MACROECONOMICS

Edition

McCONNELL, Brue, Flynn,20th

St. Johns University, Spring 2016 Economics

1001
Goods and Services Productive Resources

Labor b) Managerial Talent c) tools and machinery (technology) d)

land e) natural resources (mineral deposits)
1. Land- provides for food grown on Farms with technology
2. Steelworkers Produce Steel from Iron Ore in Steel Mills which is
used in construction of buildings which house talent for service
jobs.
3. Teachers, Doctors, Lawyers, Pharmacist all provide services
needed by consumers in order to produce goods (health, legal
advice, education) and services.

Economic Perspective

Provides a unique perspective or way of thinking as a result of

interrelated features:
1. Scarcity and Choice limited goods and services restricts options
and choices. We must decide what we will have and the quantity.
(Opportunity Cost)
2. Opportunity Cost- No Free Lunch A decision to use resources in
one way prohibits it from being used in another opportunity.
a. Example Tree- demand for lumber utilized in a house vs.
use for paper goods.
b. Strike or Weather temporary restriction on supply.

Purposeful Behavior:
A Rational Self Interest. Individuals pursue opportunities to increase
their Utility Pleasure or Happiness from CONSUMING a

Product or Service.
A Personal decision and sacrifice must be made to achieve this Utility. It
may include a decision to pay a childs college education.

Marginal Analysis Comparing of Benefits and

Cost
Marginal Analysis compares benefit and cost resulting
in a marginal or extra change.

Each option involves a Marginal Benefit. (p5) Cost

of Engagement Diamond and Size of Diamond. The

Opportunity Cost is the value of the next best thing

foregone and how that money is utilized.

Theories, Principles and Models

Scientific Model
1. Observe Real Behavior and Outcome
2. Based on Observations a Possible Explanation of Cause and Effect
( Hypothesis)
3. Test explanation by comparing the outcomes of specific events to the
outcome predicted by Hypothesis.
4. Accept or Reject and Modify the Hypothesis based on these comparisons.
5. Continue to test Hypothesis against facts if favorable results evolve into
Economic Principle which enables prediction of the probable effects of
certain actions.

Theories of Behavior
1. Develop on individuals (Consumers or Workers)
2. Institutions (Businesses or Government)
3. These individuals and institutions are engaged in production,
consumption or exchange of goods and services.
4. Economic Principles based upon Generalizations relating to economic
behavior expressed in tendencies of an AVERAGE Consumer Worker,
Business institution.

Microeconomics and Macroeconomics.

Micro- decisions making by individual consumer, Industry or business

firms.

Macro- Examines the Economy as a Whole or its sub divisions,

e.g. government, consumer or business sectors.
An aggregate collections of specific economic units and treat
as if one unit. (E.g. National Housing compared to Housing in
Queens.)
This provides an Overview or General Outline of Relationships
of Aggregates. It examines the Forest not the Tree.
Positive and Normative Economics
Positive is Facts and Cause and Effect driven in a Relationship.
It describes what is and the cause of it.
Normative Economics is Economic Policy which incorporates
judgments about what the economy should be like or what
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particular policy actions should be recommended to achieve a

desirable goal, e.g. Minimum Wage Impact on Income, Wealth
and Gross Domestic Product, may result in judgment to
increase or decrease. Tax polices e.g. the deduction of local
taxes may be outcome to place more deductions in areas of the
country with Income Tax.
Review (1.1 P 7)

Economic Perspective:

Resource Scarcity and necessity of making choices.

Assumption of Purposeful (Rational) Behavior.
Opportunity Cost- people choose and incur the value of the next best
option.
Economist use Scientific Model or Cause and Effect Generalizations.
Microeconomics- specific decision of the economy.
Macroeconomics- Examines Economy as a Whole.
Positive Economist- Factual Based Analysis
Normative Economics- Value judgments of Economic Policy.

Individuals Economizing Problem

Need to make decisions because wants Exceeds Means.
(Supply and Demand)
Limited Income: Forces Decision.
Types of Income: a) wages b)Interest c) Dividends d)
rental e) Trust
Government programs and Family Contribution. (Tuition
Housing Food)

ALL INCOME IS FINITE BUT WANTS UNLIMITED

Goods and Services provide utility and are necessities. Those which are
not necessary are Luxuries, e.g. jewelry, boats, and vacations.
Goods are products produced to satisfy our needs or utilities.
Services are actions for which we pay income. The services provide us
with the ability to produce goods or other services. Examples: Education,
Health Care, Mass Transit.
Utilities satisfy consumer needs from the purchase of demands for goods
and services.

 BUDGET LINE OR CONSTRAINT

A Budget Line or Constraint shows relationship between
two products. (Figure 1-1 P.9)

ATTAINABLE OR UNATTAINABLE COMBINATIONS:

Combinations within the Budget Line are attainable in various
combinations.
All combinations outside the Budget Line are Unattainable.
We Trade Off due to the Limited Income and Opportunity Costs.
The Straight Budget Line Constraint indicates constant
Opportunity Cost.
Choice- Limited Income forces people to choose
what to purchase and to forego to fulfill wants.

Review 1-2 ( page 10)

Wants exceed Income- Consumer or Institution MUST decide
what to buy and forego.
Budget Line Constraint shows combinations of two goods.
Straight Line shows Constant Opportunity Cost for both goods.
Societys Economizing Problem
Supply and Demand- Limited Economic Resources that are
used in production of goods or services, e.g. natural, energy,
Human, Education Level.
Categories:
Land- All Natural Resources, e.g. land, water, wind,
minerals arable land.
Labor- physical and mental activities which contribute
to production of goods and services. E.g. Doctor
Shortage
Capital- Capital Goods ( Made for More than one Year.)
Provide indirect satisfaction of consumer needs. E.G.
Tractors used on farms to plant crops and make land
arable.
ENTREPRENURIAL ABILITY
Special Human Resources Distinct from Labor. The Entrepreneur makes
the Strategic Business Decisions and sets the Course of the Enterprise
and the Risk. E.G. Warren Buffet or Bill Gates. Or Ra Krock- McDonalds.

Innovates and commercializes new products, techniques or new forms of

business organization. (Fast Food- Technology)
Bears the RISK and is subject to the RISK OF FAILURE.

FACTORS OF PRODUCTION: (INPUTS)

Full Employment employing all or less than full employment
determine the production level.
Fixed Resources- Quantity and Quality of Production are Fixed.
Fixed Technology- The Technology Available at the time of
production.
Production has the output of two types of goods:
Consumer- Satisfies are needs directly, e.g. food
Capital- satisfies needs indirectly, e.g. tractor that
harvest crops.
PRODUCTION POSSIBILITIES TABLE ( Table 1-1
page 11)
Movement to all resources for consumer satisfaction satisfies demands
NOW.
Movement to all Capital goods satisfies demands LATER.

PROUCTION POSSIBILITIES CURVE

Different combinations of Goods and Services can produce in a fully
employed economy.
Points within the Curve are Fully Attainable in Production.
Points Outside the Curve are Unattainable in Production.

LAW OF INCREASING OPPORTUNITY COST.

The Opportunity Cost for each consumer unit is greater than the
preceding.
Law of Increasing Opportunity- the production of a particular goods
increases, the opportunity cost of producing an additional unit rise.
It is driven by inability to adapt to alternative uses.

LAW OF OPTIMAL ALLOCATION

Decision centered on comparisons of Marginal Benefit (MB) and Marginal
Cost (MC).
Any Economic activity should be expanded as long as Marginal Benefits
(MB) exceeds Marginal Cost.

Review 1.3 (Page 14)

Economic resources are Land, Labor, Capital and Entrepreneurial Ability.

Production Possibilities Curve ideas:
o Scarcity of resources are implied by the area of unattainable
combinations.

o Choice among outputs are reflected in he variety of attainable

combinations.
o Opportunity Cost illustrated by the downward slope curve.
o Comparison of MB and MC is needed to determine the Optimal Mix
on a Production Possibilities Curve.

UNEMPLOYMENT,GROWTH AND THE FUTURE

Unemployment in the Great Depression 1929, was25 % and Production

Slowdown was 33%.
Unemployment in the 2007-2009 was 10% at peak with Production
Slowdown of 3.7%.
Figure 1.4 (p. 15) Unemployment and he Production Possibilities Curve.
o Point U the Unemployment for Production, the Gap between Point U
and Full Employment.

GROWING ECONOMY:
RESOURCES CHANGE OVER TIME BY THE FOLLOWING Factors:
o Growing Population ( converts labor to entrepreneurial skills)
Improved education and skills improve quality.
o Some Natural Resources (oil) is depleted and new forms e.g. natural
gas, solar wind are utilized.
o The Economy will achieve growth in the form of expanded potential
output . This growth results from the increase in resources e.g. U.S.
being self sufficient in natural resources drives down the cost of
Production and increases the Margin Benefits over Margin Cost.

Advances in Technology
o New an better goods and improved ways of production are he result
of technology.
o Advances in biotechnology resulted in important agricultural and
biomedical discoveries.

Economic Growth Result of :

Increase in supplies of resources e.g. energy

Improvement in Resource Quality
Technology Advances.
Goods for eh future are Capital goods and Present are Consumer
goods. E.g. food, clothing
o Figure 1.6 (Page 18) Facebook- Presentville /Futureville.
o
o
o
o

International Trade

Output limits imposed on domestic production Possibilities Curve creates

demand for goods from other nations.
International Trade with each country exchanging the items the at it can
produce at the lowest Opportunity /cost. E.g. Coffee or Bananas in South
and Central America.

Canada is our largest Trading Partner.

Economics is the social science that explains how individuals- institutions

and society make and Opportunity Cost Decision.
Economic Perspective includes; scarcity, choice, purposeful behavior and
margin analysis.
Economics Employs the Scientific Method and this form test the
hypotheses of cause and effect and the relationships to generate
theories, laws and principles into an economic model.
Microeconomics examines the decision making of specific institutions.
Macroeconomics examines economy as a whole.
Positive Economic analysis deals with facts.
Normative economics reflects value on judgment
Budget Line or Constraint illustrates the various combinations of two
products that a consumer can produce and purchase for his utility.
Economic Resources are input into the production process, land, labor,
capital and entrepreneurial ability
An economy Fully Employed operating on its Production Possibilities
Curve must Sacrifice to produce Moe for NOW or Future and analyze
the Opportunity Cost.
Optimal Point of Production Possibilities Curve represents the most
desirable mix of Goods an is measured until MB=MC.

