Classical and Keynesian Economics

Classical:

• Trickle Down Theory 
• Help the rich first then everyone else
• In the long run, the economy will balance @ full employment output
• The Invisible Hand

Keynesian 

• AD is the key, not AS
• In the long run, we are dead
• Leaks cause recessions

Reasons why prices tend to be "sticky" or inflexible in a downward direction

1. Menu Cost
2. Wage Contracts
3. Minimum Wage
4. Fear of Price Wars
5. Morale, Effort-Productivity 

Loanable Funds Market

• Ig: Gross Private Domestic Investment
• r: interest rate
• Sm: supply of money

Multiplier

The Spending Multiplier Effect: An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending or aggregate demand

Multiplier = Change in AD / Change in Spending (C, Ig, G, Xn)

• Why: expenditures and income flow continuously which sends off a spending increase in the economy

Spending Multiplier = 1 /1-MPC or 1 /MPS

Increase in Spending = +

Decrease in Spending = - 

Tax Multiplier: When government taxes, multiplier works in reverse

• Why: Now money is leaving the circular flow

Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS

• Tax Cut = +
• Now more money in the circular flow

Consumption and Saving

Disposable Income: Income after taxes or net income

DI= Gross Income - Taxes

• With disposable income, households can either:
• Consume (Spend Money on goods and services)
• Save (Not spend money on goods and services)

Consumption

• Household Spending
• The ability to consume is controlled by:
•  The amount of disposable income
• The propensity to save
• Do households consume if DI=0?
• Autonomous Consumption
• Dissaving

Saving

• Household NOT spending
• The ability to save is constrained by:
• The amount of disposable income
• The propensity to consume
• Do households save if DI=0?
• No

APC and APS

APC= Average Propensity to Consume

APS= Average Propensity to Save

APC + APS = 1

1 - APC = APS

1 - APS = APC

-APS = Dissaving

APC > 1 = Dissaving

MPS and MPS

MPC= Marginal Propensity to Consume

Change in C / Change in DI

• % every extra dollar earned that is spent

MPS= Marginal Propensity to Save

Change in S / Change in DI

• % of every extra dollar earned is saved

MPC + MPS = 1

1 - MPC = MPS

1 - MPS = MPC

Determinants of Consumption and Saving

• Wealth
• Expectations
• Household Debt
• Taxes

AS/AD Model

• The equilibrium of AS and AD determines current output (GDPr) and the price level (PL)
• Full Employment: Exists where SRAS and LRAS intersects
• Inflationary Gap: Output is high and employment is less than NRU
• Recessionary Gap: Output low and unemployment is more than NRU

Aggregate Supply

Aggregate Supply: The level of real GDP that firms will produce at each price level

• Long-Run: Period of time where input prices are completely flexible and adjust to changes in the price level
• The level of real GDP supplied is independent to the price level
• Short-Run: Period of time where input prices are sticky and do not adjust to changes in the price level
• The level of real GDP supplied is directly related to the price level

Long-Run Aggregate Supply (LRAS)

• Marks the level of full employment in the economy (analogous to PPC)

Short-Run Aggregate Supply (SRAS)

• Input prices are sticky and do not adjust to changes in the price level
• Level of real GDP supplied is directly related to the price level
• Upward Sloping
• Increase ---->
• Decrease <----

Per-Unit Production Cost

Total Input Cost/Total Output Cost

Determinants of SRAS

1. Input Prices

• Domestic resource prices 
• Wages (75% of all business costs)
• Cost of Capital
• Raw Materials (Commodity Prices)
• Foreign Resource Prices
• Stronger $= lower foreign price
• Weaker $= higher foreign price
• Market Power 
• Monopolies/Cartels that control resources
• Control price

2. Productivity

3. Legal Institutional Government 

• Taxes and subsidies
• Taxes ($ to government) on business increase pre unit of production cost= SRAS <----
• Subsidies ($ to government) to business reduce per unit production cost= SRAS ---->
• Government Regulation
• Creates a cost of compliance= SRAS <----
• Deregulation reduces compliance cost= SRAS ----> 

Interests Rates and Investment Demand

Investment: Money spent or expenditures on

• New Plants (Factories)
• Capital Equipment (Machinery)
• Technology (Hardware and Software)
• New Homes
• Inventories

Expected Rates of Return

• Businesses make investment decisions: Cost/Benefit Analysis
• Businesses Determine the benefits: Expected Rate of Return
• Businesses count the cost: Interests Costs
• Businesses determine the amount of investment they undertake: Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

Real (r%) vs. Nominal (i%)

• Real Interest Rate (r%)= i%-pi%

Investment Demand Curve (ID)

• Downward Sloping
• Because when interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable. 

Shifts in Investment Demand

• Cost of production
• Businesses Taxes
• Technological Change
• Stock of Capital
• Expectations 

Aggregate Demand

Aggregate Demand Curve:

*AD is the demand by consumers, businesses, government, and foreign countries

*Change in the price level cause a move along the curve, NOT a shift of the curve

Aggregate (AD):

• Shows the amount of Real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level 
• The relationship between the price level and the level of real GDP is inverse

Reasons Why AD is Downward Sloping

1. Wealth Effect

• Higher prices reduce purchasing power of $
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures
• Price Level +
• GDP Demand -

*EX: Price in bank $50,000, Inflation reduces purchasing power; you reduce spending

2. Interest Rate Effect

• As 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

*EX: 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.

3. Foreign Trade Effect

• When US price level rises, foreign buyers purchase fewer US goods and Americans buy more foreign goods. 

