Unit 3: Aggregate Supply

Definition:The level of real  GDP (GDPr) that firms will produce at each price level (PL)

• Long Run vs. Short Run 
• Long Run: Period of time where input prices are completely flexible and adjust to changes in the price level
• Short Run: Period of time where input prices are sticky and don't adjust to change in the price level
• Long run Aggregate Supply (LRAS):
•  The LRAS marks level of fall employment in  the economy (analogous to PPC)
• Because input prices are completely flexible in the long-run, change in price-level don't change firm's real profits and thus do not change firms level of output
• Means LRAS is vertical vertical at economies level of full employment 

• Change in SRAS:
• An increase in SRAS it will shift right
• An decrease in SRAS it will shift left
• Key to understanding shifts in SRAS is per unit cost of production
• Per unit production cost = total input cost/ total output

• Determinants of SRAS: ( all of the following affect unit production) 

1. Input prices
2. Productivity 
3. Legal-institutional environment  

Input prices :

• Domestic resource prices

-wages ( 75% of all business costs)

-cost of capital

-raw materials (Commodity Prices)

• Foreign Resource Prices
• Market Power
• Increase in resource prices = SRAS shift left
• Decreases in resources prices = SRAS shift right  

Productivity:

• Total output / Total input 
• More productivity = lower unit production cost = SRAS shift right  
• Lower productivity = higher unit production cost = SRAS shift left

Legal- Institutional Environment:

• Taxes and subsidies:
• Taxes ($ to gov) on business increases per unit production cost = SRAS shifts right
• Subsidies ($ from gov) to business reduce per unit production cost = SRAS shifts right 

• Government regulation: 
• Government regulates creates a cost of compliance = SRAS shifts left
• Regulation reduces compliance costs = SRAS right 

 Full Employment

• Equilibrium exists where AD intersects SRAS & LRAS at the same point .

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

Unit 3: Aggregate Demand Curve

Definition: AD is the demand by consumers, businesses, government, & foreign countries  

What definitely doesn't shift the curve ?

• Change is in price level cause a move along the curve 
• Formula : AD = C + Ig +G +Xn

Why is AD downwards sloping?

Real-Balance Effect
Definition: Higher price levels reduce the purchasing power of money 

• This decreases quantity of expenditure 
• Lower price levels increases purchasing power and increase expenditures 
• Ex: If the balance in your bank was $50,000, but inflation erodes your purchasing power you will likely reduce your spending  

 Interest Rate Effect 
Definition: When the price level increases, lenders need to change higher interest rates to get real return on their loans.

• Higher interest rates discourage consumer spending and businesses investment. WHY?

Foreign Trade Effect

Definition: When U.S price level rises, foreign buyers purchase fewer U.S fewer U.S good & Americans buy more foreign goods

• Exports fall and imports rise causing Real GDP demanded to fall (Xn decreases) 

Shifters of Aggregate Demand:

• Formula: GDP = C + Ig + G + Xn
• There are two parts to a shift in AD 
• Change in C, Ig, G, and / or Xn  
• Multiplier effect that produces a greater change than the original change in components  
• Increase in AD shifts AD right 
• Decrease in AD shifts AD left  

Determinants of AD :

Consumption:

• Household spending is affected by:
• Consumer Wealth
•  more wealth= more spending ( AD shifts right)
•  less wealth= less spending ( AD shifts left) 

Consumer Expectations

• Positive Expectations= more spending (AD shifts left) 
• Negative Expectations= more spending (AD shifts left) 

Household Indebtedness

• Less Debt = more spending ( AD shifts right )
• More Debt= less spending ( AD shits left) 

Taxes

• Less taxes = more spending (AD shifts right)
• More taxes = less spending (AD shifts left )

Gross Private Investment:

• Investment spending is sensitive to:
• Lower real interest rate = more investment ( AD shifts right)
• Higher real interest rate = less investment (AD shifts left) 
• Expected returns:
• Higher expected returns = more investment ( AD shifts right )
• Lower Expect returns = less investments ( AD shifts left )
• Expected returns are influenced by:
• Expectations of future profitability
• Technology  
• Degree of excess capacity (existing stock of capital)
• Business taxes  

Government Spending:

• More government spending ( AD shifts right)
• Less government spending ( AD shifts left) 

Net Exports:

• Next exports are sensitive to:
• Exchange rates ( international value of $)
• Strong $ = more imports and fewer exports ( AD shifts left) 
• Weak $ = fewer imports and more exports ( AD  shifts right)
• Relative Income:
• Strong foreign economies = more exports  (AD shifts right) 
• Weak Foreign Economies =  less exports ( AD shifts left)

Unit 2- Interest Rate

Real Interest Rate
(Adjusted for Inflation) A % increase in purchasing power, the lender receives when the borrower repays the loan with interest.
Formula: Nominal Interest Rate (-) Inflation

• Unanticipated Inflation

Nominal Interest Rate

(Not adjusted for Inflation) The % increase in dollars you pay the lender for the use of dollars that you borrowed. AKA Interest.

