Economics Notes: Chapter 14 Monetary Policy: 14.

1 More supply = Less Buyers therefore prices will decline = Less demand more supply and vice versa - greater supply, lower the interest rate= excess supply (price decreases) therefore less consumers and vice versa. Supply volume of notes in circulation Monetary policy supply of money and the interest rates (interlinked) http://www.preservearticles.com/201012281819/meaning-and-objectives-ofmonetary-policy.html Monetary policy is concerned with the changes in the supply of money and credit. It refers to the policy measures undertaken by the government or the central bank to influence the availability, cost and use of money and credit with the help of monetary techniques to achieve specific objectives tool used to regulate money supply Monetary policy aims at influencing the economic activity in the economy mainly through two major variables, i.e., (a) money or credit supply, and (b) the rate of interest. The techniques; of monetary policy are the same as the techniques of credit control at the disposal of the central bank. Various techniques of monetary policy, thus, include bank rate, open market operations, variable cash reserve requirements, selective credit controls. The monetary policy is defined as discretionary action undertaken by the authorities designed to influence (a) the supply of money, (b) cost of money or rate of interest and (c) the availability of money." Monetary policy is not an end in itself, but a means to an end. It involves the management of money and credit for the furtherance of the general economic policy of the government to achieve the predetermined objectives. Various objectives or goals of monetary policy are: Neutrality of Money (change in supply affect nominal (no inflation adjusted) variables= prices, wages, exchange rates) not affect real variables like employment, real GDP and real consumption. supply of money wont affect things like employment, real GDP and real consumption. Price Stability Economic growth

Exchange Stability stable exchange rates Full Employment (when everyone has employment)

Federal reserve system chapter 14 14.1

The Federal Reserve has several goals intended to promote a well-functioning economy: (1) price stability, (2) high employment, (3) economic growth, (4) financial market stability, (5) interest rate stability, and (6) foreign-exchange market stability. Fluctuations in inflation can also arbitrarily redistribute income, as when lenders suffer losses when inflation is higher than expected. (1) price stability In practice, the Feds goal of price stability means that it attempts to achieve low and stable inflation rather than zero inflation. With low and stable inflation, market prices efficiently allocate resources in the economy, so the economy is more productive and living standards are higher in the long run.(1) (2) high unemployment unemployment means GDP is below its potential level and causes financial distress and decreases self-esteem for workers who dont have jobs. (2)- Aim is not necessarily for zero unemployment because there will be cyclical unemployment at some stages. If there was zero unemployment, cyclical unemployment would be negative thereby making the real GDP exceed the potential GDP tremendously. (2)- The major aim is to keep the cyclical unemployment as close as possible to zero. The actual unemployment rate needs to be in proportion with the natural rate of unemployment (3) economic growth policymakers want stable economic growth because it allows households and firms to plan accurately and helps encourage long-run investment which in return produces and sustains growth. It is the only source for an increase in real incomes. (3) economic growth will allow for greater savings for the purpose of investment funds as well as business investment. (3)-High employment facilitates economic growth. As a result, businesses are likely to be more confident that demand for their products will remain strong, and so will be willing to engage in the long-term investment necessary for growth. In brief high employment produces economic growth and therefore increases the demand for products thus at the same time long-term investment rises to produce economic growth. All this is because of high employment since more workers are employed to produce more. (3) With high unemployment, businesses have unused productive capacity and are much less likely to engage in long-term investment. (3) - Stable economic growth - stable business environment - allows firms and households to plan accurately -encourages the long-term investment - sustain growth.

(4) financial markets and institutions not efficient in matching savers and borrowers = loss of resources (4) Efficient flow of funds from savers to borrowers= Firms with the potential to produce high-quality products and services cannot obtain the financing they need to design, develop, and market these products and services. Savers waste resources looking for satisfactory investments.

