Only $2.99/month

Terms in this set (154)

7. Scharf sells T-shirts. When she sells 35 T-shirts, it costs her a total of $40, and when she sells 36 T-shirts, it costs her total of $45 Based on this information, which is definitely true.

A. It would be irrational for Scarf to sell any T-shirts for less than $40.
B. It would be irrational for Scharf to sell the 36th T-shirt unless she received at least $45 for it.
C. Scharf shouldn't sale T-Shirts as it will never be possible for her to make a profit.
D. It would be irrational for for Scharf to sell the 36th T-shirt unless she received at least $5 for it.

1. 35/40=$.8705 per shirt
2. Marginal cost of $1 (rounded) - Marginal cost of extra unit of t-shirt at $5= NET LOSS OF -4$
3. So long as the marginal benefit of the next unit of something is AT LEAST AS GREAT as the cost of that unit, the consumer should/will ALWAYS PURCHASE THE NEXT UNIT.
4. She would have to receive at least $5 which is the cost of selling it.

The total cost of producing 36 units is $45 and the total costs of producing 35 units is $40, so the MARGINAL COST OF PRODUCING THE 36TH UNIT IS $45-$40=$5.00. Thus, a rational decisionmaker will sell the 36th unit if she can get at least as great as the cost of that unit or $5.00 for it.

8. Which of the following would be considered capital?
A. The money raised to start a business.
B. A factory.
C. A worker.
D. Electricity.

Capital is sth made (built or produced) and that is used to produce other things. Electricity and other forms of energy are natural resources.
Factors affecting price elasticity of demand

1. The number of close substitutes - the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch.

2. The cost of switching between products - there may be significant costs involved in switching. In this case, demand tends to be relatively inelastic. For example, mobile phone service providers may insist on a12 month contract.

3. The degree of necessity or whether the good is a luxury - necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.

4. The proportion of a consumer's income allocated to spending on the good - products that take up a high % of income will tend to have a more elastic demand

5. The time period allowed following a price change - demand tends to be more price elastic, the longer that consumers have to respond to a price change. They may search for cheaper substitutes and switch their spending.

6. Whether the good is subject to habitual consumption - consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).

7. Peak and off-peak demand - demand tends to be price inelastic at peak times and more elastic at off-peak times - this is particularly the case for transport services.

8. The breadth of definition of a good or service - if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.
If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is: Percentage change in quantity supplied divided by the percentage change in price: (Es+%changeQs/%changeP)

When Pes > 1, then supply is price elastic (unit normal curve)
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic (vertical supply curve)
When Pes = infinity, supply is perfectly elastic following a change in demand (horizontal supply curve)

What factors affect the elasticity of supply?

1) Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand.
--The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.

2) Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity in the market.

3) The ease and cost of factor substitution: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. A good example might be a printing press which can switch easily between printing magazines and greetings cards.

4) Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels.
--In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield.
--In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place.
A PRICE CEILING occurs when the government puts a legal limit on how high the price of a product can be. In order for a price ceiling to be effective, it must be set below the natural market equilibrium.

When a price ceiling is set, A SHORTAGE OCCURS shortage occurs. For the price that the ceiling is set at, there is more demand than there is at the equilibrium price. There is also less supply than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied. An inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss.

A price floor is the lowest legal price a commodity can be sold at. Price floors are used by the government to prevent prices from being too low. The most common price floor is the minimum wage--the minimum price that can be payed for labor. Price floors are also used often in agriculture to try to protect farmers.

For a price floor to be effective, it must be set above the equilibrium price. If it's not above equilibrium, then the market won't sell below equilibrium and the price floor will be irrelevant.

1. gov control of quantity= quota;
2. gov control of price = price ceiling
3. any quantity below or above equilibrium price = deadweight loss and a reduction in total surplus; NOT EFFICIENT; NOT COMPETITIVE
4. Deadweight loss is simply the dollar value of all the mutually beneficial transactions (consumers/producers) that are lost because of something that prevents the market equilibrium from being reached.
The Bureau of Labor Statistics does not count discouraged workers as unemployed but rather refers to them as only "marginally attached to the labor force".

