# Nicholson- AP MACRO REVIEW

## 10-15% National Income and Price Determination

A. Aggregate demand

1. Determinants of aggregate demand

2. Multiplier and crowding-out effects

B. Aggregate supply

1. Short-run and long-run analyses

2. Sticky versus flexible wages and prices

3. Determinants of aggregate supply

C. Macroeconomic equilibrium

1. Real output and price level

2. Short and long run

3. Actual versus full-employment output

4. Economic fluctuations

## The Income-Consumption and Income-Saving Relationships

The idea here is that we have two choices with how to use our incomes (usually abbreviated as “Y” in economics). We can spend it (Consumption – usually abbreviated as “C” in economics) or we can save it (Saving - usually abbreviated as “S” in economics). If we use an equation to show this – it would be

Y = C + S

The entire amount of our income has to be used in one of these two ways. Now spending in the entire economy must also equal total incomes – otherwise where would it come from if not from people’s spending? This means that household spending (called Consumption = C) and Business Spending (called Investment = I) must add up to total income (Y) in the economy. As an equation that means:

Y = C + I

Therefore, in a closed, no government economy (no government, no international trade), S must equal I because:

Y = Y
C + S = C + I
S = I

This means that for Investment to rise, people must save more.

## As income increases, both consumption and savings will increase.

The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption.

•Wealth (financial assets)

•Expectations about future prices and income

•Real Interest Rates

•Household Debt

•Taxes

## The Consumption Schedule

We know that the more money we have – the more money we spend (all other things equal). It’s only human nature that we buy more when we have more. But we also know that even if we had nothing, we would spend some money – by either borrowing it or by dipping into our savings accounts. These two obvious relationships help us determine the shape of the Consumption curve. Even if income is “0”, we know that spending would be more than zero (we do have to eat!). And as income rises from “0”, we expect consumption to rise too.

## The Saving Schedule

We’ve already noted that Saving and Consumption are linked. (Totaled together they equal income --> Y = C + S). Since that’s true, their curves must be linked. So for example, if our income (Y) is “0” and C = 40; then S must be –40. If income is 100, and C is 80, the other 20 must have been saved. I.e at very low levels of income, we spend more than we make – so we dissave (or borrow) – so S would be negative. At some point, we might make more than we spend, so now S would be positive.

## APC & APS

APC + APS = 1

1 – APC = APS

1 – APS = APC

APC > 1 .: Dissaving

-APS .: Dissaving

## MPC & MPS

Marginal Propensity to Consume

ΔC/ΔDI

% of every extra dollar earned that is spent

Marginal Propensity to Save

ΔS/ΔDI

% of every extra dollar earned that is saved

MPC + MPS = 1

1 – MPC = MPS

1 – MPS = MPC

## The Interest-Rate - Investment Relationship

Like any demand curve, the Investment demand curve is downward sloping and the level of Investment falls as the price of Investment rises. But what is the Price of Investment? Since many businesses borrow to Invest, we call that cost – the interest rate. They have to pay that cost to invest. You’ll quickly think “hey wait, sometimes they use money they already have instead of borrowing” True, but that means they forgo the money that they would have earned by saving it – i.e. they lose that interest rate. So either way – the cost of investment is interest. The higher the price (the rate of interest) the less Investment happens.

## Expected Rate of Return r

the expected rate of return is the internal profit we expect to have from an investment. What does that mean? It means that If I know an investment will cost me \$100,000 and will give me back \$120,000, I’m gaining 20% over cost of the item

## The Real Interest Rate i

This takes into account the costs of investing. So an investment that gives an internal return of 20%, when the interest rate is 12% - only gives a net return of 8% over costs. As long as an investment gives a better rate of return than the interest rate cost of investing, a project will be profitable. So if r > i, then it’s profitable, but if r < i, then it’s not profitable.

## Shifts in the Investment Demand Curve:

• Acquisitions, maintenance and Operating Costs – the more it costs for other things (like maintenance) the more internal rate of return is necessary to make that investment profitable. So the higher these costs are, the less investment there will be. The ID curve shifts back.
• Business Taxes – The higher the taxes are to businesses, the more internal rate of return is necessary to make that investment profitable. The ID curve shifts back.
• Technology Change – Technological changes create profitable opportunities – no matter what the interest rate is. So the more technological change – the more the ID curve shifts out.
• Stock of Capital Goods on Hand – The more capital goods we already have, the less likely we are to invest in more capital. Therefore, the ID curve shifts back.
• Expectations – Again – it depends on what we expect, but if it’s a good expectation, we will be more likely to invest, and the ID curve shifts out. If it’s a bad expectation, the ID curve shifts back.

## Instability of Investment: Investment varies a lot. It jumps all over the place. There are several reasons for this:

• Durability – because many investment goods are durable goods, we can postpone investment until conditions make it more profitable to invest. Because of this, whenever anything changes the profitability of an investment, the level of Investment reacts.
• Irregularity of Innovation – As inventions and innovations come to light, there are new opportunities for investment. Since these innovations are not regular – neither is their effect on investment levels.
• Variability of Profits – So many things effect profits, that a change in present profits may change a firm’s appetite for further investments.
• Variability of Expectations – Again, this seems fairly obvious. Since our expectation can vary widely – so can the level of investment.
• ## The Multiplier Effect

The change in spending can echo through the economy. In other words, when I spend \$100 more than before, that isn’t the only change in the economy. I can’t just say that income goes up by \$100 when I do this, because after it goes up for someone – they go out and spend part of it. And then someone else’s income goes up because of that. So if everyone spends 80% of their income (MPC = .8). My injection of \$100 into the economy, creates \$100 of extra income for someone. They go out and spend \$80 more than before, because they have \$100 more than before. That’s increases a third person’s income by \$80, and they go out and spend 80% of that (.8 * \$80 = \$64). This goes around and around until it dies out.

b = MPC
Macro 3.9- Multiplier Effect, MPC, and MPS (AP Macroeconomics)

## AGGREGATE SUPPLY AND DEMAND (AS/AD MODEL)

Macro Unit 3 Intro- Aggregate Demand, Aggregate Supply, and Fiscal Policy

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 Real GDP is inverse

## Three Reasons AD is downward sloping

Real-Balances Effect

–When the price-level is high households and businesses cannot afford to purchase as much output.

