Macroeconomics Unit 3

A. Aggregate Expenditures
1. Keynesian Equilibrium
Keynesian economics began during the Great Depression and explained the lingering
unemployment. John Maynard Keynes developed this theory. He stated that wages and priced
were highly inflexible so therefore changes is prices and interest rate would not bring the
economy back to full employment.
The basic Keynesian model is that:
Aggregate expenditures= planned consumption+ planned investment+ Planned government
expenditures+ Planned net exports
Keynesian equilibrium occurs when: Planned Aggregate Expenditures=Current output
If total Aggregate Expenditures< current output then the firm will obtain unplanned
inventories and will cut back on output and employment.
If total Aggregate Exppenditures>current output then the inventories for the firm will fall and
the bussiness will respond with an expansion in output.
Keynesian Equilibrium Model

2.Multipliers represents the additional income that results from an increase in spending,
investment, etc. These multipliers are not in a one to one ratio. For example, an increase in
investment may cause a proportionally greater increase in income. Three common examples are
as followed:

Government expenditure Multiplier= 1/(1-MPC) OR 1/MPS

Investment Multiplier= 1/(1-MPC) OR 1/MPS
Tax multiplier= -MPC/(1-MPC) OR -MPC/MPS
*Remember that:
MPC=change in consumption/change in disposable income
MPS=change in savings/change in disposable income
ALWAYS remember that :
The investment multiplier is ALWAYS equal to the government expenditure multiplier.
The investment and government spending multiplier are ALWAYS positive.
The tax multiplier is ALWAYS negative.
3. Effects of investment spending decisions on national output
Any increase in investment spending will cause an increase in the output or GDP. As a result, this
graph shows that the increase in the Aggregate output from Y0 to Y1 will cause the aggregate
demand curve to shift from AD0 to AD1

Any decrease in investment spending will cause an decrease in the output or GDP. As a result,
the Aggregate demand curve will shift from YE to Y2 and shift the aggregate demand curve from
AD to AD2.

4. Inventory changes in response to difference between aggregate expenditures and income

Inventory: is the goods and

materials that are held in stock by
a business. If a good could be
produced instantaneously then
there would be no need for
inventories. However, since most
goods take a period of time to
manufacture and deliver,
businesses create goods in
anticipation of future sales.

Businesses strive for an optimal

inventory level to insure that goods are available when the demand arises. However,
businesses also want to make sure that the investment in the inventory is kept to a
minimal.

If there is a higher than expected demand for a product, in the short run the supply will be
too small resulting in a reduction in inventory. The business will have to produce more of

this product in the long run in order to increase the supply or they will loose sales
because the customer will go to a competitor. Conversely, if demand is lower than
expected inventory levels will increase.

These inventory changes are directly related to the differences between aggregate
expenditures and income. Income functions as a product to the demand, because if people
have greater income they are more likely to buy more. The aggregate expenditures relate
to the supply side. In order to create a supply you need to spend money or expenditures.

Therefore, fluctuations in aggregate expenditures or income cause inventory levels to

increase or decrease in the short run. This requires businesses to adjust the levels of
expenditures to bring the inventory back to the optimal level

Some fun info on aggregate expenditures

helpful info on understanding inventories
.

B. Aggregate Demand
1. Aggregate demand is the amount of real output (real GDP) buyers desire at each price
level. It is the TOTAL amount of final goods and services demanded by buyers at each
price level, while plain old demand is the number of units of a particular good or service
desired at each price. Although demand and aggregate demand both slope downwards,
the units of measure for each graph are different:
2. Aggregate Demand Curve

Aggregate Demand Curve

Demand Curve

2. Components and Determinants of Aggregate Demand

C+I+G+N
Consumption + Investment + Government Spending + Net Exports=AD=GDP
Consumption is the amount of money people can and will spend on goods and services.
Consumption changes with disposable income, income available after taxes. An increase in
disposable income will increase consumption and shift the aggregate demand curve to the right.

