Unit 4

Demand for Money

• Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded.
1. What happens to the quantity demand of money when interest rate increase?
   Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities.
2. What happens to the quantity demanded when interest rates decrease?
   Quantity demanded increases there is no incentive to convert cash into interest earning assets.
• Money Demand Shifters
1. Changes in price level
2. Changes in income
3. Changes in taxation that affects investment
• Increasing the Money Supply
• If the FED increases the money supply, a temporary surplus of money will occur a 5% interest.
• The surplus will cause the interest rate to fall to 10%.
• Decreasing the Money Supply
• If the FED decreases the money supply, a temporary shortage of money will occur a 5% interest.
• The shortage will cause the interest rate to rise to 10%.
• How does this affect AD?
  Decrease money supply→Increase interest rate→Decrease investment→Decrease AD

Financial Sector

• Financial Assets vs. Financial Liabilities
• Financial Assets: stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain obligations.
• Financial Liabilities: liabilities incurred by the issuer of a financial asset to stand behind the issued asset.
• Interest Rate: the price paid of a use of a financial asset
• Stocks vs. Bonds
• Stocks: a financial asset that conveys ownership in a corporation
• Bonds: a promise to pay a certain amount of money plus interest in the future.

Unit 4

Time Value of Money

• Is a dollar today worth more than a dollar tomorrow?
  Yes
• Why?
• Opportunity cost & Inflation
• This is the reason for charging and paying interest.
• Let v=future value of money
  p=present value of money
  r=real interest rate (nominal rate - inflation rate) expressed as a decimal
  n=years
  k=number of times interest is credited per year
• The Simple Interest Formula
  v=(1+r)ⁿ×p
• The Compound Interest Formula
  v=(1+r/k)^nk×p
• Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1% after 1 year.

Unit 4

Money

1. 3 Uses of Money
1. Medium of Exchange: barter
2. Unit of Account: establishes economic work in the exchange process.
3. Storage Value: money holds its value over a period of time.
2. Types of Money
1. Commodity Money: it gets its value from the type of material from which it is made.
2. Representative Money: paper money backed by something tangible that gives it value.
3. Fiat Money: use in the US, it is money because the government says so.
3. Characteristics of Money
1. Portable
2. Durable
3. Divisible
4. Limited Supply
5. Acceptable
6. Uniform
4. Money Supply
• M1 Money: consist of money in circulation, checkable deposit (checking account) and travelers checks (75%). Held as a medium of exchange. It is the most liquid.
• M2 Money: consist of M1 money along with savings accounts, money market accounts, and deposits held by banks outside of the US.
• M3 Money: encompasses M2 money and certificate deposits (CD).

Unit 3

Fiscal Policy

Changes in expenditures or tax revenues of the federal government.

• 2 Tools of fiscal policy:
• Taxes: government can increase or decrease taxes.
• Spending: government can increase or decrease spending.
• 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 aa budget deficit.
• Government borrows from
• Individuals
• Corporations
• Financial Institution
• 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)
• Discretionary v. 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.
• Automatic: Unemployment compensation & 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.

• Expansionary Fiscal Policy	Contractionary Fiscal Policy
  Combat a recession Increase in Government Spending Decrease in Taxes	Combat inflation 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 policymakers.
• Social security
• Unemployment
• Medicaid/Medicare
• Veterans compensation

Progressive Tax System

• Average tax rate (tax revenue/GDP)

Proportional Tax System

• Average tax rate remains constant as GDP changes

Regressive Tax System

• Average tax rate falls with GDP.

Unit 3

The Spending Multiplier Effect

• An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregare spending, or Aggregate Demand (AD)
• Multiplier = ΔAD/ΔC, I, G, or X

Calculating the Spending Multiplier

• The Spending Multiplier can be calculated from the MPC or the MPS.
• Multiplier = 1/1-MPC or 1/MPS
• Multiplier are (+) when there is an increase in spending and (-) when there is a decrease.

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse
• Why?
• Because now money is leading the circular flow
• Tax Multiplier (note: it's negative)
• = -MPC/1 - MPC or -MPC/MPS
• If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow.

