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Study Guide 3

by: Kate Notetaker

Study Guide 3 Econ 1012

Kate Notetaker

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Notes on chapter 12 for test 3.
Dr. John Volpe
Study Guide
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This 11 page Study Guide was uploaded by Kate Notetaker on Wednesday March 23, 2016. The Study Guide belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 341 views. For similar materials see Macroeconomics in Economcs at George Washington University.


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Date Created: 03/23/16
February 18, 2016 Chapter 12 Homework 1. The aggregate expenditure model can be written in terms of four spending categories. Which equation shows the relationship between aggregate expenditure and the four spending categories? a. AE = C + I + G + NX i. Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports 2. Aggregate expenditure represents a. The amount of spending that occurs in an economy 3. We say that the economy as a whole is in macroeconomic equilibrium if a. Aggregate expenditure equals GDP b. Total spending equals total production c. Aggregate expenditure equals total production d. Total spending equals GDP 4. If inventory is rising due to the overproduction of crops, then it does not signal bad times a. Inventory is not increasing because of a fall in demand 5. Determinant of investment a. Taxes b. Interest rates c. Expectations about future profitability 6. Total government purchases include a. Spending on goods and services by all federal, state and local governments 7. Relationship between the marginal propensity to consume and the marginal propensity to save can best be described as a. MPC + MPS = 1 b. MPC = 1 – MPS c. MPS = 1 – MPC 8. The multiplier represents a. The total amount of additional increases in consumption spending induced by an initial change in aggregate expenditure Chapter 12 Textbook  Aggregate expenditure model o Focuses on the short-run relationship between total spending and real GDP o Assumption of the model  price level is constant o In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure  Aggregate Expenditure o Early 1930s  US, UK and other industrial countries suffered declines in real GDP of 20 percent or more o Four components of aggregate expenditure that together equal GDP  Consumption  Spending by households on goods and services, such as automobiles and haircuts  Planned investment  planned spending by firms on capital goods, such as factories, office buildings, and machine tools and on research and development, and spending by household and firms on new houses  Government purchases  spending by local, state and federal governments on goods and services, such as aircraft carriers, bridges, and the salaries of FBI agents  Net exports  spending by foreign firms and households on goods and services produced in the US minus spending by US firms and households on goods and services produced in other countries o Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports  AE = C + I + G + NX  Planned Investment vs. Actual Investment o Planned investment spending  Component of aggregate expenditure o Inventories  Goods that have been produced but have not yet been sold  Changes in inventories  included as part of investment spending  Along with spending on machinery, equipment, office building, and factories o Amount businesses plan to spend on machinery and office buildings  Equal to the amount they actually spend  Amount businesses plan to spend on inventories may be different o Actual investment spending will be  Greater than planned investment spending WHEN there is an unplanned increase in inventories  Less than planned investment spending WHEN there is an unplanned decrease in inventories o Actual investment will equal planned investment only when there is no unplanned change in inventories  Macroeconomic Equilibrium o Occurs when total spending, or aggregate expenditure equals total production, or GDP  Aggregate expenditure = GDP o Why GDP fluctuates in the short run  Adjustments to Macroeconomic Equilibrium o When aggregate expenditure is greater than GDP  total amount of spending in the economy is greater than the total amount of production  Many businesses will sell more goods and services than they had expected to sell  Inventories will decrease  Total employment will increase o When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase o Aggregate expenditure is less than GDP  spending is less than production  Many businesses will sell fewer goods and services than expected  Inventories will increase  GDP and total employment will decrease o Aggregate expenditure equals GDP  Firms sell what they expected  Inventories unchanged  Not have an incentive to increase or decrease production  Macroeconomic equilibrium o Macroeconomic policies  Federal government may implement these if economists forecast that aggregate expenditure is likely to decline and that the economy is headed for a recession  Determining the Level of Aggregate Expenditure in the Economy o Components measured in real terms o Consumption  Follows a smooth, upward trend  Only in period of recession does the growth in consumption decline  Variables  Current disposable income o Most important determinant o Income remaining to households after they have paid the personal income tax and received government transfer payments o Macroeconomic consumption  total of all consumption of US households o Increase when the current disposable income of households increases o Decrease when the current disposable income of households decreases  Household wealth o Value of its assets minus the value of its liabilities o Wealth of households increases  consumption should increase o Stock increases  wealth of households increase o Permanent increases in wealth have a larger impact than temporary increases  Expected future income o Current income explains current consumption  Only when current income is not unusually high or unusually