1. Section 4 Lecture November 2016 Mr. Gammie
AP Macroeconomics
Section 4 Lecture
November 2016
Mr. Gammie

2. Module 16: Income and Expenditure

3. What exactly is a bubble? What is a housing bubble?

4. How can a housing bubble, or a real estate market like that seen in Vancouver, lead to economic growth throughout the entire province?

5. How does a bubble burst?

6. 15%
12% for Canada
Usa 6%
India 8%
Diversification = good

7. Marginal Propensity to Consume
Consumption
GDP = C+I+G+(X-M)
Disposable Income (Yd) is ….
Disposable Income (Yd) can be used in two ways…
Yd = +
Consumption accounts for 2/3s of total spending in an economy Disposable income is what is left over after gov’t taxes (+ t payments)
Consumption or saving
Yd = C + S

8. What happens when your income goes up?
Consumption increases, but so does saving

9. Marginal Propensity to Consume
MPC = Δ consumption/ Δ disposable income The marginal propensity to consume is the amount by which consumer spending increases if disposable income increases by $1.
Rises or falls

10. Marginal Propensity to Save
MPS = Δ saving/ Δ disposable income
What is the MPS statement?
The marginal propensity to save is the amount by which consumer saving increases if disposable income increases by $1.
The marginal propensity to save is the amount by which consumer saving increases if disposable income increases by $1.

11. MPC + MPS = ? 1

12. Consumption Function Yd C S MPC MPS 5,000 -5,000 10,000 13,000 -3,000
5,000
-5,000
10,000
13,000
-3,000
0.8
0.2
20,000
21,000
-1,000
30,000
29,000
1,000
40,000
37,000
3,000
This is a hypothetical consumption function for a household.
When income = 0, some consumption still occurs due to borrowing.
The $5,000 at 0 income is referred to as autonomous consumption.
When income increases by $10,000, consumption increases by 8 and savings by 2.
Therefore MPC = 8/10 = 0.8, MPS = 0.2
If a household receives 1 additonal dollar of income, they will consume 80 cents and save 20.
We can create a consumption function with this information.

13. Consumption Function C = a + MPC x Yd
The consumption function is an equation that represents how a household’s spending varies with disposable income.
a, represents autonomous spending, the y intercept
MPC is the slope
C = *yD
C = a + MPC x Yd

14. What happens when disposable income increases to 20?
Consumption Function
Movement along the curve
C = 5+0.8*20 = 21
What happens when disposable income increases to 20?

15. What would cause the consumption function to shift?
Shift up and down
Different from demand and supply
What would cause the consumption function to shift?

16. Shifts in the Consumption Function
1. Changes in Expected Future Disposable Income 2. Changes in Aggregate Wealth
Changes in expected future income – imagine you knew that when you turned 25, your parents were going to give you $1,000,000. How might that affect your spending today?
Changes in aggregate wealth – stock market real estate, etc.

17. Accumulated wealth in vancouver, housing bubble, causes people to increase consumption, based on their “net worth”

18. Question Most recessions originate from which of the following events:
A fall in consumer spending
A fall in government spending
A fall in investment spending
A fall in the stock market c

19. Investment Spending Key driver of the business cycle
What would lead a business to increase investment spending?
Interest rate changes
Expected future economic growth
Production capacity

20. Investment Spending Spend money to make money
Investment decisions are based on cost-benefit analysis.
What role do interest rates play in the cost of investing?
Market interest rate really = the cost of investment
How much will we spend compared to how much do we expect to make.

21. Interest Rates
Example: A firm decides to build a new factory. This will increase sales, but also require borrowing to finance the investment.
Expected return on investment
= (total revenue – total cost)
total cost
Investment = 450
10% interest
Interest cost = $45
Expected revenue = 1000
/495 = 102% - might you invest? Yes
Interest rate goes up to 13%
Interest cost = 58.5
/508.5 = .966 *100 =97%
Would you invest? No

22. Compound Interest Mortgages

23. Interest Rates Interest Rate = cost of investment
Interest Rate is the cost of borrowed funds
It is also the cost of investing your own funds (forgone income)
Ownership vs. renting

24. Interest Rates and Investment Spending
Investment decisions will only go ahead if firms expect to make more money than they would have to pay to borrow the funds to finance it.
Interest rate increase? Fewer projects will pass that test.
Higher interest rates make it more expensive to borrow money.

25. Interest Rates
There is a negative relationship between interest rates and investment spending.

26. Expected Future Real GDP
Your firm has expectations that the economy for widgets is going to take off next year due to an increase in income levels around the world. What would you do today?

