E202: Macroeconomics Paul Graf What you should do between now and the exam (in order): 1.

Exam 2 Spring 2011

Get on the e-mail list and check www.TutoringZone.com before your exam. If I have any new information or suggestions, I will get in touch with you through email and our website. Do the practice problems from the old exams. We have a couple of old exams, and you should definitely do them. Use the practice problem breakdown to master one category at a time! Check out our supplements! Go to apps.TutoringZone.com and log in. Good Luck!

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3. 4.

This review: Should last 2.5 - 3 hours. Feel free to take a break anytime. You can always continue to watch it later! Outline: 1. LRAS and Aggregate Demand The Classical Model 2. AD / AS The Keynesian Model 3. The Dynamic AD / AS Model 4. Consumption, Real GDP, and the Multiplier
Tutoring zone, a private enterprise, is offering this review. This review is neither affiliated with nor endorsed by the Indiana University, the College of Business Administration nor E202. You are NOT required to attend this review by means of your enrollment in this course. This review sheet breaks down types of problems that have appeared on tests in the past. Each topic is broken down into a few categories, in which I will explain the essence of the material and list several problems for you to practice. Of course, the usual caveats apply! This is not a substitute for watching the material on your own, and in no way does this imply that all of the potential questions for the upcoming exam are covered in this review. This is simply an attempt to help organize your thoughts and present a logical structure to help with your preparations. Now that the lawyers are happy.

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How to Succeed in E 202

Go to class: This is meant to be a supplement to class not a substitute. Learn how to draw/read graphs You will have to draw or read a graph for many of the questions on the exam. o o o o Drawing graphs makes the questions easier to do. It will prevent you from making stupid mistakes. Use your intuition BUT DRAW IT OUT! This gets to be automatic over time.

How to study:

First of all STUDY HARD!!!! The exam is 20% of your final grade, and you cant drop any of the exams!!
o Study all of these in this order:

(1) Review your notes from the review (2) Do Dr. Grafs old exams (use the problem breakdown!) (3) Work on the Practice Problems from TutoringZone. (4) Review your lecture notes!! (5) Read the textbook, if you have it, but realize that it can be complicated! (6) Email me any questions you have (E202@tutoringzone.com)

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Long Run Aggregate Supply and Aggregate Demand The Classical Model
The classical model was the first model to explain the macro economy, and it attempted to explain in particular changes in inflation, output, income, employment, consumption, saving, and investment. The model rested on the following key assumptions: Pure competition exists Wages and prices are flexible (they can rise or fall easily) People are motivated by self-interest (Everyone is selfish) People cannot be fooled by money illusion Says Law is also important in understanding the Classical Model. It states that supply creates its own demand. Producing stuff will allow others to consume and buy stuff. Long-Run Aggregate Supply (LRAS) Does not depend on price level (vertical)! LRAS indicates potential (natural) GDP resources are fully employed. o The economy is on the Production Possibility Frontier When actual GDP = Potential GDP, the economy will have the natural rate of unemployment (which is NOT zero!).

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Changes of the LRAS These factors can shift the LRAS (if stuff gets better, LRAS will increase): 1. Labor o Growth of the Labor-Force Participation Rate (How many people are working?) o Productivity of Labor 2. Technology o Improvement in Technology 3. Capital o Capital Accumulation (How many machines and money do we have?) o Productivity of Capital

Right is More! Left is Less!

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Aggregate Demand Definition: The demand for goods and services from household (here and abroad), firms and government at various price level Aggregate Demand Equation:

AD = C + I + G + X
C = Consumption I = Investment G = Government Expenditures X = Net Exports (= Exports Imports)

When price levels increase, the real GDP demanded decreases When price level decrease, the real GDP demanded increases

Why does Aggregate Demand slope downward? 1. Real-Balance Effect (Wealth Effect) When the price level decreases, you can buy more. Its like being richer, and having more wealth! 2. Interest Rate Effect When the price level decreases, the interest rates will also decreases. Business will now decides to invest and spend more! 3. The Open Economy Effect When the price level decreases, both our buyers and foreign buyers will purchase more of our goods. TutoringZone - 5

