ECON 2105 1st EditionExam # 2 Study GuideLecture 8 (module 14)How do we protect ourselves from inflation? - Landlord: rent prices – you would have to raise the price of rent according to inflation rate (adjust for inflation rate) - Lenders: interest rate- charge higher interest rate - Workers: wages- as boss to be paid more to adjust for cost of living - Tuition- according to college- they have to raise tuition rates because the cost of running the school has risen - Shoe-leather cost: the increased cost of transactions cause by inflation o In Israel: inflation rate hit 500% in 1985, people spent a lot of time in line at banks. - Menu Cost: the real cost of changing a listed price - Unit- of-accounts cost: cost arising from the way inflation makes money a less reliable unit of measurement (calculations are hard when inflation is high) - Nominal interest rate adjusted for inflation is called real interest rate. - Real interest rate= Nominal interest rate- inflation rate. Lecture 9 (module 15) - Chained CPI- use the same prices but different formula and weights, it accounts for consumers’ ability to achieve the same standard of living from alternative setsof consumer goods and services. - Core CPI- all items in CPI less food and energy, a reliable measure of inflationary and deflationary periods - Price index in a given year= cost of market basket in a given year/ cost of market basket in a base year X 100-- Producer price index (PPI): similar to the CPI but measures changes in the prices of goods purchased by producers.- Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP. - The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year.Lecture 10 and 11 (module 16)- How much consumers spend when they receive more income?- Marginal propensity to consume, or MPC - MPC= ^ consumer spending/ ^ disposable income - Where ^= change - Disposable income= current income + transfer payments- tax payment - In this Module, we are assuming that the output (production) is determined by demand side of the economy. (we have an infinite supply) keep the prices constant. Demand determines the supply - The higher the demand, the higher the production, hence the higher the income (Production=income)- Aggregate spending in the economyo Closed: C(spending by household) + I (spending by firms) + G (spending by government) = GDP o Open: C + I +G + X-IM. =GDP o Y=C+I = aggregate demand - Current disposable income: income after taxes are paid and government transfers are received.- Consumption function: an equation showing how an individual household’s consumer spending varies with the household’s disposable income.o c = a + MPC × ydo Where o c = a household’s consumer spending o yd = household disposable incomeo MPC = marginal propensity to consumeo a = a constant, autonomous consumer spending—what a family would spend even with zero incomeo MPC x yd =induced spending o MPC= ^c/^yd - MPC = Δc/Δyd- Multiplying both sides of the equation by Δyd, we get:o MPC × Δyd = Δc- In other words, when yd goes up by $1, c goes up by MPC.- Aggregate consumption function: the relationship for the economy as a whole between aggregate disposable income and aggregate consumer spending.o C = A + MPC × YDo Same form as consumption function, just aggregate.- Assume aggregate consumer spending equals $5,000 when aggregate disposable income is zero, and when disposable income increases from $300 to $400, consumer spending increases by $70. What is the equation for the aggregate consumption function?o C= a + MPC x yd o Yd= 0 o MPC= 70 / 100 = 0.7o Answer: C= 5000 + 0.7 x yd - An upward shift of the aggregate consumption function- If consumers expect higher aggregate income or wealth, consumption increases at all income levels now. This will cause a shit upward on the aggregate consumption function. - A downward shift on the aggregate consumption function - If consumers expect lower aggregate income or wealth, Consumption decreases at all income levels now.- Lower consumer income = lower spending - What causes shifts?o changes in expected future disposable income changes in aggregate wealth- Multiplier effect: - Assume that in the economy, MPC= 0.9 and MPS=0.1.- If construction spending rises by $100 billion, - What is the immediate impact of this constructing spending on GDP?- It increases by _100_ billion.- Now, GDP has increased by $_100___ billion, hence income has increasedby $__100___ billion.- People will spend 90% of this additional income in the second round.- Consumption increased by $_90__ billion- Savings increased by $_10__ billion. - The impact on GDP is now $__90_ billion in the second round.- The multiplier helps us understand the extent of the chain reactions in the economy.- In this module, we want to understand how much extra income and spending are created from an initial change in spending.What drives investment spending?- Planned investment spending: the investment spending that businesses intend to undertake during a given period.- The interest rate (negatively)- Expected future real GDP (positively)- Current level of production capacity (negatively)- Interest rates are often the cost of investment projects. - When interest rates are low, more loans are undertaken and investment rises (other things equal).Inventories - Inventories: stocks of goods held to satisfy future sales.- Inventory investment: the value of the change in total inventories held in the economy during a given period.- Unplanned inventory investment: unplanned changes in inventories occurring when actual sales are more or less than businesses expected.- Actual investment spending: the sum of planned investment spending and unplanned inventory investment.- So in any period: I = IUnplanned + IPlannedLecture 12 (module 17) - Actual investment spending = I (planned) + I (unplanned) - Say, firms underestimated their sales- Which means sales > expected sales - Firms will sell from inventory - Therefore, inventory spending will fall  I (unplanned < 0 - A reduction in inventories  negative investment spending - In equilibrium…. I (unplanned) = 0 (inventory is at desired level, still have products in inventory but the amount they want) and I = I (planned) - In good times