• Exports fall and imports rise causing real GDP demanded to fall (Xn Decreases)




*EX: If prices triple in the US ----> Canada no longer buys US goods ----> Quantity demanded of US products fall

Shifts in Aggregate Demand (AD)

• A change in C, Ig, G, and/or Xn

• A multiplier effect that produces a greater change than the original change in the 4 components

Increases in AD= AD ---->

Decreases in AD= AD <----

Determinants of AD

• Consumption (C)

• 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)

• Gross Private Investment (Ig)

• Change in Investment Spending

• Real Interest Rates (Price of Borrowing $)

• If interest rates increase/decrease

• Future Business Expectations (High Expectations)

• Productivity and Technology (New Robots)

• Government Spending (g)

• War

• Nationalized Health Care

• Decrease in defense spending

• Change in Net Exports

• Exchange Rates (If US depreciates relative to its Euro)

• National Income Compared to Abroad (If importer or US has a recession)

• "If US gets a cold, Canada gets pneumonia"

Government Spending:

• More government spending (AD ---->)

• Less government spending (AD <----)

Unemployment

Unemployment Rate: The percent of people in the labor force who want a job but are not working 
Labor Force: The number of people in a country that are classified as either employed or unemployed

Employed:

• Anybody that works at least one hour per month

• Anyone considered to be temporarily absent from work

• Part Time Workers

Not in the Labor Force:

• Kids

• Full Time Students 

• People in Mental Institutions

• Military Personnel 

• Stay at home mom's/dad's 

• Retirees 

• Incarcerated (@ least 6 months)

• Discouraged Workers (Mentally/Physically Broken Down ----> Stopped looking for job; Hopeless)

Unemployment Rate: # of Unemployed / # in Labor Force (Labor Force= # of unemployed + # of employed)
Standard Unemployment Rate: 4-5%

• > 5% = Possible Recession

• < 4% = :D

4 Types of Unemployment1. Frictional Unemployment 

• "Temporarily Unemployed" or being between jobs

• Individual are qualified workers with transferable skills but they aren't working

• EX: New graduate looking for a job

2. Seasonal Unemployment

• There is a specific type of frictional unemployment which is due to the time of the year and nature of the job

• These jobs will come back

• EX: Santa Clause/Easter Bunny

3. Structural Unemployment 

• Changes in the structure of the labor force make some skills obsolete

• Workers DO NOT have transferable skills and these jobs will never come back

• Workers must learn new skills to get a job

• Permanent Loss= Creative Destruction

• EX: Decline of one industry and the rise of another

4. Cyclical Unemployment 

• Unemployment that results from economic downturns (recessions)

• As demand for goods and services fall, demand for labor falls and workers are fired

Natural Rate of Unemployment (NRU)

Frictional + Structural 

Full employment means NO cyclical unemployment!

Okun's Law: When unemployment rises 1% above the natural rate, GDP falls by about 2%

Inflation

Inflation: A general rising in the level of prices

• Reduces the "purchasing power" of money

Causes of Inflation:

1. Printing too much money (The Quantity Theory)
2. Demand-Pull Inflation ("Too many dollars chasing too few goods")
• Caused by excess of demand over output that pulls prices outward
3. Cost-Push Inflation (Higher production costs increase prices)

• Gas prices go up during Hurricane Katrina

Standard Inflation Rate: 2-3%

Inflation Rate Formula:

Current Year Price Index * Base Year Price Index / Base Year Price Index * 100

Rule of 70: Used to calculate the number of years it will take for the price level to double at any given rate of inflation

70 / Annual Inflation Rate

Deflation: A general decline in the price level

Disinflation: Occurs when the inflation rate declines 

Real Interest Rates: The percentage increase in purchasing power that a borrower pays to the lender (Adjusted for inflation)

• Nominal Interest Rate- Expected Inflation 

Nominal Interest Rate: The percentage increase in money that the borrower pays back to the lender (NOT adjusting for inflation)

Unanticipated Inflation:

• Hurt by Inflation
• Lenders: People who lend money (at fixed interest rates)

• People with fixed income (Social Security ----> Senior Citizens)

• Savers

• Helped by Inflation

• Borrowers: People who borrow money

• A business where the price of the producer increases faster than the price of resources

Real and Nominal GDP

Nominal GDP: The value of output produced at current prices; can increase from year to year if either output or prices increase.

• Current Prices

• P * Q

Real GDP: The value of output produced t constant base-year prices; Adjusted for inflation; Can increase from year to year only if output increases

• P * Q

• Accurate Sample of Economic Growth

• Only in the base year is real GDP = Nominal GDP

• Years AFTER the base year, nominal GDP will exceed real GDP

• Years BEFORE the base year, real GDP will exceed nominal GDP 

Example:

CARS (2012)

Quantity: 10

Price: $15,000

CARS (2015)

Quantity: 20

Price: $16,000

TRUCKS (2012)

Quantity: 10

Price: $20,000

TRUCKS (2015)

Quantity: 20

Price: $21,000

Nominal GDP for 2012:

Cars: 10 * 15,000 = $150,000

Trucks: 10 * 20,000 = $200,000

TOTAL: $350,000

Nominal GDP for 2013:

Cars: 20 * 16,000 = $320,000

Trucks: 20 * 21,000 = $420,000

TOTAL: $740,000

Real GDP:

Cars: 20 * 15,000

Trucks: 20 * 20,000

TOTAL: $700,000

GDP Deflator: A price index that is used to adjust from nominal to real GDP

Nominal GDP/Real GDP * 100

Consumer Price Index (CPI): Measures inflation by tracking changes in the price of a market basket of goods 

• Market Basket of Goods: Cars, Trucks, Boats

Price of Market Basket in Current Year/Price of Market Basket in Base Year * 100