low compared with expected future income  The price level o Measures the average prices of goods and services in the economy o As price level rises, the real value of wealth declines  So will consumption  The interest rate o When interest rate is high, the reward for saving is increased  Households are likely to save more and spend less o Nominal interest rate  States interest rate on a loan or a financial investment o Real interest rate  Corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate  Consumption spending  Spending on services  Spending on nondurable goods  Spending on durable goods o Most likely to be affected by changes in the interest rate  Consumption function  relationship between income and consumption  Households spend a consistent fraction of each dollar of real disposable income on consumption  Marginal Propensity to Consume o Amount by which consumption spending changes when disposable income changes o Slope of the consumption function  Relationship between consumption spending and disposable income o Estimate the MPC by estimating the slope of the production function  MPC = (change in consumption)/(change in disposable income)  Average Propensity to Consume  ratio of consumption to disposable personal income  Consumption and National Income o Disposable income = National income – Net taxes o National income = GDP = Disposable income + Net taxes  Income, Consumption and Saving o National income = Consumption + Saving + Taxes o 1 = MPC + MPS o A part of every increase in income is consumed, and with taxes constant, what is left over is saved  Marginal Propensity to save  1 = MPC + MPS o Marginal propensity to consume plus the marginal propensity to save must equal 1  Planned Investment o Expectations of future profitability  Investment goods are long-lived  Firms build more when they are optimistic about future profitability  Recessions reduce confidence  firms reduce planned investment  Purchases of new housing included in planned investment  In recession  households have reduced wealth  Less incentive to invest in new housing o Interest rate  A higher real interest rate results in less investment spending and a lower real interest rate results in more investment spending o Taxes  Higher corporate income taxes on profits decrease the money available for reinvestment and decrease incentives to invest by diminishing the expected profitability of investment  Investment tax incentives tend to increase investment o Cash flow  The difference between the cash revenues received by a firm and the cash spending by the firm  Largest contributor to cash flow is profit  Recessions  profits fall for more firms, decreasing their ability to finance investment  Government Purchases o Include purchases at all levels  federal, state and local o Does not include transfer payments, only purchases for which the government receives some good or service  Net Exports o Price level in US vs the price level in other countries o US growth rate vs growth rate in other countries o US dollar exchange rate o Determinants of Net Exports o  45-degree Line Diagram o Also known as the Keynesian Cross o GDP on x-axis and real aggregate expenditure on the y-axis o Based on the analysis of John Maynard Keynes o Only points on the 45-degree line can be a macroeconomic equilibrium  Planned aggregate expenditure equal to GDP o Determining the Equilibrium  When they receive additional income, households consume some of it and save some of it  Resulting consumption function tells us how much consumers will spend (real expenditure) when they have a particular income (real GDP)  Real GDP must equal planned aggregate expenditure  Find the “right” level of C  If there is no other expenditure, the equilibrium is wherever the consumption function crosses the 45 degree line  Income equals expenditure  Macroeconomic equilibrium is the point at which  Income equals expenditure  Y = C + I + G + NX  The level of consumption is consistent with the level of income, according to the consumption function  We call this top most line the aggregate expenditure function o Recession  If equilibrium happens at the level of potential GDP  Unemployment will be low  It will be at the natural rate of unemployment or the full employment level  When the aggregate expenditure line intersects the 45 degree line at a level of GDP below potential GDP  recession  Important Role of Inventories o When planned aggregate expenditure is less than real GDP, firms will experience unplanned increases in inventories  Even if spending returns to normal  firms have excess inventories to sell  They will do this instead of increasing production to normal levels o Economics estimate that almost half of this decline was due to firms cutting production as they sold off their unintended accumulation of inventories  Autonomous and Induced Expenditures o Small change in planned aggregate expenditure causes a larger change in equilibrium real GDP o Autonomous expenditures  their level does not depend on the level of GDP  Planned investment, government purchases, and net exports o Consumption has both an autonomous and induced effect  Its level does depend on the level of GDP  Produce the upward-sloping AE line o Increase in an autonomous expenditure shifts the aggregate expenditure line upward  Real GDP increases by more than the change in autonomous expenditures  This is the multiplier effect  The value of the increase in equilibrium real GDP divided by the increase in autonomous expenditures is the multiplier  1 / 1 – MPC or 1/MPS  Eventual Effect of the Multiplier o Eventual change in real GDP divided by the change in autonomous expenditures  (Change in real GDP)/(Change in investment spending)  The Multiplier and the Marginal Propensity to Consume o In each “round”, the additional income prompts households to consume some fraction  The marginal propensity to consume o The total change in equilibrium real GDP equals  Initial increase in planned investment spending  Plus the first, second, third, etc., induced increase  