Shifts of Aggregate Demand A non-price-level change will shift Aggregate Demand

Aggregate Demand Shifters (any change in C + I + G+ X) Increased Aggregate Demand A. Increase in Consumption - Increase in Future Income / Job Security - Tax decrease - Increase in consumer confidence B. Increase in Investment Goods - Reduction in Real Interest Rate - An increase in the amount of money in circulation C. Increase in Government Purchases D. Increase in Net Export (we export more stuff) Drop in Exchange Rate Improvement in Economic Conditions in other countries Decreased Aggregate Demand A. Decrease in Consumption - Decrease in Future Income / Job Security - Tax increase - Increase in consumer confidence B. Decrease in Investment Goods - Increase in Real Interest Rate - A decrease in the amount of money in circulation C. Decrease in Government Purchases D. Decrease in Net Export (we import more stuff) Rise in Exchange Rate Worsening of Economic Conditions in other countries TutoringZone - 6

Determining Long-Run Equilibrium The intersection of the Aggregate Demand curve and the LRAS determines long-run equilibrium. It establishes the price levels and GDP (Production).

Changes to Long-Run Equilibrium When aggregate demand or LRAS shift, there will be changes to the price level and GDP: An increase in price levels is called inflation and the purchasing power decreases A decrease in price levels is called deflation and the purchasing power increases An increase in GDP is called economic growth A decrease in GDP is called a recession

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Deflation 1. A secular deflation occurs, when the LRAS increases (assume that the AD does not increase).

As a consequence of the increase in the LRAS, the price level ______ and GDP ______. 2. Deflation occurs, when AD decreases (assume that LRAS does not change).

As a consequence of the decrease in AD, the price level ______ and GDP ______.

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Inflation

1. Inflation occurs, when LRAS decreases (assume that AD does not change).

As a consequence of the decrease in the LRAS, the price level ______ and GDP ______. Anytime both the price level and GDP ______ at the same time, we also call this stagflation.

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2. Inflation occurs, when Aggregate Demand increases (assume that LRAS does not change).

As a consequence of the decrease in the LRAS, the price level ______ and GDP ______.

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Practice Problems: 1. The long-run aggregate supply curve shifts left if A. B. C. D. the price level rises the price level falls the capital stock increases the capital stock decreases

2.

The aggregate demand curve shows the relationship between A. B. C. D. E. aggregate expenditures and GDP price level and the quantity of GDP supplied by firms price level and the quantity of GDP demanded price level and the long run GDP none of the above

3.

Which of the following shifts aggregate demand to the right? a. an increase in the price level b. an increase in the real interest rate c. a decrease in the price level d. a decrease in the real interest rate

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4.

The long-run aggregate supply curve shift to the right. This could have been caused by A. the share of people with a college degree in the population increases substantially B. the capital stock increases in the economy C. high-skilled workers immigrate to the country D. technological improvement occurs in the country E. All of the above

5.

Which of the following will occur when an economys price level decreases? A. B. C. D. The purchasing power of money will decrease The purchasing power of money will increase Aggregate demand will decrease The real value of wealth will decrease

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Aggregate Demand and Supply Model - The Keynesian Economic Model

The Classical Economic Model failed to explain why the Great Depression occurred in the 1930s. Hence, some smart dudes invented the Keynesian Economic Model. It is based on the following assumptions: 1. Prices are not flexible/in other words they are sticky We believe that prices are not flexible for two major reasons: A. Long-term contracts with employees and suppliers. Hence, prices cannot be adjusted immediately. B. Union contracts determine prices for labor and not economic forces. Short-run approach The classical model did not distinguished between shortrun and long-run, whereas the Keynesian Model does distinguish between the two. AD determines equilibrium The equilibrium level of GDP is demand determined. Capitalism may not be self-regulating

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3. 4.

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So what did economists do to include these assumptions? They invented the Short-Run Aggregate Supply (SRAS) curve. The SRAS shows how output in the economy can change in the short-run. In this class, the SRAS can have two different types of shapes:

The horizontal SRAS represents fixed prices. Prices will not change.

The upward sloping SRAS represents flexible prices, but not all of the prices adjust quickly.

