Interest rate and Investment Demand

How does business make investments decision?
-cost/benefit analysis
How determine business?
-expected rate of returns
How business count cost?
-interest cost
How business determine amount investment they undertake?
-compare expected rate of return to interest cost
-if expected return> interest cost, then invest 
- if expected return< interest cost, then do not invest. 


Real vs. Nominal:
 
What is the difference?
-nominal is the observable rate of interest. Real subtracts out inflation (pi%) and is only known ex post facto. 
What then determines the cost of investment decisions? 
-the real interest rate (r%)

What is the shape of the investment demand curve? 
-downward sloping
Why?
-when interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable. 

Shifts in investment Demand:
-cost of production
-business taxes
-technology change
-stock of capital
-expectations

Consumption and Savings

Consumption

-Household spending

-The ability to consume is constrained by

          -The amount of disposable income

          -The propensity to save

-Do households consume if DI = 0?

          -Autonomous consumption

          -Dissaving

Saving

-Household NOT spending

-The ability to save is constrained by

          -The amount of disposable income

-The propensity to consume

          -Do households save if DI = 0?

               -No

APC & APS (Average Propensity to Consume & Average Propensity to Save)

-APC + APS = 1

-1 – APC = APS

-1 – APS = APC

-APC > 1 = Dissaver

-–APS = Dissaver

MPC & MPS

-Marginal Propensity to Consume

          -Change in consumption / change in disposable income

          -% of every extra dollar earned that is spent

-Marginal Propensity to Save

          -Change in saving / change in disposable income

          -% of every extra dollar earned that is saved

          -MPC + MPS = 1

          -1 – MPC = MPS

          -1 – MPS = MPC

Determinants of C & S

-Wealth

-Expectation

-Household Debt

-Taxes

MPC, MPS & Multipliers
-The Spending Multiplier Effect
          -An initial change in spending (C, IG, G, Xn) causes a large change in aggregate spending or
           Aggregate Demand (AD).
          -Multiplier = change in AD / change in spending
          -Multiplier = change in AD / change in C, I, G, or Xn
          -Why does it happen?
               -Expenditures and income flow continuously which sets off a spending increase in the economy.
  
Calculating the Spending Multiplier
-The spending multiplier can be calculated from the MPC or the MPS
-Multiplier = 1/1-MPC or 1/MPS
-Multipliers are (+) when there is an increase in spending and (-) when there is a decrease

Calculating the Tax Multiplier
-When the government taxes, the multiplier works in reverse
-Why?
          -Because now money is leaving the circular flow
-Tax Multiplier (note: it’s negative)
          -= -MPC / 1-MPC or –MPC / MPS

-If there is a tax cut, then the multiplier is +, because there is now, more money in the circular flow

Aggregate Supply & Aggregate Demand

Recessionary Gap
-A recessionary gap exists when equilibrium occurs below full employment output


Inflationary Gap
-An inflationary gap exists when equilibrium occurs beyond full employment output



Classical

-Competition is good
-Believes in the invisible hand
-In the LR the economy will balance at FE
-Trickle Down Effect - Help the rich first and everybody else second


Keynesian

-Competition is flawed
-In LR, we are all dead


LRAS (Long Run Aggregate Supply)
-Deals with potential output

LRAS Shifts

-Technology
-Capital Resources
-Growth
-Entrepreneurship
-Resources Available

Aggregate Demand

-Aggregate Demand- shows the amount of Real GDP thats public, private and foreign sector collectively desire price level.

- The relationship between price level and the level of Real GDP is more inverse.

Downward Slope:

- Real GDP Balance effect:

  -When price level is high, households and businesses cannot afford to purchase as much output 

  -When the price level is low, households and businesses cannot afford to purchase more output

Interest Rate Effect:

 - higher price level increases the interest rate tends to discourage investments

 - lower price level decreases the interest rate tends to encourage investments

Foreign Purchase Effect:

 -higher price level increases the demand for relatively cheaper imports

 -lower price level increases the foreign demand for relatively cheaper U.S exports

Shifts A.D.

