Unit 3

Disposable Income= Consumption + Personal Savings

• For people, money earned after taxes
• For gov, GDP

Average Propensity to Consume= C/DI

Average Propensity to Save= S/DI

APC+APS=1

MPC=Change in C/Change in DI

MPS= Change in S/Change in DI

MPC+MPS=1

Spending Multiplier= 1/MPS

Change in Spending x Multiplier= Change in GDP

Keynsian Model

• Consumption=disposable income anywhere on 45 degree line
• Determinants of Consumption and Savings:
• Wealth- if our wealth goes up, we buy more stuff
• Expectations- if prices are going down in the future, we wait and save our money to buy stuff later 
• Real Interest Rates- if the cost of borrowing goes up, then we're going to borrow less and spend less
• Household debt- as our debt goes up, consumption goes up and savings go down until we reach a certain point when we can know longer build up more debts
• Taxes- consumption and savings move in same direction because increase in taxes is paid for out of future consumption and savings

Aggregate Demand/ Aggregate Supply model: Probably the most important graph of the entire course so LEARN IT!!! ***DON'T FORGET LABELS

Aggregate Demand= C+G+I+Xn (Yes, it's like GDP)

• An increase in interest rates (cost of borrowing) will cost consumption of durable goods, business investment, exports to fall
• A change in C, G, I, or Xn will shift AD

Long Run Aggregate Supply- output is the same despite rising or lowering of prices

• In the long run, as rate of inflation increases, wages increase too offsetting any change in production
• Any change in economy that alters the natural rate of output (PPC curve) shifts LRAS which are the the factors of production

Short Run Aggregate Supply

• In the short run, an increase in overall level of prices in the economy tends to raise quantity of goods and services supplied
• Sticky Wage Theory- NGDP are slow to adjust or are sticky in the short run due to wage control, etc. So in the short term, wages don't change.
• Selft Correcting Theory
• In the short run, real wages will change depending on inflation. As inflation goes up, real wages goes down because purchasing power of money goes down
• In the long run, nominal wages are flexible and are adjusted according to inflation

Fiscal Policy- enacted by Congress to alter RGDP, employment, inflation, and economic growth, only effect demand side economics

• Discretionary Fiscal Policy- deliberate manipulation of taxes and gov spending by Congress
• Expansionary Fiscal Policy- used to combat recession
• increase gov spending
• reduce taxes which is less effective because part of the extra money that doesn't go towards taxes is saved
• leads to government budget deficit (deficit spending)
• Deficit spending financed by borrowing money
• leads to Crowding out which means government demand for credit lead to higher interest rates thus choking off investment spending and consumer durable spending
• create more money, but might lead to higher levels of inflation
• Contractionary Fiscal Policy- used to combat inflation
• decrease gov spending
• increase taxes
• leads to gov budget surplus
• surplus leads to debt reduction and impounding
• Supply Side Fiscal Policy- expansionary tax cuts to shift SRAS to right
• increase of savings and investments
• increasing capital stock
• incentive to work, to take new jobs
• increasing productivity
• risk taking
• Non-discretionary Fiscal Policy-built-in automatic stabilizers to temper effects of business cycle swings
• Transfer payments (welfare)- used during recession
• Progressive tax system- higher % taxed on rich
• Regressive tax system- higher % taxed on the poor
• Timing problems- Recognition/Administration/Operational lags