27. Production Capacity
Your firm has a factory that can produce 100,000 widgets. Currently, we have a customer base that required 50,000 widgets.
If we expect real GDP to take off will we engage in investment purchases?
The best conditions for investment to occur are when real GDP is expected to grow and production capacity is close to maximum.

28. Can investment be negative?
Inventory

29. I = I unplanned + I planned
Inventories
Why do firms hold inventories?
What would lead to an unplanned increase in inventory investment?
What would lead to an unplanned decrease in inventory investment?
I = I unplanned + I planned
To satisfy future orders.
Decrease in consumer spending.
Increase in consumer spending.
Actual investment spending = planned investment spending + unplanned inventory investment

30. Module 16 Summary
An increase in spending multiplies throughout the economy as that spending becomes another person’s income, part of which is spent, which becomes part of another person’s income, part of which is spent…. Etc.
The marginal propensity to consume: MPC = Δ consumption/ Δ disposable income
The MPC is the amount by which consumer spending rises if current disposable income rises by $1. The MPC = the slope of the consumption function.
The marginal propensity to save: MPS = Δ saving/ Δ disposable income MPC + MPS = 1
The spending multiplier = 1/(1-MPC) = 1/MPS
If aggregate autonomous spending changes by (Δ AAS) dollars, the multiplier effect will change real GDP (Y) by a greater amount: ΔY = M x AAS
Investment spending is negatively related to the interest rate.
Autonomous changes in investment spending have the same multiplying impact on real GDP as changes in autonomous consumption.

31. Module 17: Aggregate Demand

33. Aggregate Demand 1933 7.9 5.0 $716 950 Aggregate price
level (GDP deflator,
2005 = 100)
A movement down the
AD curve leads to a lower
aggregate price level and
higher aggregate output.
1933
7.9
5.0
Aggregate demand
curve, AD
$716
950
Real GDP (billions of 2005 dollars)

34. NOT THE LAW OF DEMAND
The demand curve for any one good shows the quantity demanded at given prices holding ALL OTHER PRICES EQUAL

35. So why is it downward sloping?

36. Wealth Effect
As the price level increases, the purchasing power of you money decreases. Therefore you will buy fewer goods than you would if the price level remained constant.
If you had $5000, and the price level rose 25%, you would only be able to buy the equivalent of $4000 worth of goods.
Changes C

37. Interest Rate Effect
As the price level increases, people and firms need to hold more money, which reduces the amount of money available for lending.
A lower supply of money available to lend will drive interest rates up, which reduces investment spending because it is now more expensive to make investment purchases.

38. SHIFTS

39. Expecting a recession

40. Real estate boom, housing prices double

41. physical capital stocks low

42. Gov’t policies

43. New schools

44. Cut taxes

45. Money supply increase = shift right
Increase in money supply = more money to lend, interest rate down, higher investment spending at any level

46. Module 17 Summary
The aggregate demand curve illustrates the relationship between the aggregate price level and quantity of aggregate output demanded in an economy.
Aggregate demand slopes downward like other demand curves, but for different reasons.
All else equal, an increase in the aggregate price level will cause real spending to decrease. This will be a movement along the AD curve.
The wealth effect and the interest rate effect explain the aggregate demand curve’s negative slope.
Because GDP = C+I+G+(X-IM) anything that increases once of these components will cause the AD curve to shift.
Several factors shift the demand curve: expectations, wealth, capital stocks, fiscal policy, and monetary policy.

47. Module 18: Aggregate Supply

48. Business hats on

49. Profit Profit per unit = price per unit – cost per unit
Does it affect your profit?

50. Short Run AS Curve

51. Short Run AS Curve Aggregate price level (GDP deflator, 2005 = 100)
Real GDP (billions of
2005 dollars)

52. Short Run AS Curve Rationale
If the price of a unit of output is rising faster than than the cost of producing that output, that unit of output will be produced.

