Economics: Unit 4-Chapter 13&14: Understanding the Concept of Money & How Banks and Thrifts Make Money

Chapter 14: How Banks and Thrifts Make Money

Assets = Liabilities + Net Worth

Assets are what you own

Liabilities are what you owe

Net Worth is the value of property for what you may have

Bank deposits are subject to a reserve requirement

Reserve Ratio = Commercial Bank's Required Revenue/Commercial Bank's Checkable-deposit liabilities

1. Excess Reserves = Actual Reserves - Requires Resources
2. Lending Ability
3. Asset or liability to which bank

Banks create money by lending excess reserves and destroy it by loan repayment

Purchasing bonds from the public also create money

Monetary Multiplier = 1 / Required Reserve Ratio

Maximum Checkable Deposit Creation = Excess Reserve * Monetary Multiplier

Chapter 13: Understanding the Concept of Money

1. Uses of Money
1. Medium of Exchange
• Used to barter or trade
2. Unit of account
• Gives money economic worth
3. Store of value
2. Types of Money
1. Representative Money: paper money that is backed by a tangible product
• Ex. Certificate
2. Commodity Money
• Gold and Silver Coins
• Gets its value from the material which it is made
3. Fiat Money
• It is money because the government says so
3. Characteristics of Money
1. Durability
• How long is the money good for?
• Coins (long time)
• Paper money (short time)
2. Portability
• You can carry money anywhere
3. Divisibility
• Money can be broken down into smaller units
4. Uniformity
• All money is identical unless taken out of circulation and made anew
5. Scarcity
6. Acceptability
• Money is accepted anywhere you go

M1 and M2 Money

M1 money consists of currency and circulation

• Paper dollars and coins
• Traveler's check
• Checkable deposit
• Demand Deposit
• Checking Account
• Account for the 75% of money in circulation

M2 Money

• Savings Account
• Money Market Account
• Accounts held by banks outside of the US
• Account for the other 25% of money in circulation

M1 money is more liquid (able to spend it)

Multiple Deposit Expansion

Reserve Requirement: The fed requires banks to always have some money readily available to meet consumers demand for cash.

• The amount set by the Fed, is the required Reserve Ration
• The required reserve ration is the percent of demand deposits (checking account balances) that must not be loaned out.
• Typically the required reserve ration is 10 percent

The Money Multiplier

Similar tot he spending multiplier, the money multiplier shows us he impact of a change in demand deposits on loans and eventually the money supply.

To calculate the money multiplier, divide 1 by the required reserve ratio

• Money Multiplier = 1/Reserve Ratio
• Ex. If the reserve ratio is 25%, then the multiplier = 4 
• Why? 1/.25 = 4

The 3 types of multiple deposit expansion questions

• Type 1: Calculate the initial change in excess reserves
• aka. The amount a single bank can loan from the initial deposit
• Type 2: Calculate the change in loans in the banking system
• Type 3: Calculate the change in the money supply

Sometimes Type 2 and Type 3 will have the same result (ie. no Fed involvement)

The amount of new demand deposits - requires reserves = the initial change in excess reserves

The maximum change in loans + $amount of Federal reserve action = change in money supply

Economics: Unit 4-Monetary Policy

Monetary Policy

Controlled by the Fed (Federal Reserve Bank)

Influencing the economy though changes in the economy through changes in reserve which influences the money supply and available credit. 

4 Options: 

1. Reserve Requirement: The percent that is said by the Fed of the minimum reserve the bank must keep.
2. Discount Rate: The rate of interest that the Fed charges for overnight loans to banks
3. Federal Fund Rate: The rate that FDINC members charge each other for loans.
4. OMO (Open Market Operations)
• Buy or sell securities (bonds) 

If the Fed buys bonds, then the money supply expands

If the Fed sells bonds, then the money supply decreases

Prime Rate: The interest rate that banks charge their most credit worth borrowers.

• Good credit = low rate

If the Discount Rate and the Federal Fund Rate decrease; Expansionary Monetary Policy

If the Discount Rate and the Federal Fund Rate increase; Contractionary Monetary Policy

	Expansionary on Easy Money	Contractionary on Tight Money
OMO	Buy Bonds	Sell Bonds
Discount Rate	Decrease	Increase
Federal Fund Rate	Decrease	Increase
Required Reserve	Decrease	Increase

Tight Money has a higher interest rate, money will uppreciate

Easy money will depreciate

Assume 10% reserve requirement 

1. $1000 inc ash deposited into checking account
• If initial deposit is not new money, the total change in MS is only the new money created by the banking system. (=$9000)
2. No immediate change in MS
3. Assets: Reserves = $100