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Determining Short-Run Equilibrium The intersection of the Aggregate Demand curve and the SRAS determines short-run equilibrium. It establishes the price level and production/ expenditures (GDP).

If AD increases, the price level will ________ and GDP will ______.

If AD increases, the price level will _______ and GDP will _______.

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Determining Short-Run and Long-Run Equilibrium Now that we have understood the SRAS curve, we can develop a model for the shortrun and the long-run. All we have to do is to include the Aggregate Demand, SRAS, and LRAS.

Above, we have a picture where the market is in short-run and long-run equilibrium. Sometimes, though, the short-run equilibrium is NOT a long-run equilibrium: Actual GDP < Potential GDP (Recession) Price Level (Index) Price Level (Index) Actual GDP > Potential GDP (Expansion)

GDP

GDP TutoringZone - 16

What factors shift AD and SRAS/LRAS?

LRAS and SRAS Shifters Increase both LRAS/SRAS A. Increases in Labor Increases in labor supplied Increases in training and education Decreases in labor cost B. Increases in Capital Discovery of new raw material Increased production capabilities C. Increases in Technology D. Changes in Miscellaneous Increased competition Reduction in international trade barriers Reduction in input prices Decreases in marginal tax rates (businesses) Fewer regulatory impediments Decrease both LRAS/SRAS A. Decreases in Labor Decreases in labor supplied Decreases in training and education Increases in labor cost B. Decreases in Capital Depletion of new raw material Decreased Production Capabilities C. Decreases in Technology D. Changes in Miscellaneous Decreased competition Increase in international trade barriers Increase in input prices Increases in marginal tax rates (businesses) More regulatory impediments

A SHORT-TERM change in input prices changes only the SRAS curve. A reduction in input prices increases SRAS. An increase in input prices decreases SRAS. Changes in inflation expectations change only the SRAS curve. More inflation expectations decrease the SRAS curve. Less inflation (or deflation) expectations increase SRAS curve.

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Aggregate Demand Shifters (any change in C + I + G+ X) Increased Aggregate Demand A. Increase in Consumption - Increase in Future Income / Job Security - Tax decrease - Increase in consumer confidence B. Increase in Investment Goods - Reduction in Real Interest Rate - An increase in the amount of money in circulation C. Increase in Government Purchases D. Increase in Net Export (we export more stuff) Drop in Exchange Rate Improvement in Economic Conditions in other countries Decreased Aggregate Demand A. Decrease in Consumption - Decrease in Future Income / Job Security - Tax increase - Decrease in consumer confidence B. Decrease in Investment Goods - Increase in Real Interest Rate - A decrease in the amount of money in circulation C. Decrease in Government Purchases D. Decrease in Net Export (we import more stuff) Rise in Exchange Rate Worsening of Economic Conditions in other countries

A strengthening of the value of a nations currency in terms of another countries currency affects both AS / AD. Strengthening of a nations currency, shifts SRAS rightward (increases) and shifts AD leftward (decreases). Weakening of a nations currency, shifts SRAS leftward (decreases) and shifts AD rightward (increases).

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Shifting the AD or AS AD / AS Model Static means we keep LRAS constant. Here we will consider two possible scenarios: AD shifts or SRAS shifts. AD Shifts (i.e. decrease in consumption). Lets consider an economy that is in long-run equilibrium when, for some reason, there is a decrease in consumption: Price Level (Index)

GDP 1. AD shifts left, move Point A to Point B. Short-Run equilibrium is below Long-Run equilibrium. Actual GDP < Potential GDP, so prices start falling, unemployment starts rising. In the long-run: Expectations of lower future inflation are built into decisions SRAS increases (shifts right), the economy moves from Point B to Point C.

2.

The movement from B to C is known as an automatic stabilizer. How economy heals itself.

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Note from B to C, prices are falling and output is increasing prices (inflation) not always the best way to measure well-being! Here, people produce and consume more. The opposite happens with increase in consumption.

Practice Problems:

1.

Which of the following shifts short-run aggregate supply to the left? a. an increase in the price level b. an increase in the expected future price levels c. a decrease in the price level d. a decrease in the expected future price levels

2.