SUMMARY;

CHAPTER 2 THE MARKET SYSTEM AND THE

CIRCULAR FLOW

Economic Systems- a set of institutional arrangements and a

coordinating mechanism to respond to the economizing problems of
society.
o The System determines;

 How Good are produced

What Goods are produced
Who Gets the products.
How to Accommodate for Change
How to Promote Technological change.
o Systems Differ:
Who owns the method of production.
How to motivate, coordinate and direct economic activity.
o Two Significant systems:
Command or Socialism or Communism which is
government centered and owns most property resources an
economic decision making occurs through a central economic
plan.

Market System or Capitalism- characterized by the

Private Ownership of capital and communicates
through prices and coordinates economic activity
through markets. A market is a place where buyers
and sellers come together to buy goods, services and
resources. The result is competition between each
individual.
o Laissez-faire capitalism the role of government is
limited to protecting private property and establishing
an environment appropriate to the operation of the
market system.
o United States Capitalism- and most others plays

a substantial role in the economy, it promotes

economic stability and growth, but is not the
dominant economic force.

o CHARACTERISTICS OF THE MARKET SYSTEM

o Private individuals and firms own most of the property
resources and capital not the government.
o Right of Private Property coupled with the freedom to
negotiate binding legal contracts enables individuals and
businesses to obtain send dispose of property resources
as they see fit.
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o Only mutually agreeable economic transactions take

place. A fair market where a buyer and seller come to
terms as to value and exchange of property.
o Property rights facilitates exchange, via legal
documentation e.g. deeds and title.

Freedom of Enterprise and Choice

o Freedom of Enterprise ensures entrepreneurs and
private businesses are free to obtain and use economic
resources to produce their choice of goods and services
and to sell them in their chosen markets.
o Examples: Entrance into any line of work for which
qualified, free to buy the goods and services that best
satisfy their wants and that their budgets allow.

SELF INTEREST: is the motivating force of the various

economic units as they express their free choices.
Economic Unit tries to achieve its own particular goal, which
usually requires delivering something of value to others.
Entrepreneurs try to maximize profit or minimize loss.
Workers try to maximize their utility (satisfaction) by finding
jobs, that offer the best combination of wages, hours, fringe
benefits, and working conditions.

COMPETITION the market system depends on competition

among economic units.
Competition requires two or more buyers to enter or leave
markets on the basis of their economic self interest.
Competition also implies that producers can enter or leave an
industry no insurmountable barriers prevent an industrys
expansion or contraction.
Freedom to enter or exit enables the economy to adjust to
changes in consumer tastes, technology an resource
availability.

 Markets and Prices

o A market is an institution or mechanism that brings
buyers Demanders an sellers Suppliers into contact.
o The decisions made on both sides sets the product
and resource prices that guide resource owner,
entrepreneurs and consumers as they make and
revise their choices an pursue their self interest.
( Quick Review 2.1 p. 32)

Technology and Capital Goods

o The monetary rewards for new products or
production techniques accrue directly to the
innovator.
o The Markey system encourages extensive use and
deployment of capital goods, tools machinery, largescale factories and facilities for storage,
communications, transportation and marketing.

SPECIALIZATION: Using the resources of an individual, firm,

region to produce one or a few goods or services rather that
the entire range of goods and services. Those goods and
services then exchanged for full range of desired products.
o Self sufficiency breeds Inefficiency.

Division of Labor: Human specialization called he division of

labor contributes to a societys output in several ways:
Specialization makes use of differences in
ability.
Specialization fosters learning by doing.
Devoting time to doing a task learn how to

improve actions.
Specialization saves time avoids the loss of
time incurred in shifting from one job to
another.
GEOGRAPHIC SPECIALIZATION- specialization works on a
geographic basis.
This geographic specialization is also international.

USE OF MONEY :

Money is a medium of exchange. It eliminates

the swapping of goods or barter.
o Money is socially defined whatever society
accepts Is money.
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Active but Limited Government:

Government manages market short falls via various

regulations.

FIVE FUNDAMENTAL QUESTIONSOF THE Market

System:
1.
2.
3.
4.
5.

What goods and services will be produced?

How will the goods and services be produced.
Who will get the goods and services?
How will the system accommodate change?
How will the system promote Progress?
WHAT WILL BE PRODUCED?
The goods and services which can be produced at a
continuing profit will be produced while those whose
production generates a continuing loss will be discontinued.
Economic Profit= Total Revenue >Total Cost.
Consumers register their dollar votes through money which
decides if a product is produced for a consumer.

HOW WILL THE GOODS AND SERVICES BE

PRODUCED?

Goods and services will be produced in ways that minimize

the cost per unit of output, because inefficiency drives up
cost and lowers profit.

Least Cost Production means that firms must employ the

most economically efficient technique of production in
producing their output. The most efficient production in
producing their output.
o The

Most Efficient Production Techniques depends on:

The available technology
The prices of the needed resources.
Table 2.1 P 36

WHO, Will Get the Output?

o Any product will be distributed to consumers on the basis
of their ability and willingness to pay its existing market
price.
o The amount of income they have depends on (1) the
quantities of the property and human resources they
supply.
o The prices those resources command in the resource
market.
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o Resources prices ( wages, interest, rent, profit) are

crucial in determining the size of each persons income an
each persons ability to buy part of the economys output.

HOW WILL THE SYSTEM ACCOMMODATE CHANGE?

o Consumer preferences, technology and supplies of resource
all change.
Technology, allocation and consumer taste will become
obsolete and inefficient as consumer preferences change,
new techniques of production are discovered and resource
change over time.
o Consumer Sovereignty- dictates how the System Changes.
The juice industry has expanded while the domestic
milk industry has grown and found alternate products
but juice has become a preference. ? Why ? Because
the consumer has shifted taste to juice and water
drinks from milk.
Self Interest has motivated existing companies to
expand output and entice new competitors to enter the
prosperous fruit industry, e.g. Pepsi and other soft
drink companies.
The Market System communications process directs
changes in consumer demand and eventually in prices
and profits.

HOW WILL THE SYSEM PROMOTE PROGRESS?

o Society desires, economic growth, higher standards of living and
need the market to promote technological improvements and
capital accumulation.
o Market System- provides a strong incentive for technology to
advance and enables better products, process to replace inferior
ones and reduction of production or distribution cost.
Technological Advance:
o It promotes the rapid spread of technological advance
throughout and industry. Firms must obtain the latest and
most reliable technology used in their products of be replaced.
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Ex. Vinyl records were replace by CDS and IPods replaced CDs
and over time Ipods will be replaced by new technology.

CAPITAL ACCUMULATION:

o Consumer sovereignty creates capital by directing its dollars

to the production of goods it desires, both capital and
consumer.

Review Quick Review 2.3

THE INVISIBLE HAND ADAM SMITH- WEALTH OF NATIONS

1776- the Market System creates a curious unity between private and
social interest. Competitors driven by self interest still somehow
produce goods and services in an efficient manner. This efficiency
saves on scarce resources and improves the quality of our life.

THREE VIRTUES OF THE Market System:

o Promotes the efficient use of resources by guiding them into

the production of the goods most in demand by society. It
encourages the development and adoption of new and more
efficient techniques.
o Incentives Encourages skill acquisition, hard work and
innovation. Greater work skills and effort means more
production and higher incomes translate into higher quality of
living. Entrepreneurs are motivated to take risk in a system.

o FREEDOM- The major noneconomic argument for the

market system is its emphasis on personal freedom.

Demise of the Command System:

o Two Insurmountable problems:
1. Coordination- of millions of independent decisions
that were linked or dependent on the resources, e.g.
Labor- Land (Natural Resources), Capital and
Entrepreneurial Ability.
2. Incentive Problem- Central Planners determined the
output mix. They misjudge the mix, as long as the
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mangers who oversaw the production of those

goods and services were rewarded for meeting
goals.

CIRCULAR FLOW MODEL

(Figure2-2 Key Graph, p.40)

The dynamics of the market system is continuous

,repetitive flows of goods and services, resources and
money.
Households- one or more persons occupying a housing
unit. In the US there are 116 million households and
growing. They buy the goods and services that
businesses make available in the product market.
Households make income by selling or producing goods
and services in the Circular flow.
All the property in the non government economy is
privately owned.
Businesses-are commercial establishments that
attempt to earn profits for the owners (entrepreneurs)
sole proprietorship, partnership and corporation.
Businesses generate revenue when they sell goods and
services and expenses when they incur cost in the
resource market for labor, land and capital.
Product Market The place where the goods and
services and products by businesses are bought and sold.
Examples: Brick and Click Locations Buildings and
Internet.
Households flow their money through Product Markets
as they Purchase goods and services.

Resource Market Business purchase resources from

households to produce their goods and services.
Examples: Labor

The Circular flow Model depicts a complex web of

economic activity in which businesses and households
are both buyers and sellers.

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CHAPTER THREE: DEMAND,SUPPLY AND MAKET

EQUILIBRIUM
MARKETS- bring together BUYERS DEMANDERS and
SELLERS OR SUPPLIERS.

15

o Some markets are local others national or international.

Some highly personal face to face
o contact others are faceless.
DEMAND- a schedule or a curve that shows the various amounts
of a product that consumers are wiling ad able to purchase at
each of a series of possible prices during a specific period of time
at various possible prices.
o Figure 3-1 p 48 Demand Curve Example
o A consumer must be willing and able to purchase for the
consumer to be a BUYER. Willing is not sufficient.
o The consumer must be willing and able to purchase a
product at a specific period of time.

