Unit III (Discretionary vs. Automatic Fiscal Policies)

• Discretionary:
  
  
  -Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
  
  
  -Example: Recession and Inflation
  
  
• Automatic:

-Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

-Example: Medicare and Medicaid

“Easy” Expansionary Fiscal Policy	“Tight” Contractionary Fiscal Policy
Combats Recession	Combats Inflation
Increases Government Spending Decreases Taxes	Decrease in Government Spending Increase in Taxes

• Automatic or Built-In Stabilizers:

-Anything that increases the government’s budget deficit during a recession and increases its budget  surplus during inflation WITHOUT REQUIRING EXPLICIT ACTION BY POLICY MAKERS

• Economic Importance: 

-Taxes reduce spending and aggregate demand  

-Reductions in spending are desirable when the economy is moving toward inflation 

-Increases in spending are desirable when the economy is heading toward recession

Unit III (Deficits, Surpluses, and Debt)

• Balanced Budget:
  -Revenues = Expenditures
• Budget Deficit:
  -Revenues < Expenditures
• Budget Surplus:
  -Revenues > Expenditures
• Government Debt:
  -Sum of all deficits - Sum of all Surpluses
• Government must borrow money when it runs a budget deficit. They borrow from:
  -Individuals
  -Corporations
  -Financial Institutions
  -Foreign Entities or Foreign Governments

• Fiscal Policy (Two Options):

• Discretionary Fiscal Policy (action)

-Expansionary fiscal policy - think deficit

• Contractionary fiscal policy - think surplus

-Non - Discretionary Fiscal Policy (no action)

Unit III (Fiscal Policy)

- Changes in the expenditures or tax revenues of the federal government.

• 2 tools of Fiscal Policy:
  -Taxes - government can increase order or decrease taxes
  -Spending - Government can increase or decrease spending

-Inverse relationship

Unit III (The Spending Multiplier Effect)

- An initial change in spending (C, IG, G, Xn) causes a larger change in any aggregate  Spending,or Aggregate Demand (AD).

-Multiplier = Change in AD / Change in Spending-Multiplier = Change in AD / Change in C, I, G, or Xn

• Calculating the Spending Multiplier:

-The Spending Multiplier can be calculated from the MPC or the MPS.

-Spending Multiplier = 1 / 1 - MPC or 1 / MPS-Spending Multipliers are (+) when there is an increase spending and (-) when there is a decrease in spending.

• Calculating the Tax Multiplier:

-When the government taxes, the multiplier works increase 

-Why?  

-Because now $ is leaving the circular flow.

-Tax Multiplier ( note: it’s negative)-Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS-If there is a tax -CUT, then the multiplier is (+), because there is now more $ in the circular flow.

Unit III ( Marginal Propensity to Consume)

-The fraction of any change in disposable income that is consumed.

-MPC = Change in Consumption / Change in Disposable Income

-MPC = Change in Savings / Change in Disposable Income

• Marginal Propensities:

• MPC + MPS = 1
• .: MPC = 1 - MPC
• .: MPS = 1 - MPC
• Remember that people do two things with their disposable income, consume it or save it

Unit III (Disposable Income)

- Income after taxes or net income.

-Formula: DI = Gross Income - Taxes

-Two Choices

With disposable income, households can either :

• Consume (spend $ on goods and services)
• Save (not spend $ on goods and services)

• Consumption:

-Household Spending

-The ability to consume is constrained by:

-The amount of disposable income 

-The propensity to consume

-Do households consume if DI =0?
-No

• Saving:

-Household NOT spending 

-Ability to save is constrained by :

-Amount of DI

  - Propensity to consume

- Do households save if DI = 0?

-No

-APC and APS formulas:

• APC + APS = 1
• 1 - APC = APS
• 1 -  APS = APC
• APC > 1 (period of dissaving)
• -APS (period of dissaving)

Unit III (Shifts in Investment Demand)

• Cost of Production:

-Lower costs shifts ID right  

-Higher costs shifts ID left

•  Business Taxes:

-Lower business taxes shifts ID right 

-Higher business taxes shifts ID left

• Technological Change
  
  
  -New technology shifts ID right
  
  
  -Lack of technological change shifts ID left
  
  
• Stock of Capital:
  
  
  -If any economy is low on capital, then ID shifts right
  
  
  -If any economy has much capital, then ID shifts left
  
  
• Expectations:
  
  
  -Positive expectations shift ID right
  
  
  -Negative expectations shifts ID left
  
  
  

Unit III (Invest Rates and Investment Demand)

What is Investment?

- Money spent or expenditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• Inventories(goods sold by producers)

Expected Rates of Return

1. How does business make investment decisions?
1. Cost/ benefit analysis
2. How does business determine the benefits?
1. Expected rate of return
3. How does business count the cost?
1. Interest costs
4. How does business determine the amount of investment they undertake?
1. Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

Real (r%) vs. Nominal (i%)

What’s the difference?

-Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.

