ECON 104 Final: EconExam3Notes

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Department
Economics
Course
ECON 104
Professor
Adrienne Lapointe
Semester
Fall

Description
CHAPTER 12: Aggregate Expenditure and Output in the Short Run (SR) ΔPrice Level (P) ● If the price level increases, real wealth decreases and the C function shifts downward ● Real Wealth (YEAR) = (Nominal Wealth(YEAR))/(CPI/100) ● Ex: Suppose consumption decreases by $2 trillion ---> Real wealth falls The Marginal Propensity to Save: MPS=Δs/ΔYd ● MPC=Slope ● If you know the MPC, you can solve for the MPS: ○ Yd=C+S ○ ΔY=ΔC+ΔS ○ 1 = MPC+MPS ○ If MPC=0.75, 1=0.75+MPS ○ MPS=0.25 + - + + - - C=f(Ys, T, Wealth, Ye, P, r) + Means that when the variable in the function increases, C increases - Means that when the variable in the function increases, C decreases Investment Expenditures ● AE=C+I+G+NX=AD ● Approximately 17% of RGDP ● Includes spending by firms on: ○ Office buildings, factories, machines, delivery trucks, software, ect. ○ Inventories ○ Research and development (R & D) ● Investment = ΔCapital Stock ○ A nation can accelerate economic growth by increasing the capital stock = investment: PPF shifts outward ○ Investment expenditures increase the nation’s future standard of living ○ Investment over the Great Recession fell dramatically Investment Demand I=f(r) : r is negative ● Factors that affect the I function ○ ΔReal interest rate: r (move along I demand curve) ○ Shift the I demand: ■ ΔExpectations of future profitability ■ ΔTechnological change ■ ΔBusiness Taxes ΔReal Interest Rate ( r ): ● A firm will undertake I if Expected Real Return on I is greater than or equal to Interest Cost ● Ex: ○ Suppose Home Depot wants to open several new stores (5) in PA. ○ Expected Return in I for Part 1 is 12% and the Cost of Borrowing is 5%, that makes this part profitable ○ Expected Return for Part 2 is 12% and the Cost of Borrowing is 15%, this is not profitable. ● As real interest rates rise, less investment projects will be profitable. ΔExpectations of future profitability (EFP) ● Reflect firms’ confidence in the future ○ Optimistic: I demand shifts right ○ Pessimistic: I demand shifts left ● Keynes: I is driven by “animal spirits” ○ Animal spirits reflect business confidence Technological Change ● New technologies/inventions provide less costly ways of producing output ○ “Reducing cost of producing output” ● Result: Investment demand shifts rightward ● Examples: ○ Internet ○ Wireless ○ Computer/Smartphones ○ Robots ΔBusiness Takes (t) ● T is the tax rate on a firm’s revenue ● I decisions are based upon after-tax profits ○ Profits=Revenues-Costs ● Ex: Suppose Congress cuts taxes on businesses ○ I shifts right ○ Currently, t=36% ○ Remember: t does not equal T Government Expenditures as a component of AD ● AD=C+I+G+NX ● Government expenditures (G): include local, state, and federal expenditures ● G is autonomous with respect to Y ● When G increases, AD shifts right Net Exports (NX) as a component of AD ● NX=Exports(X) - Imports (M) ● NX are usually affected by the business cycle Net Exports and Relative Growth in Price Levels ● Assume: X(US)=M(US), both growing at the same rate ● Suppose π(US) 0, AD shifts to the right ● If Δ Taxes < 0, AD shifts to the right ΔConsumption ( C ) ΔWealth > 0 ΔTaxes (T) < 0 ΔYe > 0 Δr < 0 ΔInvestment ( I ) ΔEFP > 0 ΔTechnology > 0 ΔBusiness Taxes (t) < 0 Δr < 0 ΔNet Exports (NX) %ΔRGDP(US) < %ΔRGDP(ROW) ΔE¥/$ < 0 (the $ depreciates against other currencies) LRAS ● Potential output is determined by the ○ Number of workers ○ Capital stock ○ Available technology ● LRAS is vertical ○ Changes in the price level and do not affect the level of real GDP in the LR ○ Ex: As the price level rises LRAS remains unchanged ● Shifts in LRAS: a Δ in potential output ○ Δresource base ■ Δ number of workers ■ Δ in the size of the capital stock ○ Technological Δ and innovation SRAS ● Define: SRAS shows the relationship in the SR between the price level and the quantity of real GDP supplied by firms ● When prices rise in the SR from P = 100 to P = 110, firms produce more output because input prices are sticky or fixed ○ Why are they sticky or fixed? ■ It is difficult to preduct future inflation when negotiating wages and prices of inputs ● Wages and prices of inputs are often set by contracts for one year or more ● Some firms adjust their prices more slowly than others (ex menu costs) ● Example: You own a Coffee Shop ○ Suppose AD is increasing in US economy ■ This increases the price of lattes, mochas, espressos, ect ■ Input costs are very slow to adjust ● Profits and revenues increase ● You have an