2. ADAS 1. Define AD & AS. AD AQD RGDP AD – AQD [ RGDP ] desired by the private, public, & foreign inverse sector at various PLs [ inverse ] [Everyones demand for everything] AS AQS RGDP direct AS – AQS [ RGDP ] firms will supply at various PLs [ direct ] down-sloping AD 2. Three reasons for the down-sloping AD curve a. interest rate effect b. real-balances effect c. foreign purchase effect three ranges of the AS curve 3. Know the three ranges of the AS curve. 4. Predict effects of an increase in AD in Keynesian, intermediate, & classical Keynesian, intermediate, & classical ranges. increase/decreaseAS 5. Predict effects of an increase/decrease in AS on output and price level. C+Ig+G+Xn 6. Know the four AD shifters [ C+Ig+G+Xn ]. [REP]. 7. Know the three AS shifters [REP]. ratchet effect 8. Explain the ratchet effect of a decrease in AD. Classical/Keynesian 9. Compare the Classical/Keynesian Schools of Economics.

3. [ Demand (AD ) for everything by everyone] or [Amount of goods & services that will be demanded at various price levels by the private, public, and foreign sectors] AQDgreaterlower price levels [ AQD will be greater at lower price levels ] [amount of goods and services that will be produced by firms at various price levels] AQSgreaterhigher price levels [ AQS will be greater at higher price levels ] Aggregation combiningall pricesinto a single Aggregation – combining all prices into a single aggregate price level all quantities aggregate price level and – combining all quantities intoaggregate quantities AQSreal GDP into aggregate quantities [ AQS or real GDP ]

4. SRAS 1 PL Y*Y*Y*Y* RGDP AD Shifters AD Shifters [C+Ig+G+Xn] [C+Ig+G+Xn] Consumption Investment (gross) G overnment S pending [infrastructure, military spending, health care] Net eXports AS Shifters AS Shifters [ REP ] [ REP ] Resource cost Environment [legal-institutional] [legal-institutional] 1. Subsidies, 1. Subsidies, 2. Business taxes, 2. Business taxes, 3. Business regs. 3. Business regs. Productivity SRAS 2 YIYIYIYI Aggregation – we are combining all prices into price level & combining all quantities into Real GDP(Y). Y indicates 3 things: 1. Output [GDP] 1. Output [GDP] 2. Income 2. Income 3. U nemployment 3. U nemployment Y R – Recession gap Y R – Recession gap Y I – Inflation gap Y I – Inflation gap Y * – Full Employ. Y * – Full Employ. FE output D ont confuse FE output economys with the economys maximum output maximum output, which larger output that is the larger output that would be produced if everyone were forced to work as much as possible possible. CIG-XCIG-XCIG-XCIG-X AD 2 YRYRYRYR 103 AD 1 SRAS 2 LRAS

5. C+Ig+G+Xn [C+Ig+G+Xn] Consumer Spending Increases wealth increases 1. Aggregate wealth increases independent of PL [stocks, bonds, land, houses, etc.] Expectationssurging future inflation 2. Expectations of surging future inflation Consumer indebtedness is fairly low 3. Consumer indebtedness is fairly low Consumer taxes are decreased 4. Consumer taxes are decreased Interest rates are d ecreased 5. Interest rates are d ecreased [independent of PL] Investment Spending Increases Interest rates are decreased 1. Interest rates are decreased [independent of PL] Positive profit expectations 2. Positive profit expectations inventories aredown 3. Factory inventories are down *Business taxes are reduced [*will also shift AS] 4. *Business taxes are reduced [*will also shift AS] Government Spending Increases Government spending increases Government spending increases on health care, military bases, infrastructure, etc. Net Export Spending Increases Foreign incomesincrease 1. Foreign incomes increase [will buy more there and here] Dollardepreciates 2. Dollar depreciates [our exports are cheaper] PL AD 1 AD 2 Y1Y1Y1Y1 AS Health care, infrastruc., military 100 Bases May 100 Bases May Face Closure Face Closure Military base cuts would start in 2010. 100 of the nations 425 bases would be closed, saving over $75 billion annually. Y2Y2Y2Y2