Commercial banks borrow from households and firms in the form of checking and savings deposits, while investment banks borrow primarily from other financial firms, such as other investment banks, mutual funds, or hedge funds, which are similar to mutual funds but typically engage in more complex-and risky-investment strategies. (4)

14.2

The Fed aims to use its policy tools to achieve its monetary policy goals. Recall from Chapter 13 that the Fed's policy tools are open market operations, discount policy, and reserve requirements. At times, the Fed encounters conflicts between its policy goals. For example, as we will discuss later in this chapter, the Fed can raise interest rates to reduce the inflation rate. But, as we saw in Chapter 12, higher interest rates typically reduce household and firm spending, which may result in slower growth and higher unemployment. So, a policy that is intended to achieve one monetary policy goal, such as reducing inflation, may have an adverse effect on another policy goal, such as raising employment. The two main monetary policy targets are the money supply and the interest rate. As we will see, the Fed typically uses the interest rate as its policy target. Inflation is caused by the demand and supply of money. (macroeconomic) if the supply is more and output produced is less the companies will want to make excessive profit and therefore inflation rises and vice versa. So people dont make excessive profits so they basically rise the interest rates in order to reduce the excessive supply of money. (when inflation rises or is high) Inflation high = reduce the supply of money increase interest rates and vice versa when there is deflation If inflation is high, prices rise because of the demand and supply of goods. Demand is greater therefore higher prices for greater profit (seller) but for the buyer itll be expensive. Inflation increases due to profit incentive by seller. (microeconomics) Interest rates decline qty. money dd. Increases central bank ; print more notes (increase money supply = to meet the demand) its a possibly to increase inflation; less demand for money = less inflation In a nutshell = higher interest rate less inflationary it is demand for money reduces interest rate has gone up demand for money reduced supply of money will match demand of money less demand = less supply lower inflation and vice versa.

Changes in variables other than the interest rate cause the demand curve to shift. The two most important variables that cause the money demand curve to shift are real GDP and the price level. Real GDP increase = quantity of goods and services produced increase - An increase in real GDP means that the amount of buying and selling of goods and services will increase = produces employment, investment and greater demand/supply for money.

This additional buying and selling increases the demand for money as a medium of exchange, so the quantity of money households and firms want to hold increases at each interest rate, shifting the money demand curve to the right. A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. Real GDP Increase = More buying and selling of goods/services = Greater quantity demand for money = Shifts the money demand curve shifts to right interest rates will rise- because of this people will hold more money esp. the consumers to earn greater interest whereas the banks will earn interest above in brief An increase in the price level increases the quantity of money demanded at each interest rate, shifting the money demand curve to the right. A decrease in the price level decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. (Real GDP increases more demand for goods/services demand curve shifts to right quantity demanded for money will increase therefore this will increase price level leads to shift) above in brief Increase in supply of money (shift in curve) decline in interest rates more supply of money less borrowers less interest rate due to less demand For simplicity, we assume that the Federal Reserve is able to completely fix the money supply. Therefore, the money supply curve is a vertical line, and changes in the interest rate have no effect on the quantity of money supplied. Just as with other markets, equilibrium in the money market occurs where the money demand curve crosses the money supply curve.

To summarize: When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money. Extra supply of money thats bought into the system has to be absorbed = people who will borrow/need money = provided you drop your interests. excess supply money generated (e.g. in this case 900 950 = $50 billion excess supply) in the banking system has to be used by someone ; supply of money increased == interest rate will fall down We discussed the loanable funds model of the interest rate. In that model, the equilibrium interest rate is determined by the demand and supply for loanable funds. Loanable funds model is concerned with the long-term real rate of interest and money market model is concerned with the short-term nominal rate of interest.
The long-term real rate of interest is the interest rate that is most relevant when savers consider purchasing a long-term financial investment such as a corporate bond. It is also the rate of interest that is most relevant to firms that are borrowing to finance long-term investment projects such as new factories or office buildings, or to households that are taking out mortgage loans to buy new homes.

