AP Week 8 Section 4: National Income and Price Determination

AP Week 8 Section 4: National Income and Price Determination
Intro to ADAS model Consumption Function and disposable income Determinants of investment spending affect GDP Spending multiplier Determinants of AD and change in AD and movement Why it is downward sloping Determinants of AS, change, and movement Supply curve in long run and short run Potential or full employment level of output Shape of AS effect on changes to PL and output Expansionary fiscal policy affects on PL AD and RGDP Contractionary fiscal policy affects on PL, AD and RGDP Determining the size of the tax multiplier and assessing its impact on AD Difference between discretionary fiscal policy and automatic stabilizers

Monday module 16- test corrections until 5 PM Thursday REMEMBER TO START DOING THE YELLOW GRAPHS WITH ME FOR A TEST GRADE! Be able to explain what the spending multiplier is and be able to calculate the MPC and MPS for the spending multiplier Be able to discuss what happens to our spending Do Now: in notes start section 4 that covers modules 17-21 EQ: What is disposable income, what do I do with additional money? How does a dollar keep giving? Vocabulary: MPC, MPS, Autonomous change in AS, spending multiplier, consumption function, autonomous consumer spending aggregate consumption function, planned investment spending, inventory investment, unplanned inventory investments, actual investment spending,

Things to connect to with this module
Connect with circular flow model PPC and Business cycle The marginal propensity to consume is how much of an additional dollar an individual would spend, while the marginal propensity to save is how much of the additional dollar that same person would save. Things that shift aggregate consumption are basically the same as the shifters for demand

Spending Multiplier 1/(1-MPC)=1/MPS

$16 $4 $12 $14 $8 18 $10 $6 $2

Think about the chain reaction of loss of jobs in the oilfield
Think about the chain reaction of loss of jobs in the oilfield. Did only those employed in the field suffer economic loss? Who else? Why?

There is a chain reaction
The oil worker is no longer going to eat out, that makes the waitress receive less tips and the owner less revenue, they cut back on going to the grocery store, the store has less sales and they lay off people, there are fewer people buying clothes, that store lays off, fewer people are able to buy donuts and get dry cleaning done.

Assumptions: 1. producers are willing to supply additional output at a fixed price. So If we spend an extra 1 billion then GDP should rise by 1 billion and no increase in the price level. (works for short-run) 2. take the interest rate as a given 3. assume that no government spending and no taxes 4. assume no exports or imports With those simplifications what would happen if an additional billion is spent on investment spending?

A dollar spent on building a house becomes income for the carpenter, the lumber dealer etc. and that flows into homes as disposable income We don’t want to add up all the $’ s like we did with a little example so we use a formula

Marginal Propensity to consume MPC
MPC=  Consumer spending/ Disposable income This is the change in spending when a consumer has an increase or decrease in income Consumers do not generally spend all of the additional Will always be between 0-1 What we don’t spend we save CONSUMERS DO NOT “INVEST” IF THEY ARE BUYING STOCKS AND BONDS, MACRO ECO THEY ARE SAVING. BUSINESSES INVEST BY BUYING EQUIPMENT AND BUILDINGS FOR EXAMPLE

MPS is the Marginal Propensity to Save
MPS= 1-MPC Or you can say MPS=  in savings/ in income MPC + MPS= 1

So with the $20.00 example this is what took place.
Shows the concept of what happens to real GDP from a single $20.00 Investment (I) I= {1/(1-MPC) } x 20.00 Another way to figure is since 1-MPC=MPS you could say (1/MPS) x initial amount. ACDC Multiplier affect 6BXG5yzGXSiOOQi_tDl_HBs9GOQE3DyV1rlo6Re00AN9IdPxzFCAdvsqRmc7CqSMLC POTpI_G92efspoKCA Practice

Disposable income and consumer spending
Disposable income is a consumer’s income after taxes are paid. Income includes transfer payments. There is a relationship between the amount we spend and our disposable income The equation for this is a consumption function Autonomous consumer spending is the amount the household would spend if its current disposable income were zero- (spending by borrowing or using savings) MPC IS TH EAMOUNT THE HOUSEHOLD SPENDS OUT OF EACH ADDITONAL $ OF CURRENT DISPOSABLE INCOME.