1. LAW OF DEMAND All things equal- as prices fall the quantity demanded rises
and as prices rise, the quantity demanded falls.
There is a Negative or Inverse Relationship between price and quantity
demanded.
The Law of Demand is consistent with common sense. People ordinarily
do buy more of a product at a low price than at a high price. Price is an
obstacle that deters consumers from buying. The fact stores have Sales to
clear out inventory is evidence of their belief in the law of demand.
Each buyer will derive less benefit or utility or satisfaction from each
successive unit of the product consumed. TWO FOR ONE ICE CREAM.
Consumption is subject to Diminishing Marginal Utility.
The Income Effect indicates that a lower price increases the purchasing
power of a buyers money income, enabling the buyer to purchase more
of the product than before.
The Substitution Effect suggests that at a lower price buyers have the
incentive to substitute what is now a less expensive product for other
products that are more expensive. Example, Price of chicken declines
permits more chicken to be purchases and substitute for pork etc.

2. DEMAND CURVE We create a graph for Quantity Demanded, compare price

(vertical) and quantity (horizontal) It indicates more purchased at lower price (figure
3.1)

3. MARKET DEMAND to create a market must have more than one consumer.

Assumption that all the consumers are willing and able to purchase the goods.
To determine the Market merely multiply the number of consumers and the
amount they are willing to purchase to determine the Market.

Determinants- cause the Demand Curve to change when it changes

the demand data.
1)Consumer Taste

2) Number of buyers in the market 3)consumer incomes

4) the prices of related goods

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5) consumer expectations.

A shift in demand is called a change in demand e.g. An increase in demand

for a particular product at each possible price.
Taste- favorable or unfavorable change In consumer tastes for a product will
change demand and price.
Number of Buyers ex. Demographics of the US has resulted in increase for
more retirement communities.

Income- causes an increase in demand . Superior or normal goods are

products whose demand various directly with money income. At some point
in income cue the demand for used tires etc decreases and luxury items e.g.
vacations increases.
Prices of Related goods-change in price for a related good may either
increase or decrease the demand for a product, based upon it being a
substitute or complementary good.
o Substitutes-will be used in place of another good. It will either
increase production and decrease price or the inverse.
o Complements- simply work together like pc and software.
o Independent or Unrelated Goods- simply stand on their own e.g.
butter and golf balls they are not substitutes or complements.
Consumer Expectations- the psychological motivations of the market buy
home or losing your job.

CHANGES IN QUANTITY DEMANDED

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A change in Demand- shift of the demand cure to the right ( an increase) or

left ( decrease). Demand is a schedule or a curve , a change in demand
means a change in the schedule and a shift in the curve.
A CHANGE IN QUANTITY DEMANDED is a movement from one point to
another from one price-quantity combination to another . (See Figuer3.3) p
51

SUPPLY is a schedule or curve showing the various amounts of a product

that producers are willing and able to make available for sale at each of a
series of possible prices during a specific period. ( See Figure 3.4 p. 54)
LAW OF SUPPLY a positive or direct relationship prevails between
price and quantity supplies. As price rises, the quantity supplied rises as
price falls the quantity supplied falls.
o To a Supplier-price represents revenue which serves as an
incentive to produce and sell a product. The higher the price, the
greater this incentive and the greater the quantity supplies.
o A Manufacturer usually encounters increases in marginal costthe added cost of producing one more unit of output. Certain
productive resources in particular the firms plant and machinery
cannot be expanded quickly, so the firm uses more of other resources
e.g. labor to produce more output. Over time, each added worker
produces less added output and the marginal cost of units of output
rises.

THE SUPPLY CURVE corresponds with the price-quantity supplied data in

Figure 3.4 The relationship between price and quantity supplied is positive or
direct.
THE MARKET SUPPLY CURVE- sum the quantities supplied by each
producer at each price, horizontally add the curve of the individual producers.
DETRIMANTS OF SUPPLY- the curve most determinant is Price. The curve is
drawn on the assumption that these other things are Fixed and do not change.

BASIC determinants of Supply are:

o Resource Prices used in the production of goods Higher the cost
reduction in profits since Marginal Cost increase.
o Technology- improvements in technology enable firms to produce
units of output with fewer resources.
o Taxes and Subsidies- taxes are cost an increase in taxes will
increase production costs and reduce supply. Tax Subsidies lower cost
of production.
o Prices of Other Goods- use plant and equipment to produce
alternative goods, say basketballs and volleyballs. The higher prices of
other gods may entice producers to switch production to those goods in
order to increase profits.
o Producer Expectations- producer has expectations about the
future price of a product may affect the producers current willingness to
supply that product. E.g. farmer withholding part of his crop anticipating
higher prices.
o Number of Sellers- the larger the number of suppliers the greater
the market supply.

CHANGES IN SUPPLY
o Resource Prices: the prices of the resources used in the production process determine the
costs of production incurred by firms. Higher resource prices raise production cost and
assuming a particular product price squeeze profits. Example: increase in the price of crushed
rock for cement may increase production cost and reduce supply.
o The decrease in price of iron ore results in the decrease in price of steel.
o Technology improvements enable firms to produce units of output with fewer resources. An
example: flat screen monitors use less resources.
o Taxes and Subsidies Businesses treat taxes as cost, increase in taxes results in increase in
production cost. In contrast, Subsidies are taxes in reverse lower production cost.
Example: NY Tax Free Zones.
o Prices of Other Goods- Use plant and equipment to produce alternative goods, e.g.
basketballs and volleyballs. This increases revenue and reduces production cost for new plant.
o Production Expectations: Changes in expectations about the future price of a product may
product may affect the producers current willingness to provide the product. Example;
Farmers withholding part of a crop.
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o Number of Sellers: the larger the number of suppliers the greater the market supply. As
more firms enter an industry, the supply curve shifts to the right.

CHANGES IN QUANTITY SUPPLIES

o Change in Quantity Supplies is a movement from one point to another on a fixed supply curve.
The cause of a movement is a change in the price of the specific product being considered.
(Figure 3.5 p. 55) Example of Change in Quantity Supplied.
MARKET EQUILIBRIUM PRICE AND QUANTITY
The Equilibrium Price- or market clearing price is the price where he intentions of buyers and
sellers match. The Price where Quantity demanded equals Quantity Supplied. ( Figure 3.6)
A Surplus is excess production which drives prices down.
A Shortage is an excess in demand at a set price. The Shortage is changed to Market
Equilibrium by raising the price.
Rationing Function of Prices is the ability of a competitive forces of supply and demand to

o
o
o
o

establish a price at which selling and buying decisions are consistent is Rationing Function of

Prices.
o Productive Efficiency- is the production of any particular good in the least costly way.
Example: Resources of $100 able to provide production at $3 society has $97 to invest in other
products. Higher the cost of production less to invest in other products.
CHANGESIN SUPPLY,DEMAND AND EQUILIBRIUM
o Changes in Demand- An increase in Demand Raises Both Equilibrium price and quantity. A
decrease in Demand decreases both the equilibrium price and quantity.
o Changes in Supply- Demand is constant but supply increases ( ex. Flash drives). The result the
new intersection of supply and demand is located at lower price and higher quantity.
o Complex Cases- Both Supply and Demand Change, the effect is a combination of the individual
effects.
Supply Increase; Demand Decrease (ex. apples) Both changes decrease price so he
net result is a price drop greater than that resulting from either change alone.
Supply Decrease, Demand Increase ( ex. Gasoline) Increase in Equilibrium price
while a demand increase boost it. If the Increase in Supply greater than the increase
in demand the equilibrium price will fall. Opposite it will increase.
Supply Increase, Demand Increase Both increase for some goods ( ex. Cell phones) a
supply increases drops equilibrium price, while a demand increase boosts it.
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Supply Decrease; Demand Decrease Decreases in both for some goods ( ex. New
homes) if the decrease in supply is greater than the decrease in demand the price
will increase.
APPLICATION: GOVERNMENT-SET PRICES
o Government sometimes concludes that supply and demand will produce prices that are
unfairly high for buyers or unfairly low for sellers. The govt. places legal limits on how high
or low prices may change.
o Price Ceiling sets the maximum legal price a seller may charge for a
product or service. (ex. Rent controls, usury laws)
o Graphical Analysis Demand for automobiles increased results in
demand for gasoline. This results in the increase in equilibrium price
for gallon of gas. The rapidly rising price of gas burdens the low and
moderate income households which pressure govt. to take action.
o The ceiling price is below the Equilibrium Price below the
Equilibrium creates a shortage. Competition among buyers bids up
price, inducing more production and rationing some buyers out of the
market.
Rationing Problem The Available supply less than the demand
results in the govt. setting regulation on distribution of
demand, e.g. Coupon rationing.
Black Markets many buyers willing to pay over the ceiling
price illegally.
Rent controls or Stabilization shows how the govt. attempts to
control the price and quantity of housing units.
Resources will be invested in other real estate, e.g.
shopping centers.
o Price floors of Wheat A minimum price fixed by the govt. when
society feels that the free functioning of the market system has not
provided a sufficient income for certain groups of resource suppliers
or producers.
o

CHAPTER FOUR- MARKET FAILURES:PUBLIC GOODS AND EXTERNALITIES

Market Failures- the presence of competition involving many buyers and many sellers may not
by itself be enough to guarantee that a market will allocate resources correctly.
o Demand Side Failures occur when demand curves do NOT reflect consumers full
willingness to pay for a good or service.
o Supply-side Failures occur when supply curves do not reflect the full cost of producing a
good or service.

20

DEMAND Side Market Failures- arise because it is impossible in certain cases to charge
consumers what they are willing to pay for a product. E.G. Outdoor fireworks display no way to
exclude the public from seeing the display. Therefore, private firms unwilling to produce outdoor
fireworks displays unless it has a business reason, Macys Fourth of July Fireworks Display.
SUPPLY SIDE Market Failures-A firm does not have to pay the full cost of production its output.