–When the price-level is low households and businesses can afford to purchase more output.

Interest-Rate Effect

–A higher price-level increases the interest rate which tends to discourage investment

–A lower price-level decreases the interest rate which tends to encourage investment

Foreign Purchases Effect

–A higher price-level increases the demand for relatively cheaper imports

–A lower price-level increases the foreign demand for relatively cheaper U.S. exports

Consumption (C)

Gross Private Investment (IG)

Government Spending (G)

Net Exports (XN) = Exports - Imports (X – M)

Consumption

Household spending is affected by:

–Consumer wealth

•More wealth = more spending (AD shifts >)

•Less wealth = less spending (AD shifts<)

–Consumer expectations

•Positive expectations = more spending (AD shifts >)

•Negative expectations = less spending (AD shifts <)

–Household indebtedness

•Less debt = more spending (AD shifts >)

•More debt = less spending (AD shifts <)

–Taxes

•Less taxes = more spending (AD shifts >)

•More taxes = less spending (AD shifts <)

Household spending is affected by:

–Consumer wealth

•More wealth = more spending (AD shifts >)

•Less wealth = less spending (AD shifts <)

–Consumer expectations

•Positive expectations = more spending (AD shifts >)

•Negative expectations = less spending (AD shifts <)

–Household indebtedness

•Less debt = more spending (AD shifts >)

•More debt = less spending (AD shifts <)

–Taxes

•Less taxes = more spending (AD shifts >)

•More taxes = less spending (AD shifts <)

Gross Private Investment

Investment Spending is sensitive to:

–The Real Interest Rate

•Lower Real Interest Rate = More Investment (AD>)

•Higher Real Interest Rate = Less Investment (AD<)

–Expected Returns

•Higher Expected Returns = More Investment (AD>)

•Lower Expected Returns = Less Investment (AD<)

•Expected Returns are influenced by

–Expectations of future profitability

–Technology

–Degree of Excess Capacity (Existing Stock of Capital)

Investment Spending is sensitive to:

–The Real Interest Rate

•Lower Real Interest Rate = More Investment (AD>)

•Higher Real Interest Rate = Less Investment (AD<)

–Expected Returns

•Higher Expected Returns = More Investment (AD>)

•Lower Expected Returns = Less Investment (AD<)

•Expected Returns are influenced by

–Expectations of future profitability

–Technology

–Degree of Excess Capacity (Existing Stock of Capital)

Government Spending

Net Exports

Net Exports are sensitive to:

–Exchange Rates (International value of \$)

•Strong \$ = More Imports and Fewer Exports = (AD <)

•Weak \$ = Fewer Imports and More Exports = (AD >)

–Relative Income

•Strong Foreign Economies = More Exports = (AD >)

•Weak Foreign Economies = Less Exports = (AD <)

Net Exports are sensitive to:

–Exchange Rates (International value of \$)

•Strong \$ = More Imports and Fewer Exports = (AD <)

•Weak \$ = Fewer Imports and More Exports = (AD >)

–Relative Income

•Strong Foreign Economies = More Exports = (AD >)

•Weak Foreign Economies = Less Exports = (AD <)

## Summary

AD reflects an inverse relationship between PL and GDPR

Δ in PL creates real-balance, interest-rate, and foreign purchase effects that explain AD’s downward slope

Δ in C, IG, G, and/or XN cause Δ in GDPR because they Δ AD.

## Aggregate Supply

Keynesian Economics with Jacob Clifford

## Aggregate Supply Factors:

R: resource prices (The CELL/ wages and materials, as well as OIL)

E: environment [legal-institutional] (Taxes, Subsidies, more regulation)

P: productivity (better technology)

## Short-Run and Long-Run

Short Run:

Assumes that nominal wages are “sticky” and do not respond to price level changes.

Is Upward sloping as businesses will increase output to maximize profits

Generally considered to be a year or less.

Long Run:

Curve is vertical because the economy is at its full-employment output.

As prices go up, wages have adjusted so there is no incentive to increase production.

Generally considered to be longer than a year.

Curve is vertical because the economy is at its full-employment output.

As prices go up, wages have adjusted so there is no incentive to increase production.

Generally considered to be longer than a year.

## Aggregate Supply Shifters

1. Input Prices (domestic resource availability [land, labor, capital, entrepreneurial ability], prices of imported resources, market power)

2. Productivity

3. Legal – institutional environment (business taxes and subsides, government regulation)

## AS Curve ranges

Horizontal range – includes only real levels of output which are substantially less than full-employment output. A change in real output in this range won’t affect price level at all.

Vertical range – economy has already reached its full-capacity real output. Any increase in the price level at this range won’t affect real output at all.

Intermediate range – an expansion of real output is accompanied by a rising price level. The full-employment output is found in this range.

## NOTE!!

•For the AP exam, assume that there are only two determinants that simultaneously affect BOTH short term aggregate supply and aggregate demand

foreign currency changes.

•A change in business taxes shifts AD and AS in the same direction

•A change in FX sends both curves in the opposite directions.

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

## Full Employment

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.

Macro 3.8- Classical vs. Keynesian Aggregate Supply- Macroeconomics