1. $1000 Fed purchase of bonds from the public (deposited into checking account)
2. Immediate increase in MS of $1000
3. Liabilities: Checkable Deposits = $1000

Either deposit would increase actual reserves by $1000

Required Reserve = $100 (.10 * $1000 deposit)

Single Bank: Amount of money single bank can create (loan out) = ER; AR - RR = ER

Banking System: Can create money by a multiple of its initial ER

Deposit Multiplier = 1/RR

System Now $ = Deposit multiplier * Initial ER

Economics: Unit 4-Countercyclical Policies : Keynesian Fiscal Policy Vs. Monetary Policy

Countercyclical Policies : Keynesian Fiscal Policy Vs. Monetary Policy

In the early 21st Century, here in the USA: 

An efficient, "full employment" economy will probably have :

1. An annual unemployment rate of 4-5%
2. An annual inflation rate of 2-3%

If the economy goes into recession:

     3. The real GDP will decrease for at least 6 months

     4. The unemployment rate will go to 6% or more.

     5. The inflation rate will probably go to 2% or less.

If congress enacts Keynesian Fiscal policies to attempt to slow/stop the recession, then:

     6. The policy will try to improve consumption, or government spending (parts of AD)

     7. Congress will cut federal taxes

     8. Congress will increase job and spending programs

     9. The federal budget will probably create a deficit

    10. Due to changes in Money Demand, interest rate will increase

          (Crowding out might occur, but Keynesian don't care.)

If the Federal Reserve Employs Monetary policy options to slow/stop the recession, then:

     11. The policy will target improvement in Ig (part of AD)

     12. The Fed will target a lower federal fund rate.

     13. The Fed can lower the discount rate.

     14. The Fed can buy bonds (Open Market Operations)

     15. The Fed can (theoretically) lower the reserve requirement. but probably wont because it is to complex for the banks.

     16. These Fed policies will lower the interest rates through changes in the Money Supply. 

     17. These options should increase Ig. 

If the economy suffers from too much demand-pull inflation or cost-push inflation, then

     18. The unemployment rate will go to 3 or less.

     19. The inflation rate will probably go to 4% or more.

Of Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the inflation problems, then:

     20. the policy will try to decrease consumption, or government spending (parts of AD)

     21. Congress will raise federal taxes. 

     22. Congress will decrease job and government spending programs

     23. The federal budget will probably create a surplus.

     24. Due to changes in Money Demand, interest rates will decrease

If the Federal reserve employs Monetary policy options to slow/stop the inflation problems, then:

     25. The policy will target decreases in Ig (part of AD)

     26. The Fed will target a higher federal fund rate.

     27. The Fed can raise the discount rate.

     28. The Fed can sell bonds (Open Market Operations) 

     29. The Fed can (theoretically) raise the reserve requirement, but probably wont because it is ti complex for the banks.

     30. These Fed policies will raise the interest rates through changes in the Money Supply. 

     31. These options should decrease Ig.

Economics: Unit 4-How Banks and Thrifts Create Money

How Banks and Thrifts Create Money

1. In this chapter, a commercial bank may also be called a thrift institution and a deposit at a bank may also be called a checkable deposit.
2. The balance sheet of a commercial bank is a statement of the bank's assets, the claims of the owners of the bank called net-worth, and claims of the non owners called liabilities. this relationship would be written in equation form as: Assets = liabilities + Net Worth
3. The banking system used today is a fractional reserve system, which means that less than 100% of the money deposited in a bank is kept on reserve.
4. There are two significant characteristics of the banking system as of today.
• Banks can crease money depending on the amount of reserves they hold
• Banks are susceptible to panics or "runs", and to prevent this situation from happening, banks are subject to government regulation.
5. The coins and paper money that a bank has in its possession are vault cash or till money
6. When a person deposits cash in a commercial bank and received a checkable deposit in return, the size of the money supply has not changed
7. The legal reserve of a commercial bank  (ignoring vault cash) must be kept on deposit at the Federal Reserve Bank
8. The reserve ration is equal to the commercials bank's required reserves divided by its checkable deposit liabilities
9. The authority to establish and vary the reserve ration within limits legislated by Congress is given tot he fractional reserves.
10. If commercial banks are allowed to accept (or create) deposits in excess of their reserves, the banking system is operating under a system of fractional reserves
11. The excess reserves of a commercial bank equal its actual reserves minus its required reserves
12. The basic purpose for having member banks deposit a legal reserve int he federal Reserve Bank in their district is to provide control of the banking system by the Fed
13. When a commercial bank deposits a legal reserve in its district Federal Reserve and, the reserve is an asset to the commercial bank and liability to the Federal Reserve Bank
14. When a check is Drawn on Bank X, deposited in Bank Y, and cleared, the reserves of Bank X are decreased and the reserves of Bank Y are increased; deposits in Bank Y are increased.
15. A single commercial bank in a multibank system can safely make loans or buy government securities equal in amount to the excess reserves of that commercial bank
16. When a commercial bank n\makes a new loan of $10000, the supply of money increases by $10000, but when a loan is repaid , the supply of money decreases by $10000
17. When a commercial bank sells $10000 government bond to a securities dealer, the supply of money decreases by $10000, but when a commercial bank buys a $10000 government bond from a securities dealer, the supply of money increases by $10000
18. (21.) The grater the reserve ration, the smaller the money multiplier
19. (22.) The banking system can make loans and create money in an amount equal to its excess reserves multiplied by the monetary multiplier
20. (23.) Assume that the required reserve ration is 16.67% and the banking system is $6 million short of required reserves. If the banking system is unable to increase its reserves, the banking system must decrease the money supply by $36 million.
21. (24.) The money-creating potential of the commercial banking system is lessened by the withdrawal of currency from banks and by banks not lending excess reserves.

