Classical vs Keynesian

Classical Schools:

• Trickle down theory to help the rich 1st a then everyone else
• In the LR, the economy will balance @ full employment output
• The invisible hand

Keynesian School: 

• AD is the key, not AS
• In the LR, we are dead
• Leaks cause recessions 
• Savings cause recessions

Digging deeper please visit:

http://www.investopedia.com/university/macroeconomics/macroeconomics1.asp

Multiplier Effect

The Spending Multiplier Effect: 

• An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or Aggregate Demand (AD). 
• Multiplier = Change in AD/Change in Spending 
• Multiplier = Change in AD/ Change in C, Ig, G, Xn 
• Why does this happen?
• Expenditures and income flow continuously which sets off a spending increase in the economy. 

Calculating the Spending Mulitplier 

•  The spending multiplier can be calculated from the MPC or the MPS. 
• Mulitplier = 1/(1-MPC) or 1/MPS
• Multipliers 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 leaving 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 & Saving

Disposable Income (DI)

• Income after taxes or net income 
• DI= Gross Income - Taxes

2 choices: 

• With disposable income, households can either 
• Consumer (spend money on goods & services)
• Save (not spend money on goods & 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, there is nothing to save 

APC & APS

APC= Average propensity to consumer

APS= Average propensity to save

APC + APS = 1

APC > 1 : Dissaving 

-APS : Dissaving 

MPC & MPS

• Marginal Propensity to Consume
• change in C/ change in DI
• % of every extra dollar earned that is spent
• Marginal propensity to save
• change in S/ change in DI
• % of every extra dollar earned that is saved 
• MPC + MPS= 1

Determinants of Consumption and Saving: 

• Wealth
• Expectation 
• Households Debt
• Taxes

The AS/AD Model

The equilibrium of AS & AD determines current output (GDPr) and the price level (PL)

Full employment 

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

Inflationary Gap

• Output is high and unemployment is less than NRU 
• Actual GDP above potential GDP 

Recessionary Gap 

• Output low and unemployment is more than NRU 
• Actual GDP below potential GDP 

Aggregate Supply

Aggregate Supply: the level of Real GDP that firms will produce at each price level (PL)


Long run v Short run

Long run: 

• period of time where input prices ar 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 supply or LRAS marks the level of full employment in the economy (analogous to PPC)

Short-Run Aggregate Supply (SRAS)

• Because input prices are sticky in the short-run, the SRAS is upward sloping. 

Changes in SRAS

• An increase in SRAS is seen as a shift to the right. SRAS -->
• A decrease in sRAS is seen as a shift to the left. SRAS <--
• The key to understanding shifts in SRAS in per unit cost of production 

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

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

Input prices

• Domestic Resource Prices
• Wages (75% of all business cost)
• Cost of Capital
• RAW Materials (commodity prices)
• Foreign Resource Prices 
• Strong $ = lower foreign resource prices
• Weak $ = higher foreign resource prices 
• Market Power
• Monopolies and cartels that control resources control the price of those resources. 
• Increases in Resource Prices = SRAS <--
• Decreases in Resource Prices = SRAS -->

Productivity 

• Productivity= total output/ total input
• More productivity= lower unit production cost = SRAS -->
• Lower productivity = higher unit production cost = SRAS <--

Legal-Institutional Environment 

• Taxes and Subsidies 
• Taxes ($ to government) on business increase per unit production cost = SRAS <--
• Subsisdies ($ 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 -->

Interest rates & Investment Demand

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 

What then, determines the cost of an investment decision? 

• 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

• Cost of Production
• Business Taxes 
• Technological Change
• Stock of Capital
• Expectations 

A little video to help further understand this topic: 

Aggregate Demand

Aggregate Demand Curve

AD: is the demand by consumers, businesses, government and foregin countries
AD=  C + I
y axis: price level
x axis: Real Domestic output

Changes in price level cause a move along the curve not a shift of the curve

Aggregate Demand (AD)

• Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level. 
• The relationship between the price level and the level of Real GDP is inverse

3 reasons Why is AD downward sloping 

1.  Wealth Effect

• Higher prices reduce purchasing power of $
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures
• Ex: If the balance in your banks was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending. 
1. Interest-Rate Effect
• As 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.
• Ex: Increase in price lead to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.  
2.  Foreign Trade Effect
• When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods
• Exports fall and imports rise causing real GDP demanded to fall (Xn decreases)
• Ex: If price triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. 

Shifts in Aggregate Demand (AD) 

There are two parts to a shift in AD: 

• A change in C, I, G, and/for Xn
•  a multiplier effect that produces a greater chage than the originial change in the 4 components. 
• Incrase in Ad= AD

Determinant of AD

• Consumption
• Gross Private Investment
• Government Spending
• Ne tExporots 

Change in consumer Spending

• Consumer Wealth (Boom in the stock market..)
• Consumer Expectations 
• Household indebtedness (more combine debt)
• Taxes

Change in investment spending 

• Real interest rates (price of borrowing) 
• Future Business expectations
• Productivity and technology 

Change in Government Spending

• (War...)
• ( Nationalized Health CAare)
• (Decrease in defense spending...)