Remember Consumer spending is the largest portion of GDP at approx. 70%

Tuesday- come in to make corrections on test by Thursday 5 PM Module 17 HAVE YOU DONE ANY OF THE YELLOW GRAPHS? Objective: be able to explain aggregate consumption, and role of interest on investment, compare AD to D Be able to verbalize the definition and explain the impact to AD and AS Do Now: Find in your notes law of demand, shifters of demand EQ: how is AD similar to D and how is it different? Vocabulary: AD curve, wealth effect to change in price level, interest rate effect, fiscal policy, monetary policy,

There are also changes to Investment spending (I or Ig )
When firms are considering investment spending they are looking to see what the cost-benefit is for spending money on investment The (expected profit) or expected rate of return is = (total revenue-total cost)/investment cost If the expected rate of return is greater than the interest rate on borrowed funds then businesses will invest THIS INVESTMENT IS ON THINGS THAT WOULD IMPROVE THE COMPANY- NOT STOCKS AND BONDS SPENDING ON A NEW FACTORY, NEW EQUIPMENT. . .

Even if a company pays cash for the investment- there is a cost
They could put that money into savings or other interest earning opportunities

Expected future RGDP, production capacity and investment spending
Companies may only invest in replacing existing equipment to maintain current production If they expect to see increases in sales they may spend/invest on things that would increase production If the company is already able to produce at a greater capacity than it needs then they are less likely to invest

Inventories and unplanned investment spending
Most firms maintain inventories/stock Or inventory of input materials needed When a company increase inventory it is a type of investment spending

Interest rates are critical to investment spending
Higher interest rates will reduce investment spending Lower interest rates will increase investment spending An inverse relationship Housing is considered an investment due to the length of time to pay for a home. The housing boom in 1990’s and early 2000’s was driven by a lower interest rate. Businesses will still invest with high interest rates if they expect the economy to really take off

Demand and Supply Review
Define Demand and the Law of Demand. Identify the three concepts that explain why demand is downward sloping. Identify the difference between a change in demand and a change in quantity demanded. Identify the Shifters of Demand. Define Supply and the Law of Supply. Why is supply upward sloping? Identify the Shifters of Supply.

Demand

Aggregate Demand

What is Aggregate Demand?
Aggregate means “added all together.” When we use aggregates we combine all prices and all quantities. Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. The Demand for everything by everyone in the US. There is an inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases.

Aggregate Demand Curve
AD is the demand by consumers, businesses, government, and foreign countries Price Level What definitely doesn’t shift the curve? Changes in price level cause a move along the curve AD = C + I + G + Xn Real domestic output (GDPR)

Why is AD downward sloping?
Real-Balance Effect- Higher price levels reduce the purchasing power of money This decreases the quantity of expenditures Lower price levels increase purchasing power and increase expenditures Example: If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending. So…Price Level goes up, GDP demanded goes down.

2. Interest-Rate Effect When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. WHY? Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. Result…Price Level goes up, GDP demanded goes down (and Vice Versa).

3. Foreign Trade Effect When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods Exports fall and imports rise causing real GDP demanded to fall. (XN Decreases) Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. Again, Price Level goes up, GDP demanded goes down (and Vice Versa).

Shifters of Aggregate Demand
C+I+G+Xn GDP = C + I + G + Xn

Shifts in Aggregate Demand
An increase in spending shift AD right, and decrease in spending shifts it left Price Level AD1 AD = C + I + G + Xn AD2 Real domestic output (GDPR) 31

Change in Consumer Spending Consumer Wealth (Boom in the stock market…) Consumer Expectations (People fear a recession…) Household Indebtedness (More consumer debt…) Taxes (Decrease in income taxes…) CONSUMER SPENDING WILL FALL AS AN INDIRECT RESULT OF A DECLINE IN INVESTMENT SPENDING- AS BUSINESS CUT BACK PRODUCTION THERE IS LESS PAY/DISPOSABLE INCOME 2. Change in Investment Spending Real Interest Rates (Price of borrowing $) (If interest rates increase…) (If interest rates decrease…) Future Business Expectations (High expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes means…)

Change in Government Spending (War…) (Nationalized Heath Care…) (Decrease in defense spending…) Change in Net Exports (X-M) Exchange Rates (If the us dollar depreciates relative to the euro…) National Income Compared to Abroad (If a major importer has a recession…) (If the US has a recession…) If dollar depreciates, more Europeans will buy US products causing Net Exports to increase “If the US get a cold, Canada gets Pneumonia” AD = GDP = C + I + G + Xn 33

Fiscal Policy: is the use of either government spending (purchases of final goods and services and government transfers or tax policy to stabilize the economy. Tax policy impacts disposable income for consumers- an increase in taxes will decrease DI a decrease in taxes will increase DI Because consumers will save part of the increase to DI from taxes the tax multiplier is always 1 less than the spending multiplier. Changes to taxes on businesses will change the Investment portion of the AD. Monetary policy is through the central bank. In our country that is the Federal Reserve. They have three tools that they can use to change the quantity of money and interest rates.