A decrease in disposable income will decrease consumption and shift the aggregate demand
curve to the left.
Investments are affected by interest rates. An interest rate is the cost of borrowing money. As
interest rates rise, investments decrease, and aggregate demand shifts to the left. When interest
rates fall, investments increase, and the aggregate demand curve shifts to the right. Think of
interest rate as the cost of a good, money. As the cost increases, the demand for that particular
good decreases. All else equal, this causes aggregate demand to decrease as well.
Government spending is basically just consumption by the government. As it decreases,
aggregate demand decreases, and as it increases, aggregate demand increases. The government
will sometimes purposely increase to decrease spending to control inflation. See fiscal policy for
more information.
Net Exports are the total value of all goods exported from the United States. It is basically
consumption of domestic goods by international consumers. As net exports decrease, aggregate
demand decreases. The opposite is true if net exports increase.
N = Imports - Exports

3. Why the AD curve slopes downward

The aggregate demand curves slopes downwards because the relationship between price levels
and output is inverse. In other words, as price levels increase, AD decreases, and as price levels
decrease, AD increases. Three reasons for this are called Pigou's wealth effect, Keynes's interestrate effect, and Mundell-Fleming's exchange-rate effect.
Pigou's Wealth Effect
As the price level for products decreases, people can purchase more with their disposable
income. Because of this increase in purchasing power, consumers feel richer, and are able and
willing to spend more.
Keynes's Interest-Rate Effect
When price levels are low, consumers use less of their disposable income to make purchases.
They tend to save the rest, which in turn drives down the interest rate. A low interest rate drives
down the cost of investments; therefore investments increase and aggregate demand increases.
Mundell-Fleming's Exchange-Rate Effect
Keynes's Interest-Rate Effect Law tells us that as price levels decrease, saving increases, and
interest rates fall. This is good for people taking out money for mortgages and loans; however,
for those investing in the bank, this decreases their return. Therefore, people begin to invest in
foreign countries. The real exchange rate for domestic currency depreciates, and net exports
increases because it is cheaper for foreigners to buy domestic goods from a country whose
currency value has decreased. In turn net exports increase causing aggregate demand to increase.

So as the price level drops, interest rates fall, domestic investment in foreign countries increases,
the real exchange rate depreciates, net exports increases, and aggregate demand increases.
Article Relating To Aggregate Demand
SHIFT ME BABY ONE MORE TIME

C. Aggregate Supply
Aggregate Supply (AS) is the measure of the amount of goods and services produced within an
economy at a given price level. Aggregate supply and price level have a positive relationship,
when prices begin to rise, it is generally a sign for businesses to increase production to meet a
higher level of aggregate demand. When demand increase in an economy, it should be followed
by an expansion of aggregate supply.
Aggregate supply is determined by the supply side performance of the economy. It reflects
the productive capacity of the economy and the costs of production.

Short Run Aggregate Supply Curve

1. Determinants of Aggregate Supply:

Any rightward shifts in the production possibilities curve translate into rightward shifts in
the aggregate supply curve.

An increase in the supply of national resources will cause a decrease in per unit
production costs. A decrease in production costs per unit will cause an rightward shift in
the aggregate supply curve. Domestic or national resources include land, labor, capital,
and entrepreneurial ability.

Prices of imported resources: If the price of an imported resource falls, then there will be an
increase in aggregate supply, with a rightward shift in the AS curve.
American Exchange rate: Changes in the U.S. exchange rate affect the price of imported
resources. When the value of the dollar increases and the price of foreign currency falls
Americans are able to buy more foreign currency with each U.S. dollar. American producers are
then able to buy more foreign resources with each dollar, therefore causing a rightward shift in
the aggregate supply curve.
Market Power: Market power is the ability of a firm to set a price above the price that would
occur competitively. For example, OPEC controlled most of the oil industry therefore, an
increase in the price of oil, will cause the aggregate supply curve to shift leftward because of an
increase in per unit production costs.
Changes in productivity: Productivity = real output / input When productivity is increased,
there is an increase in the amount of good produced without an increase in the cost of production,
resulting in a shift in the AS curve.
Changes in legal-institutional environment: Taxes can be considered costs by a business.
When the government increases taxes, per unit production costs also rise. It is usually costly for a
business to follow government regulations. An increase in government regulations or taxes
increase per unit production costs and causes a shift in the aggregate supply.
2. Alternative aggregate supply curve shapes

