Week 10 Macroeconomics Chapter 12 Review
Week 10 Macroeconomics Chapter 12 Review Econ 1012
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This 7 page Study Guide was uploaded by Caroline Jok on Thursday March 24, 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 162 views. For similar materials see Principles of Economics II in Economcs at George Washington University.
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Date Created: 03/24/16
Chapter 12 Review Vocabulary: Aggregate demand curve: shows the relationship between price level and level of aggregate expenditure. Aggregate expenditure: Total amount of spending in the economy Aggregate expenditure model: focuses on the relationship between total spending and real GDP in the short run assuming that the price level is constant Autonomous expenditure: expenditure that does not depend on the level of GDP. Cash flow: difference between cash revenues received by a firm and the cash spending of the firm. Consumption function: relationship between consumption and disposable income Inventories: goods that have been produced but not yet sold Marginal propensity to consume: change in consumption divided by change in disposable income Marginal propensity to save: change in saving divided by the change in disposable income Multiplier: ratio of the change in equilibrium GDP to the change in autonomous expenditure. Multiplier effect: process by which an increase in autonomous expenditure leads to a larger increase in real GDP Objectives: - Macroeconomic equilibrium is determined in the aggregate expenditure model - Which uses a 45 degree line diagram - The multiplier effect is used to calculate changes in equilibrium and GDP - There are four components of aggregate expenditure o Consumption, planned investment, government purchases and net exports. - Relates to the business cycle as fluctuations in total spending - In any particular year, the GDP is determined mainly by the level of AE - Situations: o AE increases as much as the production of goods/services § Firms sell about what they expected to sell and remain production and employment unchanged o AE increases more than the production § Firms increase production and hire more workers o AE doesn’t increase as much as production § Cut back on production and lay off workers. Notes: Aggregate Expenditure and Output in the Short Run • Aggregate Expenditure: Total spending in the economy: sum of consumption, planned investment, government purchases and net exports. • Years where total spending in the economy increases more than the production of goods and services: firms increase production and higher more workers 12.1 The Aggregate Expenditure Model • GDP: value of all final goods/service in an economy during a particular year • Real GDP corrects nominal GDP for inflation • Aggregate Expenditure model: macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. o In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure Aggregate Expenditure: • John Keynes: The General Theory of Employment, interest and money: analyzed the relationship between changes in aggregate expenditure and changes in GDP • Four components of AE = GDP o Consumption (C): the spending by households on goods/services o Planned investment (I): Planned spending by firms on capital goods, such as factories, office buildings etc. and spending by households and firms on new houses o Government Purchases (G): spending by local, state and federal governments o Net Exports (NX) : spending by foreign firms and households on goods and services produced in the US minus Spending by US firms/households on goods/services produced in other countries. • AE = C + I + G + NX The Difference between Planned Investment and Actual Investment • Planning investment spending vs actual investment spending • Inventories: goods that have been produced but not yet sold. o Changes in inventories are included as part of investment spending along with spending on machinery, equipment, office buildings and factories. • Actual investment will equal planned investment only when there is no unplanned change in inventories. • Assume that the economy is not growing: the equilibrium GDP will not change unless AE changes Adjustments to Macroeconomic Equilibrium • Sometimes the quantity demanded is greater than that which is supplied and vise versa • Sell more than expected: likely to order more when AE is greater than GDP, inventories will decline and GDP and total employment will increase • AE < GDP inventories will increase and GDP and total employment will decrease • AE = GDP: Firms sell what they expect = equilibrium • If economist forecast AE decline and the economy is headed for recession - gov implements macroeconomic policies 12.2 Determining the Levels of Aggregate Expenditure in the Economy • Components of AE measured in real terms (values corrected for inflation by begin measured in billions of 2009 dollars) • Consumption is the largest component • Investment and government are similar • Net Exports typically smallest Consumption • Variables o Current disposable incomes • Most important • Income remaining to houses after they have paid income tax and received government transfer payments • Higher = spend more • Increases with the increase of disposable income • Total income declines during recessions o Household wealth • Value of assets minus value of liabilities § Asset: anything of value owned by a person or a firm § Liability: anything owed • Assets include: home, stock/bonds, banks • Liabilities: loans • Increase in wealth = increase in spending • Permanent increases have larger impact then temporary o Expected future income • Most people keep their consumption steady • Explains well only when current income is not unusually high or unusually low compared with expected future income. o Price level • PL measures the average prices of goods and services in the economy. • Affected by changes in price level • Increase in price of one product on the quantity demanded of the product is different from the effect of an increase in the price level on total spending • Increase in price level = decrease in the real value of wealth • As price level rises, real value of wealth declines so does consumption o Interest rate • Interest rate is high = reward for saving increases, houses likely to save more and spend less • Nominal interest rate: stated interest rate on a loan • Real interest rate; corrects nominal interest for the effect of consumption • Spending on durable goods is most likely to be affected by changes in interest rate • Consumption spending is divided: o Services o Nondurable goods o Durable goods • The Consumption Function: the relationship between consumption spending and disposable income • Marginal propensity to consume: slope of the consumption function: amount by which consumption in spending changes when disposable income changes. • MPC = Change in consumption / change in disposable income • Change in consumption = Change in disposable income * MPC The Relationship between Consumption and national income • GDP and national income used interchangeably • Disposable income = national income + government transfer payments = taxes • Taxes - government transfer payment = net taxes • National income = GDP= Disposable income + net taxes • Can always calculate MPC using change in national income or change in disposable income Income, Consumption, and Saving • National income = consumption + saving + taxes • National income increases there is an increase in its factors • Y = national income, C = consumption, S = Saving, T = taxes • Marginal Propensity to save: amount by which saving changes when disposable income changes. • 1 = MPC + MPS Planned Investment: • Variables: o Expectations of future profitability • Investment goods: factories, office buildings, machinery and equipment • Unlikely to build a new factor unless it is optimistic that the demand for its product will remain strong for at least several years • Expansion = some firms may become optimistic and increase spending on investment goods • The optimism or pessimism of firms is an important determinant of investment spending • Residential construction is included § Decline in 2006 was a factor of the recession o Interest rate • Some business investment is financed by borrowing • Higher interest rate = more expensive it is to borrow • Higher real interest rate results in less investment spending and a lower real interest rate results in more investment spending o Taxes • Affect the level of investment spending • Firms focus on the profits that remain after they pay taxes • Corporate income tax imposed on profits corporations earn • Increase in CIT decreases after tax profitability of investment spending • Investment tax incentives: increase investment spending o Cash flow • Cash flow: difference between the cash revenues received by a firm and the cash spending by the firm • Non cash receipts nor non cash spending is included • Largest contributor: profit • More profitable = greater cash flow Intel Moves into Tablets and Perceptual Computing: • Intel encouraged hardware and software with innovations in perceptual computing: allows users into interact with computers through speaking, gesturing with hands and fingers or changing facial expressions. Government Purchases • Include all spending by federal, local and state governments for goods and services. • Government purchases do not include transfer payments • Federal government purchases decline, so do state governments Net Exports: • Exports minus imports • Taking the value of spending by foreign firms and households on goods/services produced in the United States and subtracting the value of spending by U.S. firms and households on goods/services produced in other countries. • Usually increases when U.S. economy is in a recession • 3 most important variables that determine the level of net exports: o The price level in the United States relative to the price levels in other countries • If inflation in the US is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products in other countries § Slower increase in U.S. price level increases demand for U.S. products • Exports decrease which increases net exports • Reverse: happens during periods when the inflation rate in the United States is higher than the inflation rates in other countries o Growth rate of GDP in the United States relative to the growth rates of GDP in other countries • As GDP