On your white boards: Draw and label an AD curve Show what would happen if: Consumers and firms become more optimistic. Why? When the real value of household assets falls. Why? The existing stock of physical capital is relatively small. Why? When government increases spending. Why? When government raises taxes. Why?

How does this cartoon relate to Aggregate Demand?

Wednesday module 18 Corrections to test must be finished by 5PM Tomorrow.
Be able to draw and explain ADAS, be able to list the shifters of aggregate supply and explain why there are 2 supply lines. Be able to listen and connect to what you read. Do Now: Go back in your notes and highlight the shifters of demand, chunk the notes on what shifts demand and make sure you know the components of demand. Test yourself and your neighbor for MPC. What happens to the tax multiplier? EQ: Why are there 2 aggregate supply lines?

Review Define Aggregate. Define Aggregate Demand.
Explain and give an example of the Wealth Effect. Explain and give an example of the Foreign Trade Effect. Explain and give an example of the Interest-Rate effect. Identify the Shifters of AD. Give examples for each shifter.

Supply

Aggregate Supply

What is Aggregate Supply? The supply for everything by all firms.
Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply Wages and Resource Prices will not increase as price levels increase. These are referred to as sticky wages Long-run Aggregate Supply Wages and Resource Prices will increase as price levels increase.

Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT increase as price levels increase. (sticky wages) Example: If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit? Profit = $100 - $80 = $20 What happens in the SHORT-RUN if price level doubles? Now 100 units sell for $2, TR=$200. Profit = $120 With higher profits, the firm has the incentive to increase production.

Since supply cost are generally input cost of materials and wages we note that in the short run these costs do not increase overnight. We refer to the wages as sticky wages, nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor Also note that nominal wages are the wages you actually are paid- you make $10.00 an hour. Your wages are often part of contracts and do not increase as rapidly as prices might change, Unit of Account cost of inflation.

Aggregate Supply Curve
An increase in AS is a shift to the right A decrease is a shift to the left Even if it looks like it is up or down Price Level AS AS is the production of all the firms in the economy Again note the proper labels Real domestic output (GDPR) 45

Shifts in Aggregate Supply
An increase or decrease in national production can shift the curve right or left AS2 Price Level AS AS1 This slopes upward because some input prices, like wages are “sticky” and do not rise or fall very quickly in response to a change in demand for them Real domestic output (GDPR) 46

SHIFTERS OF AGGREGATE SUPPLY
P changes in Productivity, this could happen due to new technology or skills, education, etc. E changes is Expectation: if they expect prices will rise or fall people will expect higher wages over time, A Actions by government: Taxes on Producers (Lower corporate taxes…) Subsidies for Domestic Producers, (Lower subsidies for domestic farmers…), Government Regulations, (EPA inspections required to operate a farm…) R change in Resource (input) costs like wages and materials (commodity prices)

Long-Run Aggregate Supply
In the Long Run, wages and resource prices WILL increase as price levels increase. Same Example: The firm has Total Revenue(TR) of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now TR=$200 In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160 Profit = $40, but REAL profit is unchanged. If REAL profit doesn’t change the firm has no incentive to increase output.

Long run Aggregate Supply
In Long Run, price level increases but GDP doesn’t LRAS Price level Long-run Aggregate Supply Full-Employment (Trend Line) QY GDPR We also assume that in the long run the economy will be producing at full employment.

The LRAS only shifts if the potential output actually changes.
This is like shifting the PPC inward or outward, Overtime it is moving to the right- think of the Trend line on the Business Cycle (it is upward sloping because the economy is growing) DO NOT SHIFT THIS FOR THE PEAR! Long-run Aggregate Supply Curve LRAS Aggregate price level (GDP Deflator, 2005= 100 15.0 Leaves the quantity of aggregate output supplied unchanged in the long run Fall in aggregate price level 7.5 Real GDP (billions of 2005 Dollars) The LRAS is what we are aiming to produce. If equilibrium is short of that mark then we have recessionary gap. If the equilibrium goes beyond that mark then we have inflationary gap. Potential output, Yp also labeled as YF (Full employment- this indicates the 4-6%) The potential output is the level of RGDP the economy would produce if all prices, including nominal wages, were fully flexible

If the price of a material or commodity decreases which way would the AS shift?
If the nominal wage increases which way would it shift If workers become more productive which way would it shift? If inflation is expected to be lower?

Exit Ticket On white board draw a ADAS, correctly labeled.
Write out PEAR and state what each letters represent.