6. Environment [Legal-Institutional Environment for businesses change] 1. Subsidies are increased. 2. Regulations on businesses are decreased. 3. *Business taxes decrease. Resource Cost Decrease (domestic) 1.Land – new raw materials (oil) are found. 2.Labor– labor force increases or wages decrease. 3.Capital stock or entrepreneurial ability increases. 4.The number of sellers of resources increase. Productivity Increases Technological breakthrough leads to an increase in productivity [more outputs from same inputs]. *Notice that a decrease in business taxes increases both AD & AS. PL 1 AD AS 1 Y1Y1Y1Y1 Resource Cost Decrease (overseas) Resource Cost Decrease (overseas) 1.Imported resources decrease in price. appreciates 2.Dollar appreciates [foreign inputs are cheaper]. 3.OPEC nations cheat by producing more oil. AS 2 Y2Y2Y2Y2 PL 2

7. Real Domestic Output PriceLevel [Production cost] AD PLe Ye SRAS [ REP ] [CIG-X][CIG-X][CIG-X][CIG-X]

8. R eal Wealth [M oney-balances] E ffect R eal Wealth [M oney-balances] E ffect – economys monetary wealth. If we buy fixed bundle of goods & services every month a fixed bundle of goods & services every month (food/clothing/ shelter), at lower prices, it now takes less money. money. Our accumulated savings balances [401k, CDs, bonds] will purchase more purchase more. AD Interest Rate Effect Interest Rate Effect – lower interest rates increase investment and consumption. Foreign Purchase Effect Foreign Purchase Effect – with lower U.S. prices, both Americans & foreigners buy more American goods. Market Basket PL 1 PL 2 QD 1 QD 2

9. interest rate effectincrease in the PL 5. The interest rate effect suggests that an increase in the PL will (incr/decr) the demand for money, (incr/decr) interest rates and (increase/decrease) consumption and investment which would cause a(an) (increase/decrease) in (AD/AQD). real-balances effecthigher price level 6. The real-balances effect indicates a higher price level will (increase/decrease) the real value of money, (increase/decrease) consumption, and therefore (increase/decrease) (AD/AQD). foreign purchase effectincrease in PL 7. The foreign purchase effect suggests that an increase in PL relative to other countries (increase/decrease) our exports and (incr/decr) our imports which would (incr/decr) (AD/AQD). Lower PL Higher PL AQD 2 AQD 1 PL 2 PL 1 AD

10. Points of Emphasis for AD/AS Questions Points of Emphasis for AD/AS Questions 1. Wages (labor), this is resource cost, so AS shifter. 1. Wages (labor), this is resource cost, so AS shifter. 2. Increase/decrease in union workers hired – 2. Increase/decrease in union workers hired – they get paid more – so labor, so AS shifter. they get paid more – so labor, so AS shifter. 3. Appreciation/depreciation of a currency [either AD or AS ] 3. Appreciation/depreciation of a currency [either AD or AS ] a. Resource cost is part of REP, so it is AS shifter. a. Resource cost is part of REP, so it is AS shifter. b. Exports are part of C+Ig+G+Xn, so it is AD shifter. b. Exports are part of C+Ig+G+Xn, so it is AD shifter. 4. Regulations and subsidies [legal-institutional 4. Regulations and subsidies [legal-institutional Environment], part of REP, so they are AS shifters. Environment], part of REP, so they are AS shifters. 5. For all C+Ig+G+Xn, does the situation result in 5. For all C+Ig+G+Xn, does the situation result in an increase or decrease in AD & therefore GDP? an increase or decrease in AD & therefore GDP? 6. For REP, think of production costs – 6. For REP, think of production costs – if producers make more money, there is an increase in AS, if producers make more money, there is an increase in AS, if producers make less money – there is a decrease in AS. if producers make less money – there is a decrease in AS.