increases in the United States the incomes of households rise • Leading them to increase purchases of goods/services • Incomes rise faster in the Untied states than in other countries, U.S. consumers' purchases of foreign goods/services increase faster than others o Exchange rate between the dollar and other currencies. • As value for USD rises, foreign currency price of US products sold in other countries rises and the other dollar price of foreign products sold in the US falls. • Increase in the value of the dollar reduces exports and increase imports causing net exports to fall. The iPhone is made in China … or is it? • IPhone contains components that rate produced by a number of firms in several different countries • Global supply chain: take advantage of both lower production costs in other countries and the ability to of different firms to use their engineering and manufacturing to produce the components. • Global supply chains makes it difficult to develop more accurate measures of imports and exports. 12.3 Graphing Macroeconomic Equilibrium • Macroeconomic equilibrium: occurs when GDP equals AE • 45 degree line diagram - illustrates macroeconomic equilibrium. (Aka: Keynesian cross) • Represents all the points that are equidistant from both axes • GDP on the X axis and AE on the Y axis • All points of macroeconomic equilibrium must lie along the line. • Changes in GDP have greater effect on consumption than on planned investment, government purchases, net exports • Assume that changes in GDP have no effect on planned investment, government purchases or net exports • Level of planned AE at any level of GDP = amount of consumption spending + sum of planned investment + government purchases and + net Exports. • If GDP increases, economy moves up the AR line as consumption increases. Showing a recession on the 45 degree line diagram • Normal capacity: economy will be at natural rate of unemployment • NRU the economy is at full employment • For equilibrium to occur at potential GDP, planned AR must be high enough • The short fall in planned AE is = to the unplanned increase in inventories that will occur. Import Role of Inventories: • Planned AR is less than Real GDP = unplanned increase in inventories Numerical Example of Macroeconomic Equilibrium • Forecasting real GDP: Economist rely on quantitative models of the economy • Shortfall in AE results in recession • Because consumption depends on GDP it increases as GDP increase. 12.4 The Multiplier Effect • Effects of a change in AE on equilibrium real GDP • Autonomous expenditure: expenditure that does not depend on the level of GDP. • Increases in planned investment spending has a multiplied effect on equilibrium real GDP • Consumption: o Autonomous component: doesn't depend on GDP • Multiplier: increase in equilibrium real GDP divided by the increases in autonomous expenditure • Multiplier effect: process by which increase in Autonomous expenditure leads to a larger increase in real GDP • Increase in production also results in increases in national income • Calculate the value of the Multiplier: Change in real GDP / Change in investment spender. Formula for the Multiplier: • Each round of increases in consumption is smaller than in the previous round • 1/1-MPC = Multiplier Summarizing the Multiplier Effect: • Multiplier effect occurs when autonomous expenditure increases and decreases • Makes the economy more sensitive to change in autonomous expenditure than it would otherwise be. • Larger the MPC the larger the value of the multiplier • Formula for MPC is oversimplified o Ignores: • Real world complications such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes. The Paradox of Thrift: • Increase in saving can increase the rate of economic growth • Short run: if households save more and spend left, AE and GDP will decline • If many households decide at the same time to increase their saving and reduce their spending - makes themselves worse off: AE to fall. • Lower income in the recession 12.5 The Aggregate Demand Curve • Demand for a product increases: firms usually respond by increasing production (also likely to increases prices) • Demand falls, production falls, and prices may also fall. • AE also affects price level • 3 main reasons for the inverse relationship between changes in the price level and changes in aggregate expenditure o Rising price level decreases consumption by decreasing the real value of house-hold wealth; a falling price level has the reverse effect o If price level in the United States rises, relative to the price levels in other countries, US. Exports will become relatively more expensive and foreign imports will become less expensive - net exports fall • Falling price level has the reverse effect o Prices rise: firms and households need more money to finance buying and selling. • Central bank does not increase the money supply • Result will be increase in the interest rate • Aggregate demand curve: 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. • Decrease in price level causes the AE line to shift up and equilibrium GDP to rise • Increase in price level causes AE line to shift down and Equilibrium GDP to fall.
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