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)