New User Special Price Expires in

Let's log you in.

Sign in with Facebook


Don't have a StudySoup account? Create one here!


Create a StudySoup account

Be part of our community, it's free to join!

Sign up with Facebook


Create your account
By creating an account you agree to StudySoup's terms and conditions and privacy policy

Already have a StudySoup account? Login here

Econ Prin & Probs

by: Mae Koelpin

Econ Prin & Probs ECO 212

Mae Koelpin
GPA 3.94


Almost Ready


These notes were just uploaded, and will be ready to view shortly.

Purchase these notes here, or revisit this page.

Either way, we'll remind you when they're ready :)

Preview These Notes for FREE

Get a free preview of these Notes, just enter your email below.

Unlock Preview
Unlock Preview

Preview these materials now for free

Why put in your email? Get access to more of this material and other relevant free materials for your school

View Preview

About this Document

Class Notes
25 ?




Popular in Course

Popular in Economcs

This 8 page Class Notes was uploaded by Mae Koelpin on Thursday September 17, 2015. The Class Notes belongs to ECO 212 at University of Miami taught by Staff in Fall. Since its upload, it has received 21 views. For similar materials see /class/205758/eco-212-university-of-miami in Economcs at University of Miami.


Reviews for Econ Prin & Probs


Report this Material


What is Karma?


Karma is the currency of StudySoup.

You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!