11. availability of key natural resources ___33. Decrease in the availability of key natural resources (R)? productivity ___34. Increase in resource productivity (P)? foreign spending ___35. Increase in foreign spending on our products (Xn)? government spending ___36. Substantial reduction in government spending (G)? prices ofimported resources ___37. Declines in the prices of imported resources (R)? incomes of our trading partners ___38. Declines in the incomes of our trading partners (Xn)? business profit expectations ___39. Improvement in business profit expectations (Ig)? Stock market plunge consumer wealth ___40. Stock market plunge affects consumer wealth (C)? increase in interest rates ___41. There is an increase in interest rates [stable prices] (C & Ig)? Consumer indebtednesslow ___42. Consumer indebtedness is very low (C)?Extra: Increased governmentregulations ___43. Increased government regulations are forced on businesses (E)? government increases subsidies ___44. The government increases subsidies to all farmers (E)? D C A B C B A B B A D C [REP] 2 2 2 2

12. Interest Rates Nominal interest rate [5%]Nominal interest rate [5%] 5% –Measures interest in terms of the current dollars paid [lets say 5% on a 1-year T-bill] –Appears on the borrowing agreement –The rate quoted in the news media Real interest rate [3%]Real interest rate [3%] 5% 2% –Equals the nominal rate of interest [5%] minus the anticipated inflation rate [lets say 2%] 3% –Expressed in dollars of constant purchasing power [3%]

13. Interest Rates 3%With no inflation, the nominal and real interest rates would be identical [lets say, 3%] 2%5% 3%With inflation [2%], the nominal interest rate [5%] exceeds the real interest rate [3%] 6% -1%- 6%-1% –If the inflation rate is high enough [6%], the real interest rate can actually be negative [ -1% or 5% - 6% = -1%] –The nominal interest would not even offset the loss in spending power because of inflation, so lenders would lose purchasing power –This is why lenders and borrowers are concerned more about the real interest rate than the nominal interest rate

14. 1965 Interest Rates (percent per year) 15 Real interest rate 10 5 0 –5 1970197519801985199019952000 Copyright©2004 South-Western [negative here] Nominal interest rate

15. NominalInterestRate RealInterestRate InflationPremium - 8%8%8%8% 6%6%6%6% 2%2%2%2% [Nominal I.R. – inflation rate = Real I.R.] = = -

16. NominalInterestRateRealInterestRate InflationPremium = 8% 6% [Real I.R. + anticipated inflation = nominal I.R.] + + =

18. nominal interest rate has been 6%no expected inflation 2 (c) Suppose that the nominal interest rate has been 6% with no expected inflation. inflation is now expected to be 2%,value of each If inflation is now expected to be 2%, determine the value of each of the following. new nominal interest rate (i) The new nominal interest rate new real interest rate (ii) The new real interest rate 2(c)(i): The nominal interest rate is 8%. 2(c)(i): The nominal interest rate is 8%. [6% real + 2% expected inflation premium] [6% real + 2% expected inflation premium] 2(c)(ii): The new real interest rate would be 6%. [8% new nominal in. rate – 2% anticipated inflation = 6% real I.R.] [8% new nominal in. rate – 2% anticipated inflation = 6% real I.R.] Real Interest Rates 6%6%6%6%

19. [A 20% cost of funds attract $100 billion of investment 25% 15% 10% Change in QID [interest rate change, point to point movements] QID 1 QID 2 I.R. QID 100 200 A 5% cost of funds attracts $200 bil. Ig 050 150 250[MEI] D I (MEI) Firms invest with their profits & also borrow(5%) to invest.(10%) Real Interest Rates 20% 5%

20. Inflation and the Interest Rate High interest rates are the ugly twin sister of inflation. Interest Rate Inni flation