This means that the officially measured unemployment captures so-called "frictional unemployment" and not much else.[8] This has led some economists to believe that the actual unemployment rate in the United States is higher than what is officially reported while others suggest that discouraged workers voluntarily choose not to work.[9] Nonetheless, the U.S. Bureau of Labor Statistics has published the discouraged worker rate in alternative measures of labor underutilization under U-4 since 1994 when the most recent redesign of the CPS was implemented.[10][11]

The United States Department of Labor first began tracking discouraged workers in 1967 and found 500,000 at the time.[12] Today, In the United States, according to the U.S. Bureau of Labor Statistics as of April 2009, there are 740,000 discouraged workers.[13][14] There is an ongoing debate as to whether discouraged workers should be included in the official unemployment rate.[12] Over time, it has been shown that a disproportionate number of young people, blacks, Hispanics and men, make up discouraged workers.[15][16] Nonetheless, it is generally believed that the discouraged worker is underestimated because it does not include homeless people or those who have not looked for or held a job during the past twelve months and is often poorly tracked.[12][17]

According to the U.S. Bureau of Labor Statistics, the top five reasons for discouragement are the following:[18]

The worker thinks no work is available.
The worker could not find work.
The worker lacks schooling or training.
The worker is viewed as too young or too old by the prospective employer.
The worker is the target of various types of discrimination.
Employees in poor bargaining positions lose out - for example people in low paid jobs with little or no trade union protection and my see the real value of their pay fall when inflation is high. In this sense, inflation can cause an arbitrary redistribution of income.

Inflation can favour borrowers at the expense of savers because inflation erodes the real value of existing debts. And the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers.

Inflation can disrupt business planning - although businesses are aware of what has happened to prices in the past, they cannot be certain what will happen in the next few months and years. Budgeting becomes difficult and this may reduce planned investment spending. Lower investment has a detrimental effect on the economys long run growth potential.

Inflation is a possible cause of higher unemployment - particularly if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their international trade performance. If inflation in the UK economy is significantly above that of our major trading partners, British exporters may struggle to maintain their share in international markets and import penetration into our domestic economy would be expected to grow. Both factors could lead to worsening balance of payments problems.

Rising inflation is associated with higher interest rates because the independent Bank of England seeks to control inflationary pressure by raising the level of base interest rates this reduces economic growth and can lead either to a slowdown or (worse) a recession.
Nominal vs Real Interest Rate and Effective Rate

Nominal Interest Rate:
--the stated interest rate of a given bond or loan.
--referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. T
--in essence is the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.

Real Interest Rate:
--The nominal interest rate doesn't tell the whole story due to inflation's impact on purchasing power of lender or investor
--real interest rate is so named because it states the "real" rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate.
--If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%.
--it's the actual mathematical rate at which investors and lenders are increasing their purchasing power with their bonds and loans.
--possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%.

A comparison of real and nominal interest rates can therefore be summed up in this equation:

Nominal interest rate - Inflation = Real interest rate
Several economic stipulations can be derived from this formula that lenders, borrowers and investors can use to make more informed financial decisions.

Real interest rates can not only be positive or negative, but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But real rates can also exceed nominal rates during deflation periods.
A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.

Effective Interest Rate
One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account. For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%. Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Note that the rules pertaining to how the AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR).
--DOWNWARD SLOPING due to the principle that people will consume different amounts at different price levels; whereas the demand curve sloped downward in Micro-economics due to the law of demand

Slopes downward (movement down ALONG the curve) for three reasons:

1) wealth effect (aka Pigou wealth effect) WHEN THERE IS AN INCREASE IN THE PRICE LEVEL, THE PURCHASING POWER OF MONEY GOES DOWN and people are less able to purchase at increased price levels;

2) interest-rate effect - When price level goes up, people need to hold onto more money to make purchases as opposed to putting into bank assets, then the bank has less money to lend out and that drives interest rates up; WHEN INTEREST RATES INCREASE, INVESTMENTS DECREASE (the i part of the AD), thus as price level increases, amount of AD decreases

3) Exhange-rate effect: When price level in one country increases, people naturally try to substitute with goods and services from other countries and IMPORTS INCREASE which increase the supply and lowers demand and imports are NOT a part of our output (GDP) so not helpful to the economy.