Consumption and Savings

• Disposable Income (DI)
• Income after taxes or net income
• DI = Gross Income - Taxes
• 2 Choices
• With disposable income, households can either
• Consume (spend money on goods and services)
• Save (not spend money on goods and services)
• Consumption
• Household spending
• The ability to consume is constrained by
• The amount of disposable income
• The propensity to save
• Do households consume if DI = 0?
• Autonomous consumption
• Dissaving
• Saving
• Household NOT spending
• The ability to save is constrained by
• The amount of disposable income
• The propensity to consume
• Do households save if DI = 0?
• NO
• APC & APS
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = Dissaving
• -APS = Dissaving
• Marginal Propensity to Consume (MPC)
• The fraction of any change in disposable income that is consumed.
• MPC = ΔC/ΔDI
• Marginal Propensity to Save (MPS)
• The fraction of any change in disposable income that is saved.
• MPS = Δsavings/ΔDI
• Marginal Propensities
• MPC + MPS = 1
• MPC = 1 - MPS
• MPS = 1 - MPC

Unit 3

Classical vs. Keynesian

Topic	Classical	Keynesian
Modern followers	Neoclassical Supply siders Adam Smith J. B. Say David Richards Alfred Marshal	Neokeynesians J. M. Canes
Say's Law	Supplies creates its own demand. Production = income = spending Under-spending is unlikely	Depressions refute Say's law Demand creates its own supply Underspending persist
Savings and Investment	Savings = Investment income	Savings ≠ Investment Different motivations
Loanable Funds Market	Table Cell	Investment from savings, cash, checking, accounts Leanding creates money which causes supply of money increase. Inflation and unemployment is unstable.
Wage/price flexibility	If AD decrease, price level decrease and assumes competition	Inflexible downward Flexible upward only
Supply Curve	Vertical	Horizontal
Output and Employment	AS determines output and employment	AD determines output and employment
Unemployment	Rarely exist due to wage/price flexibility Causes: external-war	Usually exist Causes: external-war               internal-savings ≠ investment
Aggregate Demand (AD)	AD determines the price level AD is reasonably stable if money supply is stable	AD changes due to the determinants AD is unstable even if money supply is stable due to fluctuations
Basic Equation	MV = P x Q	C + Ig + G + Xn = GDP
Role of Government	Monetary rule maintain a money supply Laissez Faire is best Economy is self regulating	Fiscal policy means Active government Economy is not self regulating
Inflation	Caused by too much money	Caused by too much demand
How long the short run is	Very short time	Long time
Emphasis Today	Microeconomics	Macroeconomics

Unit 3

Investment

• Money spent or expenditures on:
• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• New homes
• Inventories (goods sold by producers)
• Expected Rates of Return
• How does business make investment decisions?
• Cost/Benefit Analysis
• How does business determine the benefits?
• Expected rate of return
• How does business count the cost?
• Interest costs
• How does business determine the amount of investment they undertake?
• 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.
• How do you compute the real interest rate (r%)?
• r% = i% - π%
• What then, determines the cost of investment cost?
• The real interest rate (r%)
• Investment Demand Curve (ID)
• What is the shape of the investment demand curve?
• Downward sloping
• Why?
• When interest rates are high, fewer investments are profitable, when interest rates are low, more investments are profitable.
• Shifts in Investment Demand (ID)
• Cost of Production
• Lower costs shift ID →
• Higher costs shift ID ←
• Business Taxes
• Lower business taxes shift ID →
• Higher business taxes shift ID ←
• Technological Change
• New technology shifts ID →
• Lack of technological change shifts ID ←
• Stock Capital
• If an economy is low on capital, then ID →
• If an economy has much capital, then ID ←
• Expectations
• Positive expectations shift ID →
• Negative expectations shift ID ←

Unit 3

Full Employment

• Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point.
  
• A recessionary gap exists when equilibrium occurs below full employment output.
  
• An inflationary gap exists when equilibrium occurs beyond full employment output.
  

Nominal Wages vs. Real Wages

• Nominal wages: the amount of money received by a worker per unit of time.
• Real wages: the amount of goods and services a worker can purchase with their nominal wage.
• Sticky wages: nominal wage level that is set according to an initial price level and it does not vary due to labor contracts or other restrictions.