When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in the money supply. So, when the Fed takes actions to increase the short-term nominal interest rate, usually the longterm real interest rate also increases. When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in the money supply short term policy is accurate are dictated by demand and supply and therefore it helps in predicting of what will happen in the long run. Federal/central bank (Print currency-e.g. Bank of England, Reserve Bank of India Govt. Mint) banks under them are told to lend 90% of the deposit to the customers. The balance 10% is left with the federal/central bank.- not relevant for households Fed uses monetary policy targets to affect economic variables such as real GDP or the price level, that are closely related to the Fed's policy goals. The Fed can use either the money supply or the interest rate as its monetary policy target. The Fed has generally focused more on the interest rate than on the money supply. There are many different interest rates in the economy. For purposes of monetary policy, the Fed has targeted the interest rate known as the federal funds rate. b/w banks interbank call rate The federal funds rate is the interest rate banks charge each other on loans in the federal funds market. The loans in the federal funds market are usually very short term, often just overnight. The federal funds rate is not set administratively by the Fed. Instead, the rate is determined by the supply of reserves relative to the demand for them. Fed can increase and decrease the supply of bank reserves through open market operations, it can set a target for the federal funds rate and usually come very close to hitting it. Only banks can borrow or lend in the federal funds market. However, changes in the federal funds rate usually result in changes in interest rates on other short-term financial assets, such as Treasury bills, and changes in interest rates on long-term financial assets, such as corporate bonds and mortgages. The effect of a change in the federal funds rate on longterm interest rates is usually smaller than it is on short-term interest rates, and the effect may occur only after a lag in time.

14.3

Fed uses the federal funds rate as a monetary policy target because it has good control of the federal funds rate through open market operations (short term nominal interest rate)

And because it believes that changes in the federal funds rate will ultimately affect economic variables that are related to its monetary policy goals. Recall that we calculate the real interest rate by subtracting the inflation rate from the nominal interest rate. Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual) We will assume that the Fed is able to use open market operations to affect long-term real interest rates. = depends on the ability to affect real interest rates such as real interest rates on mortgages and corporate bonds. A nominal variable, such as a nominal interest rate, is one where the effects of inflation have not been accounted for. Real interest rates are interest rates where inflation has been accounted for. Changes in interest rates affect aggregate demand i.e. the total level of spending in the economy How Interest Rates Affect Aggregate Demand: Consumption, Investment, Net exports Consumption = lower interest rates increased spending on durables total cost of these goods to consumers is lower since interest payments on loans are lower and conversely higher interest rates increase cost of durables households buy fewer of them Consumption higher rate = save more and spend less and vice versa for lower rate. This is concerning the interest rate. Investment = firms finance spending on machinery, equipment and factories by profits or borrowing Investment = firms either borrow from banks or borrow from financial markets by issuing corporate bonfs Investment = higher and lower interest on corporate bonds or bank loans works the same way. Investment = lower interest rates - increase in investment in stocks (compared to bonds) - stocks more attractive as an investment - increase in stock prices - future profitability of investment projects (increased) firms issue more stocks and acquire funds - all due to increased demand and potential Investment = spending by households on new homes when interest rates on mortgage loans rises/falls less/more homes will be purchased. Net exports= value of $ rises (home currency) = (appreciates) exports will be expensive in other countries (goods produced in USA will be expensive) thereby making the imports cheaper (foreign currency) since the home currencys ($) can purchase more of a currency as the rates have declined.

Net exports = interest rates rise in USA greater than other countries =investment in USA assets will be desirable as a result foreign investors will demand for $s and will increase value of $ and therefore exports will be pricey and will fall and vice versa happens.

EFFECTS OF MONETARY POLICY ON REAL GDP AND PRICE LEVEL

INTEREST RATE INCREASE CONSUMPTION FALLS OUTPUT AND DEMAND DROP = THEREFORE GDP DROPS AND VICE VERSA. AGGREGATE DEMAND in a has shifted from point A to B because the money supply has been increased which results into interest rates therefore shift in demand from A to B (expansionary monetary policy) increasing supply of money and reduce interest rates = aggregate demand has moved up it means aggregate supply has to match it up. Firms and companies will have to invest more. Demand = Supply more investment therefore more employment that Is what has led to increase in GDP and price level.

Contractionary policy = the aggregate demand shifts downwards and the price level decreases so does the real GDP. In this case at point B it is the potential GDP and A is the actual/current level. Real gdp and price levels fall. Real gdp > potential gdp = inflation = excessive demand which supply cannot meet therefore prices rise (contractionary policy) the prices will drop therefore leading to price stability GOALS: PRICE STABILITY & HIGH EMPLOYMENT IN THE SHORT RUN AFFECTS PRICE LEVEL AND THE REAL GDP. In the basic version of the model, we assume that there is no economic growth, so the long-run aggregate supply curve does not shift.