Economics: Video Responses

Video #1

• There are 3 different types of money
1. Commodity Money
1. Money that serves as other things
2. Most primitive/basic type
3. Goods that represent other goods
2. Representative Money
1. Represents a specific quantity backed by a precious metal
2. Drawback is when the value of the metal changes, so does the value of the national currency
3. Fiat Money
1. Money not backed by metal
2. Money that is backed by the word of the government
3. "Because the government says so"
• Function of Money
• Medium of Exchange
• "It is through money that exchange happens"
• Store of Value
• When you put money away
• The value is still the same
• Unit of Account
• Look at price (implies worth) to the quality
• The price of good/service (quality wise) should be expected
• The more you spend the better it is
• used to judge based on the value of the quality

Video #2

As price increase, quantity decreases

As price decrease, quantity increases

SM does not vary on interest rate; it is fixes or set by the Fed

An increase in demand puts pressure on interest rate

To bring the interest rate down, Fed can increase the money supply

If the money supply is unstable, they cannot predict the level of investment, cannot predict consumer spending, thus cannot manipulate aggregate demand. 

Video #3

Expansionary (easy money)

• Decrease the Reserve Requirement 
• Decrease the Discount Rate
• Buy Bonds (increase the money supply)

Contradictory (tight money)

• Increase the Reserve Requirement
• Increase the Discount Rate
• Sell bonds (reduces the money supply)

The Reserve Requirement is the amount of money the bank must keep as vault cash or as reserve on a Fed branch

When the RR is low, the RR money becomes Excess Reserves to make loans

When you raise the RR, there is less money for the bank to loan out

Banks lended out to much money that led tot he Great Depression

The Federal Fund Rate is the rate at which banks borrow from each other

The DR is the rate at which banks can borrow from the Fed

• Lenders of last resort
• Not that effective or popular (not guaranteed"
• "Buy bonds=Big Bucks"

Video #4

SLF is the amount of money people have in banks; depends on savings

Example-when the government runs a deficit

As the demand for money increases in the loan-able funds "market", so does the supply of money in the money market

If the government is in a deficit:

Then it demands money, it jacks up the interest rate, and Decreases supply to increase interest rate

Both cause the same change

Video #5

Money is created by making loans

Money multiplier is 1/RR

Example: RR=20%, bank make a loan amount of $500

1/.2=5

5*loan; 5*$500=2500

Bob gets 500, puts it in a bank

Loan to Joe, $400 (transfers to bank)

Loan to Suzy, $320 (transfers to bank)

If continued until it went to zero, then the added total should be $2500

Does not guarantee $2500 because it goes on the assumption that there are no excess reserves.

Video #6

In a deficit, the government borrows from others

Mostly borrows from its people

To show change in LF

• Increase demand
• Reduce national available supply

Change is the same in all graphs

MV=PQ

A change in M causes a change in P

The fissure effect is that the change in the interest rate and the Pl have to be equivalent

Economics: Unit 3-Interest Rates and Investment Demand

Interest Rates and Investment Demand 

What is an investment?

---Money spent or expenditures on:

• New Plants (factories)
• Capital Equipment 
• Technology (hardware and software)
• Now Homes
• Inventories (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?
• Cost or benefits analysis
• How does businesses determine the benefit?
• Expected rate of return
• How does businesses count the cost?
• Interest costs
• How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest cost
• If the expected return is greater then the interest cost, then people should invest
• If the expected return is smaller then the interest cost, then people should NOT invest

Real (r%) vs. Nominal (i%)

What's the difference?