EFFICIENTLY FUNCTIONING MARKETS:

o Two conditions if a competitive market is to produce efficient outcomes:
The demand curve in the market must reflect consumers full willingness to pay
The Supply curve in the market must reflect all the cost of production.
If these conditions hold, the market will produce only units for which benefits are at
least equal to costs. It will maximize the amount of benefits surpluses that are
shared between consumers and producers.
o Consumer Surplus: the benefit received by a consumer in a market is a consumer surplus.
It is the difference between the maximum price a consumer is willing to pay for a product
and the actual price that they pay.
The maximum price a consumer is willing to pay for a unit of a product
depends on the opportunity cost for the consumers consumption
alternatives.
o Example: Consumer willing to purchase an apple for up to $1.25. Any
purchase price less than this provides an Opportunity Cost for
alternative investment. Expenditures= Product Price x Quantity. The
consumer only pays the Equilibrium Price creating a surplus from the
Demand Price willing to be paid. ( Example: P 94 Table 5.1)
o Producer Surplus: the difference between the actual price a producer receives or
producers receive and the minimum acceptable price that a consumer would have to pay
the producer to make a particular unit of output available.
A producers minimum acceptable price for a particular unit will equal to
producers marginal cost of producing that particular unit. The Marginal
cost will be the sum of the rent, wages, interest and profit that the producer
will need to pay in order to obtain the land, labor , capital and
entrepreneurship required to produce that particular unit.
In addition, a producers minimum acceptable price can also be interpreted
as the opportunity cost of bidding resources away from the production of
other products. The resources needed for one product could be used for
another in greater demand and price.
The Minimum Acceptable price is the lowest price you could pay producer
that her cost =benefit. (p 96 Table 5.2)
o Efficiencies:
Productive efficiency is achieved because competition forces the producer to
use the best technologies and combinations of resources available.
Allocative efficiency is achieved because the correct quantity (Q1) is
produced relative to other goods and services.
21

o Ways to understand why Q is the correction production level. Any

resources directed toward the production of units are resources that
could have been used to produce other products.
o Demand and Supply Curve measure Marginal Benefit (MB) and
Marginal Cost (MC).The Maximum Price a consumer is willing to pay
for any unit is equal to the benefit if they were to consume that unit.
Each unit adds a(positive amount= maximum willingness to pay
minimum acceptable price)to the total of the consumer and producer
surplus.
o Allocative efficiency occurs at the market equilibrium quantities that
maximize the sum of consumer and producer surplus. When the
following three conditions exist simultaneously:
MB=MC
Maximum willingness to pay= minimum acceptable
price
Total surplus= sum of consumer and producer surplus.

Efficiency Losses or Deadweight Losses:

Efficiency losses result are losses of combined consumer and producer

surplus from both underproduction and overproduction. Buyers and sellers
are members of society it represents an efficiency loss or deadweight loss.
o When demand reflects consumers full willingness to pay and when
supply reflects all costs the market equilibrium quantity will
automatically equal the allocatively efficient output level. This will
ensure that there are neither efficiency losses from under nor
efficiency losses from over production.

Quick Review Chapter 4

o Market failures in competitive markets have two possible causes; demand curves that do
not reflect consumers full willingness to pay and supply curves that do not reflect
producers full cost of production.
o Consumer surplus is the difference between the maximum price that a consumer is willing
to pay for a product and the lower price actually paid.
o Producer surplus is the difference between the minimum price that a producer is willing to
accept for a product and the higher price actually received.
o At the Equilibrium Price and Quantity in competitive markets, marginal benefit equals
marginal cost, maximum willingness to pay equals minimum acceptable price and the total
of consumer surplus and producer surplus is maximized. Each of these conditions defines
allocative efficiency.
o Quantities less than or greater than the allocatively efficient level of output create efficiency
losses or deadweight losses.

22

PUBLIC GOODS: Demand side market failures arise in competitive markets when demand
curves fail to reflect consumers full willingness to pay for a good or service. Market fails to
produce all of the units for which there are net benefits because demand curves underreport how

much consumers are willing and able to pay. Markets may fail to produce any of the public good,
because its demand curve may reflect none of its consumers willingness to pay.

PRIVATE GOODS CHARACTERISTICS: Produced in the market system and offered in retailers
to consumers.
o Rivalry One person buys and consumes a product, it is not available for another to buy
and consume.
o Excludability- sellers can keep people who do not pay for a product from obtaining its
benefits.
PUBLIC GOODS CHARACTERISTICS
o Non rivalry- CONSUMPTION OF A GOOD DOES NOT PRECLUDE CONSUMPTION
BY ANOTHER E.G. National Defense.
o Non-excludability- once it is in place no way to exclude anyone from its benefit e.g.
National Defense.
o These two characteristics create a Free Rider Problem. A producer provides a public good,
everyone including non-payers can benefit.
o Only a few public goods can be subsidized by closely related private goods since it would be
unprofitable. The two remaining ways for a particular public good to be produced are by
private philanthropy or government provision.
o Once a govt. decides to produce a particular public good, how can it determine the optimal
amount that it should produce. It can estimate the demand for a public good through
surveys or votes. It then compares the MB of added units of goods against the MC.
COST BENEFIT ANALYSIS:
o All resources are limited, therefore, the more resources used in govt. sector means less for
the private sector.
o There will be an Opportunity cost as well as benefit. The cost is the loss of satisfaction
resulting from the accompanying decline in the production of private goods the benefit is
the extra satisfaction resulting from the output of more public goods.
o An Example of Cost Benefit Govt. Project is the Highways. ( p 103) Table 5.4
o MARGINAL COST MARGINAL BENEFIT RULE identifies the plan tat provides society
with the maximum net benefit. If the Marginal Cost exceeds the Benefit it should not be
undertaken.

Quasi-Public Goods: Goods and services which could be priced and provided by private firms
through the market system. But the benefits of these goods flow well beyond the benefit to
individual buyers these goods would be under produced by the market system, e.g. education.

EXTERNALITIES: occur when some of the cost of the benefit of a good or service are passed
onto or spill over to someone other than the immediate buyer or seller. They are both positive
and negative externalities. Negative, cost of breathing polluted air, positive is benefit of having
everyone inoculated to prevent disease.
o Negative cause Supply Side Market Failures because producers do not account for the
cost that their negative externalities imposed on others. This failure to account for all

23

production costs causes firms supply curves to shift to the right or below where they would
be if firms properly accounted for all costs.
o Positive cause Demand Side Market Failures. Market Demand curves in such cases fail to
include the willingness to pay the third parties who receive he external benefits cased by
the positive externality.

GOVERNMENT INTERVENTION:

o Government can use direct controls and taxes to counter negative externalities; it may
provide subsidies or public goods to deal with positive externalities.
o DIRECT CONTROLS- the direct way is to pass legislation prohibiting that activity e.g.
auto emission standards.
o SPECIFIC TAXES the Government levies taxes or fees for specifically related goods, e.g.
gasoline or luxury tax.
SUBSIDIES And GOVERNMENT PROVISION:
o Subsidies to Buyers correct the under allocation of a resource directly to the buyer e.g.
energy credits to reduce the oil consumption.
o Subsidies to Producers It is a tax reverse where government gives the producer a tax credit
to produce a good or service, e.g. low income housing.
o Government Provision- Positive externalities are extremely large, the government may
decide to provide the product for free to all.
EQUILIBRIUM QUANTITY the optimal reduction of an externality occurs when societys
marginal cost and benefit of reducing that externality are equal. WHEN the MB exceeds MC the
additional abatement moves society toward economic efficiency. The added benefit of cleaner air
or water exceeds the benefit of any alternative use.

CHAPTER 5- Governments Role and Failure

GOVERNMENT INTERVENTION:

24

o Government can use direct controls and taxes to counter negative externalities; it may
provide subsidies or public goods to deal with positive externalities.
o DIRECT CONTROLS- the direct way is to pass legislation prohibiting that activity e.g.
auto emission standards.
o SPECIFIC TAXES the Government levies taxes or fees for specifically related goods, e.g.
gasoline or luxury tax.
SUBSIDIES And GOVERNMENT PROVISION:
o Subsidies to Buyers correct the under allocation of a resource directly to the buyer e.g.
energy credits to reduce the oil consumption.
o Subsidies to Producers It is a tax reverse where government gives the producer a tax credit
to produce a good or service, e.g. low income housing.
o Government Provision- Positive externalities are extremely large, the government may
decide to provide the product for free to all.
EQUILIBRIUM QUANTITY the optimal reduction of an externality occurs when societys
marginal cost and benefit of reducing that externality are equal. WHEN the MB exceeds MC the
additional abatement moves society toward economic efficiency. The added benefit of cleaner air
or water exceeds the benefit of any alternative use.

AN INTRODUCTION TO MACROECONOMICS
CHAPTER 6
Macroeconomics studies two topics:

25

Long Run Economic Growth- economy shows that in long run higher
output and higher standard of living .
Short run fluctuations are considered variability.
Recession- output and living standards actually decline.
These are referred to as the Business Cycle.

PERFORMANCE AND POLICY:

Major Statistics of Macroeconomics:
Real GDP (Gross Domestic Product) measures the
value of final goods and services produced with the

borders of a country during a specific period of time,

normally a year.
o Nominal GDP- government calculates the totals
the dollar value of all goods and services produced
within the borders of a country using their current
prices during the year that they were produced.
Nominal GDP uses the prices in place in the year the
output was produced it suffers from a major
problem: It can increase from one year to the next
even if there is no increase in output.
Examples Commercial Blacksmith produced 10
iron spiral staircases last year and 10 identical
this year. Output did not change But if the
prices changed from $10,000 this year to
$20,000 this year nominal GDP increased from
$100,000 to $200,000. Real GDP eliminates
these kinds of price changes. More output
means greater consumption possibilities
including not only the chance to consume more
things both fun and serious.

o Unemployment- the state a person is in if unable

to find a job despite willingness to work and actively
seeking work.
High Rates of Unemployment undesirable
because they indicate economy is not using a
large portion of its most important resource
the talents and skills of its people.
o Inflation is an increase in the overall level of
prices. An increase in price will cost a household and
business more money for the same items and limit
their purchase power. If their salaries or revenue to
not meet inflation increases less can be purchased
and the standard of living will fall due to Inflation.
Powers and Limits of Government Economic Policy:
o Can Govt. promote long term economic growth
o Reduce the severity of Recession by smoothing out short fun
fluctuations
o Certain Govt. policy tools e.g. manipulating interest rates
( monetary policy) more effective at mitigating short run
fluctuations than other government policy tools e.g. tax rates.
o Trade off between higher rates of unemployment and inflations.