CAN CENTRAL BANKS ELIMINATE RECESSIONS IN A COUNTRY?

Central bank can reduce the length of recession but not eliminate them. If to be successful = sharp in understanding demand and supply of money and play with interest rates to control the economy. It only reacts to the situation and dont know demand and supply of lending by consumers.

14.4
Interest rate increase/decrease has an inverse relation with price, GDP and aggregate Demand Equilibrium = aggregate demand equals the aggregate supply Pessimistic future cut consumption less output Potential vs actual consumption = figure 14.9 potential GDP (produced and sold aggregate0 is 14.4. if the fed does not intervene without policy it will be at 14.3. With policy = government has intervened and without policy = government hasnt intervened in the short run. The aggregate demand 1 is basically the normal one at point B. Point C is potential GDP - expectation Short run = without policy = actual consumption is at B govt. doesnt do much about policy. This is before the new policy. Trouble is matching inflation and increasing demand inflation low and employment 100% = target of the govt. Interest rates drop = inflation rises

14.5
Interest rates drop = inflation rises Remember that the Fed controls the money supply, but it does not control money demand. Money demand is determined by decisions of households and firms. (Cant get into consumer head- therefore no control)

Chapter 15 Fiscal Policy: 15.1

"To promote maximum employment, production, and purchasing power." Also make changes in taxes and government purchases to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. Changes in taxes and govt. spending that are intended to achieve macroeconomic policy objectives (above 3 objects) are called fiscal policy. Collect sufficient money in terms of taxation (direct/indirect) that money is spent in govt. spending Automatic stabilizers: the ones which happen without govt. intervention as they go along with the business cycle change spending or taxes and discretionary fiscal policy = when govt. changes spending or taxes - - discretion: hands of individual (govt. actions) in this context to increase spending In addition to purchases, there are three other categories of government expenditures: interest on the national debt, grants to state and local governments, and transfer payments

Interest on national debts expenditure when govt. are in deficit and pay loans and along with that an interest Grants to govt. = aids Transfer payments = unemployment insurance, social security, medical care etc.

15.2 + 15.3
Because changes in government purchases and taxes lead to changes in aggregate demand, they can affect the level of real GDP, employment, and the price level. When the economy is in a recession, increases in government purchases or decreases in taxes will increase aggregate demand. As we saw in Chapter 12, the inflation rate may increase when real GDP is beyond potential GDP. Decreasing government purchases or raising taxes can slow the growth of aggregate demand and reduce the inflation rate. The inflation rate may increase when real GDP is beyond potential GDP. Decreasing government purchases or raising taxes can slow the growth of aggregate demand and reduce the inflation rate.

Real GDP inflation adjusted prices

LRAS Long run aggregate supply

FIGURE 15.6 = economy began at A economy has a potential to go to C in case the govt. uses expansionary policy and thats where the SRAS, LRAS and AD curve all interact together (use expansionary policy). At point B dont use expansionary policy the equilibrium will be B which is below the potential GDP which is point C. real gdp indicating potential gdp missed the target of reaching the potential GDP despite favourable conditions. (C- Potential GDP SRAS + LRAS + DEMAND real GDP considered if it goes to that point) AT B short run supply (15.3) = expansionary fiscal policy

EQUILIBRIUM = DEMAND AND SUPPLY INTERSECTION

15.4
Multiplier effect = govt. uses discretionary fiscal policy measure chain reactions Effects of change in tax rates higher the taxes lower/poorer the multiplier effect therefore effect wont be large affects their disposable incomes When the government increase expenditure = aggregate demand rises increase in consumer spending Figure 15.10 = the govt. tries to raise consumption = shift from a c indicates that at c = lras, sras and dd. All interact with each other

15.5
Timing of fiscal and monetary policy matters because in the case the economy has used contractionary fiscal policy in an economy thats moved into recession will make the effects worse and whereas if the economy has come out of recession and using expansionary fiscal policy means the inflation rise. Thereby causing more harm than good.