Change in Net Exports

• Exchange Rates
• national income compared to Abroad

Government Spending: More (AD goes right) Less (AD goes left)

Unemployment

Unemployment rate: percent of people in the labor force who want a job but are not working.

Labor force: the number of people in a country that are classified as either employed or unemployed.

Employed:

1. someone who works at least one hour a month
2. someone considered temporarily absent from work 
3. Part-time people 

Not in Labor Force: 

1. Kids
2. Full-Time Students
3. People who are in mental institutions
4. Military personnel
5. Stay at home parents 
6. Retirees  
7. People who are incarcerated (time in jail)
8. Discouraged workers 

Unemployment rate=  (# unemployed/ # in labor force(# unemployed + # employed)) x 100

Standard Unemployment Rate= 4-5%

Types of Unemployment:

1. Frictional Unemployment:  

• "Temporarily unemployed" or being between jobs
• Qualified workers with transferable skills but they aren't working 

      2.  Seasonal Unemployment: 

• Time of the year and the nature of the job 
• These jobs will come back 
• Ex: Santa claus, easter bunnies, lifeguards 

       3.  Structural Unemployment

• Structure of the labor force make some  skills obsolete
• Workers DO NOT have transferable skills and these jobs will never come back 
• Workers must learn new skills to get a job
• permanent loss of these jobs is called "creative destruction" 

      4.  Cyclical Unemployment

•  Unemployment that results from economic downturns (Recessions) 
• AS demand for goods and services falls, demand for labor falls and workers are fired. 

Frictional Unemployment + Structural Unemployment = Natural Rate of Unemployment (Full employment)(4-5%)

Full employment means NO cyclical unemployment 

Okun's Law: When unemployment rises 1 percent above the natural rate, GDP falls by about 2 percent 

Inflation :

Inflation: general rising level of prices

• reduces the "purchasing power" of money 
• Example: 
• It takes $2 to buy today what $1 bought in 1982
• It takes $6 to buy today what $1 bought in 1961

Three Causes of Inflation

1. Printing too much money (The Quantity Theory) 
2. Demand-Pull Inflation 
1. "Too many dollars chasing too few goods" - caused by an excess of demand over output that pulls prices upwards
3. Cost-push inflation 
1. Higher Production costs increase prices

Standards Inflation Rate: 2-3%

Inflation Rate=(Current Year Price Index - Base year Price Index/ Base Year Price Index) x 100

Rule of 70: used to calculate the number of years it will take for the price level to double at any given rate of inflation 

Rule of 70= (70/ annual inflation rate)

Deflation: general decline in the price level 

Disinflation:  it occurs when the inflation rate declines 

Real Interest Rates: percentage increase in purchasing power  that a borrower pays to the lender. (adjusted for inflation)

Real= nominal interest rate - expected inflation

Nominal Interest Rates: the percentage increase in money that the borrower pays back to the lender not adjusting for inflation 

Ex: You lend out $100 with 20% interest

Unanticipated inflation: 

Hurt by Inflation: Lenders-People who lend money (at fixed interest rates) , People with fixed incomes, Savers 

Helped by Inflation: Borrowers- People who borrow money , A business where the price of the products incrassees faster than the price of resources. 

Nominal GDP vs Real GDP

 Nominal GDP: the value of output produced at current prices.

• can increase from year to year if either output or prices increase.
• Nominal GDP= Price X Quantity

Real GDP: the value of output produced at constant based year prices. 

• it is adjusted for inflation
• Real GDP= Price X Quantity
• can increase from year to year only if output increases 

Key Tips:

• If you want to measure economic growth, you measure Real GDP
• Only in the base year does Real GDP equal to Nominal GDP
• In years after the base year, Nominal GDP will exceed Real GDP 
• In years before the base year, Real GDP will exceed Nominal GDP
• If base year is not given, the earliest year is the base year

GDP Deflator: a price index that is used to adjust from Nominal to Real GDP 

• GDP Deflator= (Nominal GDP/ Real GDP) x 100

Consumer Price Index (CPI): it measures inflation by tracking changes in the price of a market basket of goods. 

• CPI= (Price of Market basket in current year/ Price of market basket in base year) x 100

Calculating the GDP: Expenditure and Income Approach

Depreciation: the loss of value of capital equipment due to normal wear and tear.

Formulas: 

Expenditure Approach to GDP= C + Ig + G + Xn
C= Consumption
Ig= Gross Domestic Investment
G= Government Spending
Xn= Net Exports

Income Approach to GDP= W + R + I + P + Statistical Adjustment

W- Wages/ Compensation of employee/ salary

R- Rent 

I- Interest 

P- Profit 

Budget= Government Purchases of Goods and Services + Transfer Payments - Government Taxes & Fee Collection   (if answer is +=deficit -= surplus)

Trade= Exports - Imports (if answer is += surplus -= deficit)

National Income=

•  Compensation of employees + Rental Income + Interest Income + Properitors Income + Corporate Profit 
• GDP - Indirect Business Taxes - Depreciation - Net Foreign Factor Payments 

Disposable Personal Income= National Income - Personal Household Taxe + Government Transfer Payments. 

Net Domestic Product = GDP - Depreciation 

Net National Product = GNP - Depreciation 

Gross Investments= Net Investment + Depreciation 

GNP= GDP + Net Foreign Factor Payment