Thursday Module 19- today at 5 is last day to correct for credit
Thursday Module 19- today at 5 is last day to correct for credit. HAVE YOU DONE ANY OF THE YELLOW GRAPHS? Objective: be able to describe a demand and supply shock. Be able to draw at equilibrium, recessionary gap and inflationary gap. Be able to describe the data from the graphs you draw Do now: In your notes make sure you have highlighted the points on LRAS, that you know what the AD and the SRAS shifters are EQ: Can I draw the graphs

Shifters of Aggregate Demand Shifters of Aggregate Supply
AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply Change in PRODUCTIVITY Change in Expectations Actions by government Change in Resource cost

THE AD-AS MODEL IS THE MOST FREQUENTLY TESTED PART OF THE AP TEST
THE AD-AS MODEL IS THE MOST FREQUENTLY TESTED PART OF THE AP TEST. IT IS ALMOST ALWAYS IN AT LEAST ONE OF THE FRQ. YOU MUST BE ABLE TO DRAW AND SHIFT AS WELL AS ANALYZE. WE ARE ALWAYS CURRENTLY IN THE SHORT-RUN LEVEL. SOMETIMES OUR SHORT-RUN LEVEL OF OUTPUT IS BELOW, OR ABOVE THE ECONOMY’S POTENTIAL LEVEL OF OUTPUT. WITH NEW RESOURCES EMPLOYED, PRODUCTIVITY IMPROVEMENTS AND TECHNOLOGY CHANGES DRIVE LONG-RUN AGGREATE SUPPLY CHANGES.

WHEN ASKED TO GRAPH THE EFFECT OF A CHANGE, GRAPH THE FIRST THING THAT HAPPENS IN THE SHORT-RUN UNLESS THE QUESTIONS TELLS YOU TO LOOK AT THE LONG-RUN.

Putting AD and AS together to get Equilibrium Price Level and Output

DEMAND SHOCKS ARE EVENTS THAT SHIFT THE AGGREGATE DEMAND CURVE
WHAT HAPPENS TO PRICE LEVEL AND OUTPUT? NOTE THAT THEY BOTH MOVE IN SAME DIRECTION DEMAND SHOCKS DEMAND SHOCKS ARE EVENTS THAT SHIFT THE AGGREGATE DEMAND CURVE NEGATIVE DEMAND SHOCK SHIFTS LEFT AND A POSITIVE DEMAND SHOCK SHIFTS TO THE RIGHT RGDP

SUPPLY SHOCKS NOTE WHAT HAPPENS TO PRICE AND OUTPUT SUPPLY SHOCKS SHIFT THE SRAS CURVE. THESE CAUSE THE PRICE LEVEL AND THE OUTPUT TO MOVE IN OPPOSITE DIRECTIONS. NEGATIVE SHIFTS TO THE LEFT. THE COMBINATION OF INFLATION AND FALLING AGGREGATE OUTPUT IS CALLED STAGFLATION

Inflationary and Recessionary Gaps
61

Example: Assume the government increases spending
Example: Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 62

Inflationary Gap Output is high and unemployment is less than NRU LRAS
Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 63

Stagnate Economy + Inflation
Example: Assume the price of oil increases drastically. What happens to PL and Output? LRAS Price Level AS1 AS PL1 Stagflation Stagnate Economy + Inflation PLe AD Q1 QY GDPR 64

Recessionary Gap Output low and unemployment is more than NRU LRAS
Price Level AS1 Actual GDP below potential GDP PL1 AD Q1 QY GDPR 65

AD and AS Practice Worksheet
66

How does this cartoon relate to Aggregate Demand?
67

Draw AD and AS at full employment
LRAS AS Price Level P2 P1 AD2 AD=C+I+G+X Qf (Y*or FE) Q2 GDPR Output Increases PL Increases 68

Short Run and Long Run 69

Shifts in AD or AS change the price level and output in the short run
LRAS Price Level AS PLe AD QY GDPR 70

Example: Assume consumers increase spending
Example: Assume consumers increase spending. What happens to PL and Output? LRAS Price Level AS PL1 PLe AD1 AD QY Q1 GDPR 71

Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 72

AS increases as workers accept lower wages and production costs fall
Example: Consumer expectations fall and consumer spending plummets. What happens to PL and Output in the Short Run and Long Run? Price Level LRAS AS AS1 AS increases as workers accept lower wages and production costs fall PLe Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment PL1 PL2 AD AD AD1 Q1 QY GDPR 73

Friday Objective: be able to identify what you did wrong on the test last week as we go over the questions. On your test- write an explaination to what you did wrong on all of the questions you got wrong. Do Now: Get out your notes over measuring the economy EQ: What do I not understand on measuring the economy

Get the test booklet and scan tran
find the errors and correct them- you no longer get points for this. That ended yesterday. Complete the released test questions with a partner. Practice drawing the ADAS for different circumstances Present graphs for the yellow sheet.

AP Week 8 Section 4: National Income and Price Determination

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