Modern Economic Growth:

26

o INDUSTRIAL REVOLUTION- factory and automation output grew

faster than population and improved the standard of living.
o Citizens of the richest nations today have material standards of
living hat are on average more than 50 times higher than those
experienced by citizens of the poorest nations. (p 199 Global
Perspective 6.1)
GDP is converted into USD from local currency.
The average amount of output each person in each country
could have if each countrys total output were divided equally
among its citizens.
Adjust for Purchasing Power Parity to adjust for the fact that
prices are much lower in some countries than others.

Savings, Investment and Choosing between Present and Future

consumption:
Savings- current consumption is less than current output.

o Households are the principal source of Savings.

Investment resources are devoted to increasing future
output by building he next generation of capital goods.
o Businesses are the main investment advisers.
Banks and other financial institutions convert the Savings of
Households into loans for Business Investment.

EXPECTAIONS AND UNCERTAINTIES:

Expectations about the Future:
o Pessimistic expectations will lead to less current
investments by businesses.
o Firms are forced to deal with shocks in which they
were expecting one thing to occur and something
else occurred.
Firms deal with shocks by considering options
for use, more investment or new options.

o SHOCKS:
Demand are expected changes in the
demand for goods and services.
o Positive Demand- refers to a
situation in which demand turns out
to be higher than expected.
o Negative Demand- demand turns
out to be lower than expected.
27

The prices of many goods and services are

inflexible in the short run.
Price changes do not quickly equalize the
quantities demanded of such goods and
services with their respective quantities
supplied.
Response to Demand Shock is primarily
through output and employment.

DEMAND CURVES: (figure 6.1- p.122)

Dl- Demand Low
DM- Demand Medium- the Equilibrium

Price and Quantity Demanded.

Dh- Demand High

Inventory:
o Manufacturing firms
o

o
o

attempt to deal with unexpected

changes in demand by maintaining an inventory.
Inventory- a store of output that has been produced but not yet
sold. They allow to grow or decline in periods when demand is
unexpectedly low or high, allowing production to smoothly produce
when demand is variable.
Inventory Build UP- if inventory continues to build up without
sales it will lead to layoffs of employees, which will lead to
additional layoffs of adjacent businesses.
Inflexible Prices or Sticky Prices explain how
unexpected changes in demand lead to the fluctuations in GDP.
Flexible Prices- may have instant response to price increase OR
DECREASE E.G. COMMODITIES.

o THE Prices of Most Finished Goods and Services are quite

sticky.
o Consumers prefer stable, predicable prices that do not
fluctuate rapidly with changes in demand.
o Price wars between large companies who control large
percentage of market may cause sticky prices.

28

o In terms of time, short run can be thought of as the first

few weeks and months after a demand shock, long run can
extend for many months.

MEASURING DOMESTIC OUTPUT AND NATIONAL INCOME

CHAPTER 7
ASSESSING THE ECONOMYS PERFORMANCE:
o National Income Accounting- measures the economys overall
performance
Compares Levels of production at regular intervals.
Tracks the Long Run course of the Economy for growth or
decline.
Formulate polices to improve the economys health.
o GROSS DOMESTIC PRODUCT:
29

The annual total output of goods and services or the aggregate

output.
GDP- defines aggregate output as the dollar value of all final
goods and services produced with the borders of a country
during a specific period of time, typically a year.
It is a Monetary Measure- it measures the value of output
in monetary terms, without it we would not have a way of
comparing the relative values of the vast number of
goods and services produced in different years.
The GDP only includes the market value of final goods
and ignores intermediate goods altogether.
o Intermediate goods are products purchased for
resale or further processing or manufacturing ex, oil
o Final goods are products that are purchased by their
end users ex, gasoline.
o If we included Intermediate goods is excluded
because the Final goods includes their values and it
would be Multiple Counting.
o Value Added in the market value of a firms output
less the value of the inputs the firm has brought
from others, at each stage the difference between
what a firm pays for in puts and what it receives
from selling the product made from the inputs is
paid out.
GDP EXCLUDES NONPRODUCTION TRANSACTIONS:
o Financial or Secondhand sales.
Financial Transactions:
Public Transfer Payments- direct
payments made by govt. to households,
e.g. Social security.
Stock Market Transactions-exchange of
stocks not adding to economy but
transferring.
o Secondhand Sales- Contribute nothing to current
production.

Two Ways of Looking at GDP Spending and Income:

o The Output of Expenditure approach looks at the GDP as the
sum of all the money spent in buying it.
All output produced is purchased by households, businesses
and government or foreign buyers.
30

o Income Approach- the income derived or created from producing

it .

THE EXPENDITURE APPROACH:

o Personal Consumption Expenditures (C)- all expenditures by
households on goods and services in a typical year.
Usually 10% are durable Goods- lives of three years or more.
Another 30% are Nondurable Goods- less than three years,
include goods like food clothing and gasoline.
Services- 60 % The U.S. is a Service Economy.

o Gross Private Domestic Investment (Ig)

All final purchases of machinery, equipment and tools by

business enterprises.
All construction residential and commercial.
Changes in inventories considered to be investment since in
effect unconsumed output.
Inventories Draw downs- is the sale of inventories from
previous years showing the economy sold more than
produced.
All spending by private businesses not by government (public)
agencies and it domestic and not abroad.

o GROSS INVESTMENT VS NET INVESTMENT:

Gross

means ALL investment goods. It is all the investment

necessary to replace machinery, equipment and buildings that
were used up in producing the current years output and any
net additions to the economys stock of capital.
Net Private Domestic Investment includes only
investment in the form of added capital. The amount of capital
that is used up over the course of a year is called depreciation.
Net Investment = Gross Investment-

Depreciation

o The economy disinvest when more capital than it

is producing and the nations stock of capital
shrinks.

o GOVERNMENT PURCHASES (G)

31

Expenditures for goods and services that govt. Consumes in

providing public services

Expenditure for publically owned capital e.g. schools and

highways.

Net Exports (Xn):

Exports are goods and services produced within the border

of the U.S. thus foreign spending on our exports must be
included in GDP.
Imports are goods and services produced outside the U.S.
Since these are not domestically produced they must be
deducted from the Exports to determine the GDP.
Xn (Net Exports)= Exports (X)- imports (M)

PUTTING IT ALL TOGETHER: (Table 7.3- p 135)

GDP= C+ Ig+ G+ Xn

THE INCOME APPROACH:

COMPENSATION - Employees salaries by business and

government t oemployees.
RENT Income received by households and businesses that
supply property resources.
INTEREST Money paid by private businesses to the suppliers
of loans used to purchase capital.
PROPRIETORS INCOME:
o Proprietors Income net income of sole proprietorships,
partnerships and other unincorporated businesses and
corporate profits.

CORPORATE PROFITS:
o Corporate Income Taxes taxes levied on corporations
that flow to the government ( federal and state).
o Dividends- part of after tax profits that corporations
choose to pay out or distribute to their stockholders.
o Undistributed Corporate Profits- Retained Earnings.

Taxes on Production and Imports include General Sales Tax, Excise

Taxes, business property tax, license fees and customs duties.

NATIONAL INCOME is the total of all sources of private income plus

government revenue from taxes on production and imports.

32

o Net Foreign Factor Income- deduct foreign earned income from

the Total National Income to determine the Foreign Factor Income
and deduct from National Income to compare GDP Income and
Expenditures Approach.

Consumption of Fixed Income- huge Depreciation Expense made

against publicly and privately owned capital each year is called
Consumption of Fixed Capital.

o It is capital committed to the replacement of capital goods and does

not add to the production value of current year goods. However, it
is included in the Expenditure Approach so it is Added back into the
Income Approach.
OTHER NATIONAL ACCOUNTS:
o Net Domestic Product- GDP does not make allowances for
replacing the capital goods used up in each years production.
NDP= GDP consumption of fixed capital (Depreciation)
o National Income- The Total Income Statistical Discrepancy
(Number Assigned by govt. to match income and production) + Net
Foreign Factor Income = National Income.
o Personal Income- all income received whether Earned or
Unearned. It differs from National Income because NI only counts
earned income.
o Disposable Income-is Personal Income less personal taxes,
including income, property and inheritance. It is the amount of
income that households have left over after paying their personal
taxes. The DI is then divided between consumption (C) and Savings
(S), DI=C+S.

CIRCULAR FLOW-P 139 Figure 7.4 GDP- NDP-NI-PI DI

Nominal GDP VS Real GDP
o Compare the MV of GDP year to year if the Value of money
itself changes in response to inflation or deflation.
o The value of GDP by multiplying total output by market prices.
o The quantity of goods produced and distributed to households
that affects our standard of living, not the price of those goods
and services.
o NOMINAL or UNADJUSTED GDP- a GDP based n the prices that
prevailed when the output was produced.
o A GDP that has been deflated or inflated to reflect changes in
the price level is called Adjusted or Real GDP
33

 ADJUSTMENT PROCESS IN A ONE PRODUCT ECONOMY:

o Basic Way to adjust Nominal GDP to reflect price
changes: Obtain actual amount of units of output and the
actual price per unit and multiply.
o Price Index is a measure of the price of a specified collection
of goods and services called a market basket in a given year as
compared to the price of an identical market basic in a
reference year.
a. Price Index in given Yr. = price of market basket in
specific yr.x100
Price of same market
basket in base year . See p 141 Table 7.5 for example.
o Dividing Nominal GDP by the Price Index:
o Real GDP=
nominal GDP
o Price Index
o RELATIOSHIPS BETWEEN GDP, REAL GDP, and the GDP

Price Index
o Table 7.7 p 143)

SHORT COMINGS OF GDP:

o Non-Market Activities e.g. home repairs and stay at home
parents.
o Leisure Time- increase in hours off from work.
o Improved Product Quality
o Underground Economy
o GDP an environment
o Non Economic Sources of Well Being
o

34

ECONOMIC GROWTH CHAPTER 8

Economic Growth:

o An increase in real GDP occurring over time.