Shifts: When AD increases it shifts outward (to the right); when AD decreases it shifts inward (to the left); several factors cause this:
--changes in expectations: if consumers and firms pessimistic about the future will save more and spend less; if optimistic
--changes in wealth
--government fiscal (increases/decreases spending or taxes) and monetary policies (Fed controls money supply to influence interest rates, which influences C and I of AD.

REMEMBER IF SOMETHING AFFECTS C, I, G, X OR M through something besides the price level, it WILL change the AD.
How to Know which ones to use?

If showing a change in wage costs or oil prices, I would use a SRAS.
For showing Long run economic growth, and an increase in capital stock and investment I would show a shift in LRAS.

Keynesian view of LRAS:
A further complication is that there are different views of the LRAS. The Classical view is an inelastic LRAS. The Keynesian view suggests it is elastic at a point up to inelastic. In a sense the Keynesian view is a combination of the short run aggregate supply and long run. The Keynesian LRAS shows that there is a point in the economy of spare capacity where firms can use more. There also comes a point where full capacity is reached.

1) SRAS is upward sloping, which means higher levels GDP supplied are associated with higher price levels, in the short run, even though it doesn't make sense intuitively, three main theories for this:
a) Misperceptions theory
b) sticky price theory (don't respond quickly)
c) sticky wage theory (contracted for, etc.)

2) LRAS is vertical: In the long run, prices have had a chance to fully adjust and the level of production is independent to the price level


1) LRAS shifts when CONDITIONS change for inputs to production (land, labor, capital, and technology); when the stock of these increases - - LRAS shifts to the right; when the stock of these decreases --LRAS shifts to the left

2) SRAS shifts when PRICES of one or more of inputs to production change - - if labor, etc. increases, then SRAS shifts to the left, short run supply decreases; if labor etc decreases, supply increases (shift to the right)
Aggregate Supply Determinants (Shifting)

An assortment of ceteris paribus factors that affect short-run and long-run aggregate supply, but which are assumed constant when the short-run and long-run aggregate supply curves are constructed. Changes in any of the aggregate supply determinants cause the short-run and/or long-run aggregate supply curves to shift. While a wide variety of specific ceteris paribus factors can cause the aggregate supply curves to shift, they are commonly grouped into three broad categories--resource quantity, resource quality, and resource price.

Aggregate supply determinants are held constant when the aggregate supply curves are constructed. A change in any of these determinants causes a shift of either the short-run aggregate supply curve, the long-run aggregate supply curve, or both.
The assortment of aggregate supply determinants fall into three categories (1) resource quantity--the amounts of labor, capital, land, and entrepreneurship available, (2) resource quality--the productivity of the four factors of production, and (3) resource price--the prices of the inputs used in production.

While a complete list is lengthy, four specific determinants that tend to stand out in the study of macroeconomics and aggregate market (AS-AD) analysis are:

Wages: This is the price of labor, which works through the resource price determinant. It is the key determinant underlying the self-correction mechanism of the aggregate market. Wages affect the short-run aggregate supply curve, but not the long-run aggregate supply curve.

Technology: Improvements in production techniques, often embodied in product inventions and innovations, is a prime example of a resource quality determinant. Technology causes shifts in both the short-run and long-run aggregate supply curves.

Energy Prices: These are the prices of key energy inputs, especially petroleum, that are essential to any modern industrialized economy. Like wages, energy prices also work through the resource price determinant. Also like labor, energy prices affect the short-run aggregate supply curve, but not the long-run aggregate supply curve.

Capital Stock: This is the total quantity of capital used by the economy for production. It is a prime example of a resource quantity determinant and affects both the short-run and long-run aggregate supply curves.
Other determinants of aggregate supply, each important in its own right, include education',500,400)">education, population growth, labor-force participation, resource exploration, and assorted material input prices.
The aggregate supply determinants shift both the short-run aggregate supply curve, abbreviated SRAS, and the long-run aggregate supply curve, abbreviated LRAS. The exhibit to the right presents a standard short-run aggregate supply curve in the top panel and a typical long-run aggregate supply curve in the bottom panel.
The short-run aggregate supply curve is positively sloped and captures the specific one-to-one relationship between the price level and real production.