1. Short run aggregate supply (SRAS) - Aggregate supply during a short period of time.
Includes changes in firms such as a change in the amount of labor used but not capital.
For examples building a new factory. This form of aggregate supply shows what happens
to the economy under the most slack, when resources are underused. An Upward shift in
SRAS will generally cause output to increase but not price. The SRAS curve is
horizontal. The concept is that wages, the price of labor, doesn't change in the short run.
2. Long run aggregate supply (LRAS) - In the long run, only capital, labor, and technology
affect the aggregate supply curve of the macroeconomic model. At this point everything
in the economy is assumed to be used optimally. In most situations, the LRAS is viewed
as a static curve because it shifts the least of the three types of aggregate supply. The
LRAS is shown as a vertical line, reflecting the belief that any changes in aggregate
demand (AD) will have temporary changes on the economy's total output.
3. Medium run aggregate supply (MRAS) - As an interim between SRAS and LRAS, the
MRAS form slopes upward and reflects when capital as well as labor can change. When
graphing an aggregate supply and demand model, the MRAS is generally graphed after
aggregate demand (AD), SRAS, and LRAS have been graphed, and then placed so that
the equilibria occur at the same point. The MRAS curve is affected by capital, labor,
technology, and wage rate.

3. Effects of the labor market on aggregate supply

The labor force is defined as the number of people employed plus the number unemployed but
seeking work. The nonlabor force includes those who are not looking for work, those who are
institutionalised such as in prisons or psychiatric wards, stay-at home spouses, children, and
those serving in the military. The unemployment level is defined as the labor force minus the

number of people currently employed. The unemployment rate is defined as the level of
unemployment divided by the labor force. The employment rate is defined as the number of
people currently employed divided by the adult population. Self-employed people are counted as
employed.
Changes in the labor force are due to long run variables such as natural population growth, net
immigration, new entrants, and retirements from the labor force. Changes in unemployment
depend on: inflows made up of non-employed people starting to look for jobs and of employed
people who lose their jobs and look for new ones; and outflows of people who find new
employment and of people who stop looking for employment.
Any changes of the labor market directly affect the aggregate supply curve. An increase in
employement, will lead to an increase in production, and a rightward shift on the aggregate
supply curve. An increase in the unemployment rate will cause production to decrease and a
leftward shift on the aggregaet supply curve.
4. How wages are determined
When productivity gains drive up wages in one industry or occupation, it is anticipated that
workers will be drawn from other industries and occupations, thereby returning relative wages to
their initial level. If productivity increases at the national level, however, the equivalent effect
would require that workers be drawn from other countries. But, as Canada restricts the number of
immigrants, this effect will be much less important for national wage levels than it was for
industry wage levels.
Also, a productivity gain at the national level is less likely to lead to a reduction in output prices
than is an equivalent gain at the industry level. When output increases in an industry, everything
else being constant, the industry may have to lower prices in order to sell that increase. When
output increases in the nation as a whole, however, all workers will have higher incomes and
those incomes may be used to purchase the increased output. In a sense, the increased output
creates the increased demand to purchase that output. Prices need not fall.
And if prices do fall, the real incomes of all workers will increase. That is, even if observed (or
nominal) wages do not change, workers will be able to buy more goods and services with their
incomes. They will be better off in a real sense. Thus, an economy-wide increase in
productivity could cause an increase in the welfare of workers, not through an increase in
observed money wages, but through a decrease in average prices.

Aggregate Supply Aggregate Supply practice question

D. Macroeconomic Equilibrium
1. Aggregate demand and aggregate supply together: the AD-AS model allows for insights on
economic growth, inflation, and unemployment.
The supply curve slopes upward because an increase in prices induces the producers to supply
more goods and services.
The following explain why there is an inverse reationship between price and GDP in the AD

model:
- real balances effect- produced by change in price level; it is the tendency for an increase in the
price level to lower the purchasing power of existing financial assets, which decreases total
spending
- interest rate effect- it is the tendency for an increase in the price level to increase demand for
money, raise interest rates, and reduce total spending. Basically when the price increases, goods
and services requite more dollars so people sell off bonds, driving up interest rates.
- foreign purchases effect (exchange rate effect)- the inverse relationship between the net exports
of an economy and it's price level relative to foreign price levels. (When interest rates increase, it
attracts foreign investors, allowing the dollar to appreciate.)