Unit 3

Aggregate Study

• The level of Real GDP (GDP_R) that firms will produce at each Price-Level (PL)

Long-Run v. Short-Run

• Long-Run
• Period of time where input prices are completely flexible and adjust to changes in the price-level.
• In the long-run, the level of Real GDP supplied is independent of the price level.
• Short-Run
• Period of time where input prices are sticky and do not adjust to changes in the price-level.
• In the short-run, the level of Real GDP supplied is directly related to the price-level.

Long-Run Aggregate Supply (LRAS)

• The Long-Run Aggregate Study marks the level of full employment in the economy (analogous to PPC)
• Because input prices are completely flexible in the long-run, changes in price-level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment.

Changes in SRAS

• An increase in SRAS is seen as a shift to the right. SRAS →
• A decrease in STAS is seen as a shift to the left. SRAS ←
• The key to understanding shifts in SRAS is per unit cost of production.
• Per unit production cost = total input cost/total output cost

Determinants of SRAS

• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost Capital
• Raw materials (commodity prices)
• Foreign Resource Prices
• Market Power
• Increases in Resource Prices = SRAS ←
• Decreases in Resource Prices = SRAS →
• Productivity
• Productivity = total output/total inputs
• More productivity = lower unit production cost = SRAS →
• Lower productivity = higher unit production cost = SRAS ←
• Legal-institution environment
• Taxes and Subsidies
• Taxes ($ to government) to business reduce per unit production cost = SRAS ←
• Subsidies ($ from government) to business reduce per unit production cost = SRAS →
• Government Regulation
• Government regulation creates a cost of compliance = SRAS ←
• Deregulation reduces compliance costs = SRAS →

Unit 3

Shifters of Aggregate Demand

• There are two parts to a shift in AD:
• A change in C, Ig, G and/or Xn
• A multiplier effect than produces a greater change than the original change is the 4 components.
• Increases in AD = AD →
• Decreases in AD = AD ←
  

Determinants in AD

• Consumption
• Household spending is affected by:
• Consumer wealth
• More wealth = more spending (AD shifts →)
• Less wealth = less spending (AD shifts ←)
• Consumer expectations
• Positive expectation = more spending (AD shifts →)
• Negative expectation = less spending (AD shifts ←)
• Household indebtedness
• Less debt = more spending (AD shifts →)
• more debt = less spending (AD shifts ←)
• Taxes
• Less taxes = more spending (AD shifts →)
• More taxes = less spending (AD shifts ←)
• Gross Private Investment
• Investment Spending is sensitive to:
• The Real Interest Rate
• Lower Real Interest Rate = More Investment (AD →)
• Higher Real Interest Rate = Less Investment (AD ←)
• Expected Returns
• Higher Expected Returns = More Investment (AD →)
• Lower Expected Returns = Less Investment (AD ←)
• Expected Returns are influenced by
• Expectations of future profitability
• Technology
• Degree of Excess Capability (Existing Stock of Capital)
• Business taxes
• Government Spendings
• More Government Spending (AD →)
• Less Government Spending (AD ←)
• Net Exports
• Net Exports are sensitive to:
• Exchange Rates (International value of money)
• Strong $ = More Imports and Fewer Exports = (AD ←)
• Weak $ = Less Imports and More Exports = (AD →)
• Relative Income
• Strong Foreign Economies = More Exports = (AD →)
• Weak Foreign Economies = Less Exports = (AD ←)

Unit 3

Aggregate Demand Curve

• AD is the demand by consumers, businesses, government, and foreign countries.
  What definitely doesn't shift the curve?
  Changes in price level cause a move along the curve.
• Why is AD downward sloping?
1. Real-Balance Effect
• Higher price levels reduce the purchasing power or money.
• This decreases the quantity of expenditures.
• Lower price levels increase purchasing power and increases expenditures.
• Ex: If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.
  So... Price level goes up, GDP demand goes down.
2. Interest-Rate Effect
• When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.
• Higher interest rates discourage consumer spending and business investment. WHY?
• Ex: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.
3. Foreign Trade Effect
• When U.S. price level rises, foreign buyers purchase fever U.S. goods and Americans buy more foreign goods.
• Exports fall and imports rise causing real GDP demanded to fall. (Xn Decreases)
• Ex: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. Again, Price Level goes up, GDP demanded goes down (and Vice Versa)