The long-run aggregate supply curve is vertical at the full-employment level of production, indicating that real production is independent of the price level.
The ceteris paribus factors, that is, the aggregate supply determinants, are assumed to remain constant when these curves are constructed. Similar to other determinants, the aggregate supply determinants shift these two aggregate supply curves. A change in any of the determinants can increase or decrease one or both of the aggregate supply curves.

Short-Run Aggregate Supply: Consider first the short-run aggregate supply curve. An increase in short-run aggregate supply is illustrated by a rightward shift in the SRAS curve in the top panel. A decrease in short-run aggregate supply is illustrated by a leftward shift. Click the [Increase in SRAS] or [Decrease in SRAS] buttons for a demonstration.

Long-Run Aggregate Supply: Now consider the long-run aggregate supply curve. An increase in long-run aggregate supply is illustrated by a rightward shift in the LRAS curve in the bottom panel. A decrease in long-run aggregate supply is illustrated by a leftward shift. Click the [Increase in LRAS] or [Decrease in LRAS] buttons for a demonstration.

What does it mean to have an increase in supply? It means that for every price level, the business sector is willing and able to supply more real production. A decrease in supply is obviously the exact opposite. For every price level, the business sector is willing and able to supply less real production.
Three Basic Determinants

Resource Quantity: The first major determinant is the quantity of resources--labor, capital, land, and entrepreneurship--that the economy has available for production. This determinant causes shifts of both the SRAS and LRAS curves. Quite simply, if the economy has more resources, then aggregate supply increases and both aggregate supply curves shift rightward. With fewer resources, aggregate supply decreases and both curves shift leftward.

Some of the specific determinants that can cause changes in resource quantity include:

Population: The total size of the population, which is affected by births, deaths, and migration, is a key influence on the quantity of labor. A larger population means more potential workers. While population generally increases through both natural growth and immigration, it can decrease as well. Reasons for a declining population including emigration, wars, famines, diseases, and natural disasters.

Labor Force Participation Rate: The labor force participation rate is another key influence on the labor quantity. A change in the proportion of a given population that is willing and able to work changes the labor force and shifts the aggregate supply curves. The U.S. economy, for example, has seen an increase in its labor force participation rate over the last 50 years largely through an increase in the proportion of women in the labor force.

Capital Stock: Changes in the economy's stock of capital is the most important influence on the quantity of capital. These changes are brought about through a combination of investment and depreciation. Investment adds to the capital stock and depreciation reduces it. Investment has the curious role of affecting both the aggregate demand curve, as one of the four aggregate expenditures, and the aggregate supply curves, by influencing the capital stock.

Exploration: Discovering new sources of raw materials or other natural resources influences the quantity of land. While the economy is unlikely to "discover" large masses of land like explorers did a few centuries back, exploration does identify mineral deposits, fossil fuel reserves, and other natural resources that increases the aggregate supply curves. Alternatively, depletion of existing natural resources causes a decrease in the aggregate supply curves.
Resource Quality: The second major determinant of the aggregate supply curves is the quality of resources. If the quality of labor, capital, land, and entrepreneurship changes, then the SRAS and LRAS curves shift. An improved quality increases aggregate supply and a decline in quality decreases aggregate supply.
Education: Education includes formal, college-type, get-a-degree education, and informal on-the-job training and learn-by-doing experiences. Education affects the quality of labor. Higher quality labor, brought about by more education, is more productive and causes the aggregate supply curves to increase. Of course, it is also possible for less education to reduce the quality of labor and cause the aggregate supply curves to decrease.

Technology: Technology is the information that the economy has concerning production techniques. Technology generally affects the quality of capital, but can also peripherally affect the quality of labor, land, and entrepreneurship. In modern times, technology has invariably advanced, causing increases in the quality of capital and thus increases in aggregate supply. It is, however, possible for a technological backstep that would cause a decrease in the quality of capital and aggregate supply.
Resource Price: The third major aggregate supply determinant is resource price. The prices of resource affect the cost of producing output and thus the price level charged for an existing quantity of real production. This determinant ONLY affects the short-run aggregate supply. Because the long-run aggregate supply is independent of the price level it is also unaffected by changes in resource prices and production cost.
Two of the more important resource prices that influence production cost and shift the SRAS curve are:

Wages: Wage payments to labor are usually at the top of any list of resource prices. Wages account for about 60 percent of production cost of the economy. Economy-wide changes in wages shift the SRAS curve. Higher wages, by increasing production cost, cause a decrease short-run aggregate supply. Lower wages, by decreasing production cost, cause an increase short-run aggregate supply.

