Unit 3 - Consumption & Saving

Disposable Income (DI)

• income after taxes or net income
• DI = gross income - taxes

2 Choices

• with disposable income, households can either
• consume (spend money on goods & services)
• save (not spend money on goods & services)

Consumption

• household spending
• the ability to consume is constrained 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 & APS (Average Propensity to Consume/Save)

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APS > 1 ∴ dissaving
• - APS ∴ dissaving

MPC & MPS

• Marginal Propensity to Consume
• the fraction of any change in disposable income that is consumed
• MPC = change in consumption / change in disposable income
• MPC = (Δ C) / (Δ DI)
• % of every extra dollar earned that is spent
• Marginal Propensity to Save
• the function of change is disposable income that is saved
• MPS = change in savings / change in disposable income
• MPS = (Δ S) / (Δ DI)
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

Unit 3 - Investment Demand

What is Investment?

• money spent of expenditures on:
• new plants (factories)
• capital equipment (machinery)
• technology (hardware & software)
• new homes
• inventories (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?
• cost/benefit analysis
• How does business determine the benefits?
• expected rate of return
• How does business count the cost?
• interest cost
• How does business 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%) v. Nominal (i%)

• What determines the cost of an investment decision?
• the real interest rate (r%)

Investment Demand Curve

• shape 
• downward sloping
• Why?
• when interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
• conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Unit 3 - AD/AS

The AS/AD Model

• The equilibrium of AS and AD determines current output (GDPR) and the price level (PL)

Recessionary Gap

• A recessionary gap exists when equilibrium occurs below full employment output

Inflationary Gap

• An inflationary gap exists when equilibrium occurs beyond full employment output

Changes (Δ) in AD

• Δ Consumption (C)
• C↑ ∴ AD → ∴ GDPR↑ and PL↑ ∴ u%↓ and π%↑
• C↓ ∴ AD ← ∴ GDPR↓ and PL↓ ∴ u%↑ and π%↓
• Δ Gross Private Investment (Ig)
• Ig↑ ∴ AD → ∴ GDPR↑ and PL↑ ∴ u%↓ and π%↑
• Ig↓ ∴ AD ← ∴ GDPR↓ and PL ↓ ∴ u%↑ and π%↓
• Δ Government Spending (G)
• G↑ ∴ AD→ ∴ GDPR↑ and PL↑ ∴ u%↓ and π%↑
• G↓ ∴ AD← ∴ GDPR↓ and PL↓ ∴ u%↑ and π%↓
• Δ Nex Exports (Xn)
• Xn↑ ∴ AD→ ∴ GDPR↑ and PL↑ ∴ u%↓ and π%↑
• Xn↓ ∴ AD← ∴ GDPR↓ and PL↓ ∴ u%↑ and π%↓

Increase in AD

• C↑, Ig↑, G↑, and/or Xn↑ ∴ AD→ ∴ GDPR↑ and PL↑ ∴ u%↓ and π%↑

Decrease in AD

• C↓, Ig↓, G↓, and/or Xn↓ ∴ AD← ∴ GDPR↓ and PL↓ ∴ u%↑ and π%↓

Changes (Δ) in SRAS

• Δ Input Prices
• Input Prices↓ ∴ SRAS→ ∴ GDPR↑ and PL↓ ∴ u%↓ and π%↓
• Input Prices↑ ∴ SRAS← ∴ GDPR↓ and PL↑ ∴ u%↑ and π%↑
• Δ Productivity
• Productivity↑ ∴ SRAS→ ∴ GDPR↑ and PL↓ ∴ u%↓ and π%↓
• Productivity↓ ∴ SRAS← ∴ GDPR↓ and PL↑ ∴ u%↑ and π%↑
• Δ Legal-Institutional Environment
• Deregulation ∴ SRAS→ ∴ GDPR↑ and PL↓ ∴ u%↓ and π%↓
• Regulation ∴ SRAS← ∴ GDPR↓ and PL↑ ∴ u%↑ and π%↑

Increase in SRAS

• Input Prices↓, Productivity↑, and/or Deregulation ∴ SRAS→ ∴ GDPR↑ and PL↓ ∴ u%↓ and π%↓

Decrease in SRAS

• Input Prices↑, Productivity↓, and/or Regulation ∴ SRAS← ∴ GDPR↓ and PL↑ ∴ u%↑ and π%↑

Unit 3 - Aggregate Supply

• The level of Real GDP (GDPR) that firms will produce at each price level (PL)
• Long Run vs. Short Run
• Long-Run Aggregate Supply (LRAS)
• 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 independent of the price-level
• marks the level of full employment in the economy (analogous to PL)
• Short-Run Aggregate Supply (SRAS)
• 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
• because input prices are sticky in the short run, the SRAS is upward sloping
• Changes in SRAS
• 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 production cost = (total input cost) / (total output cost)

• Determinants of SRAS:
• Input Prices
• domestic resource prices
• wages (75% of business costs)
• costs of capital
• raw materials (commodity prices)
• foreign resource prices
• strong $ = lower foreign resource prices
• weak $ = higher foreign resource prices
• market power
• monopolies and cartels that control resources control the price of those resources
• increases in resource prices = SRAS ←
• decreases in resource prices = SRAS →
• Productivity
• productivity = (total outputs) / (total inputs)
• more productivity = lower unit 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 costs = SRAS →

Unit 3 - Aggregate Demand

• Aggregate (total) demand curve

• AD is the demand by consumer, businesses, government, and foreign countries
• Changes in the price level cause move along the curve, not shift of 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 price level and level of Real GDP is inverse
• 3 reasons why AD is downward sloping
1. Wealth Effect
• higher prices reduce purchasing power of the dollar
• this decreases the quantity of expenditures
• lower price levels increase purchasing power and increase expenditures
• ex: if the balance in your bank has $50,000, but inflation erodes your purchasing power, you will likely reduce your 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's spending and business investment
• ex: increase in prices lead to an increase in the interest rate from 5% to 25% -- you are less likely to take out loans to improve your business
• result... price level goes up, GDP demand goes down (and vice versa)
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 demand to fall (Xn decreases)
• ex: if prices triple in the US, Canda will no longer buy US goods causing quantity demanded of US products to fall
• Shifts in AD
• there are two parts to a shift in 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 ←
• Increase/decrease in AD

• Determinants of AD
1. Δ in consumer spending (C)
• consumer wealth (boom in the stock market)
• consumer expectations (people fear a recession)
• household indebtedness (more consumer debt)
• taxes (decrease in income taxes)
2. Δ in investment spending (Ig)
• real interest rates (price of borrowing money) (if interest rates increase) (if interest rates decrease)
• future business expectations (high expectations)
• productivity and technology (new robots)
• business taxes (higher corporate taxes means)
3. Δ in government spending (G)
• war
• nationalized health care
• decrease in defense spending
4. Δ in net exports (Xn)
• exchange rates (if  the US dollar depreciates relative to the Euro)
• if the US has a recession
• "if US gets a cold, Canada get pneumonia"
• more government spending (AD →)
• less government spending (AD ←)