21. Nominal (stated or book) value v. $1.00 Actual marketreal Actual ( market or real ) value

22. AQS 2 Reasons For Upsloping AS Curve 1. There is increasing opportunity cost if firms dont produce. 2. Current producers produce more [overtime/more shifts] 3. New producers are attracted to the market. AS refers to the whole AS curve & refers to all price levels AQS refers to a point on the AS curve & refers to a particular price level AQS refers to a point on the AS curve & refers to a particular price level Change in AQS 1. Price Level change updown 2. Move ment (up/down) AS curve) 3. Point to point (along AS curve) AS AQS 1 AQS 1 PL 2 PL 1

23. Change in AS Environment [Legal-institutional] REP 1. N on price level c hange. Either R, E, or P 2. Whole AS curve shifts. 3. AQS changes but is not caused by a change in PL PL AQS 1 AQS 1 AS 3 AS 1 AS 2 1. Lower business taxes 2. Decrease in regulations 3. Increase in subsidies P Increase in P roductivity You save money. We dont require dental or medical insurance. You dont have to pay us a pension and we dont take sick days. And – we can dance. AQS 2 AQS 3 Anything that lowers the cost of production will shift AS right. So – AS Shifters are REP AS Shifters(REP ) 1. Resource cost 2. Environment [legal-institutional environment for businesses change, environment for businesses change, affecting production costs affecting production costs [subsidies, bus. taxes, regulations] [subsidies, bus. taxes, regulations] 3. Productivity R Increase in the availability of R esources

24. 11 % Y R Y A $ 9 1% Y I Y A $ 11 [Recessionary Gap, Inflationary Gap, or no gap] [5%(real) cyclical unemployment] Recess. GDP Gap 10% (5 x 2%=10%) Recess. GDP Gap 6 % Y* Y P $ 10 SR output [product] prices increase/decrease but input SR – output [product] prices increase/decrease but input [wages] prices remain fixed in the presence of [wages] prices remain fixed in the presence of unanticipated inflation/disinflation [sticky] unanticipated inflation/disinflation [sticky] LR – both output [product] and input [wages] prices change. 103 LRAS SRAS 110 RecessGap I nflat Gap 1 01 AD 2 Inflationary GDP Gap [ 10 %( 5x2 %) Inflationary GDP Gap AD 1 AD 3

25. 11 % Y R Y A $ 9 1% Y I Y A $ 11 [5%(real) cyclical unemployment] 10% (5 x 2%=10%)Recess. GDP Gap 10% (5 x 2%=10%) Recess. GDP Gap 6 % Y* Y P $ 10 103 AD 3 SRAS 110 RecessGap I nflat Gap 1 01 AD 2 Inflationary GDP Gap [ 10 %( 5x2 %) Inflationary GDP Gap AD 1 Input prices have responded to unanticipated changes in output unanticipatedinflationdisinflation prices in LR. [They respond to unanticipated inflation or disinflation. Two sets of prices are changing in LR - output and input. LRAS SRAS 3 SRAS 2

26. Long-Run input prices [wages] are completely flexible adjust –Period of time where input prices [wages] are completely flexible and adjust to changes in the PL Real GDP supplied is independent of the PL –In the long-run, the level of Real GDP supplied is independent of the PL Short-Run input prices [wages] are sticky do not adjust –Period of time where input prices [wages] are sticky and do not adjust to changes in the PL Real GDP supplied is directly related to the PL –In the short-run, the level of Real GDP supplied is directly related to the PL

27. LRAS PL GDP R LRAS YFYFYFYF LRASfull employment PPCThe Long-Run Aggregate Supply or LRAS marks the level of full employment in the economy (analogous to being on the PPC) …also called the Classical (vertical) range input prices [wages] are completely flexibleBecause input prices [wages] are completely flexible in the long-run, changes in PL do not change firms real profits and therefore do not change firms level of output. This means that the LRAS is vertical at the economys level of full employment. land, labor, capital, or entrepreneurship increaseLRAS curve increases decrease in the factors of production decreases the LRAS curve What Shifts the LRAS Curve? The LRAS curve is directly influenced by more or better resources or better technology. If land, labor, capital, or entrepreneurship increase, then LRAS curve increases. A decrease in the factors of production decreases the LRAS curve. Black Plague steam engine increased the LRAS The medieval Black Plague that wiped out a third of the European population reduced the LRAS curve. The invention of the steam engine increased the LRAS curve.