It is measured as a percentage increase over the previous year, e.g. 3%. However
over a period of Recession it is Negative.
Example: GDP (207) $13,254.1-GDP(2006) $12,976.2/ $12,976.2 = 2.1%
o Percentage Rate of Growth per quarter or year.
o
o An increase in real GDP per capita. It is the size of the total population, e.g. GDP/
Population = Real GDP per capita.
Example: GDP (2006) $12,976.2/ Population 298.8 million = $43,432.
In 2007, Real GDP grew t o$43,929 $43,432/$43,432) x 100 = 1.1 %
Growth is a widely held economic goal. It permits society to better able to meet peoples wants
and resolve socio- economic problems. Growth lessens the burden of scarcity, unlike a static
economy can consume more today while increasing its capacity to produce more in the future.
o Difference in Growth Rate- Current nominal GDP = $14.3 Trillion, the difference between
a 3 % and 4 % rate of growth is about $142 billion. A poor country, a difference of of a
percentage point in the rate of growth ma mean the difference between starvation and mere
hunger.
THE RULE OF 70- find the number of years it will take for some measure to double given its
annual percentage increase, by dividing that percentage increase into the number 70.
o Formula:
Approximate # of years required to double real GDP =

70
Annual % Rate of Growth

o Example: 3 % annual rate of growth double real growth in about 23 years.

23=
70
3%
GROWTH IN THE U.S. (Table 8.1) Qualifications of Raw Numbers:
o Improved Products and Services when not included in the GDP understates the GDP.
o Added leisure
o Other impacts- Quality of Life and Environment.

MODERN ECONOMIC GROWTH:

35

o Characterized by sustained and ongoing increases in living standards that can cause
dramatic increases with the standard of living.
o Modern economist set 1776 as the start of the Industrial Revolution- when the Scottish
inventor James Watt discovered and defined he steam engine.
It resulted in:
Mass produced goods.
Increase in long distance trading.
Population shift from country to city.
Culturally the vast increases in wealth and living standards have allowed
ordinary people for the first time in history to have significant time for
leisure activities and the arts.
Socially- eliminated rules and regulations imposed upon class of people.
Politically- tendered to move toward democracy.
In the mid 1800s Central and South America began to experience modern
economic growth.
In 1820 per capita incomes in all areas were quite similar with the richest
o Per capita of $1232 and the lowest for African countries of $418. The
difference show just how the richest countries grew three times the
income in the poorest.
The adoption of technology by richer countries results in more quickly than
they can invent it. Inventing and implementing new technology is slow and
costly, real GDP per capita in the richest leader countries grows by an
average annual rate of just 2 or 3 percent per year.
Poorer Follower Countries grow much faster since all they need to do is
adopt existing technologies from rich leader countries. Example: Africa
skipped over landline telephones and based upon technology use cell phones.
LABOR- U.S. GDP is 44 % higher than French GDP
o US citizens put in more labor time.
o Larger fraction of population is employed than other rich leader
countries.
o Total working hours exceed France by 20%

INSTITUTIONAL STRUCTURES THAT PROMOTE GROWTH

o Strong Property Rights necessary for rapid and sustained economic
growth.
36

o Patents and Copyrights- a constant flow of innovative new

technologies and sophisticated new ideas. These provide the exclusive
right to market and sell their creations, patents and copyrights give a
strong financial incentive to invent and create.
o Efficient financial institutions- channel the savings generated by
households toward the businesses, entrepreneurs and inventors that
do most of societys investing and inventing.
o Literacy and Widespread Education.
o Free Trade- promotes economic growth by allowing countries to
specialize so that different types of output can be produced in the
countries where they can be made most efficiently.
o A Competitive Market System
DETERMINANTS OF GROWTH
o Supply, Demand and Efficiency Factors.
SUPPLY FACTORS;
o Increases in the Quantity and Quality of Natural Resources
o Human Resources
o Supply or stock of Capital goods.
o Improvements in Technology.
DEMAND FACTORS:
o To achieve the higher production potential created by the supply factors,
households, businesses and government must purchase the economys
expanding output of goods and services.
o When this occurs no unplanned increases in inventories and resources
will remain fully employed.

EFFICIENCY FACTOR: - to reach full production potential an economy must

achieve economic efficiency as well as full employment.
o The economy must use its resources in the least costly way ( production
efficiency) to produce the specific mix of goods and services that
maximizes peoples well being ( allocatie efficiency).

PRODUCTION POSSIBILITIES ANALYSIS: (CHAPTER 1) Chapter 8 (p.157 Figure)

37

A Production Possibilities Curve indicates the various maximum combination of

products an economy can produce with its fixed quantity and quality of natural,
human and capital resources and it stock of technological knowledge. (chapter 1)
A Demand factor is needed to increase total spending to move the economy
from a point of Production to a Higher Level.

The inability of one of the Supply Factors to reach its level of participation
reduces the Production, e.g. Labor not being used to its efficiency.

Labor and Productivity increase real output and income in two

fundamental ways:
o Increasing its input of resources
o Raising the productivity of those inputs.

o Real GDP depends on the input of labor measured in

hours of work multiplied by labor productivitymeasured as real output per hour of work.

Example: Nation has ten (10) workers, each woks 2000 hours per year or 50
weeks at 40 hours. Total hours worked is 20,000 hours.
o If Average Productivity is $10 per hour then the Real GDP is
$200,000 or 20000x10. If the hours worked increased to 20,200 and the
Labor Productivity increased to $10.40 per hour.GDP INCREASES
TO $210,800 or 5 %.
Hours of Work Depends on the following:
o Average hourly workweek.
o The size of the Labor-Force Size size of the working age population
and
o The labor force participation Rate dictates the number in the Labor
Force.
LABOR EFFICIENCY:
o Determined by Technological progress, the quantity of capital goods
available to workers, quality of the labor itself (skills and education) and
the efficiency with which inputs are allocated, combined and managed.
Productivity rises when the health, training, education and
motivation of workers improve.

GROWTH Accounting- measures a) increase in hours of work and increase

in labor productivity. (P 159 Table 8-3)
o Changes in Productivity Growth Rate:
Technological Advance accounts of 40% of Growth and
is single largest factor . It includes not just innovative production
techniques but new managerial methods and forms of business
organization that improve the process of production.
Technology advance and capital formation are closely related since
tech advance usually promotes investment in new machinery and
equipment.

38

Amount of Capital each worker has to work the

second major contributor 30% of the efficiency
improvement with more and better plant and equipment
In 2008, infrastructure per worker was $118,200.
Investment in public Infrastructure by the government e.g.
highways, bridges, mass transit and water treatment facilities
along with educational facilities.

Education and Training- an estimate of 15 % increase in

productivity is from education. (figure8-4 p. 160) Education is the
Human Capital Function.

Economies of Scale reduction in per unit production costs

that result from increases in output levels are called economies of
scale. More and better equipment and staff provided by economies
of scale.

Resource Allocation- workers over time have moved from low

productivity employment to high productivity employment. Shift
from agriculture to manufacturing to new forms of manufacturing
e.g. pc and airplane.

THE RISE IN THE AVERAGE RATE OF PRODUCTIVTY GROWTH

o Labor Productivity Rates:
1973-1995
1.5%
1995-2009
2.8%- due to technology and global competition.
o Increase in Productivity Growth is important for real output, real income,
and wages
REASONS FOR RISE IN THE AVERAGE RATE OF PRODUCTIVITY GROWTH
o The Microchip (Microprocessor) and Information Technology
o New Firms ( Start Up Firms) or Types of Firms- Start Up Firms advance
Information Technology- Intel, Cisco, AOL, Apple, IBM.
o Economies of Scale- cost reductions result from increases in output levels.
More Specialization- E Commerce us more productive capital and
workers as they expand their operations.
Development cost spread out over more units reducing cost of
research and development by producing more cost.
Simultaneous consumption- no redundancy.
Network effects- Inter connectivity advantages are called Network
Effects- increases in the value of a product to each user , including
existing users rises. An example is the Internet has produced Network
Effects.
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Learning by doing reduces time in production.

Global competition

GROWTH DESIRABEL AND SUSAINABLE:

o Two views:
Antigrowth- industrialization and growth result in pollution, climate

change, ozone and depletion of resources.

No proof Growth has solved Sociological Problems.
Defense of Growth-enables the nation to improve the infrastructure,
enhance the care of he sick and elderly, greater access for he disabled and
provide more police, safety and fire protection. Only realistic way to
reduce poverty. ex: A/C workplace more pleasant than steamy
workshops.

CHAPTER 9 BUSINESS CYCLES,UNEMPLOYMENT AND

INFLATION
o Business Cycle- the long run trend of the economy is one of economic
growth. They are alternating rises and declines in the level of
economic activity.
1. Phases of the Business Cycle:
a. A PEAK business activity as reached a temporary maximum. The economy is near or at
full employment and the level of real output is close to capacity.
b. A RECESSION is a period of decline in total output, income and employment. Downturn
last six months of more, marked by widespread contraction of business activity in many
sectors of the economy, along with declines in real GDP, significant increases in
unemployment. (p. 171 Table 9.1 Recession Table since 1950)
i. Trough- output and employment bottom out at the lowest levels.
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ii. Recovery- usually follow and there is Expansion, a period in which real GDP,
income and employment RISE.