Chapter 12 ad and as 12.1 = AGGREGATE DEMAND

Aggregate demand - level of planned aggregate expenditure in t he economy comprises of C + I + G + NX = in this case all factors are constant and price isnt Decline in price = Rise in C + I + NX (Why AD is downward sloping?) Rely more on monetary makers take actions within it to curtail the bad effects of the business cycle reduce cyclical unemployment Interest rate and money supply A rule or formula that a central bank uses to set interest rates in response to changing economic conditions. Aggregate supply = the total quantity of goods and services that firms are willing to supply. Goal of central bank (monetary policy) = price stability lower inflation Interest rate and inflation rate = directly proportional increase interest rate to curtail demand and vice versa Monetary policy rule = central bank response to changes

Certain goals will contradict with inflation goals and thereby causing problems Short term nominal interests will affect long term real interest rates Nominal interest = In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation Real interest = adjusted for inflation actual worth of the money in the real world real world example
A higher real interest rate also increases the exchange rate between the U.S. dollar and foreign currencies, which reduces net exports. Because aggregate expenditure and real GDP decrease as the real interest rate increases, there is a negative relationship between the real interest rate and the quantity of real GDP demanded by households and firms.

A curve that shows the relationship between aggregate expenditure on goods and services by households and firms and the inflation rate.
Aggregate demand curve downward sloping = WEALTH EFFECT, INTEREST RATE EFFECT, INTERNATIONAL TRADE EFFECT (SEE REFERENCE) EXTRA: Chapter 9 IS/MP Below Chapter 9 IS MP = EXTRAAA

The ISMP model is a macroeconomic model that analyzes the determinants of real GDP, the inflation rate, and the real interest rate in the short run. What determines = real GDP, inflation rate and real interest rate in the short run

The ISMP model explains the main reasons real GDP fluctuates and to allow us to understand the key aspects of monetary policy and fiscal policy reasons of real GDP fluctuation and also study of fiscal and monetary policies IS = Aggregate supply MP = Monetary policy change in interest rates

12.2a = measure of x axis represents output simply Y axis = real interest rate Output gap = difference b/w output from one point to another output

A and B a change in monetary policy and real interest rate results in quick change in AD curvettherefore output gets reduced in both the curves. In deriving the AD curve, we assumed that the IS curve would remain constant. Anything that causes the IS curve to shift to the right will cause the AD curve to shift to the right, and anything that causes the IS curve to shift to the left will cause the AD curve to shift to the left.

Aggregate demand - level of planned aggregate expenditure in t he economy Rely more on monetary makers take actions within it to curtail the bad effects of the business cycle reduce cyclical unemployment Interest rate and money supply

SHIFTS IN AD CURVE =
If any other variable other than price changes then its a shift in the curve A change in the monetary policy rule will also cause the AD curve to shift. There are two key components of the monetary policy rule: the inflation target and the sensitivity of the real interest rate to the inflation rate.

SHIFTS IN AD CURVE =

autonomous consumption = An expenditure that doesnt depend on the level of GDP Certain bills and expenses are deemed to be autonomous (or independent), such as electricity, food and rent, because these expenses cannot ever be entirely eliminated whether you have money or not. Even in the worst-case financial scenario, you would still need to eat and have a place to live. If a consumer's income were to disappear for a time, he or she would have to dip into savings or increase debt in order to pay these expenses, which is also known as being in a "dissaving mode". = Autonomous consumption Changes in autonomous consumption, investment, and government purchases of goods and services, changes in taxes and transfer payments, and changes in net exports. = Factors Factors in brief = change on govt. policies change in expectations of households and firms changes in foreign variables Factors = monetary policy change interest rates consumption and investment will change leads to a shift in curve (govt. policies) Factors = fiscal policy means changes in federal taxes and purchases shift the curve (govt. policies) Govt. policies change in household expectations and firms change in foreign variables Govt. policies = monetary and fiscal policy monetary: reduce interest rates lower borrowing costs higher consumption and investment spending shifts curve to right Continued = fiscal policy is changes in federal taxes and purchases to achieve macroeconomic policy objectives = high employment, price stability and high rates of economic growth Fiscal policy = govt. purchases are part of aggregate demand an increase/decrease in this variable will lead to shifts accordingly and the same for personal income taxes increase/decreases spendable/disposable income available to households and as well business taxes in brief = govt. purchases personal income taxes business taxes = disposable income end of govt. policies interest rates/govt. purchases and personal income/bus taxes as a whole Changes in expectations of households and firms = if households more optimistic about future incomes they are likely to increase their current consumption leading to shift to the right and vice versa for pessimistic. The same logic applies to firms who are optimistic or pessimistic about the future profitability of investment spending (firms expectations) leads to rise in investment spending Changes in foreign variables = an increase in net exports at every price level = shifts aggregate demand curve to the right and if real GDP grows more slowly than in other countries or if value of dollar falls against other countries (DROP IN HOME CURRENCY VS. FOREIGN CURRENCY) leads to shift in the demand curve