Date Created: 09/17/15
5 Forward Looking Models of Consumption Demand De nition 61 CONSUMPTION SMOOTHING People prefer consumption to be stable from year to year De nition 62 PERMANENT INCOME HYPOTHESIS proposes that individuals will spend a proportion of the present value of their expected lifetime consumption Suppose we live for N years Then N yd PV Z 60 2 1 r2 0d iPV 61 2 N Ignoring discounting7 as I did in class7 simpli es the above to N PV Zy 62 i1 0d iPV 63 Z N c We don7t change our spending pattern much unless we believe that there is a change in permanent income 0 Temporary tax cuts result in little change in spending De nition 63 LIFE CYCLE HYPOTHESIS says that consumption is related to our situ ation in life whether we are growing working or retired 0 Students borrow against future expected income negative saving7 mpc gt 1 0 Workers save for retirement and to pay o student loans positive savings7 mpc lt 1 o Retirees spend savings negative saving7 mpc gt 1 Both theories smooth consumption Both theories show that temporary tax cuts have little e ect on spending However7 the life cycle theory points out that retirees and students who are borrowing constrained7 may spend a large fraction of even temporary tax cuts 6 Interest rate The primary determinant of investment spending demand is the interest rate All income that is not consumed is saved Savings are in turn spent on investment spending lf interest rates fall7 then buying new houses plants and equipment is cheaper7 and so investment spending rises 7 Taxes Taxes on investment reduce investment spending These include 1 Changes in Depreciation allowance 2 Investment tax credits 3 Capital Gains tax cut 8 Expectations An increase in con dence about the economy causes rms to start new businesses and expand existing plants Households are more con dent in their jobs and buy bigger houses The result is an increase in investment spending Expectations are quite volatile7 which Keynes called animal spirits77 B Government Spending Demand Government spending is determined primarily by the demand for public goods7 not r De nition 64 A POLICY VARIABLE is a variable under control of the government G is a policy variable The government may raise or lower G in an attempt to improve the performance of the economy C Net Export Demand lf domestic interest rates rise7 our investments become more attractive to foreigners Thus foreigners demand our dollars to buy our assets The value of the dollar7 or nominal exchange rate7 rises A higher exchange rate implies that US exports are more expensive and US imports are cheaper Thus exports fall and imports rise Thus Net exports fall In e fect7 foreigners buy more US assets and less US goods The increase in US asset purchases are traded for imports TR TE lXTM lXiM 64 E ect of an increase in interest rates on spending H Consumption falls because savings is more attractive N Investment spending falls because it is more expensive to borrow to buy new houses and new businesses 03 Net exports fall because the increased demand for US assets and driven up the exchange rate making exports more expensive and imports cheaper These are all shifts of the spending line because they are caused by r changing not y The decline in spending means store owners and workers have less income which means store owners and workers spend less and so on until we converge to the new equilibrium with lower 0 I X 7 M Y and spending II Aggregate Demand and In ation 0 NOT TRUE that in ation makes things more expensive so aggregate demand falls Aggregate demand includes all goods so we cannot subtitute to a lower priced good when prices rise 0 TRUE ln ation raises interest rates which in turn reduces C I and X 7 M and thus total spending De nition 65 TAYLOR RULE A formula for determining the FED s policy on M and r from macroeconomic conditions The FED7s primary goal is to keep in ation at some target level When in ation rises above the target level the FED reduces the money supply and increases interest rates recall MV PY so a decrease in the growth of M reduces in ation lf in ation is below the FED7s target the FED will increase the money supply and lower interest rates T quot FED raisesral CIX7Mal AD So aggregate demand is downward sloping III Equilibrium A Potential GDP Long run production depends only on capital7 labor7 and technology7 not in ation B In ation Adjustment Line Firms change production and not raise prices in the short run7 because of 1 Menu costs costs to quickly changing prices7 associated with printing new menus and catalogs 2 Contracts some prices are xed by contract for a period of time Firms increase production in the short run by increasing capacity utilization running factories more hours or bringing idle factories on line and by hiring extra workers7 which decreases unemployment De nition 66 INFLATION ADJUSTMENT LINE IA Short mm aggregate supply curve The IA line is horizontal because the in ation rate is xed in the short run C Aggregate Demand Aggregate Demand increased in ation causes the FED to raise R lncreased R causes lower 07 I7 X 7 M Short run equilibrium is then where the IA line crosses the AD line In that case H Equilibrium exists in that 7r is such that the short run supply of goods equals aggregate demand N Equilibrium exists in that r balances demand and supply of loans 03 Equilibrium exists in that E is such that supply equals demand in the foreign exchange market He Equilibrium exists in that the quantity of labor demanded is set at the wage oor 5quot Spending7 lncome7 and short run production are equal Long run equilibrium is where lA7 AD7 and potential GDP all intersect At that point7 1 5 above hold plus 6 Long run aggregate supply equals aggregate demand 34 D Proof of Long run equilibrium Suppose potential GDP exceeds aggregate demand GDP is below potential and hence the economy is in a recession Capacity utilization is low and unemployment is high Firms have an incentive to cut prices and increase production since it is relatively cheap to bring some factories online and produce more goods This causes the IA line to shift down ln ation falls so the FED is less concerned about in ation and lowers 7 But then C I and X 7 M rise increasing aggregate demand up to potential E Recessions and Booms General form of fall in AD 1 Always start in a long run equilibrium 2 In the short run 0 AD shifts to the left Spending falls which means less income for store owners and workers which means store owners and workers reduce consumption and so on Income and spending fall 0 The shift to the left on the AD AS graph includes both the initial reduction in AD and subsequent reductions due to the fall in income 0 Firms do not raise prices but reduce capacity and hiring causing higher unem ployment 0 GDP growth is below potential a recession 0 The economy is in a short run equilibrium since AD crosses IA 3 In the Long run 0 AD is less than potential GDP Firms have surplus capacity and workers and will thus lower prices The lA line thus shifts down 0 The FED responds to the lower in ation by decreasing interest rates 0 I and X 7 M rise 0 Spending rises which generates more income more consumption spending and so OH 0 The economy recovers from the recession IV Application Fiscal Policy A Increase in Government Spending nanced by borrowing The increase in G has to come from somewhere The government borrows it from a consumer The consumer only spends a part b of the income whereas the the government spends all of it Thus spending goes up RULE 1 An increase in G nanced by either higher taxes or borrowing dominates the reduction in spending caused by higher taxes or borrowing Thus an increase in G nanced by either higher taxes or more borrowing increases total spending The long run e ect is relative to the initial equilibrium not relative to the short run equilibrium RULE 2 If income returns to potential there is no income e ect on consumption in the long run Thus if G falls in the short run due to a fall in income and rises in the long run as income returns to potential the overall e ect is that G returns to normal De nition 67 GROWDING OUT Government spending tends to replace private spending In the short run an increase in G can cause a boom but in the long run an increase in G simply replaces private spending De nition 68 TWIN DEFICITS Budget de cits cause trade de cits Here the twin de cits occurs because the increase in G caused the budget de cit The government had to increase borrowing and the rise in r caused a rise in E which made US exports more expensive and imports cheaper worsening the trade de cit B Permanent increase in income taxes nanced by less borrowing The increase in taxes comes from household income in the form of reduced consumption and savings The government saves all of the tax increase thus overall spending falls Rule 3 In the short and long run Y G 1 G X 7 M Consumption changes for 3 reasons 0 taxes are up G falls 0 income is down and then up by Rule 2 these e ects cancel and there is no income e ect on G o and interest rates fall G rises Since I and X 7 M are up7 we must have C decreases because Y G I G X 7 M C Increase in Goverrnent Spending nanced by an increase in taxes Overall spending still rises7 by Rule 1 Short run change in G Suppose government spending rises by AG Then taxes also rise by AG7 so consumption falls by b AG the rest was moved from saving to government consumption Now G rises due to the increase in income Income rises one for one with spending7 so income rises by 1 7 b AG So spending rises by I 1 7 b AG In general ACb17bAGb217bAG7bAG 65 1 7 b b AG 7 bAG 0 66 So consumption is constant in the short run V Application Monetary Policy Suppose the FED decides to TARGET A HIGHER INFLATION RATE At the current equilibrium7 the the interest rate is just low enough to generate the given in ation rate 7139 To raise the in ation rate7 the FED must reduce interest rates By loaning printed money in the FED Funds market7 the money supply rises and the FED Funds rate falls The FED is lowering 7 7 but not because of a change in 7139 Therefore7 we shift AD to the right De nition 69 NUETRALITY OF MONEY Changes in monetary policy do not a ect real variables In ation is a nominal variable so the model implies money is neutral in the long run but not in the short run Now a loose monetary policy has short run bene ts an increase in Y7 but long run costs an increase in 7r Thus the model predicts that an independent central bank with a longer term view should propose lower in ation than a central bank which is less independent VI Application Price Shock Suppose an increase in the price of oil increases the price of most goods This is called a positive price shock in that prices go up7 even though it is a bad thing We are changing 71397 so we move along the curve De nition 70 STAGFLATION Simultaneous high inflation and a recession The model predicts a price shock causes stag ation in the short run VII Application CounterCyclical Policy De nition 71 COUNTER CYCLICAL POLICY Changing government policy so that spend ing moves in the opposite direction as GDP A CounterCyclical Monetary Policy Suppose a fall in business expectations FED uses a counter cyclical policy of increasing the in ation target lf the FED acts in the short run7 the recession is shorter B Counter Cyclical Fiscal Policy We can also use G and T to smooth the cycle These counter cyclical policies must be both timed perfectly and have perfect magnitude lf the timing is too late or if the size of the recession is underestimated7 the economy may overshoot the long run equilibrium7 causing some long run in ation De nition 72 AUTOMATIC STABILIZERS Counter cyclical policies which take e ect automatically Policies such as income taxes are automatic stabilizers When income falls7 households pay less taxes automatically