Aggregate Demand & Supply 1

This video is related to supply and demand so I figured I would add it. It may or may not be very
useful though. http://www.youtube.com/watch?v=qEDgejfDAjw
2. Short-run equilibrium: Equilibrium price and quantity are found where the aggregate
demand and aggregate supply curves meet.
An increase in aggregate demand would increase both GDP and the price level.
EX: Foreigners increase their spending.

Aggregate Demand & Supply 3

There is an increase in AD because whenever their is an increase in spending; there is an increase
in exports which leads to an increase in real GDP. (The equilibrium price increases, as well as the
level of GDP.)
A decrease in AD may or may not have a similar opposite effect because the prices may be
inflexible at the time for various reasons.
EX: Consumers decrease their spending because they predict that there will be a recession in the
future.

Aggregate Demand & Supply 2

When there is a decrease in spending, there is a decrease in demand for goods and services. This
leads to a decrease in output and the supply of products. (The equilbrium price has decreased and
so has the equilibrium quantity of GDP.)
An increase in aggregate supply inccreases real GDP, reduces employment, and lowers prices.
EX: There are technological advances.

Aggregate Demand & Supply 5

New technology allows for increased output and a fall in prices. (The equilibrium point has
shifted to the right and then down which is what consumers like because there are a lot of goods
and services and the prices are low.)
A decrease in AS decreases economic growth, increases unemployment, and raises the prices.
EX: An increase in inflation has caused workers to demand higher wages.

Aggregate Demand & Supply 4

When workers demand higher wages, companies cannot afford to hire as many people. Therefore
AS falls back and reduces output. (The equilibrium price has increased while equilibrium GDP
has decreased.)
This link goes straight to an amazing and in-depth explanation of equilbrium, both long-run and
short-run. It gives a great example that may help to refresh your memory on the topic.
http://www.raybromley.com/notes/ADASequiMove2.html
3. Effects of aggregate supply and aggregate demand shocks
Supply shocks change the price of a good or service suddenly. They are often due to changes in
the supply of that good or service.
When the supply decreases there will be an increase in prices and the AS curve will move back
to the left, reducing total output as well. This negative supply shock can cause stagflation
(combination of inflation, little to no output, rising unemployment, and recession).
There is an opposite effect when the supply increases. Prices decrease and the AS curve shifts to
the right. This is caused by anything that makes a nation produce goods and services more
efficiently.
Demand shocks are similar to supply shocks. A positive demand shock results in increases in
GDP and price level while a negative demand shock causes a decreases in both areas.

Image:economics_supply_shock.png
4. Long-run equilibrium and production possibilities curve
Refresher:
The LRAS curve is a vertical line that shows the amount of goods and services a nation can
produce. In the long-run, a nation wants as much output as possible at a certain price, but there is
only so much you can produce before the price makes it change.
Note: Price matters in the short-run more than in the long-run.
Also remember that the PPC is a graph comparing the maximum outputs of two goods or
servicees that a nation gan produce. If a nation wants to produce more of one thing, they must
produce less of the other.
This PPC shows that a nation is producing food and computers. When it is producing 11 units of
food it is producing 0 computers. If the nation was at a point on the inside of the curve, then they
are not producing goods and services very efficiently, and when they are at a point outside of the
curve, they have gained new technological advances or something of the sort that has allowed
them to become more efficient.
5. Analysis of the economy moving from the short-run to the long-run equilibrium
If there was an increase in AD starting at full employment then the AD curve would shift right. If
the economy was to move to the long-run equilbrium, then the SRAS curve would move back as
AD moves to the right in order to adjust wages. There will only be a change in the price level.

There are output changes at the LRAS curve but not at the SRAS curve. Wages will continue to
rise or fall, depending on prices. If prices go up then workers demand higher pay so that they can
afford things. Higher prices eventually leads to a decline in employment (rise in unemployment)
because businesses cannot afford to have as many employees when they have to pay each one
more money.