12.2 = AGGREGATE SUPPLY

Definition = Effect of changes in price level on quantity of goods and services that firms are willing and able to supply.

As aggregate expenditure (demand) rises the real GDP rises up therefore causing capacity constraints as a result firms raise prices leading to a shift in inflation according to the graph and the output gap is lesser than before Demand shock difference between real and potential GDP = capacity constraints leads to rise in inflation rate

Supply shock price of a key input rises leads to an increase in inflation rate

SHIFTS IN THE AGGREGATE SUPPLY

Increase in labor force and capital stock = if there are more workers and physical capital supply more output at every price level and shifts to right costs of production at every level of output Technological change = increase in productivity as a result more output with same amount of labor and machinery reduces cost of production and more output at every price and shifts to the right. costs of production at every level of output Expected changes in future price level = if price levels rise then workers and firms will try to adjust their wages and prices accordingly. In final if workers and firms expect price level to increase by a certain %, the SRAS curve will shift by an equivalent amount (inflationary expectations) Adjustments of workers and firms to errors in past expectations about the price level = wrong predictions therefore leads to compensate for those errors if price level higher than expected shifts to the left and vice versa (inflationary expectations) Unexpected changes in the price of an important natural resource = if natural resource price rises therefore the costs of production will rise for these firs and it leads to firms facing rising costs and they will supply same level of output at higher price thereby shifting to the left. It is a supply shock which is caused by an unexpected increase/decrease in the price of an imp. Natural resource or in other words an unexpected event that causes the short-run aggregate supply curve to shift

LRAS = LONG RUN AGGRGATE SUPPLY CURVE (potential GDP or full employment GDP in the Long run) The level of real GDP is determined by = number of workers, the capital stock (factories, office buildings, machinery and equipment plus the technology) these are the determinants Changes in price level dont affect no. of workers, capital stock, machinery and equipment or technology in the long run = therefore changes in price level dont affect the level of real GDP but factors other than price which are mentioned above will lead to the shifts. Shifts occur because = the potential real GDP increases each year as the number of workers, capital stock, machinery and equipment and technology increase. BOTTOMLINE = IN THE LONG RUN CHANGES IN PRICE LEVEL DONT AFFECT THE LEVEL OF REAL GDP AND LEVEL OF GDP IN LONG RUN = POTENTIAL GDP/FULL-EMPLOYMENT GDP

SUPPLY SHOCK IN DETAIL BY GRAPHS (details later 12.3)

SRAS AND AD CURVES (12.1+12.2) SRAS

Price increases = quantity of goods and services firms are willing to supply will increase As prices of goods and services rise price of inputs workers + resources rise more slowly and then profits rise when the revenue gained from sellng is greater than the costs faced by firms

AD: WHY IS IT DOWNWARD SLOPING?

Wealth effect: How a change in the price level affects consumption; when the price level rises accordingly the real value of household wealth declines and so will consumption and vice versa when the price level falls down. Impact of the price level on consumption = wealth effect Interest rate effect: How a change in the price level affects investment; higher price means households and firms need more money to finance buying and selling and therefore borrowing and selling financial assets and withdrawals from banks are at its peak. The bottom line is: A higher interest rate on the bottom line means greater cost of borrowing for firms and households and therefore less borrowing as a result consumption will decline and the opposite holds true. Esp. for firms

International trade effect: How a change in the price level affects net exports; low prices in home country means net exports rise and vice versa when prices are high. Its the impact of the price level on net exports is known as international trade effect

12.3: Macroeconomic Equilibrium in the Short and Long Run SUPPLY SHOCK
Supply Shock = in the short run increase in natural resource price shifts supply to left to a lower real GDP and a higher price level and this leads to inflation and recession due to less output it is stagflation in this case. Plus in addition to that in the long run because of the stagflation which leads to increase in inflation as well as unemployment means workers accept lower wages and firms will accept lower prices. It leads to a shift in supply from the recession point when it shifted to the left in short run to the equilibrium when potential GDP is at original price level = Supply shock Alternative to deal with the above is to use monetary and fiscal policy to shift AD to the right whereas above dealt with the AS only!

