Consumption & Saving

Disposable Income:

• Income after taxes (net income)
• DI = gross income - taxes
• One can only spend or save DI
• Consume: spend on goods and services
• Save: not spend

Consumption:

• Household spending 
• Ability to consume constrained by:

              - amount of disposable income
              - propensity to save

• Do households consume if DI = 0? -Autonomous Consumption

Saving:

• Household not spending 
• Ability to save constrained by:

              - amount of DI
              - propensity to consume

• Do they save if DI = 0? -No

APC & APS:

• APC + APS = 1 
• 1 - APC = APS
• 1- APS = APC
• APC < 1 = dissaving
• -APS = dissaving

Marginal Propensity to Consume (MPC):

• fraction of any change in DI consumed 

MPC = Δ consumption
                    Δ DI

Marginal Propensity to Save (MPS):

• fraction of any change in DI saved

MPS = Δ savings
                Δ DI

MPC + MPS = 1 

1 - MPC = MPS

1- MPS = MPC

Spending Multiplier Effect:

• initial change in spending (C+Ig+G+Xn) causes larger change in AD (ag. spending)

Multiplier =      Δ AD

                   Δ spending

Spending Multiplier = 1/MPS

• (+) when increase in spending
• (-) when decrease in spending

Tax Multiplier:

• when the government taxes, multiplier works in reverse because money leaves the circular flow chart

Tax Multiplier = -MPC/MPS

• Answer will always be negative (-)
• Unless it's a tax cut, then it will be (+) because there is more in the circular flow

Investment Overview

Money spent or expenditures on:

• new plants (factories)
• capital equipment (machinery) 
• technology (hard & soft)
• new homes
• inventories (goods sold by producers)

Expected Rates of Return:

• How does business make investment decisions?

           - Cost/Benefit Analysis

• How does business determine benefits?

          - Expected Rate of Return

• How does business count the cost?

           - Interest Costs

• How does business determine the amount of investment they undertake?

         - compare expected return to interest
              - return > cost = invest
              - return < cost = do not invest 

Real (r%) v. Nominal (i%): 

           nominal is observable rate if interest, real subtracts inflation (π%) and is known as ex post facto

• How do you compute the real interest rate?

         - r% = i% - π%

• What determines the cost of investment?

         - real interest rate (r%)

Investment Demand Curve (ID):

• What is the shape?

         - downward sloping

• Why?

         - when interest is high, fewer investments are profitable; when interest rates are low,              more investments are profitable

Aggregate Graphs

Full Employment:

Full employment equilibrium exists where AD intersects with SRAS and LRAS

Recessionary Gap:

exists when equilibrium occurs below full employment output

Inflationary Gap:

exists when equilibrium occurs beyond full employment output

Keynesian Model:

Keynesian (Recession):

• Prices; fixed
• Wages; fixed
• Employment; flexible 
• Depends on changes in employment level

Classical/Vertical (Inflation):

• Price; flexible
• Wages; flexible
• Employment; fixed
• Independent of changes in price level

Nominal Wages:

• amount of money received by a worker per unit of time

Real Wages:

• amount of goods and services that a worker can purchase with their nominal wages 
• purchasing power of nominal wages

Sticky Wages:

• nominal wage level set according to an initial price level that does not vary due to the labor contracts or other restrictions

Classical vs Keynesian Video for Referance

Classical vs. Keynesian

Classical:

• Competition is good
• Self-regulating economy
• Long Run; economy balanced at full employment 
• Supports trickle down effect; rich first 

Keynesian:

• Competition is flawed 
• AD is key, not AS
• Leaks and savings cause recessions
• Ratchet effect and sticky wages blocks Say's Law
• Long Run; we are dead

Aggregate Supply

-Level of Real GDP that firms will produce at each given Price Level (PL)

Long Run v. Short Run

Long Run:

• Period of time where input prices are flexible and adjust to changes in the price level
• Level of Real GDP supplied is independent of the price level

Short Run:

• Period of time where input prices are sticky and do not adjust to price level change
• Level of Real GDP is directly related to the price level

Long Run Aggregate Supply (LRAS)

• Marks level of full employment in economy (analogous to PPC)
• Because input prices are flexible, changes in price level do not change firms' real profits and therefore do not change a firms' level of output. LRAS is vertical at full employment  

Changes in SRAS (Short Run)

• Increase is to the right; Decrease is to the left 

per unit cost of production = total input cost 

                                          total output

Determinants:

1.) Input Prices

          -Domestic Resource Prices

               - wages (75% of business costs)

               - cost of capital

               - raw materials (commodity prices)

          -Foreign Resource Price

               - Strong $ = lower foreign resource price

               - Weak $ = higher foreign resource price

          - Market power 

               - increases in resource prices = SRAS shift to the left

               - decrease in resource prices = SRAS shift to the right

2.) Productivity

total output

total input

          - More productivity = lower unit prod. cost: SRAS shifts right

          - Less productivity = higher unit prod. cost: SRAS shifts left 

3.) Legal-Institutional Environment

          - Taxes and Subsidies

               - tax on business increase per unit prod. cost = SRAS shift left

               - subsidies to business reduce per unit prod. cost = SRAS shift right 

          - Government Regulation

               - gov't regulation creates cost of compliance = SRAS shift left 

               - deregulation reduces compliance cost = SRAS shift right