Formula: Real Rate of Interest (+) Inflation Premium

• Anticipated Inflation

Hurt by Inflation:

1. Savers 
2. Lenders/ Creditors 
3. Those Who are on a Fixed Income

Helped by Inflation

1. Debtors 

Cost Of Living Adjustment ( C.O.L.A. )

*Automatic wage increases when inflation occurs*

Unit 2- Formulas

National Income (2 ways to calculate)

1. Compensation of  Employees + Rents + Interest Income + Proprietor's Income + Corporate Profits
2. GDP - Indirect Business Taxes - Depreciation - Net Foreign Factor Payment 

Gross
Formula: Net + Depreciation

Net Domestic Product(NDP)
Formula: GDP -Depreciation

Net National Product (NNP)
Formula: GNP - Depreciation

Gross National Product (GNP)
Formula: GDP - Net Foreign Factor Payment

Nominal GDP
Definition: The value of output produced in current prices. Output = Quantity × Production

Real GDP
Definition: The value of output produced in constant base year prices.

Formula: Price × Quantity = Nominal and Real GDP

• If you wanted to measure economic growth = GDP 
• If you wanted to measure price increase AKA inflation = Nominal 
• In the base year Nominal GDP will = Real GDP
• In the years after the base year Nominal GDP will exceed Real GDP 
• In the years before the base year Real GDP will exceed Nominal GDP 

GDP Deflation

Definition: Price index used to adjust from Nominal GDP  to Real GDP 

Formula: Nominal GDP ÷ Real GDP ×100

• In the base year, the GDP Deflator = 100
• Years after the base year, the GDP Deflator > 100
• Years before the base year, the GDP Deflator < 100

Consumer Price Index(CPI) 

Definition: The most commonly used measurement of inflation. It measures the cost of a market basket of goods for a typical urban American family.

Formula: Cost of a Market Basket of Goods in a given year ÷ Cost of a Market Basket of Goods in a base year × 100

Inflation

Formula: Price Index in year 2 - Price Index in year 1 ÷ Price Index in year 1 × 100

• Year 1 = Base Year
• Year 2 = Current Year

         

Unit 2- Statistical Adjustments/ Budget and Trade

Statistical Adjustment

1. Indirect Business Taxes
2. Consumption of Fixed Capitals
• AKA depreciation
3. Net Foreign Factor Payment

Budget Surplus/ Deficit

(+) positive = deficit

(-) negative = surplus

Trade Surplus/ Deficit

(+) positive = surplus

(-) negative = deficit

Unit 2- Calculating GDP

Income Approach
Definition: Add up all the income that resulted from selling all final goods and services produced in a given year.

• Income approach is not used often because the general population will lie about their incomes.

Formula:

Wages + Rent + Interest + Profits(AKA Proprietor's Income) + Statistical Adjustments

Expenditure Approach

Definition: Add up all the spending on final goods and services produced in a given year.

Formula:

GDP= C + IG + G + Xn

Vocabulary:

1. Compensation of Employees- Could include wage and salary supplements such as pensions, health insurance, and welfare.
2. Rents - Income received by the households and businesses that supply property resources.
• Ex: Monthly payment of rent
3. Interest - Money paid to suppliers of loans 
• *You owe the lender money*
4. Proprietor's Income - This comes from sole proprietorship and partnerships.
5. Corporate Profits - Could include dividens, corporate income taxes, and undistributed corporate profits.

Unit 2- Gross Domestic Product

Gross Domestic Product (GDP)
Definition: The total market value of goods and services that is produced within a country's borders in a given year .

Gross National Product (GNP)
Definition:the total market value of all the final goods and services by citizens of that country on it's land or foreign land.

Included in GDP:

1. Personal Consumption Expenditures C - (65%)
2. Gross Private Domestic Investment IG - (17%)
• New factory equipment 
• Factory equipment maintenance
• Construction of housing
• Unsold inventory of products built in a year
3. Government Spending G - (20%)
4. Net Exports (Exports-Imports) Xn - (-2%)

Not Included in GDP:

1. Intermediate Goods - Goods that require further processing before they are ready for final use.    Ex: Steering wheel, engine, windows.
2. Used or Secondhand Goods 
3. Purely Financial Transaction - Does not involve a good or service.                                           Ex: Stocks and Bonds.
4. Illegal Activities                                                                                                                                      Ex: Drugs
5. Unreported Business Activities                                                                                                  Ex:Unreported tips
6. Transfer Payments                                                                                                                                Ex: Public- Social, Welfare                                                                                                                   Private- Scholarships
7. Non-Market Activity                                                                                                                          Ex: Volunteering, Babysitting, Trading, and Any work that you do for yourself.