Using the AD / AS. There has been a decrease in government expenditures. As a result, the GDP ______, and the price level ______. A) B) C) D) Increases, increases Increases, decreases Decreases, decreases Decreases, increases

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3.

Using the AD / AS. The price of oil, which is a crucial input for the economy, has decreased temporarily in the short run. As a result, the GDP ______, and the price level ______. A) B) C) D) Increases, increases Increases, decreases Decreases, decreases Decreases, increases

4.

Using the AD / AS. The US Dollars has decreased in value. As a result, the GDP ______, and the price level ______. A) B) C) D) E) Increases, increases Increases, decreases Decreases, decreases Decreases, increases Cannot be determined, increases

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The Dynamic Aggregate Demand / Aggregate Supply Model

New assumptions of the dynamic model: Potential and real GDP increase continuously (LRAS shifts right) KEY SRAS shifts if LRAS shifts Most of the time AD increases as well EVERYTHING CHANGES!!!

Consider that the LRAS increased due to an increase in labor, capital or technology. In addition, the AD increased due to increases in consumer confidence. The effect of the LRAS change is equal to the effect of the AD change.

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What happens if aggregate demand and aggregate supply do not change in the same way? Aggregate Demand Shift > Aggregate Supply Shift

Aggregate Demand Shift < Aggregate Supply Shift

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If spending (aggregate demand) grows faster than total production (aggregate supply), prices will rise. If spending (aggregate demand) grows faster than total production (aggregate supply), prices will fall.

Example Consider the following economic data:

Year 1 Year 2

Actual Real GDP $11.2 trillion $11.1 trillion

Potential Real GDP $11.4 trillion $11.7 trillion

Price Level 102.5 105.2

Assuming that the AD did NOT shift, answer the following questions:

This is an example of the static / dynamic model?

The gap between actual and potential GDP became bigger / smaller?

Over this time period, unemployment must have gotten better / worse?

Based upon the data, what else MUST have happened?

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SRAS MUST have shifted left due to something else (such as an increase in oil prices)!

Practice Problems:

1.

In the Dynamic AD/AS model assume actual GDP is $12 trillion, and the price level is 90 and full employment GDP is $14 trillion. A year later technology has decreased; there has been a temporary spike in oil price, and an increase in government purchases. However, the oil price shock is greater than the government shock and the technology shock. The government shock is also greater than the technology shock A) B) C) D) Prices rise, output falls, employment falls Prices rise, output falls, employment rises Prices fall, output falls, employment rises Prices fall, output falls, employment falls

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Consumption, Real GDP, and the Multiplier

Lets start with some basic definitions: Disposable Income = Consumption + Saving Saving = Disposable Income Consumption Keynes stated the following real savings and consumption decisions depend primarily on a households present and real disposable income. The Consumption and Savings Function

Consumption Function: C = Intercept + Slope * Yd(DI) Intercept = Autonomous Consumption Slope = MPC (rise / run) Autonomous Consumption: Consumption that is independent of the level of disposable income. Even if you have no money, you will still consume this amount!!! Dissaving: Occurs when consumption is greater than disposable income. Saving: Occurs when consumption is less than disposable income. TutoringZone - 26

Some Formulas: Average Propensity to Consume (APC) = real consumption / real disposable income APC decreases as real disposable income increases Average Propensity to Save (APS) = real saving / real disposable income APS increases as real disposable income increases Marginal Propensity to Consume (MPC) = change in real consumption / change in real disposable income MPC remains the same as real disposable income increases Marginal Propensity to Save (MPS) = change in real saving / change in real disposable income MPS remains the same as real disposable income increases APC + APS = 1 MPC + MPS = 1 Investment Function Investment consists of expenditures on new building and equipments and changes in business inventories. As the real interest rate increases, the planned real investment decreases. As the real interest rate decreases, the planned real investment increases. Firms and business will invest more, when interest rates are low, and vise versa.