Energy Prices: Energy prices, especially petroleum prices, are a second key group of resource prices. Because energy, like labor, is critical in the production of virtually every good and service in the economy, changes in energy prices also tend to shift the SRAS curve. Like wages, higher energy prices increase production cost and cause a decrease short-run aggregate supply. Lower energy prices decrease production cost and cause an increase short-run aggregate supply.
Two Changes

Shifts of the short-run or long-run aggregate supply curve, brought about by such things as education or technology, an increase in the size of the population or the capital stock, or changes in wages or energy prices, can be the source of disequilibrium in the aggregate market. Such disequilibrium then results in changes in the price level. The key is that aggregate supply determinants CAUSE shifts of the aggregate supply curves which CAUSE disequilibrium which then CAUSES changes in the price level.
This suggests an important difference between two related changes--a change in aggregate supply and a change in real production.

A change in aggregate supply is any shift of either of the aggregate supply curves. With this change, the entire curve shifts to a new location. A change in aggregate supply is caused by a change in the aggregate supply determinants. This is comparable to a change in supply in the analysis of the market.

A change in real production is a movement along a given aggregate supply curve. This change involves the movement from one point on the existing curve to another point on the SAME curve. The curve does not move. A change in real production is caused by a change in the price level, and ONLY a change in the price level! This is comparable to a change in quantity supplied in the analysis of the market.

While a change in real production, as a movement along the curve, applies in principle to both short-run and long-run aggregate supply curves, because real production does not change in the long run, from a practical standpoint, a change in real production primarily applies to the short-run aggregate supply curve.

Shorter table on page 236 with Column Headings:

Change . . . Effect (shift) . . . Price Level Result . . . Output Result . . . Unemployment Result
A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities, but there are risks in the market that any investor needs to be aware of including the risk of default on securities such as commercial paper.

The money market is different from the capital market.


Money demand curve: how much money people are willing to hold at various interest rates due to the opportunity cost of holding money - the interest rate.

Changes in factors can shift the demand curve for money in (decrease) or out (increase):
--changes in the aggregate price level will increase the demand for money
--if GDP changes, so does the demand for money - if it grows they need more money for purchasing
--technology and habits: christmas time sees an increased demand, ATM's have decreased demand since folks need to keep smaller amounts on person nowadays
According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.

According to Keynes, demand for liquidity is determined by three motives:[2]
--the transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
--the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
--speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

Economist John Maynard Keynes describes liquidity preference theory in Chapter 13, "The General Theory of the Rate of Interest," of his famous book, "The General Theory of Employment, Interest and Money." Keynes said that people value money for both "the transaction of current business and its use as a store of wealth." Thus, they will sacrifice the ability to earn interest on money that they want to spend in the present, and that they want to have it on hand as a precaution. On the other hand, when interest rates increase, they become willing to hold less money for these purposes in order to secure a profit.


Traditionally economic theory held best course of action was to do nothing when large or prolonged swings in unemployment, output, and inflation occurred. (Classical Theory)

Then the Great Depression exposed this as a bad idea; and fiscal or monetary policy, or both, was used to affect macroeconomic variables.

According to Classical Theory, the Great Depression should never have been possible, but:
--individual actions of private producers DID NOT AGGREGATE into an efficient macroeconomic outcome.
--Say's law had fallen apart: supply did not create its own demand.
--Allowing the macroeconomy time to self-adjust had led to a downward spiral that started with something spooking aggregate demand and output going down, but wages and other prices were not flexible, and SRAS didn't adjust. SRAS curve stated completely horizontal up the the full-employment output.

1) any decrease in aggregate demand can potentially lead to a permanent reduction in output. ONCE AN ECONOMY HAS STARTED A DOWNWARD SPIRAL, IT CANNOT CORRECT ITSELF AND SOME SORT OF INTERVENTION IS NECESSARY.
2) impacts of any actions to correct aggregate demand will have no effect on the price level UNLESS AGGREGATE DEMAND EXPANDS BEYOND FULL EMPLOYMENT. In other words, any shift in aggregate demand will not cause inflation as long as output is below full-employment (Keynesian Model).

