Econ Unit 3 Study Guide

Study Guide: Unit 3

1. Consumption Schedule

a. What is it?

Consumption Schedule: A schedule showing the amounts households plan to spend for consumer goods at different levels of disposable income.

B. What will cause it to shift?

Schedule Shifts: changes in wealth, expectations, interest rates, and household debt will shift the consumption schedule in one direction and the saving schedule in the opposite direction

~A tax increase shifts both schedules downward, and vice versa

C. Know when the consumption schedule is at equilibrium.

45° Line: a reference line; each point on it is equidistant from the two axes

C = DI

(consumption equals disposable income)

2. Investment Demand Curve

A. What is it?

Investment Demand Curve: shows the amount of investment forthcoming at each real interest rate; the level of investment depends on the expected rate of return and the real interest rate

B. What will cause it to shift?

Expected Rate of Return on Investment:

~Acquisition, Maintenance, and Operating Costs

~Business Taxes

~Technological Change

~Stock of Capital Goods on Hand

3. MPC & MPS

A. What are they?

Marginal Propensity to Consume (MPC): the fraction of any change in income consumed

Marginal Propensity to Save (MPC): the fraction of any change in income saved

B. Be able to find someone's MPS & MPC if I tell you their new income and spending habits

MPC = change in consumption

change in income

MPS = change in saving

change in income

MPC + MPS = 1

4. Multiplier

A. Be able to determine the total change in spending if given the initial change in spending.

Multiplier = change in real GDP

initial change in spending

Change in GDP = multiplier X initial change in spending

B. Know the 3 ways to calculate the multiplier

Multiplier = 1/(1-MPC) = 1/(APC - 1) = change in real GDP/ initial change in spending

5. Aggregate Supply and Aggregate Demand

A. What are the determinants of each?

Determinants of Aggregate Supply

1.) Change in input prices

~Domestic resource prices

~Prices of imported resources

~Market Power

2.) Change in Productivity

3.) Change in legal-institutional environment

~Business taxes and subsidies

~Government regulations

Determinants of Aggregate Demand

1.) Change in Consumer Spending

~Consumer wealth

~Consumer expectations

~Household indebtedness

~Taxes

2.) Change in Investment Spending

~Interest Rates

~Expected Returns

-Expected future business conditions

-Technology

-Degree of excess capacity

-Business taxes

3.) Change in Government Spending

4.) Change in Net Export Spending

~National income abroad

~Exchange rates

B. When they shift, what happens to the price level and Q of GDP?

Aggregate Demand Curve: is downward sloping; inverse relationship between price level and the quantity demanded of Real GDP

~As price level rises, the quantity of Real GDP falls and vice versa

~Slopes downward because of:

-Wealth Effect: an increase in the price level decreases purchasing power (and vice versa)

-Interest-Rate Effect: an increase in price level increases the demand for money, thus increasing interest rates and reducing expenditures (and vice versa)

-Foreign Purchases Effect: an increase in the U.S. price level will reduce U.S. exports and increase U.S. imports (and vice versa)

Aggregate Supply Curve: up sloping; indicates a direct relationship between the price level and the amount of real output that firms will offer for sale

~As price level rises, so does GDP and vice versa

i. Because of this change in GDP, what happened to the employment level?

Aggregate Supply: a decrease in aggregate supply means a decrease in employment (and vice versa)

Aggregate Demand: an increase in demand means an increase in employment (and vice versa)

C. Know the SRAS and LRAS.

i. Why is the LRAS vertical?

In the long run, wages and other input prices rise and fall to match changes in the price level

~Price-level changes do not affect firms' profits and thus they create no incentive for firms to alter their output

ii. Understand the effect that an eventual increase in wages has on the AD, LRAS, and SRAS equilibrium

Aggregate Demand: an increase in wages will increase demand

Short Run Aggregate Supply: an increase in wages will increase supply

Long Run Aggregate Supply: no effect; wages match changes in the price level

D. Know how changes in the LRAS is similar to shifts in the PPC

The LRAS can only shift to the right if more resources are found or new technology invented, the PPC is the alternative combinations of two goods that an economy can produce with existing resources and technology in a given time period

6. Fiscal Policy

A. What are the different types (discretionary and non-discretionary/ contractionary and expansionary?) Know what they are and be able to identify examples of each.

Discretionary Fiscal Policy: policy in which the government has to take action for it to be implemented

Non-Discretionary Fiscal Policy: automatic stabilizers in the economy

~Progressive Tax: the more you make the larger percentage of your income you pay in taxes

Contractionary Fiscal Policy: causes a budget surplus

~The government has decreased spending and started taking in more money in tax revenues so the government has a surplus

Expansionary Fiscal Policy: causes a budget deficit

~The government is spending more but not taking in extra money in tax revenues so the government has a deficit

B. What type of fiscal policy should be implemented to eliminate an inflationary or recessionary gap?

Recessionary Gap: expansionary fiscal policy

Inflationary Gap: contractionary fiscal policy

7. Crowding out Effect

A. What is it?

Crowding-out Effect: a rise in interest rates and a resulting decrease in planned investment

B. What causes it?

Caused by the Federal government's increased borrowing in the money market

8. Basic Classical economic theory

Value Theory

~Labor Theory of Value: natural prices were the sum of natural rates of wages, profits (including interest on capital and wages of superintendence) and rent

~Price Determinants:

-The level of outputs at the level of Smith's "effectual demand"

-Technology

-Wages

*Stressed the benefits of trade

*Laissez-faire

Monetary Theory

~Monetarists and the currency school argued that banks can and should control the supply of money

-Theory: inflation is caused by banks issuing an excessive supply of money

~Theory of Endogenous Money: the supply of money automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans are made

9. The Phillips Curve

A. Know the relationship between inflation and unemployment on the SR Phillips curve

SR Phillips Curve: when the actual rate of inflation is higher than expected, profits temporarily rise and the unemployment rate temporarily falls