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Any non-interest-rate variable that changes can have the potential of shifting the investment function. Some of the important ones are: Expectations of business (higher expectation for the future shifts the investment function to the right) Change in productive technology (better technology shifts the investment function to the right) Change in business taxes (lower taxes shift the investment function to the right) How is investment determined? The savings function shows us how much people are willing to save at different interest rates. The higher the interest, the more people are willing to save. So, if we combine the savings function and the investment function, we can figure out the equilibrium interest rate and the amount of real investment:

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Aggregate Expenditure Model Keynesian Equilibrium Short-run model Prices and wages are fixed GDP represents output. Aggregate Expenditures represents spending. Expenditures consists of real consumption, investment, government purchases and net exports Two goals: 1. Define macroeconomic equilibrium (AE = GDP) 2. Explain short-run fluctuations in GDP AE = C + I + G + X C = Consumption I = Investment G = Government Expenditures X = Net Exports (= Exports Imports)

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1. 2. 3. 4. II.

C As income (Y) increases, consumption increases (positive slope). C + I Positive slope C + I + G Parallel to (2) since government expenditures are not a function of Y. E=C+I+G+X Equilibrium in the E Model

Consider the following scenarios: 1. AE = Y Equilibrium 2. AE > Y Unplanned drop in inventories Business increase output Y returns to equilibrium 3. AE < Y Unplanned rise in inventories Business cut output Y returns to equilibrium TutoringZone - 30

I = PI + UI I = Investment (GDP Model) PI = Planned Investment UI = Unplanned Investment If a firm produces too much of something (production > spending) they dont just burn the extrathey put it in inventory to sell next period. This is UI! It is investment but it wasnt intentional. The E Line has a positive slope (as GDP increases, spending will increase) but the slope of the E line is less than 1. The slope is known as the Marginal Propensity to Consume (MPC) it measures the fraction of an increase in income that will be spent on consumption (rather than saved, which we measure by the Marginal Propensity to Save, or MPS).

(NOTE: In the US, the MPC is .93!).

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Shocks to Equilibrium Suppose that we are in equilibrium when, for some reason, consumption shifts up

GDP > E The change in GDP > change in E because of the multiplier effect: Multiplier (M) = 1 1-MPC = 1 MPS

GDP = Shock * Multiplier The smaller the marginal propensity to save, the larger the multiplier The greater the marginal propensity to save, the smaller the multiplier

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What can be considered as a shock? Change in autonomous real consumption Change in autonomous real investment Change in government spending Change in net exports If the shock is positive, the change in GDP will be positive as well. If the shock is negative, the change in GDP will be negative.

What if prices can change in the Aggregate Expenditure model? Remember, that initially we assumed that prices could not change!!! If prices can change, any change in aggregate demand will lead to an increase in the price level and real GDP. The effect on GDP will be smaller, if prices can change

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Practice Problem:

Real GDP 4 5 6 7 8 9 1.

T 0.8 0.8 0.8 0.8 0.8 0.8

DI 3 4 5 6 7 8

C 1.9 2.7 3.5 4.3 5.1 5.9

S 1.1 1.3 1.5 1.7 1.9 2.1

I 1.8 1.8 1.8 1.8 1.8 1.8

G 0.8 0.8 0.8 0.8 0.8 0.8

X 0.3 0.3 0.3 0.3 0.3 0.3

Refer to the table above. What is the initial equilibrium real GDP? A) B) C) D) E) $6 Trillion $7 Trillion $8 Trillion $9 Trillion None of the above

2.

Refer to the table above. What is the multiplier? A) B) C) D) E) 3 4 5 6 None of the above

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3.

Refer to the table above. If autonomous investment spending falls by $0.4 Trillion, whats the new equilibrium GDP? A) B) C) D) E) $6 Trillion $7 Trillion $8 Trillion $9 Trillion None of the above

4.

Consider the figure above. At income level Yd (DI) =$60, the average propensity to save is equal to A) B) C) D) 0.167 0.200 0.800 None of the above

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5.

Consider the figure above. At income level Yd (DI) =$20, the average propensity to consume is equal to A) B) C) D) 0.167 0.200 0.800 None of the above

6.

Consider the figure above. The equation for the consumption function is A) B) C) D) E) C = 20 + 0.25Yd(DI) C = 20 + 0.50Yd(DI) C = 20 + 0.75Yd(DI) C = 20 + 1.00Yd(DI) None of the above

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