- C, Ig, G, Xn

- multiplier effect that produces a greater change in the 4 components

- increase in AD = AD ->

- decreases in AD = AD <-

Consumption:

-consumer wealth

*more wealth = more spending (<-)

* less wealth = less spending (->)

-consumer expectations

*positive expectations = more spending (->)

*negative expectations = less spending (<-)

-households indebtedness

*less debt = more spending (->)

*more debt = less spending (<-)

-taxes

*less taxes = more spending (->)

*more taxes = less spending (<-)

Determinants of SRAS 
-input prices
-productivity
-legal institutional environment

Domestic Resource Price 
-wages
-cost capital
-raw materials

Foreign
-strong $ = lower
-weak$ = higher 

Market Power
-monopolies and cartels that controls resources control money
*increase in resource prices = SRAS <-
*decrease in resource $ = SRAS ->
-Productivity = Total output
                         Total input
-more productivity = lower unit productivity cost = SRAS ->
-less productivity = higher unit productivity cost = SRAS <-

Taxes and Subsidies
-taxes ($ to government) on business increase per unit production cost = SRAS <-
-subsidies ($ to government) to business reduce per unit production cost = SRAS ->

Government Regulation
-gov't regulation creates a cost of compliance = SRAS <-
-deregulation reduces compliance cost = SRAS ->

Unemployment

Unemployment: % of people that don't have jobs but they're in the labor force.
In Labor Force- have to be employed + unemployed

No labor force:
Kids
Military
Mentally insane
Prison
Stay at home moms and dads
Full time students
Retirees
Discouraged workers= job lookers with no job

Employed: 16 years or older with job
Unemployed: 16 years or older with no job & actively looking for a job for 2 weeks

Unemployment rate: # of unemployment x 100
                                          Labor force (# or unemployed + # of employed)

Types of Unemployment:
1. Seasonal
2. Frictional
3. Structual
4. Cyclical

Full employment: (Natural rate of unemployment) = 4-5%
Okun's Law: for every 1% of unemployment above the NRU causes a 2% decline in Real GDP.

Inflation

Cost Push: higher production cost which increases prices, usually result of supply shock. Increases cost force producers increase prices.
Demand Pull: too many dollars chasing few goods. Demand pulls prices, therefore you create a shortage and an overheated economy with excessive spending.
Political panic: Depression or recession.
How inflation helps:
Hurts
- lenders (loan money at fixed rate)
- people with fixed income
- people with fixed wages

Helps
Debtors

GDP

GDP: Gross Domestic Product: total value of all final goods and services produced within a country's borders within a given year.

GNP: Gross National Product- total value of all final goods and services produced by American in a given year. (opposite G.D.P)

GDP:
-all production on income earned in the U.S
INCLUDED:
-final goods/services
-income earned
-interest payments on corp. bonds
-currents production of final goods
-unsold outputs (business inventions)
EXCLUDED:
-intermediate goods ex: tire of a car
- transfer payments:
  -S.S
  -unemployment compensation
  - scholarship
  - no cell of stocks/bonds
  -used or second hand goods
  - nonmarket transaction
  -babysitting
  - illegal drugs
  -prostitution
  - personal crops
  - self repair

GDP= C+Ig+G+Xn
GDP= W+R+I+P
Budget= Transfer payments+Gov. Purchase Goods/Services
Budget= (+deficit) (- surplus)
Trade= Exports-imports
            (+surplus) (-deficit)

Nominal GDP- value of output produced in current prices.
Real GDP- value of output produced in constant or base year prices.
Nominal GDP- can increase from year -year, if either output or price increases (inflation).

Nominal GDP= P x Q
Real GDP can increase if output increases ONLY! (economic growth)
Real GDP= P x Q

GDP Deflator:
Nominal GDP x 100 = GDP Deflator
 Real GDP
*Base year will always be 100
- years after base year, GDP deflator will be greater than 100
-years before base year, GDP deflator will be less than 100

Consumer Price Index:
* Cost market basket in a given year x 100
   Cost market basket in a base year
- measures the cost of the market basket of goods of a typical urban american family
* Real GDP is adjusted for inflation
Inflation- general rise of price level
Deflation- fall of price level
Rate of inflation: CPI2-CPI1 x 100
                                CPI1