28. 11 % Y R Y A $ 9 1% Y I Y A $ 11 T he 3 Situations: No Gap, Recessionary Gap, & Inflationary Gap [5%(real) cyclical unemployment] Recess. GDP Gap 10% (5 x 2%=10%) Recess. GDP Gap 6 % Y* Y P $ 10 103 AD 3 SRAS 110 RecessGap I nflat Gap 100 AD 2 Inflationary GDP Gap [ 10 %( 5x2 %) Inflationary GDP Gap AD 1 No Gap (Y*) - No Gap (Y*) - Potential Output($10 tr.) equals Actual Output($10 tr.) Actual Unemployment rate(6%) equals Potential Unemployment Rate(6%) Recessionary Gap - Recessionary Gap - Potential Output($10 Tr.) exceeds Actual Output($9 tr.) Actual Unemployment Rate(11%) exceeds Potential Unemployment Rate(6%) Inflationary Gap Inflationary Gap Potential Output($10 tr.) is less than Actual Output($11 tr.) Actual Unemployment. Rate (1%) is less than Potential Unemployment Rate (6%) LRAS

29. AS AS - amount of real output firms will produce at each PL. Higher price levelsincentive Higher price levels provide an incentive to produce more. AS has three ranges: Horizontal 1. Horizontal (Keynesian) (Keynesian) 2. Intermediate 3. Vertical (Classical) Price level Real domestic output, GDP Horizontal[Keynesian]Range Upsloping or Intermediate Range Vertical[Classical]Range AS

30. Classical Supply-side Eclectic AS Curve Eclectic AS Curve Keynesian Developed in 70s ModifiedKeynesian AD 1 AD 2 AD 3 AD 4 AS 1 AS 2 Pure Inflation PL 1 Y 2 Y 2 AD 1 AD 2 Y * Y * RDO PL 1 PL (103) AD Y * Y * RDO AS Keynesian segment Supply-side segment Classical segment PL AS AS [Goal was to increase AS to help Y and decrease PL ] Y1Y1Y1Y1 Y3Y3Y3Y3 PL 2 RDO PL 2 YRYRYRYR 110 10 % RDO

31. AD Shifters 8. There are (3/4) AD Shifters, that have nothing to do with PL. They are consumption (C), investment ( I G ), G, & Xn. increase in consumption 9. An increase in consumption will shift the (AD/AS) curve to the (right/left). 10. (A change in PL/A decline in the interest rate no change in PL) will cause a shift in the AD curve shift in the AD curve to the (right/left). increase in the PL 11. An increase in the PL will cause a (shift in the AD curve to the left/shift in the AD curve to the right/decrease in AQD [movement up along a stable AD curve]). increase in investment 12. An increase in investment caused by a decline in the interest rate [independent of the PL] will (cause a movement along a stable/shift the) AD curve to the (right/left). government decides to spend $60 billion on the infrastructure 13. If the government decides to spend $60 billion on the infrastructure, this will shift the (AD/AS) curve to the (right/left). national incomes of our major trading partners were to decrease 14. If the national incomes of our major trading partners were to decrease, [therefore Xn will change] our (AD/AS) curve would shift to the (right/left). not shift the AS curve 15. (An increase in the PL/A decline in business taxes) would not shift the AS curve. Range 1range 2 16. Range 1 of the AS curve is call_____________, range 2 range 3 is called _____________, & range 3 is called _________. increase in the PL 17. An increase in the PL will cause a(n) (shift to the right of the AS curve/ shift to the left of the AS curve/increase in the AQS [move up a stable AS curve]). decrease in the PL 18. A decrease in the PL will cause a(n) (shift to the left of the AS curve/shift to the right of the AS curve/decrease in AQS [move down a stable AS curve[) NS 8-18 Horizontal Intermediate Classical 1 2 3