Buy Material

Are you sure you want to buy this material for

25 Karma

Buy Material

BOOM! Enjoy Your Free Notes!

We've added these Notes to your profile, click here to view them now.


You're already Subscribed!

Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'

Why people love StudySoup

Bentley McCaw University of Florida

"I was shooting for a perfect 4.0 GPA this semester. Having StudySoup as a study aid was critical to helping me achieve my goal...and I nailed it!"

Anthony Lee UC Santa Barbara

"I bought an awesome study guide, which helped me get an A in my Math 34B class this quarter!"

Jim McGreen Ohio University

"Knowing I can count on the Elite Notetaker in my class allows me to focus on what the professor is saying instead of just scribbling notes the whole time and falling behind."


"Their 'Elite Notetakers' are making over $1,200/month in sales by creating high quality content that helps their classmates in a time of need."

Become an Elite Notetaker and start selling your notes online!

Refund Policy


All subscriptions to StudySoup are paid in full at the time of subscribing. To change your credit card information or to cancel your subscription, go to "Edit Settings". All credit card information will be available there. If you should decide to cancel your subscription, it will continue to be valid until the next payment period, as all payments for the current period were made in advance. For special circumstances, please email


StudySoup has more than 1 million course-specific study resources to help students study smarter. If you’re having trouble finding what you’re looking for, our customer support team can help you find what you need! Feel free to contact them here:

Recurring Subscriptions: If you have canceled your recurring subscription on the day of renewal and have not downloaded any documents, you may request a refund by submitting an email to

Satisfaction Guarantee: If you’re not satisfied with your subscription, you can contact us for further help. Contact must be made within 3 business days of your subscription purchase and your refund request will be subject for review.

Please Note: Refunds can never be provided more than 30 days after the initial purchase date regardless of your activity on the site.