On the left we see the Keynesian model, which shows output (real GDP) falling with a fall in AD. The fall in output corresponds with a fall in employment, and therefore a recession (or Depression). To return to full employment, aggregate demand must move back to the right (or increase). To facilitate this, Keynes and his contemporaries believed that government should increase its spending, decrease taxes (to encourage households and firms to spend) and lower interest rates (to make saving less appealing). All that is needed, say the Keynesians, is a dose of stimulus to get back to full employment (Yfe).
In the Hayekian model (very similiar to old classical theory - supply creates its own demand and therefore horizontal), no government intervention is needed at all when aggregate demand falls. In fact, in an economy with very limited government, a fall in AD will have little or no effect on output and employment. Without minimum wages or laws making it difficult or expensive for firms to reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees' wages and reduce the prices of their products to maintain their output. If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering. Wages and prices are perfectly flexible in the Hayekian view, because there is no government interfering, demanding workers for big government projects, competing wages up, enforcing a minimum wage, or paying unemployment benefits to those out of work: all policies that make it difficult for wages to adjust downwards during a recession. Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level.

The two models could not be more different. In one (Keynes') recessions will occur anytime demand falls below the level needed to maintain full employment. In the other (Hayek's), recessions are impossible as long as government gets out (and stays out) of the way.
Which models is the right model? For most of the last 100 years, most Western economies have demonstrated more of the characteristics of the Keynesian model. As the last several years show, recessions certainly are possible. Wages and prices have NOT fallen as much as Hayek's model suggest they should, and economic output has declined in many Western nations and remains below the levels achieved in 2007 in many places. Most economists would argue that this prolonged recession is likely due to a weak level of aggregate demand. And the economic policies of many Western nations have reflected the Keynesian belief that government can "fix the problem" through stimulus plans involving tax cuts, spending increases, and low interest rates.
But two years of Keynesian policies are now being reversed. US President Obama's latest attempt at a Keynesian-style stimulus (his $447 billion "American Jobs Act") has been rejected by the US Congress. Across Europe, government spending is being slashed and taxes are being raised, both policies that threaten to further reduce aggregate demand. Deregulation is the battle cry of the Republican Party in the United States one year before the next presidential election. Presidential candidates are promising to "cut taxes, cut spending and cut government", which sounds like a Hayekian battle cry. Less government will lead to more competition, greater efficiency, more employment and a stronger economy, goes the thinking. Government cannot solve our problems, government is our problem.
This debate is not a new one. It has been going on since the 1930s when two scholars, one an Englishman from Cambridge, the other an Austrian at the London School of Economics, went toe to toe on the role of government in a nation's economy. The two models of aggregate supply above survive to this day, and 80 years later, in the midst of what may be the second Great Depression, economists and politicians still haven't figured out which theory is correct. Part of our problem is that in our Western democracies in which economic policies are determined by politicians who are often only in office for two to four years, we have not had the opportunity to truly put either economic theory to the test. Less than three years ago Barack Obama, freshly elected, embarked on the greatest experiment in Keynesianism since Franklin Roosevelt's "New Deal", which was widely credited with getting the US out of the Depression. Now, with another election looming, we have politicians promising to bring America back to economic prosperity in a truly Hayekian fashion, by "cutting, cutting and cutting".
Two models for how interest rate is determined in short run:

1) liquidity preference: investors demand a larger return for securities with longer maturities (greater risk) b/c they prefer cash (less risk i.e. the more liquid an investment, the easier it is to sell quickly for its full value). BUT Because interest rates are more volatile in the short term, the premium (a sum added to an ordinary price or charge) on short- versus medium-term securities will be greater than the premium on medium- versus long-term securities. For example, a three-year Treasury note might pay 1% interest, a 10-year treasury note might pay 3% interest and a 30-year treasury bond might pay 4% interest.