Formula for the Multiplier o Multiplier = (Change in equilibrium real GDP)/(Change in autonomous expenditure)  1 / (1 – MPC)  Multiplier Effect o Occurs both for an increase and a decrease in planned aggregate expenditure o Because multiplier is greater than 1, the economy is sensitive to changes in autonomous expenditure o Larger the MPC, larger the value of the multiplier o Model is somewhat simplified  Omits some real-world complications  The value we estimate for the multiplier, from the MPC, is too high  The Paradox of Thrift o Savings equals investment  If saving does not equal investment, there is a discrepancy between spending and production that will result in unplanned inventory changes  Since firms are not in favor of seeing inventory levels change, production will change  Production will increase when inventories are deplete and fall when inventories accumulate  At the equilibrium level of GDP, inventories do not change and spending equals production o Savings were the key to long term growth o Paradox of thrift  what appears to be favorable in the long-run may be counterproductive in the short run  Short run if people save more  consumption decreases, income decrease, consumption decreases more  potentially pushes economy into recession  An increase in saving is good, because saving is borrowed and spend on investment goods  More plant and equipment increases the capacity of the economy to produce goods and services  Savings will be borrowed and spent for investment purposes  If an increase in saving doesn’t lead to more investment, we have the Paradox of Thrift  The attempt to save more may reduce GDP and leave actual saving unchanged  Price Level and Aggregate Expenditure o As demand for a product rises  production will increase, so will the product’s price o Expect that an increase in aggregate expenditure would increase the price level  Increases in the price level will cause aggregate expenditure to fall and decreases in the price level will cause aggregate expenditures to rise  How does the Price Level Affect Aggregate Expenditure? o Rising price levels decrease the real value of household wealth  consumption falls o If price levels rise in the US faster than in other countries, US exports fall and imports rise, causing net exports to fall o When prices rise, firms and households need more money to finance buying and selling  If the supply of money doesn’t change, the interest rate must rise  This will cause investment spending to fall o These effects work in reverse if the price level falls  Aggregate Demand Curve o Inverse relationship between price level and real GDP o Curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure  Consumption spending is only a part of aggregate expenditure  Graphical analysis of macroeconomic equilibrium tells us the qualitative changes that take place o Equation-based model allows us to make quantitative or numerical estimates ‘ o Rely on econometric models  Statistically estimate the relationships between economic variables  Aggregate Expenditure Equations o C = C + MPC(Y)  Consumption function o I = I  Planned investment function o G = G  Government spending function o NX = NX  Net export function o Y = C + I + G + NX  Equilibrium condition o Italicized letters are fixed (autonomous) values o Y = C + MPC(Y) + I + G + NX  Y – MPC(Y) = C + I + G + NX  Y(1-MPC) = C + I + G + NX  Y = (C + I + G + NX) / (1-MPC)  (C + I + G + NX) x (1/(1-MPC)) o Equilibrium GDP = Autonomous expenditure x Multiplier  An unplanned increase in inventories results from actual investment that is great than planned investment  When aggregate expenditure is more than GDP o There was an unplanned decrease in inventories  Disposable Income  national income + transfers – taxes  US net export spending rises when o The growth rate of US GDP is slower than the growth rate of GDP in other countries Chapter 13 o Aggregate demand and aggregate supply model o Explains short run fluctuations in real GDP and the price level o Aggregate demand curve  relationship between the price level and the quantity of real GDP demanded by households, firms and the government o Short-run aggregate supply curve  relationship in the short run between the price level and the quantity of real GDP supplied by firms o Why is the Aggregate Demand Curve Downward Sloping? o A fall in the price level increases the quantity of real GDP demanded o Change in Price Affects Consumption  Current income is the most important variable determining consumption by households  Income rises  consumption will rise  Income falls  consumption will fall  Household wealth  difference between the value of a household’s assets and the value of its debts  Sometimes held in cash or other nominal assets  As total household wealth rises, consumption will rise  When the price level rises, the real value of household wealth declines  So will consumption  Reduces the demand for goods and services  When price level falls, the real value of household wealth rises  So will consumption and the demand for goods and services  Called the wealth effect o Change in Price Affects Investment  When price level rises, households and firms will try to increase the amount of money they hold  Withdrawing funds from banks, borrowing from banks or selling financial assets such as bonds  Tend to drive up the interest rate banks charge on loans and the interest rate on bonds  Higher interest rate raises the cost of borrowing for firms and households  Firms will borrow less  Households will borrow less  Consumption will also fall as households borrow less to finance spending on durable goods  Higher price level increases the interest rate and reduces investment spending  In turn, it also reduces the quantity of goods and services demanded  Lower price level will decrease the interest rate and increase investment spending  Increases the quantity of goods and services demanded  Called the interest-rate effect o Change in Price Affects Net Exports


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