EXPANSION

SHORT RUN of an increase in AD and adjustment back to potential GDP in the long run: Firms are more optimistic about future profitability of investment therefore increase in investment shifts AD to the right and will be above potential real GDP. Firms in here are operating beyond their normal level of capacity and some workers are employed. In this case from AD1 to AD2 is the shift in demand. BOTTOM LINE = AD1 to AD2 is the short run equilibrium Therefore workers and firms adjust o higher price levels workers demand higher wages = firms will charge higher prices inflation rate rises in brief higher inflation, increased real GDP and lower unemployment rate inflation rate rises leads to AS curve shifts and point C is the equilibrium where real GDP = potential GDP. Therefore NO OUTPUT GAP!!!! A = OLD EQUILIBIRUM AND C = NEW EQUILIBRIUM at C = higher inflation no change in unemployment Adjustment back to potential GDP in the long run = also known as automatic mechanism because it occurs without government interference and also an alternative is to use both policies to shift AD curve to right in order to restore potential GDP more quickly.

RECESSION
SHORT RUN of an increase in AD and adjustment back to potential GDP in the long run: Firms are more optimistic about future profitability of investment therefore increase in investment shifts AD to the right and will be above potential real GDP. Firms in here are operating beyond their normal level of capacity and some workers are employed. In this case from AD1 to AD2 is the shift in demand. BOTTOM LINE = AD1 to AD2 is the short run equilibrium Therefore workers and firms adjust o LOWER price levels workers demand LOWER wages = firms will charge LOWER prices inflation rate FALLS in brief LOWER inflation, LOWERED real GDP and HIGHER unemployment rate inflation rate FALLS leads to AS curve shifts and point C is the equilibrium where real GDP = potential GDP. Therefore NO OUTPUT GAP!!!! A = OLD EQUILIBIRUM AND C = NEW EQUILIBRIUM at C = higher inflation no change in unemployment In this case it is a decline in investment (RECESSION) that causes the shifts in demand curves - IMPORTANT CONSLCUSION = DECLINE IN AGGREGATE DEMAND = IN SHORT RUN: RECESSION AND IN LONG RUN = DECLINE IN PRICE LEVEL THE OPPOSITE HOLDS TRUE FOR A RISE IN INVESTMENT I.E. EXPANSION

Chapter 11 Output and expenditure in the short run: 11.1 In this case it is talking about the aggregate expenditure which is C+I+G+NX and it is equated to real GDP in the short run thereby price level is constant in the short run. The level of GDP is determined by aggregate expenditure. AE = C + I + G + NX C = Spending by households on goods and services I = planned spending by firms on capital goods and households on new homes and in this case it is assumed planned equals the actual spending for capital goods but not for inventories. I = Changes in inventories are a part of investment since there is a difference between planned and actual inventory spending. In terms of business plan to spend. G = It is the spending by the governments: (local/state/federal) NX = exports imports (trade balance)

Therefore actual investment = planned investment when there is no unplanned change in inventories in this case we are referring to a macroeconomic equilibrium. Macroeconomic equilibrium in this case is when the aggregate expenditure = GDP that is total spending = total production and in this case economic growth is zilch. Things go as per plan. When aggregate expenditure> GDP the spending is greater than production and selling more goods/services than expected and vice versa when GDP is greater. In the fridge example if the opening stock is at 50 and the closing stock is at 20. This indicates to us that sales are high and therefore an unplanned change in inventories since inventory drops by 30 units. Therefore there will be more ordering of fridges which will increase production and therefore an increase in number of workers to hire if it affects all the sectors in the economy such as appliances, furniture, transportation etc. The above situation reflects to us when Aggregate Expenditure > GDP and GDP and employment rise and inventories fall down and vice versa when aggregate expenditure < GDP. MACROECONOMIC EQUILIBRIUM: AGGREGATE EXPENDITURE = GDP no change in inventories

11.2

The factors behind consumption are: o disposable income, o household wealth (assets liabilities), o price level and o Interest rate levels in real terms o taking into account inflation - interest rate and price level o Plus expected future income. Consumption function is the relationship b/w disposable income and consumption. Marginal propensity to consume change in consumption/ change in disposable income Marginal propensity to save change in saving/ change in disposable income The consumption function gradient is the MPC which determines how much spending/consumption happens when income changes.