2. Causation: A First Glance:

a. Fluctuations are driven by shocks, unexpected events that individual and firms may have
trouble adjusting. Short Term Stickiness is widely believed to be a major factor
preventing the economy from rapidly adjusting to shocks. Prices are sticky in the short
run, price changes cannot quickly equalize the quantities demanded of goods and services.
The economy is forced to react through changes in output and employment rather than
through changes in prices.
i. Sources of Shocks:
1. Irregular Innovation- new product or production methods can rapidly
spread through the economy, sparking sizable increases in investment,
consumption, output and employment.
2. Productivity- output per unit of input unexpectedly increases, the economy
booms, when productivity unexpectedly decreases, economy recedes.
3. Monetary factors- the Federal Reserve Bank shocks the economy by
creating more money than people were expecting and inflationary boom in
output occurs.
4. Public Events- e.g. terrorist attacks like 911.
5. Financial Instability- Rapid Asset Price Decreases can spillover to general
economy by expanding or contracting lending and boosting or eroding
consumer confidence. An example of Financial Instability and Monetary

Factors is the Great Recession of 2007-2009, led to over valued

real estate and unsustainable mortgage debts.
CYCLICAL IMPACT: DURABLES AND NONDURABLES:
o Firms producing Capital Goods, housing heavy equipment or Consumer Durables, autos,
refrigerators are impacted most by the business cycle. Firms and consumer can postpone
purchases within limits.
o Service Industries that produce nondurable consumer goods are somewhat insulated from
the most severe effects of recession. It is difficult to cut back on medical or legal services.
UNEMPLOYMENT:
Measurement of Unemployment- Bureau of Labor Statistics conducts a nationwide random
survey of 60,000 households each month to determine who is employed.
Three Categories of Population:

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Under 16 years of age and people institutionalized- Not Condidered Potential

members of the Labor Force.
Not in Labor Force- adults who are potential workers but are not employed
and are not seeking work. E.g. full time students, stay at home parents or
retirees.

Labor force- slightly more than 50% of the total population- people who are
able and willing to work, actively seeking work, whether employed or
unemployed.
Unemployment Rate = Unemployed x 100
Labor Force
Part Time Workers are listed as Fully Employed by the BLS, most by choice
others unable to find suitable full time work.
Discouraged Workers- workers who were unable to find work and stopped
looking for it.
Types of Unemployment:

o Frictional Unemployment- workers voluntarily between jobs or searching for first jobs, fresh out
of school.
o Structural Unemployment- changes over time in consumer demand and in technology alter the
structure of the total demand for labor as well as geography, e.g. Upstate NY- industrial area.

Cyclical Unemployment- It is caused by a decline in total spending and typically happens in the
recession phase of the business cycle.

o Full Employment- something less than 100% of the labor force. The economy is fully employed
when it is experiencing only frictional and structural Unemployment. The Natural Rate of
Unemployment (NRU) or Full Employment the economy is said to be producing its potential
output. This is the real GDP that occurs when the economy is fully employed. It does not mean
Zero Unemployment. The Current Rate of NRU is close to 4 or 5 %.
ECONOMIC COST OFUNEMPLOYMENT:
o Unemployment means that potential production of goods and services is lost.
o GDP gap = actual GDP potential GDP
o OKUNs LAW FOR EVERY 1 %THE ACTUAL rate exceeds the Real Rate , a negative GDP gap
of about 2% occurs. ( Example: The Unemployment Rate is 9.3% or 4.3% above the periods
natural rate of 5%. Multiply the 4.3% by 2 indicates the real Loss to potential GDP of 8.6 %.
UNEQUAL BURDENS:
o Cost is unequally spread among workers.
Occupation- workers in lower skilled jobs have higher unemployment rates than
workers in higher skilled occupations.
Age teenagers higher than adults.
Race and Ethnicity
Gender
Education
Duration

Non-economic costs- social catastrophe, loss of skills, self respect, family disintegration.
International Comparisons- U.S. unemployment rate is lower than the rates in foreign
countries.

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INFLATION:

Inflation is he rise in the general level of prices. It reduces the purchasing power of money.
Measurement of Inflation-the Consumer Price Index (CPI) reports the inflation rates
each month and year. It is used to adjust Social Security and tax rates. (Figure 9.4 )
o MARKET BASKET the CPI is based on spending patterns of urban consumers in
a specific period. It changes the basket make up every two years. The base year for the CPI
is 1982-1984, the formula for CPI is
CPI= price of he most recent market basket in the particular year x 100
Price estimate of the market basket in 1982-1984
EX; the rate of inflation is equal to the % growth of CP:I from one year to
next. 2006-201.6 and 2007 207.3
Rate of Inflation= 207.3-201.6 100= 2.8%
201.6

DEMAND PULL INFLATION- increase in the price level are caused b an excess of total spending
beyond the economys capacity to produce. The excess demand bids up the prices of the limited
output producing demand-pull inflation.

COST PUSH INFLATION- the mid 1970s the price level increased even though total spending was
not excessive. These were periods when output and employment were both declining- evidence that
total spending was no excessive while the general price level was rising. This theory explains rising
prices in terms of factors that raise per unit production costs at each level of spending. It is the
average cost of a particular level of output. It is found by dividing the total cost of all resource
inputs by the amount of output produced.
o Per Unit Production Cost = total input cost
Units of output
Example: Price of increase in oil resulted in surged upward in transporting virtually every
product in the economy, in the late 70s.

43

CORE INFLATION- Rapid changes in some flexible priced items within the market basket e.g.
food and energy result in month to month price volatility. Example: price of grains and livestock
move rapidly in one direction nor the other leading to sizable changes in prices of food items.
Therefore, food and energy are stripped from the CPI to provide a Core Inflation.

 Redistribution Effects of Inflation:

o Nominal Income- number of dollars received for wages, rent , interest or profit.
o Real Incomes is a measure of the amount of goods and services nominal income can buy; it
is the purchasing power of nominal income, or income adjusted for inflation.
Real Income =
nominal income
Price index (in hundredths)

ANTICIPATIONS:

Unanticipated Inflation- these cause real income and wealth to be redistributed, harming

some and benefiting others.

Anticipated Inflation- ability to see inflation in advance and planning ahead to avoid or lessen
the redistribution effects associated with inflation.

Who is hurt by inflation:

o Fixed Income Receivers- incomes are fixed see real incomes fall
when inflation occurs.
o Savers- prices rise the real value or purchasing power of an accumulation
of savings deteriorates.
o Creditors- loans are paid off with cheaper money which affects lenders.

WHO is Unaffected or Helped by Inflation:

Fixed Income Receivers- affects of cost of Living Adjustments.
Debtors-pay back loans with cheap dollars. This Includes the government,
federal, state or city repaying bonds.

ANTICIPATED Inflation
o Set Inflation Premiums as lender or consumer ;
o Real Interest Rate-percentage increase in purchasing power that the
borrower pays the lender.
o Nominal Interest Rate- percentage increase in money that the
borrower pays the lender
o Nominal Interest Rate =Real Interest Rate + Inflation Premium
(expected Rate of Inflation)

OTHER REDISTRIBUTION ISSUES:

44

Deflation- the reverse of those of inflation,

Fixed Nominal Incomes will find their real

incomes enhanced, creditors will benefit and savers will discover that purchasing power
has grown.
o Mixed Effects-a person both income earner and saver and debtor will probably find
that the impact of unanticipated inflation is cushioned.
o Arbitrariness- Effects of inflation occur regardless of societys goals and values.
o

COST PUSH INFLATION AND REAL OUTPUT:

o Economic events of the 70s provide and example of how inflation can reduce real output.
OPEC exerting market power quadrupled the price of oil. This generated rapid inflation
from 1973 to 1975 and unemployment rose from 5 % to 8.5%.
DEMAND PULL INFLATOIN ANDREAL OUTPUT
o Even low inflation less than3% has an effect on changes in production at a cost.
Hyperinflation is extraordinarily rapid inflation can have a devastating impact on real output and
employment.

CHAPTER 10 Macroeconomics Models and Fiscal Policy

Relationships that exist between three different pairs of economic aggregates:
o Income and Consumption or Saving
o The Interest Rate and Investment
o Changes in Spending and Output.
Personal Savings-that part of disposable (after tax) income not consumed.
o Savings (S) =Disposable Income (DI) Consumption
o 45 Degree Line- bisects the 90 degree angle formed by the two axes of
the graph Consumption and Disposable Income. C=DI.

THE CONSUMPTION SCHEDULE: (P 191 Table 10.1)

o The Consumption Schedule or Function reflects the direct consumption- disposable income
relationship suggested in data in Figure 10.1. It is consistent with many Household Budget
Studies- households increase their spending as their disposable income rises and spend a
larger proportion of a small disposable income than of a large disposable income.
o THE Saving Schedule or Function- to determine the amount Saved (S) subtract
Consumption (C) from Disposable Income to = Saved.

45

o Break Even Income- is the income level at which households plan to consume their entire
incomes (C=DI).
AVERAGE AND MARGINAL PROPENSITIES:
o The fraction or percentage of total income that is consumed is the average propensity to
consume (APC).
APC= Consumption
o Income
AND
APS= Saving
o Income
APC+APS =1 (100%)
Example p. 195
MPC and MPS the fact households consume a certain proportion of a particular total incomes,
does not guarantee they will consume the same proportion of any change in income the might
receive.
o MPC- Marginal Propensity to Consume- the extra or a change in MPC is the ratio of a
change in consumption to a change in the income that cause the consumption change:
MPC= Change in Consumption
Change In Income
o MPS- the fraction of any change in income saved is the marginal propensity to save.
MPS= Change in Saving
Change in Income
o MPS+MPC = 1 for any change in disposable income.
o MPC And MPS Slopes is the numerical value of the slope of the Consumption Schedule and
the Savings Schedule
Example:
MPC Change in DI is $20 billion, change in C is $ 15 billion or 15/20= .75
MPS Change in DI is $5 billion S the value of slope of MPS is 5/20= .25
MPC Slope + MPS Slope =1 = .75+.25

Non income Determinants of Consumption and Saving

o Disposal Income is the basic Determinant of the amounts households will consume and
save.
o Other Determinants:
Wealth- the dollar amount of all the assets that it owns minus the dollar amount of
its liabilities (A=L+OE).
Wealth Effect- shifts the consumption schedule upward and the saving
downward. ( The More You Make the More You Spend)
Reverse Wealth Effect- in 2008, plunging real estate and stock market
prices joined together to erase $11.2 trillion of household wealth. This
reduced consumption Schedule .
46

Borrowing- increases current consumption beyond what would be possible if its

spending were limited to its DI.
Expectations- household expectations about future prices and income may affect
current spending and saving. (House Mortgage).
Real Interest Rates- as rates fall borrow more and consume more and save less.
Lower Rates reduce monthly loan payments and induces consumers to purchase
autos and other goods bought on credit.
Taxation- taxes are paid partly at the expense of consumption and savings, shifts
the schedules I nthe same direction.
Stability- the schedules are stable unless altered by Major tax Increase or
Decrease.