2) market for loanable funds model: Supply is UPWARD-SLOPING and it originates from the savings that exist in an economy:
--households and businesses supply their savings thru financial intermediaries and price they receive is the interest rate
--as the interest rate increases, the amt of savings they are willing to supply increases (b/c opportunity cost of consuming increases)
--Demand is DOWN-WARD SLOPING b/c loanable funds are used for INVESTMENT and the interest rate is the PRICE OF INVESTING
--the more expensive it is to borrow money, the lower the rate of return on investments and therefore the less investment takes place
--SHIFTS in the supply curve for loanable funds occur when there are CHANGES IN SAVINGS FROM OTHER COUNTRIES
--Demand for loanable funds is a DERIVED DEMAND (i.e. demand of an item derived from the demand of another) of - FOR FIRMS - the demand for factors of production (land, labor, capital, entrepreneurship), and - FOR GOVERNMENT - demand for funds to spend above the tax revenue it collects.
--THUS changes in the demand for loanable funds occur when their are changes in the investment climate that would not allow for profitable pursuit of these factors OR changes in the government's budget balance.
Government Spending
Government spending is not a major force in a classical economic theory. Classical economists believe that consumer spending and business investment represents the more important parts of a nation&amp;rsquo;s economic growth. Too much government spending takes away valuable economic resources needed by individuals and businesses. To classical economists, government spending and involvement can retard a nation&amp;rsquo;s economic growth by increasing the public sector and decreasing the private sector.

Keynesian economics relies on government spending to jumpstart a nation&amp;rsquo;s economic growth during sluggish economic downturns. Similar to classical economists, Keynesians believe the nation&amp;rsquo;s economy is made up of consumer spending, business investment and government spending. However, Keynesian theory dictates that government spending can improve or take the place of economic growth in the absence of consumer spending or business investment.

Short Vs. Long-term Affects
Classical economics focuses on creating long-term solutions for economic problems. The effects of inflation, government regulation and taxes can all play an important part in developing classical economic theories. Classical economists also take into account the effects of other current policies and how new economic theory will improve or distort the free market environment.

Keynesian economics often focuses on immediate results in economic theories. Policies focus on the short-term needs and how economic policies can make instant corrections to a nation&amp;rsquo;s economy. This is why government spending is such a key cog of Keynesian economics. During economic recessions and depressions, individuals and businesses do not usually have the resources for creating immediate results through consumer spending or business investment. The government is seen as the only force to end these downturns through monetary or fiscal policies providing instant economic results.
To determine how much to increase spending or decrease taxes:

The proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income. MPC is depicted by a consumption line- a sloped line created by plotting change in consumption on the vertical y axis and change in income on the horizontal x axis.

The marginal propensity to consume (MPC) is equal to ΔC / ΔY, where ΔC is change in consumption, and ΔY is change in income. If consumption increases by 80 cents for each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8.

Suppose you receive a $500 bonus on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new business suit and save the remaining $100, your marginal propensity to consume will be 0.8 ($400 divided by $500). This also means that your marginal propensity to save will be 0.2 ($100 divided by $500).

If you decide to save the entire $500, your marginal propensity to consume will be 0 ($0 divided by 500). The other side of marginal propensity to consume is marginal propensity to save, which shows how much a change in income affects levels of saving. Marginal propensity to consume + marginal propensity to save = 1.

Given data on household income and household spending, economists can calculate households' MPC by income level. This calculation is important because MPC is not constant; it varies by income level. Typically, the higher the income, the lower the MPC, because as wealth increases, so does the ability to satisfy needs and wants, so each additional dollar is less likely to go toward additional spending.

According to Keynesian theory, an increase in production increases consumers' income, and they will then spend more. If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a continuous cycle. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment.
The proportion of an aggregate raise in pay that a consumer spends on saving rather than on the consumption of goods and services. Marginal propensity to save is a component of Keynesian macroeconomic theory and is calculated as the change in savings divided by the change in income.

Marginal propensity to save = change in saving/ change in income

MPS is depicted by a savings line: a sloped line created by plotting change in savings on the vertical y axis and change in income on the horizontal x axis.

Suppose you receive a $500 bonus with your paycheck. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the remaining $100, your marginal propensity to save is 0.2 ($100 change in saving divided by $500 change in income). The other side of marginal propensity to save is marginal propensity to consume, which shows how much a change in income affects purchasing levels. Marginal propensity to consume + marginal propensity to save = 1. In this example where you spent $400 of your $500 bonus, marginal propensity to consume is 0.8 ($400 divided by $500). Adding MPS (0.2) to MPC (0.8) equals 1.