incentive to increase output ● Profits (increase) = Revenues (increase) - Costs (unchanged) Conclusion ● A rising price level leads to a larger quantity of goods and services supplied in the short run ● If firms and workers had perfect foresight Shifts in SRAS ● An unexpected change in the price of an important natural resource ○ Ex: an increase in the price of oil (supply shock) increases the cost of production ○ As a result, less is produced at every price level ● Increase in the labor force and/or the capital stock (SRAS shifts right) ● Technological changes that increase productivity (SRAS shifts right) ● An increase in the expected future price level (SRAS shifts left) ○ Workers will ask for higher wages and firms will increase their output prices ● Workers and firms adjust to errors in past expectations about the price level (due to incorrect predictions) ○ If prices are higher than expected, SRAS shifts left ■ Workers will ask for higher wages and firms will increase their output prices ○ If prices are lower than expected, SRAS shifts right ■ Workers will be willing to work for lower wages and firms will lower their output prices Summary ● Factors that shift LRAS to the right: ○ Increase in size of resource base: ■ Increase in the number of workers ■ Increase in the size of the capital stock ○ Technological Δ/Innovation (increases worker productivity) ● Factors that shift SRAS to the right ○ Factors that LRAS to the right ○ Unexpected decrease in the price of an important natural resource ○ Adjustments of workers and firms to errors in past expectations about the price level ■ Recession: workers accept lower wages => firms cut prices (SRAS shifts right) ● This is how the economy returns to LR Equilibrium AD/LRAS/SRAS Model ● Ex 1: An increase in AD and the automatic adjustment of prices and real output ○ An increase in G or decrease in r results in AD shifting right at P=100 (shortage) ○ Firms step up production to try to meet the increase in AD (expansion) ○ Why? Output prices rise (shortage) relative to input prices (sticky/fixed); %Δprofits > 0 ○ As output and prices increase, the economy moves from E1 to E2, the SR equilibrium, where AD2 = SRAS1 ○ From SR to LR: Workers and firms will adjust to the price level being higher than expected ■ Workers will ask for higher wages; firms will increase their prices ■ As a result, SRAS shifts left until Y equals Y bar at the new equilibrium: AD2 = SRAS2 = LRAS at E3 Ex 2: A decrease in AD and the automatic adjustment of prices and output (no policy intervention) ● A decrease in G or increase in r results in AD shifting left at P = 100 (surplus) ● Firms cut production and lay off workers (recession) ● Why? Inventories build up and firms are forced to cut their prices/ Output prices fall (surplus) relative to input pries (sticky/fixed); %Δprofits <0 ● As output and prices fall, the economy moves from E1 to E2, the SR equilibrium, where AD2 = SRAS1 ● From SR to LR: Workers and firms will adjust to the price level being lower than expected ○ Workers will be willing to accept lower wages; firms will accept lower prices ○ As a result, SRAS shifts rightward until Y is equal to Y bar at the new LR equilibrium where AD2 = SRAS2 = LRAS at E3 Ex 3: Oil Price Shock ● An increase in the price of oil, increases the cost of production. SRAS shifts to the left ● At P = 100 there is a shortage. Prices rise and we move up along the curve. ● Output falls and prices rise; the economy moves from E1 to E2, SR equilibrium where AD1 = SRAS2. This combination of inflation and recession is referred to as stagflation ○ As price level rises from E1 to E2 we move up long the AD because of the NX effect, Wealth effect, interest rate effect. ● From SR to LR: ○ With the economy in recession (falling output and rising unemployment), workers will be willing to accept lower wages; firms will accept lower prices ○ As a result, SRAS shifts rightward from SRAS2 to SRAS1 until Y equals Y bar where: AD1 = SRAS1 = LRAS at E1 = E2 Summary ● The automatic adjustment mechanism when Y does not equal Y Bar ● A shock to the economy occurs and AD or SRAS shift: ○ Is there a surplus or a shortage? ■ Impact on price level? ■ How do firms respond? ○ From SR to LR equilibrium (LRAS = SRAS = AD) ■ Revision of expectations for the price level which results in the adjustment in output prices and wages ● SRAS brings economy back to LR quilibrium ○ What is the alternative to waiting for the automatice mechanism to end recession? ■ Monetary Policy (Federal Reserve: Δinterest rates) ■ Fiscal Policy (Congress and The Presiden
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