REVIEW:
o Both Consumption an Saving rises when DI increases both fall when DI decreases.
o The Average Propensity to Consume (APC) is the fraction of any specific level of DI that is
spent on consumer goods and the (APS) Average Propensity to Save is the fraction of any
specific level of DI saved. APC falls and APS rises as DI increases.

THE INTEREST RATE INVESTMENT RELATIONSHIP:

o Investment consist in expenditures on new plants, capital equipment, machinery and
inventories.
o The Investment Decision is a Marginal Benefits and Cost Decision.
Marginal Benefits (MB) the expected Rate of Return on Investment
Marginal Cost is the Interest Rate that must be paid.
Businesses will invest in all projects for which the expected rate of return exceeds
the interest rate.
A project has a 10% Expected Rate of Return (r) it is the expected rate not
the guaranteed.
Interest the financial cost of borrowing capital to purchase equipment for a
project is computed by multiplying the Interest Rate 7% (i) times Loan
Amount will reduce the Expected Rate of Return by the Interest or in an
example of $1000/x 7%= $70 If the Return on $1000 was 10% or $100 The
Real Interest Rate would be the Expected the Interest for Actual Return.
Inflation Factor reduces the value of the dollar by the Inflation Rate.

Investment Demand Curve: determines the Expected Rate of Returns from ALL investment
projects. Set an Expected Rate of Return for Projects

o Projects should be undertaken up to the point where :

Return (r) =Interest Rate (i)
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 NON INTEREST RATE DETERMAINANTS OF INVESTMENT DEMAND :

o High or Lower operating Cost drive the Investment Demand Curve to right or left.
(up or down)
o Business Taxes Expected returns after taxes in making decision, an increase lowers the
profitability and shifts curve to left.
o Technological change- stimulates investment, lowers production cost.
o Stock of Capital Goods on Hand when the economy is overstocked of production
facilities and firms have excessive inventories of finished goods, the expected rate of return
on new investment declines.
o Planned Inventory Changes firms are expecting either faster or slower sales.
o Expectations- capital goods are durable and last years thus the expected return on
capital investment depends on the firms expectations.

INSTABILITY OF INVESTMENT- Investment is the most volatile component of total

spending.
o Variability of expectations quickly change when some event suggests a significant
possible change in future business conditions.
o Durability- Capital goods have indefinite useful life spans, within limits purchases of
capital goods are discretionary and can be postponed.
o Irregularity of Innovation- new products and processes stimulate investment.
o Variability of Profits- high current profits generate optimism abut the future
profitability of new investments. A portion of Retained Earnings set aside and use to
finance new investments.
o Pessimism- during the Great Recession contributed to low expectations of return on
investment and thus a weak investment demand.

MULTIPLIER EFFECT-Changes in spending and Real GDP.

More spending results in higher Real GDP
A change in spending ultimately changes output and income by more than the initial
change in spending, The Multiplier Effect.
The Multiplier Effect-determines how much later the change will be, it is the ratio of
a change in GDP to the initial change in spending.
o Multiplier = change in real GDP
Initial change in Spending
Example: Investment increases $30 billion, GDP $90
billion the Multiplies is 3=90/30
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o Rationale P 204 (Pass the Dollar ) Figure 10.8 p. 205

Multiplier MULTIPLIER AND THE MARGINAL PROPENSITIES:
o

THE MPC AND THE mps DETERMINE THE CUMULATIVE RESPENDING EFFECTS OF ANY
INITIAL CHANGE IN SPENDIGN AND DERTERMINE HE SIZE OF THE MULTIPLIER.

o FORMULAS:
Multiplier=

1-MPC
MULTIPLIER =
1

MPC+MPS = 1

MPS

Example:

MPS is .2 businesses increase investment by $5 Billion.

Savings will increase by $1 Billion
Consumption increase by $ 4 Billion

.2x $5 = $1 Billion
.8x $5 = $4 Billion

THE AGGREGATE EXPENDITURES MODEL CHAPTR 11

The Keynesian Cross Model- origins with John Maynard Keynes, 1936, is
that the amount of goods and services produced an the level of employment depend directly on the
level of aggregate expenditures(total spending). Businesses will produce only a level of output that
they think they can profitably sell. The most fundamental assumption behind the aggregate
expenditures model is that prices in the economy are fixed. It is an extreme model of the Sticky
Price Model Prices before the Great Depression had not dropped enough to continue GDP at the
pre Depression levels. Real GDP dropped 27 % from 1929 to 1933.and the unemployment rate
rose to 25 %. As households and businesses greatly reduced their spending, inventories of unsold
goods rocketed. Unable or unwilling to cut their prices, firms could not sell all the goods they had
already produced. So they greatly, reduced current production, closing more factories and
increasing unemployment and reducing consumption.

PRIVATE CLOSED ECONOMY- WITHOUT INTERNATIONAL TRADE:

The two components of aggregate expenditures are :
o (C) Consumption
o (Ig) Gross Investment
o Add the investment decisions of businesses to the consumption plans of
households. Requires an Investment Schedule showing the amounts of
business firms collectively intend to invest their Planned Investment- at
each possible level of GDP.
EQUILIBRIUM GDP- output whose production creates total spending just sufficient to purchase
that output.
o It is the level at which the total quantity of goods produced (GDP) equals the total
quantity of goods produced.
49

o Equals the total quantity of goods produced (C+Ig).

o There is no over production nor is there an excess of total spending, which would draw
down inventories of goods and prompt increases in the rate of production.
o Savings and planned investment (S=Ig)
o There are no Unplanned changes in Inventory.

Disequilibrium- No level of GDP other than Equilibrium can be sustained. Example: firms
produced $410 billon of GDP it would yield $405 billion in consumer spending, supplement by $20
billion in planned investment, aggregate expenditures (C+ Ig) would be $425 billion. The economy
would provide an annual rate of spending more than sufficient to purchase the $410 billion of
production. Consumers would purchase goods quicker than firms could produce and unplanned
decline in business inventories of $15 billion would occur.

SAVINGS EQUALS PLANNED INVESTMENT:

o Savings is a leakage or withdrawal of spending from the economys circular flow of income
and expenditures. It is what causes consumption to be less than total output or GDP.
If the leakage of savings at a certain level of GDP exceeds the injection of
investment, then C+Ig will be less than GDP an that level of GDP cannot be
sustained. Any GDP for which saving exceeds investment is an above equilibrium.
o Capital Goods are sold by businesses to other businesses. These purchases are an
Investment in the future an injection of spending into the income expenditures stream.
(Table11.2 p214).
o S=Ig where the leakage of saving is exactly offset by the injection of planned investment
will aggregate expenditures equal real output (GDP).
o Planned changes In INVENTORIES firms may decide to increase or decrease their
inventories, there are no unplanned changes in inventories at equilibrium GDP.

CHANGES IN EQUILIBRIUM GDP AND HE MULTIPLIER:

o Formula : Multiplier = _Change in real GDP
Initial change in Spending
o Size of he multiplier depends on the size of the MPS in the economy.
Multiplier=
1
MPS
o If he expected rate of return on investment decreases or if the real interest rate
rises, investment spending will decline.

PRIVATE OPEN ECONOMY:

o A Closed Economy becomes open when we include Exports (X) and
Imports (M).
o

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Net Imports are exports imports

NET EXPORTS AND AGGREGAE EXPENDITURES:

o Exports create domestic production, income and employment for a nation.
o Open Economy Formula: C+Ig+(X-M) or Net Exports (Xn) = (X-M)
o If the Net Export Schedule is Xn1, it is accounted for by adding it to the C+Ig
schedule, this increases the aggregate expenditures schedule by this amount. If this amount
is $5 billion in Xn1, then the Multiplier of 4 adds $20 billion to the GDP in an Open
Economy.
o If the imports are more than exports by $5 billion, then we deduct $20 billion from
the GDP.

INTERNATIONAL ECONOMIC LINKAGES:

o Prosperity Abroad- a rising level of GDP among US foreign trading partners enables
the US to sell more goods abroad thus raising US net exports and increasing US real GDP.
o Exchange Rates- depreciation of the dollar relative to other currencies enables people
abroad to obtain more dollars with each unit of their own currencies. The price of US goods
in terms of those currencies will fall stimulating purchases of US exports. Ex: Euro.
o TARIFFS AND DEVALUATIONS- Higher net exports increase real GDP,
countries often retaliate and impose their tariffs and taxes.

THE PUBLIC SECTOR FACTOR:

o
o
o
o

A Private Open Economy to a Mixed Economy- including Government expenditures.

Government expenditures of $20 billion add $80 billion to the GDP by the multiplier.
Government Purchases (G) Formula: C+ Ig+ Xn+ G= GDP
A DECLINE IN GOVERNMENT EXPENDITURES RESULT IN A MULTIPLIED
DECLINE I N THE EQUILIBRIUM, REDUCE $20 Billion to $10 Billion, reduces GDP by
$40 Billion.

GOVERNMENT TAXATION:
o Government spends and collects taxes.
o Lump sum Tax a tax of a constant amount or yielding he same amount of revenue at each
level of GDP.
o Households use DI both to consume and save, the tax lowers both.
o Example: MPC.75 the government tax collection of $20 billion will reduce consumption by
$15 billion= .75x $20 billion and MPS is .25 Saving will drop by $5 billion =.25x $20 billion.
o Taxes reduce DI relative to GDP by the amount of the taxes.
o A Decrease in existing rates will raise he AE schedule as a result of an increase in
consumption at all GDP levels.

Injections, Leakages an Unplanned changes in Inventories:

o Injections into the income-expenditures stream = leakages from the income stream.
o Saving, Importing and Paying Taxes are all uses of Income that subtract from Consumption.

51

o Consumption will now be less than GDP creating potential spending gap, in the amount of
after tax savings (
(Sa), imports (M) and taxes (T), but exports (X) and Govt. purchases (G) along with
investment (Ig) are injections into the income-expenditures steam.
o The sum of the leakages = the sum of injections.
Sa+M+T=Ig+X+G

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