CHAPTER 9 NEW CLASSICAN AND KEYNSIAN Business cycle continuing pattern over time of expansions contractions booms busts in circular flow of economic activity in an economy Macroeconomic policies attempt to achieve macroeconomic policy goals low stable rate of inflation low unemployment economic growth good international relations by intervening in some form in the operation of economy o DEMAND SIDE POLICIES FISCAL taxes government spending transfer payments MONETARY POLICIES Federal Reserve Banking System that regulates interest rates Circular flow through markets of g s economic growth o Y national income Cd Id Gd Exd Imd in terms of demand Serves for a statement of equilibrium in the economy AD AS Keynesian and New Classical economists have very different views on what happens next in an economy LR and what variables determine circular flow of economic activity o New classical don t believe government can do much for the economy in short run occasional fiscal monetary policies bad Government should announce a fiscal monetary plan and stick through it so businesses people know what to expect Very little government intervention Perfectly elastic AS curve shift depends on improvement of QUANTITY QUALITY of FOP Shifts in AD affect prices but not output See macroeconomics economy as something that follows Laws of Supply Demand income costs of FOP ecc Movement of supply curve depends on momentary run vertical no FOP can be varied short run some FOP can be varied long run all FOP can be varied lower costs of production elasticity Believe in SUPPLY SIDE POLICIES Interventionist policies Investment in human capital R D Market based policies to increase incentives for labor to work lower income taxes o Keynesians believe in demand side policies as a tool to manage economy close government control of market Output responds to changes in AD because economy is filled with market imperfections Wages prices are sticky Don t believe prices wages are key to determining circular flow like New Classicals do Short run can last for long as long as FOP are present Market reacts to changes in demand may lead to recessions of economy DEMAND SIDE POLICIES help the economy Wages prices are fixed in short run CHAPTER 10 NATIONAL INCOME DETERMINATION CONSUMPTION FUNCTION amount households are willing able to consume on g s throughout the year CONSUMPTION DEMAND Cd DISPOSABLE INCOME level of disposable income which households can use to spend on goods or that can be saved o Related to level of income Cd Id Yd MARGINAL PROPENSITY TO CONSUME MPC slope of the consumption function tells how changes in income affect consumption o MPC change in Cd change in Yd graphically consumption y axis income x axis Portion of every ADDITIONAL dollar of disposable income that household consume Value is between 0 and 1 if MPC 1 household has spent everything AVERAGE PROPENSITY TO CONSUME APC ratio between consumption demand and disposable income APC levels of Cd levels of Yd o Rapidly decreases as consumption increases ability to spend in terms of money available SAVING FUNCTION how much households are willing to save during year Sd MARGINAL PROPENSITY TO SAVE MPS slope of saving function o MPS change in Sd change in Yd graphically savings y axis income x axis Portion of every ADDITIONAL dollar that a household is willing to save MPC MPS 1 APC APS 1 LIFE CYCLE HYPOTHESIS assumes that households plan their consumption over their lifetimes borrowing lending to smooth consumption relative to income New classical view INVESTMENT flow variable that aims at increasing stock capital in a year Components of INVESTMENT DEMAND Id TOTAL INVESTMENT DEMAND 1 2 3 o 1 PLANT EQUIPMENT PE long term tangible asset not expected to be turned into cash desired stock capital is related to investment in PE which is related to CHANGE in investment Desired stock of capital depends on production technology cost of capital COSTI OF CAPITAL annual cost to a firm of purchasing an additional unit of output depends on price of each unit of capital interest rates rate of depreciation taxes fiscal policy tools used to influence cost of capital o 2 INVENTORY INVESTMENT inventory can be quickly adjusted depending on what is being produced Keynesians economists don t allow for depletion or accumulation of inventory if demand is high they increase production hire more workers to get rid of it o 3 HOUSING INVESTMENT Highly sensitive to changes in cost of capital especially to changes in EQUILIBRIUM LEVEL OF NATIONAL INCOME mortgage interest rates o Occurs when AD level of national income Y generated in production o AGGREGATE DESIRED EXPENDITURES ADE relationship between AD for final g s national income ceteris paribus o Equilibrium occurs at intersection between 45 line and ADE o When Y AD presence of unwanted inventory decrease production to equilibrium o When Y AD shortage increase production to equilibrium o In general equilibrium occurs when saving investment CHAPTER 11 SPENDING MULTIPLIER FISCAL POLICIES UNEMPLOYMENT Levels of AD and national income are affected by things like unemployment lowers AD inflation caused by efforts to increase AD too much Fiscal monetary policies are applied to reach goal of national income o Either contractionary or expansionary o Fiscal policies taxes government spending ex subsidies spending on public goods System o Monetary policies related to interest rates regulated by Federal Reserve We now add Gd to national income equation Y Cd Id Gd SPENDING MULTIPIER MSPENDING ratio that relates changes in equilibrium level of national income Y to shifts in AD consumption investment changes o Shift in AD change in Y Increase in AD increase in disposable income which increases consumption demand which further increases Y MSPENDING 1 1 MPC or M The higher the MPC is the higher MSPENDING viceversa We now add Gd to national income equation Y Cd Id Gd Spending multiplier applies to government spending because government spending is a component of AD Taxes and transfer payments redistribution of existing income from one economic agent to another ex pensions are not part of AD o However a change in their level will affect levels of AD and Y because they affect consumption and investment o TAX MULTIPLIER ratio that relates change in equilibrium level of national income to a change in taxes on households MTAX MPC 1 MPC o TRANSFER MULTIPLIER ratio that relates to change in equilibrium level of national income to a change in transfer payments