function.
3. If tax is a lump sum tax T, C = C0 + c (Y – T), so C = (C0 – cT) + cY. Tax reduces
autonomous consumption. Lower autonomous consumption shifts AE down and
reduces equilibrium GDP.
4. If tax is a Net Tax, NT = tY, t is a net tax rate, then C = C0 + c(Y-tY), so C = C0 +
c(1-t)Y, net tax rate reduces the slope of the consumption. Net tax rate changes the
slope of the consumption function and AE function, it changes the multiplier,
multiplier = 1/slope of AE = 1/(1-c(1-t)), so it reduces equilibrium GDP.
Note: It is important to review the examples of lecture 7, especially slides 25-28 to
understand how G and T (/NT) affect equilibrium GDP.
Lecture 8 is about AD/AS model. I. The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures
A. Both models measure real GDP on horizontal axis.
B. Aggregate demand shifts and the aggregate expenditures model
1. When there is a change in one of the determinants of aggregate demand, there
will be a change in the aggregate expenditures as well.
2. The change in aggregate expenditures is multiplied and aggregate demand shifts
by more than the initial change in spending
3. Shift of AD curve = initial change in spending x multiplier
4. The effect of the shift on real domestic output and the price level will depend on
the starting point relative to full-employment output, as well as the relative
steepness of the aggregate supply curve.
II. Introduction to AD-AS Model
A. You should be able to:
1. Define aggregate demand (AD) and explain the factors that cause it to change.
2. Define aggregate supply (AS) and explain the factors that cause it to change.
3. Discuss how AD and AS determine an economy’s equilibrium price level and
level of real GDP.
B. AD-AS model is a variable price model. The aggregate expenditures model
assumed constant price.
C. AD-AS model provides insights on inflation, unemployment and economic growth.
II. Aggregate Demand
A. A schedule or curve that shows the various amounts of real domestic output that
domestic and foreign buyers will desire to purchase at each possible price level.
B. The aggregate demand curve.
1. It shows an inverse relationship between price level and domestic output.
2. The explanation of the inverse relationship is not the same as for demand for a
single product, which centered on substitution and income effects.
a. Substitution effect doesn’t apply in the aggregate case, since there is no
substitute for “everything.”
b. Income effect also doesn’t apply in the aggregate case, since income now
varies with aggregate output.
3. What is the explanation of inverse relationship between price level and real
output in aggregate demand?
a. Real balances effect: When price level falls, the purchasing power of existing
financial balances rises, which can increase spending.
b. Interestrate effect: A decline in price level means lower interest rates which
can increase levels of certain types of spending.
c. Foreign trade effect: When price level falls, other things being equal,
Canadian prices will fall relative to foreign prices, which will tend to increase spending on Canadian exports and also decrease import spending in favour
of Canadian products that compete with imports.
C. Changes in aggregate demand: Determinants are the “other things” (besides price
level) that can cause a shift or change in demand
III. Aggregate Supply
A. A schedule or curve showing the level of real domestic output available at each
possible price level.
B. Aggregate supply in the immediate short run
1. In the long run the aggregate supply curve is horizontal at the current price level.
C. Aggregate supply in the short run
1. The short-run aggregate supply curve is upward sloping.
2. The lag between product prices and resource prices makes it profitable for firms
to increase output when the price level rises.
3. To the left of full-employment output, the curve is relatively flat. The relative
abundance of idle inputs means that firms can increase output without
substantial increases in production costs.
4. To the right of full-employment output the curve is relatively steep. Shortages of
inputs and production bottlenecks will require substantially higher prices to induce
firms to produce.
D. Aggregate supply in the long run
1. In the long run the aggregate supply curve is vertical at the economy’s full-
2. The curve is vertical because in the long run resources prices adjust to changes
in the price level, leaving no incentive for firms to change their output.
E. Changes in aggregate supply: Determinants are the “other things” besides price
level that cause changes or shifts in aggregate supply
1. A change in input prices, which can be caused by changes in several factors.
2. Changes in productivity (productivity = real output / input) can cause changes in
per-unit production cost (production cost per unit = total input cost / units of
output). If productivity rises, unit production costs will fall. This can shift
aggregate supply to the right and lower prices. The reverse is true when
productivity falls. Productivity improvement is very important in business efforts
to reduce costs.
3. Change in legalinstitutional environment, which can be caused by changes in
IV. Equilibrium: Real Output and the Price Level
A. Equilibrium price and quantity are found where the aggregate demand and supply
B. Increases in aggregate demand cause demand-pull inflation.
1. Increases in aggregate demand increase real output and create upward pressure
on prices, especially when the economy operates at or above its full employment
level of output. 2. The multiplier effect weakens the further right the aggregate demand curve
moves along the aggregate supply curve. More of the increase in spending is
absorbed into price increases rather than generating greater real output.
D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result.
Prices don’t fall easily.
1. Wage contracts are not flexible so businesses can’t afford to reduce prices.
2. Employers are reluctant to cut wages because of impact on employee effort, etc.
Employers seek to pay efficiency wages – wages that maximize work effort and
productivity, minimizing cost.
3. Minimum wage laws keep wages above that level.
4. Menu costs are difficult to implement.
5. Fear of price wars keeps prices from being reduced.
Note: Please practise on Lyryx lab 8.
Lecture 9: Fiscal Policy
I. Fiscal Policy and the AD/AS Model
A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and
government spending by government to alter real domestic output and employment,
control inflation, and stimulate economic growth. “Discretionary” means the changes are
at the option of the government.
B. Discretionary fiscal policy changes are often initiated by Parliament.
C. Changes not directly resulting from congressional action are referred to as
nondiscretionary (or “passive”) fiscal policy.
D. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession
1. Expansionary Policy needed: a decline in investment has decreased AD
real GDP has fallen and also employment declined. Possible fiscal policy
a. An increase in government spending, (shifts AD to right by more than
change in G due to multiplier),
b. A decrease in taxes (raises income, and consumption rises by MPC x the
change in income; AD shifts to right by a multiple of the change in
c. Combination of increased spending and reduced taxes. d. If the budget was initially balanced, expansionary fiscal policy creates a
2. Contractionary fiscal policy needed: When demand pull inflation occurs as
illustrated by a shift of AD u