1. How do you compute the real interest rate (r%)?
1. Formula: r% = i% - pi%
2. What then, determines the cost of an investment decision?
1. The real interest rate (r%)

Unit III ( Nominal Wages, Real Wages, Sticky Wages)

-Nominal wages: amount of money received by a worker per unit of time 

-Real wages: amount of goods and services a worker can purchase with their nominal wages 

-"purchasing power of nominal wages"

-Sticky wages: Nominal wage level is set according to an initial price level and does not vary due to labor contracts or other restrictions

Unit III (Aggregate Supply )

-The level of real  GDP (GDPr)that firms will produce at each price level (PL)

• Long Run vs. Short Run 

-Long Run: Period of time where input prices are completely flexible and adjust to changes in the price level

-Short Run: Period of time where input prices are sticky and don't adjust to change in th price - level

-Long run Aggregate Supply (LRAS):

- the LRAS marks level of fall employment in  the economy (analogous to PPC)

-B/C input prices are completely flexible in the long-run, change in price-level don't change firm's real profits and thus do not change firms level of output

   -Means LRAS is vertical vertical at economies level of full employment 

• Change in SRAS:

-An increase in SRAS it will shift right

-An decrease in SRAS it will shift left

-Key to understanding shifts in SRAS is per unit cost of production

-Per unit production cost = total input cost/ total output

• Determinants of SRAS: ( all of the following affect unit production) 

-input prices

-productivity

-legal-instituational environment  

• Input prices :

-Domestic resource prices:

-wages ( 75% of all business costs)

-cost of capital

-raw materials (Commodity Prices)

• Foreign Resource Prices:
• Market Power

-increase in resource prices = SRAS shift left

-decreases in resources prices = SRAS shift right  

• Productivity:

-total output /total input 

-more productivity = lower unit production cost = SRAS shift right  

-lower productivity = higher unit production cost = SRAS shift left

• Legal- Institutional: 

-Taxes and subsidies:

-taxes ($ to gov) on business increases per unit production cost = SRAS shifts right

-Subsidies ($ from gov) to business reduce per unit production cost = SRAS shifts right 

• Government regulation: 

-Government regulates creates a cost of compliance = SRAS shifts left

-Regulation reduces compliance costs = SRAS right 

•  Full employment:

-equilibrium exists where AD intersects SRAS & LRAS at the same point 

  

 

Unit III (Aggregate Demand Curve)

-AD is the demand by consumers, businesses, government, & foreign countries  
-What definitely doesn't shift the curve ?

-change is in price level cause a move along the curve 

-AD = C + Ig +G +Xn

Why is AD downwards sloping?

• Real-Balance Effect: Higher price levels reduce the purchasing power of money 

-This decreases quantity of expenditure 

-Lower price levels increases purchasing power and increase expenditures 

-Ex: If the balance in your bank was $50,000, but inflation erodes your purchasing power you will likely reduce your spending  

•  Interest Rate Effect : When the price level increases, lenders need to change higher interest rates to get REAL return on their loans 

-Higher interest rates discourage consumer spending and businesses investment. WHY?

• Foreign Trade Effect:When U.S price level rises, foreign buyer's purchase fewer U.S fewer U.S good & Americans buy more foreign goods

-Exports fall and imports rise causing real GDP demanded to fall (Xn decreases) 

• Shifters of Aggregate Demand:

-GDP = C + Ig + G + Xn

-There are 2 parts to a shift in AD 

• change in c, Ig, G, and or Xn  
• Multiplier effect that produces a greater change than the original change in components  

-Increase in AD shifts AD right 

-Decrease in AD shifts AD left  

Determinants of AD :

• Consumption:

-Household spending is affected by:

Consumer wealth: more wealth= more spending ( AD shifts right), less wealth= less spending ( AD shifts left)  

-Consumer Expectations: 

-Positive Expectations= more spending (AD shifts left) 

-Negative Expectations= more spending (AD shifts left) 

-Household indebtedness:

-Less Debt = more spending ( AD shifts right )

-More Debt= less spending ( AD shits left) 

•  Taxes:

-Less taxes = more spending (AD shifts right)

-More taxes = less spending (AD shifts left )

• Gross Private Investment:

-Investment spending is sensitive to:

-Lower real interest rate = more investment ( AD shifts right)

-Higher real interest rate = less investment (AD shifts left) 

 Expected returns:

-Higher expected returns = more investment ( AD shifts right )

-Lower Expect returns = less investments ( AD shifts left )

-Expected returns are influenced by:

-expectations of future profitability

-technology  

-degree of excess capacity (existing stock of capital)

-business taxes  

• Government Spending:

-more government spending ( AD shifts right)

-Less government spending ( AD shifts left) 

• Next exports are sensitive to:

-exchange rates ( international value of $)

-strong $ = more imports and fewer exports ( AD shifts left) 

-weak $ = fewer imports and more exports ( AD  shifts right)

-Relative Income:

-Strong foreign economies = more exports  (AD shifts right) 

-Weak Foreign Economies =  less exports ( AD shifts left)

Unit II (Unemployment)

• the failure to use available resources, particularly labor, to produce desired goods and services.