53. Why this is… Why don’t prices and costs rise at the same rate?
Some prices are sticky.
Why this is…

54. Strong Economy
Demand  Prices  Profits per unit  Workers  Demand curve for labour ---> BUT….. Employers don’t raise wages yet Pressure on price of wages  Nominal wages eventually 
Demand for products increases, prices rising, profits per unit increasing, need more workers, demand curve for labour shifts, employers reluctant to raise wages, some are already locked into contracts, eventually increase demand for labour will result in upward pressure on price of wages, nominal wages will increase
Bottom line… the price of output rose quickly with stronger demand, but the price of labour(nominal wage) rose much more slowly
2. Demand for products is weak, producers selling fewer units, prices falling, decrease production, decrease workers, shift demand for labour, employers reluctant to lower wages, contracts already signed, as unemployment is high, wages evntually fall with high unemployment 

55. Weak Economy Demand … weak Prices … falling Profits per unit…. Falling
# of workers needed…. decreases
Demand curve for labour <---
BUT….. Employers don’t lower wages
Pressure on price of wages … downward
Nominal wages eventually …. fall
2. Demand for products is weak, producers selling fewer units, prices falling, decrease production, decrease workers, shift demand for labour, employers reluctant to lower wages, contracts already signed, as unemployment is high, wages evntually fall with high unemployment
Bottom line… price of output fell quickly with demand, but the price of labour (nominal wages) fell much more slowly

56. Decrease in Short-Run Aggregate Supply
Shifts in SRAS Curve
(a) Leftward Shift
(b) Rightward Shift
Aggregate price level
Aggregate
price level
SRAS
SRAS 2 1
SRAS
SRAS 1 2
Decrease in Short-Run Aggregate Supply
Increase in Short-Run
Aggregate Supply
Real GDP
Real GDP

57. Shifts in SRAS Curve 1. Commodities
Standardized product bought and sold in bulk
Inputs for many goods
Intermediate goods
Prone to industry related shocks
Increase in price? Decrease in price?

58. Shifts in SRAS Curve 2. Changes in Nominal Wages
Labour is a major input in the cost of production of most goods
Wage increase?
Wage decrease?

59. Shifts in SRAS Curve 3. Productivity 4. Expected Inflation
Technology, best practices
Shifts?
4. Expected Inflation
Higher expected inflation will cause workers to request higher wages to compensate

60. Shifts in SRAS Curve Government Actions PEAR Taxes, subsidies PEAR
- Productivity, expectations about inflation, actions by the gov’t, resources prices (wages, commodities)

61. Long Run AS Curve
Draw an increase in aggregate price level without any increase in output. If wages are able to increase, and with time they always will, there is no incentive to increase output.

62. A fall in the aggregate price level
Long Run AS Curve
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.
A fall in the aggregate price level
7.5
Potential output, YP
$800
Real GDP (billions of
2005 dollars)

63. Long Run AS Curve LRAS curve meets the x-axis at potential output.
That is …the level of real GDP the economy would produce at if all prices, including nominal wages, were fully flexible.

64. LRAS Curve
Given enough time the economy will adjust back to this level of output.
This level of output increases over time, due to increases in education, technology, etc.

65. SR to LR Fluctuations occur around Yp
In the AD/AS model, the economy is always operating on the SRAS curve
This only sometimes coincides with the LRAS curve.

66. SR to LR
Key point:
In the LR, the economy will adjust to where SRAS intersects LRAS at Yp.

67. Scenario 1: Strong Economy
Operating beyond “potential output”… how?
What happens?
A strong labour market has rising demand for labour.
There are very few workers that are unemployed. Employers are scrambling to find scarce employees.
Eventually nominal wages rise and SRAS shifts to the left until current output is equal to Yp.

68. Scenario 2: Weak Economy
Economy is weak and in recession operating below potential output
Current real GDP < Yp
What happens?
A weak labour market has falling demand for labour.
There are unemployed workers.
Employers find they can get workers to accept lower wages.
Eventually lower wages fall and SRAS shifts to the right until current output is = to Yp

69. Section 4: Module 19 and 20 Mini-Lecture
AP Macroeconomics
November 2016
Mr. Gammie

70. SR Macroeconomic Equilibrium
AD = SRAS

71. Surplus Shortage

72. Long Run Macroeconomic Equilibrium
AD = SRAS = LRAD
Always in SRe, if not in LRe, there is a push to get there…

73. What is considered to be the worst state the economy can be in?
Stagflation
Video Recap

75. Recessionary Gap

76. Draw stagflation

77. Inflationary Gap

78. Draw stagflation

79. Module 19 Key Concepts
There is a difference between the SR an LR macroeconomic equilibrium.
The model assumes the economy is always in a state of SR macroeconomic equilibrium. T
In the long run, when all prices are flexible, SRAS will adjust so that AD, SRAS, and LRAS will all intersect at potential output (Yp).
SR equilibrium can exist above, or below potential output (Yp).
There are a number of external factors that can cause demand shocks and supply shocks that shift the AD and SRAS curves.
Recessionary gaps occur when Ye is to the left of Yp.
Inflationary gaps occur when Ye is to the right of Yp.
The output gap can be calculated as follows:
Output Gap = (Ye-Yp) x 100 (stated in % terms) Yp
The economy is self correcting!