Given data on household income and household saving, economists can calculate households' MPS by income level. This calculation is important because MPS is not constant; it varies by income level. Typically, the higher the income, the higher the MPS, because as wealth increases, so does the ability to satisfy needs and wants, and so each additional dollar is less likely to go toward additional spending. If economists know what consumers' MPS is, they can determine how increases in production will influence saving.

MPS is also used to calculate the expenditures multiplier using the formula 1/MPS. The expenditures multiplier tells us how changes in consumers' marginal propensity to save influence production. The smaller the MPS, the larger the multiplier.
Why is there a multiplier effect?
Suppose a large corporation decides to build a factory in a small town and that spending on the factory for the first year is $5 million. That $5 million will go to electricians, engineers and other various people building the factory. If MPC is equal to 0.8, those people will spend $4 million on various goods and services. The various business and individual receiving that $4 million will in turn spend $3.2 million and so on.

If the marginal propensity to consume is equal to 0.8 (4 / 5), then the multiplier can be calculated as:

Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5

As a result of the multiplier effect, small changes in investment or government spending can create much larger changes in total output. A positive aspect of the multiplier effect is that macroeconomic policy can effect substantial improvements with relatively small amounts of autonomous expenditures. A negative aspect is that a small decline in business investment can trigger a larger decline in business activity and, thereby, create instability.

The previously mentioned formula for calculating the multiplier is a simplified one. Leakages (money spent, but not on domestic goods or domestic services) reduce the size of the multiplier. Examples of leakages include taxes and imports.

Another important point is that the multiplier effect takes time to work; months must pass before even half of the total multiplier effect is felt. Also, keep in mind that the multiplier effect can cause idle resources to be moved into production. If unemployment is widespread, then there should be little impact on resource prices.
Let us work through a couple of examples. The first one will deal with tax policy. What is the total change in output from a tax cut of $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the tax multiplier, that is [(change in taxes) -MPC] / (1 - MPC). This becomes [($-20 million) -0.8] / (1 - 0.8) = $80 million. This means that a $20 million tax cut will yield an $80 million increase in output. What is the process this equation models? Simply put, when consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues, and eventually the final change in output created by a tax cut is significantly larger than the initial tax cut itself.

The second example we will work through deals with government spending policy. What is the total change in output from an increase in government spending equal to $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the government spending multiplier: (change in government purchases) / (1 - MPC). This becomes ($20 million) / (1 - 0.8) = $100 million. A $20 million increase in government spending will cause a $100 million increase in output. When government spending increases, the populace, as the recipient of this spending, has more disposable income. When consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues. Eventually the final change in output created by a tax cut, as in the previous example, is significantly larger than the initial tax cut itself.
Liquidity Trap: Monetary policy has been rendered ineffective because the interest rate is already so low that it's up against the lower bound of zero.

--Inside Lag
Inside lag is the decision-making time that it takes governing bodies to assess a problem, determine a solution and agree on a final solution. On a federal level, this often entails an agreement between the two congressional houses and the president of the United States. On a state level, this includes the agreement between the two state congressional houses and the governor of the state. Inside lag can delay an economic solution due to a disagreement about the implementation of an economic solution, disagreement about the extent of the problem or confusing the situation with other political issues:
----Examples: Recognition lag and Decision lag (esp severe with fiscal policy that is submitted to Congressional DISCRETIONARY FISCAL POLICY procedures; one solution is AUTOMATIC STABILIZERS, provisions in the tax code and transfer payment systems that change w/o need for additional legislative action)
--Outside Lag (aka Impact Lag)
Outside lag is the delay between the time that a solution is approved and the date that the solution is implemented and/or works it way through the economy. Outside lag exists to give people in the public and private sector time to make the necessary changes in order to prepare for the economic solution. This may include scheduling development teams if the solution involves construction, upgrading the public or private sector to meet new specifications or time to save money to fund a solution.

NEITHER MONETARY NOR FISCAL POLICY IS VERY GOOD AT STIMULATING GROWTH: Stabilization policies can only return an economy to the full-employment rate of output, NOT STIMULATE ECONOMIC GROWTH.