Another model of consumption function with the exception being that disposable income at x axis is replaced by the real GDP or real national income. relation b/w consumption and national income Disposable income = national income net taxes income , consumption and savings = national income change in consumption + change in savings + change in taxes - Y= C+S+T Continued from above = change in income equates to = change in consumption + change in savings and taxes are removed since they are assumed zero and are constant. Marginal propensity to save + marginal propensity to consumer always have to equal 1 when taxes are constant. Since change in consumption and savings are divided by disposable income and the same for national income above Planned investment determinants: o future profitability or expectations about future profits, o cash flow, o interest rate and o Taxes. Net exports determinants : o Exchange rate o Growth rate compared to other countries o Price level compared to other countries

11.3 + 11.4+ 11.5 need help upon on understanding graphs 45 degrees line is where aggregate expenditure equals to real GDP known as macroeconomic equilibrium The iteration of chart is of consumption function with AE on x axis and real GDP on the y axis Macroeconomic equilibrium is when C+I+G+NX = AE bottles sold equals the GDP (real) bottles produced and also where Y=AE AND AE line equal is the equilibrium real GDP/macroeconomic equilibrium Above 45 degrees line = planned expenditure > GDP decrease in inventories and vice versa when below 45 degrees line Changes in GDP have great impact on consumption than planned investment, govt. purchases and net exports since they are assumed to be constant Variables that determine investment, purchases and exports remain constant The AE line represents expenditure in aggregate.

GDP = AE is the grey line which is Y = AE

How does a decrease in government spending affect the aggregate expenditure line? A) It shifts the aggregate expenditure line upward. B) It shifts the aggregate expenditure line downwards C) It increases the slope of the aggregate expenditure line. D) It decreases the slope of the aggregate expenditure line

If the U.S. economy is currently at point N, which of the following could cause it to move to point K? A) Households expect future income to decline. B) Household wealth rises. C) The firm's cash flow rises as profits rise. D) Government expenditures increase. If the U.S. economy is currently at point K, which of the following could cause it to move to point N? A) The price level in the United States rises relative to the price level in other countries. B) Congress passes investment tax incentives. C) The interest rate rises. D) Household wealth declines. Suppose that the level of GDP associated with point N is potential GDP. If the U.S. economy is currently at point K, A) firms are operating above capacity. B) the economy is at full employment. C) the economy is in recession. D) the level of unemployment is equal to the natural rate.

Suppose that investment spending increases by $10 million, shifting up the aggregate expenditure line and GDP increases from GDP1 to GDP2. If the MPC is 0.9, then what is the change in GDP? A) $9 million B) $10 million C) $90 million D) $100 million Suppose that government spending increases, shifting up the aggregate expenditure line. GDP increases from GDP1 to GDP2, and this amount is $400 billion. If the MPC is 0.75, then what is the distance between N and L or by how much did government spending change? A) $10 billion B) $100 billion C) $200 billion D) $300 billion

Potential GDP equals $100 billion. The economy is currently producing GDP1 which is equal to $90 billion. If the MPC is 0.8, then how much must autonomous spending change for the economy to move to potential GDP? A) -$18 billion B) -$2 billion C) $2 billion D) $18 billion
100-90 = 10 *0.8 = 8 10+/-8

If an increase in investment spending of $50 million results in a $400 million increase in equilibrium real GDP, then A) the multiplier is 0.125. B) the multiplier is 3.5. C) the multiplier is 8. 400/50 change in real gdp/change in investment spending D) the multiplier is 50. If an increase in autonomous consumption spending of $10 million results in a $50 million increase in equilibrium real GDP, then A) the MPC is 0.5. B) the MPC is 0.75. C) the MPC is 0.8. D) the MPC is 0.9.