80. Fiscal Policy Why is fiscal policy needed? What is it’s purpose?
What are the ways government can utilize fiscal policy to affect the economy?
Demand and Supply Shocks
Don’t worry about monetary policy quite yet

81. Stagflation Issues
Show AS negative shock, and what happens when gov’t attacks AD to solve the problem

82. Taxes and leakage

83. Expansionary Contractionary

84. Fiscal Policy Lags
Recognition Lag
Decision Lag
Implementation Lag

85. Content Check – is this correct?
The author describes economic growth as being a shift in AD or SRAS to the right.
– is this correct?
no… it should have been stated as a shift in LRAS to the right (PPC)

86. Module 20 Key Concepts
Stabilization policy is needed because although the macroeconomy is self correcting, it takes significant time to do so.
Fiscal policy is an important tool in managing macroeconomic fluctuations.
Fiscal policy is the combination of spending and taxation used to stabilize the economy. It is typically used to shift the AD curve.
Expansionary fiscal policy should be used during a recessionary gap through tax cuts and increased spending.
Inflationary fiscal policy should be used during an inflationary gap through tax increases and cuts in spending.
Fiscal policy is sometimes unpredictable and ineffective due to lags and inefficiencies.

87. M20 Practice
The economy is currently experiencing a recessionary gap. What are two fiscal policy options that would move the economy closer to potential RGDP?
Describe how your policy would achieve the desired result.

88. Section 4: Module 21 Mini Lecture
AP Macroeconomics
November 2016
Mr. Gammie

89. Urgent Economics
The government needs to close a recessionary gap. The economy is currently operating at $50 billion below potential output (Yp) and unemployment is beginning to rise. Does the government need to inject $5 billion into the economy to close the gap?

90. NO

91. Spending Multiplier
M = 1/(1-MPC)

92. Old news!

93. Urgent Economics
If MPC = 0.9, how much does the government need to increase spending by to close the gap?
50= g*(1/1-0.9)
50- = g*(1/0.1)
50 = g*10
g = 5

94. Inflation Alert!
The economy is currently producing at $800 billion above potential output (Yp). If MPC =0.75, what should the government do to fix the problem?
-800 = g*(1/1-0.75)
g = 200
Decrease gov’t spending by $200 B

95. Taxes and Transfers GDP = C + I + G + Xn
What happens when your taxes are increased?
What happens when you receive a transfer payment?
Why is the effect on RGDP different than through government spending?
GDP = C + I + G + Xn
It affects Yd

96. Tax Multiplier = MPC/(1-MPC)
Consumers will save some of every dollar earned (or given to them).
Tax Multiplier = MPC/(1-MPC)

97. Spending Multiplier > Tax Multiplier
ALWAYS

98. Time for a rather taxing question…
The government has decided to lower taxes by $1000. MPC = 0.9 What is the effect on RGDP?
Change = 1000*(0.9/0.1) = 9000
What change would have occurred if it was a 1000 increase in G? --- $10000.

99. Transferring tools…
The government decreases transfer payment by $500. What is the effect if MPC = 0.8?
= -500*(4) = $2000
If cut in G, = $2500

100. Tax Systems
What is a progressive tax system? What effect does a progressive tax system have on disposable income as it changes?

101. Automatic Stabilizers
Progressive tax systems
Transfer payments – employment benefits
“Non-discretionary fiscal policy”

102. Think about it…
Country A has no unemployment insurance benefits and a tax system that uses on lump-sum taxes. Country B has generous unemployment benefits and a tax system in which residents must pay a percentage of their income, increasing as they earn more. Which country will experience greater variations in RGDP in response to demand shocks?

103. Discretionary
Expansionary Contractionary

104. Key Concepts Fiscal policy has a multiplier effect.
Government spending affects RGDP through the multiplier effect. If the multiplier is equal to M, one additional dollar of government spending creates $M of additional RGDP.
A change in lump sum taxes or transfer payments also creates more RGDP through a similar, though smaller, multiplier effect.
The spending multiplier is equal to 1/(1-MPC)
The tax multiplier is equal to MPC/(1-MPC)
The balanced budget multiplier is equal to 1.
The multiplier effect is influenced by automatic stabilizers.