This link goes to a video that may serve as a bit of comic relief for all of the economic
information you have read so far. (Maybe Blaine can pick up a few jokes from this guy!!)
http://www.youtube.com/watch?v=YgB6mFmYEcM&feature=related
Sources:
http://economics.about.com/od/aggregatedemandsupply/ss/aggregate_3.htm
http://www.mhhe.com/economics/mcconnell/student/olc/outline11.htm
http://www.whitenova.com/thinkEconomics/adas.html

E. Fiscal Policy
The government policy that infulences the direction of the economy by government spending
and taxation.
1. Effects of change in government spending
- In an expansionary fiscal policy to stimulate demand, government spending increases.
When government spending increases, GDP increases.
- In a contractionary policy government spending decreases.
When government spending decreases, GDP decreases.
2. Effects of change in taxation

- Tax Decrease = increase income ---> consumption increases ---> increases amount demanded
With more money in the economy and a decrease in taxes, consumers will have more money and
are willing to spend more, which in turn causes a higher demand for goods and services.
- Tax Increase = decrese income ---> consumption decreses ---> decreses amount demanded
With less money in the economy and an increase in taxes, consumers will have less money and
will not want to spend, which in turn will cause a decrese in demands for goods and services.

3. Automatic Stabilizers
- Programs that automatically expand the fiscal policy during a recession and contract it during
booms.
- They are built into the government but do not need government action or authorization which
helps ensure that necessary adjustments can happen quickly
Example:
1. Unemployment Insurance - government spends more when unemployment rate is high.
2. Tax Code - taxes are almost proportional to wages and profits; the amount of taxes collected is
higher during a boom and lower during a recession
4. Short run effects on output and the price level
When taxes are greatly cut, spending increases and stimulated economic activity in the short run.
In the long run, however, a cut in taxes raises output less than the amount of the tax cut itself.
In the short run there will be an increase in GDP and in price levels, but over time there will be
higher prices but no change in GDP.

Sources used:
http://business.baylor.edu/Tom_Kelly/2307ch12.htm
http://www.econlib.org/library/Enc/FiscalPolicy.html
Economics Demystified, August Swanenberg, 2005 McGraw Hill

I didn't feel the need to clog up my section with graphs and tables that no one can
understand. Points for me!! ;o)

user-1438760

An "Economics" Magic Trick

BlaneParrish Jan 2, 2008
This is actually pretty funny to watch. A British man with 3 ropes of unequal length makes an
attempt to be engaging. He fails, but this video might teach you guys a little bit about income
distribution and income taxes. This is a good video for anyone who likes average magic or
laughing at British people. Please read my joke in Unit 2. It is pretty funny, even for someone
without a funny bone.
(74 words)

High Taxation Can Lead to Destruction

danielarudman Jan 1, 2008
I thought the cartoon in part E was a great example of what high taxation does to the work ethic
and productivity of and within a country. The guy is losing twenty-eight percent of his income,
which means his disposable income is worth only seventy-two percent of his the hours he puts
into his work. In turn, he decides to work seventy-two percent less. This is exactly why
economies that have extremely high taxation fall apart. People within a society who work very
hard for the living that they earn begin to feel that their return is no longer exceeding or even
equal to their input, so, based on the aggregate supply model, they cut down and become less
productive. In Socialist nations, nothing is really efficient. No one wants to work those extra
hours that they will ultimately not get paid for, but they have to because they will get fired.
Therefore, instead of cutting hours they really just cut their productivity. They stop trying to be
innovative to increase their output, so eventually input and output both decrease. Prices then
increase because supply has decreased, and people are either unwilling to or can no longer buy
the goods and services they want or need. The ultimate problems surrounding a Socialist
economy is really a simply question of supply and demand. People have no incentive to work
efficiently, so decreasing input obviously no longer produces as great of output. Prices rise since
demand stays the same, and people cannot afford their needs. Russia is a perfect example of a
country in this state. Incentive and return is the driving force behind hard work and
determination that make a country productive in more ways than one.