Unit 3 Multipliers

The Spending Multiplier Effect

• An initial change in Spending (C, IG, G, Xn) causes a larger change in aggregate spending or aggregate demand. 

Why does this happen?

• Expenditures and Income flow continuously which sets off a spending increase in the economy 

Multipliers

• Positive when there is an increase in Spening
• Negative when there is a decrease in spending
• When The government taxes the multipliers work in reverse (Because money is now leaving in circular flow) 

Tax Multiplier (Negative)

• If there is a tax-cut then the multiplier is positive because there is now more money in the circular flow 

Unit 3: Consumption and Savings

Disposable Income

• Income After Taxes (Net Income)

There are 2 Choices

• Consume (Spend money on goods and services)
• Save (Not Spend money on goods and services)

Consumption

• Household Spending 
• Ability to consume is constrained by 
• The amount of disposable income
• The Propensity to Save 

Do Households consume if DI=O?

• Autonomous Consumption
• Dis savings 

Savings

• Household NOT saving
• The Ability to save is constrained by
• The Amount of DI 
• Propensity To Consume 

Do Households Save if DI=O?

Formulas
APC+APS
APC+APS=1
1-APC=APS
1-APS=APC
APC>1 (Dissaving)
-APS (Dissaving)

MPC & MPS

• Change in C/ Change DI (% of every $ earned that is spent

MPS

• Change in S/Change in DI 

MPC+MPS=1

1-MPS=MPC

1-MPC=MPS 

Unit 3: AD/AS

Horizontal/Keynesian Range

• A lot of unemployed resources which creates a recession or depression. It includes only levels of Real GDP that are less than the full employment output. 

Intermediate Range

• Resources are getting closer to the full employment level which creates pressure on wages and prices. 

Classical/Vertical Range

• Where Real GDP is at a level with unemployment at the full employment level and where any increase in demand will result only in an increase in prices 
• The Economy is unable to produce anymore goods and services for a sustainable period of time. 

Unit 3 Aggregate Supply

Aggregate Supply

• The level of Real GDP (GDPr) that firms will produce at each price level. 

Long Run v. Short Run

Long 

• Period of time where input prices are completely flexible and adjust to changes in the price level 
• In the Long Run, the level of Real GDP supplied is independently related to the price level. 
• The Long-run aggregate supply or LRAS marks the level of full employment in the conomy

Short

• Period of time where input prices are sticky and do not adjust to changes in the price level.
• In the Short-Run the level of Real GDP supplied is indirectly related to the price level.
• In the Short-Run because input prices are sticky the SRAS is upward sloping. 
• An increase in SRAS is seen as a shift to the right 
• A decrease in SRAS is seen as a shift to the left
• The key to understanding shifts in SRAS is per unit cost of production 

Per-Unit Cost of Production 

• Total Input/Total Output 

SRAS Determinants

• Input Prices 
• Productivity
• Legal Institutional Environment 

Input Prices 

• Domestic Resources Prices (Wages: 75% of all businesses) 
• Cost of Capital 
• Raw Materials (Commodity Prices) 
• Foreign Resource Prices 
• (Strong Economy= Lower Foreign Resources Prices)
• (Weak Economy=Higher Foreign Resource Prices)

Market Power

• Monopolies and Cartels that control resources control the prices of those resources

Increases in Resource Prices= SRAS <-----

Decreases in Resource Prices= SRAS------>

Productivity= Total Output/Total Input 

• More Productivity= Lower Production Cost (SRAS ------->)
• Lower Productivity= Higher Unit Production Cost= (SRAS<------)

Legal Institutional Environment 

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

Unit 3: Aggregate Demand

Aggregate Demand

• AD is the demand by consumer businesses, government and foreign nation
• AD= C+I+G+Xn

AD

• Changes in price level cause a move along the curve not a shift in the curve. 
• 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 GDPr is inverse. 

3 Reasons why AD is downward Sloping

1. Wealth effect

• Higher Prices reduce the dollar purchasing power.
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures 

Example

• If the balance in your bank account was $50,000, but the inflation erodes your purchasing power you will likely reduce your spending.
• So if price levels go up then GDP demanded goes down 

      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.

Example

• Increase in Price leads to an increase in the interest rate from 5% to 25%. This means you are less likely to take out loans to improve your business. 

      3. Foreign Trade Effect 

• When U.S price level rises, foreign buyers purchase fewer goods and Americans buy more foreign goods. 
• Exports fall and Imports rise which cause Real GDP demanded to fall (Xn Decreases) 

Example

• If prices triple in the U.S, Canada will no longer buy U.S goods causing quantity demanded of products to fall. 

Shifts in AD (Two Parts) 

• A change in C, IG, G, and or Xn 
• A multiplier effect that produces a greater change than the original change in components.
• Increase in AD= AD--->
• Decrease in AD= AD<------

Determinants of AD 

• Consumption
• Gross Private Investment 
• Government Spending 
• Net Exports (Xn)= Exports-Imports 

Change in Consumer Spending 

• Consumer wealth (Boom in the stock Market)
• Consumer Expectations (People fear a recession)
• Household in debetness (More consumer dept) 
• Taxes (Decrease in income Taxes) 

Changes in Investment Spending

• Real Interest Rate (Price of borrowing $) 
• If interest Rate Increases 
• If interest decreases
• Future Business Expectations (High Expectations) 
• Productivity and Technology (New Robots) 
• Business Taxes (Higher corporate taxes) 

Change in Government Spending

• War 
• Nationalized Health Care 
• Decrease in Defense Spending

Change in Net Exports (Xn) 

• Exchange Rates 
• If the U.S $ depreciates relative to the euro. 

National Income Compared to abroad 

• If a major importer has a recession
• If the U.S has a recession 

IF THE U.S GETS A COLD, CANADA GETS PNEUMONIA 

AD=GDP

Government Spending

• More Government Spending: AD----->
• Less Government Spending: AD<------