• Unemployment Rate: 

-4% - 5% is full employment- Natural Rate of Unemployment (NRU)

• Labor Force:

- above 16 yeas old- able and willing to work

• NOT in the Labor Force:

- military- jail/prison folks- mental institution folks- retirees- under 16- students- homemakers- people who are not looking for a job

• How to Calculate the Unemployment Rate:

- # of unemployed/(# of employed + # of unemployed) x 100

• Types of Unemployment:

Frictional- temporarily unemployed- in-between jobs1. possibly a high school/college grad looking for jobs2. left old job for a better position- looking for better opportunities

Seasonal- due to time of year and nature of the job1. bus drivers2. santa claus impersonators3. lifeguard

Structural- workers do not have transferable skills and these jobs will never come back- need to learn a new skill

Cyclical- results from economics down turns- as demand for goods and services falls, demand for labor and workers falls tooex) recession

GDP Gap: it is the amount by which actual GDP falls short of potential GDP

Okun's Law:  For every 1% in which the actual employment rate exceeds natural rate of unemployment a GDP gap of 2% occurs 

-Ex: in 2012, unemployment rate for Mexico was 7.4%, natural rate of unemployment rate for Mexico was 6% 

7.4-6= 1.4 x 2

Rule of 70:  use to determine how many years it will take for a value to double given a particular annual growth rate 

-Ex: If you put 20,000 dollars in the bank and it earns a yearly interest of 7%, how many years will it take for your income to double?

70/7 = 10 years(answer) 

Unit II (Inflation)

• Hurt by Inflation:

- lenders (banks)- people w/ a fixed income (elderly, welfare)- savers (save money at a certain rate)

• Helped by Inflation:

- debtors (locked in at a specific rate)- a business where the price of the product increases faster than the price of resources

• C O L A - Cost of Living Adjustment:

-elderly receive this, helps them. 

• Real Interest Rate(adjusted for inflation) vs. Nominal Interest Rate (NOT adjusted for inflation):

-Nominal interest: 

   -nominal interest rate = inflation + real interest rate

  -%increase in $you pay the lender for the use of $ you borrow 

              -not adjust for inflation
     
            -percent increase in purchasing power (lender receives when borrower repays land with  
            interest

           

Unit II (GDP Calculations)

• Nominal GDP

- the value of output produce in current prices- it can increase from year to year if price and quantity increase- measure price increase (inflation)- FORMULA: price x quantity

• Real GDP:

- the value of output produces in current prices (already adjusted for inflation)- it can increase ONLY if quantity increases- measures economic growth- FORMULA: price x quantity

• GDP Deflator:

- price index used to adjust from nominal to real GDP- FORMULA: nominal GDP/real GDP x 100

• Consumer Price Index (CPI)

- the most commonly used measurement of inflation for consumers- FORMULA: current year/base year x 100 (new-old/old x100)

• How to calculate inflation:

-GDP Deflator/price index of year 2 - GDP Deflator/price index of year 1 / GDP Deflator/ price index of year 1 x 100 (new-old/old x100)

• In the base year, GDP deflator = 100
• For years after the base year, GDP deflator is greater than 100.
• For years before the base year, GDP deflator is less than 100. 

Unit II (GDP)

• GDP (Gross Domestic Product): total market value that all goods and services that is produced with in a country's borders with in a given year

• What's included:

- production made in USA of a foreign product 

C - personal consumption expenditures (65%)

• Buying a contour kit at Sephora 

Ig - gross private domestic investment (17%)

• new factory equipment

•  new factory equipment maintenance 

•  construction of housing  

• unsold inventory of product built in a year 

G - government spending = a fortune (20%)

Xn - net exports (-2%)

•  exports - imports = net

What's not Included:

- GNP: the total value of all final goods and services by citizens of that country on its land or foreign land 

-Ex: Forever 21 clothes produced in China  

• -formula: GNP = GDP + net foreign factor payment

- Intermediate goods - goods that require further processing before they are ready for final use

• ex: sugar cane, car parts, and etc 

- Used/Secondhand goods (avoid double counting)

• ex: a used car from Car Max 

         -Financial Transactions (stocks and bonds)
   
         -Illegal Activities - drugs, black market

         -Unreported Business Activity (unreported tips)

        -Transfer Payments 

• public; social security, welfare, VA.

• private; scholarship

       -Non market Activity - work that is self-performed

• ex: volunteering and babysitting

Two ways to calculate GDP:

Income approach: add up all of the income that resulted from selling all final goods and services produced in a year 

• GDP = (wages) +  (rents) + (interest) +  (profit) + Statistical adjustments (indirect business taxes, depreciation, net foreign factor payment)

Expenditure approach: add up all the spending on final goods and services produced in a year

• GDP = C + Ig + G + Xn

• Compensation of employees - includes wages, salaries, fringe benefits, social security, contributions, held and planned

• Rents - income of prop. owners

• Interest - income that comes from $

• Corporate Profits - income of the company stock holders

• Proprietors Income - income of sole proprietorship and partnerships

• Net domestic product (NDP)

-GDP - depreciation (consumption of fixed capital) 

• Net national product (NNP)

-GNP - depreciation