• Nominal is the observable rate of interest.
• Real subtracts out inflation and is only known as ex post facto

How do you compare the real interest rate (r%)?

• r% = (i%) - inflation (pie%)

What then, determines the cost of investment of an investment decision?

• The real interest rate (r%)

Investment Demand Curve (ID)

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 the Investment Demand (ID)

• Cost of Production
• Business taxes
• Technological Change
• Stock of Capital 
• Expectation

Economics: Unit 3-Chapter 11 & 16: Aggregate Demand and Aggregate Supply and Determinants & LRAS vs. SRAS

Aggregate Demand: Shows the amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level.

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

Aggregate Demand Curve

3 Reasons AD is downward sloping

1. Real-Balances Effect

• When the price level is high, households and businesses cannot afford to purchase as much output.
• When the price level is low, households and businesses can afford to purchase more output.

2. Interest-Rate Effect

• A higher price level increases the interest rate which tends to discourage investment.
• A lower price level decreases the interest rate which tends to encourage investment

3. Foreign-Purchase Effect

• A higher price level increases the demand for relatively cheaper imports
• A lower price level decreases the foreign demand for relatively cheaper exports

Shifts in Aggregate Demand (AD)

There are 2 parts to a shift in AD:

1. A change in C (Personal Consumption), Ig (Gross Private Investment), G (Government Spending), and/or Xn (Net Exports)
2. A multiplier effect that produces a greater change than the original change in the 4 components

An INCREASE in AD = AD shift to the RIGHT
A DECREASE in AD = AD shift to the LEFT

Consumption

• Household spending is affected by: 
• Consumer wealth
• More Wealth = More Spending (AD shift to the right)
• Less Wealth = Less Spending (AD shift to the left)
• Consumer Expectations
• Positive Expectations = More Spending (AD shift to the right)
• Negative Expectations = Less Spending (AD shift to the left)
• Household Indebtedness
• Less Debt = More Sending (AD shift to the right)
• More Debt = Less Spending (AD shift to the left)
• Taxes
• Less Taxes = More Spending (AD shift to the right)
• More Taxes = Less Spending (AD shift to the left)

Gross Private Investment

Investment Spending is sensitive to:

• The Real Interest Rate
• Lower Real Interest Rate = More investment (AD shift to the right)
• Higher Real Interest Rate = Less investment (AD shift to the left)
• Expected Returns
• Higher expected returns = More investment (AD shift to the right)
• Lower expected returns = Less Investment (AD shift to the left)
• Expected returns are influenced by:
• Expectations of future profitability
• Technology
• Degree of Excess Capacity (Existing Stock Capital)
• Business Taxes

Government Spending

• More government spending (AD shift to the right)
• Less government spending (AD shift to the left)

Net Exports

Net Exports are sensitive to:

• Exchange Rates (international value of the dollar)
• Strong Dollar = More imports and fewer exports (AD shift to the left)
• Weak Dollar = Fewer imports and more exports (AD shift to the right)
• Relative Income
• Strong Foreign Economics = More exports (AD shift to the right)
• Weak Foreign Economics = Less exports (AD shift to the left)

Aggregate Supply

Aggregate Supply: The level of Real GDP (Real GDP) that firms will purchase at each price level (PL)

Long-Run vs. Short-Run

Long-Run

• Period of time where input prices are completely flexible and adjust to changes in the price level
• In the long-run, the level of Real GDP supplies is independent of the price-level.

Short-Run

• Period of time where input prices are sticky and do not adjust to change in the price-level.
• In the short-run, the level of Real GDP supplied is directly related to the price level.

Short-Run Graph

Long-Run Graph

Short-Run and Long-Run Integrated Together

Long-Run Aggregate Supply (LRAS)

• The long-run aggregate supply or LRAS marks the level of full employment in the economy (analogous to PPC) changes in SRAS
• An INCREASE in SRAS is seen as a shift to the RIGHT
• A DECREASE in SRAS is seen as a shift to the LEFT
• The key to understanding shifts in SRAS is per unit cost of production
• Per Unit Cost of Production = Total Inputs/Total Outputs

Determinants of SRAS (all of the following affect unit production cost)

• Input Prices
• Domestic Resources Prices
• Wages (75% of all business costs)
• Cost of Capital
• Raw Material (commodity prices)
• Foreign Resource Prices
• Strong Dollar = Lower Foreign Resources Prices
• Weak Dollar = Higher Foreign resources Prices
• Market Power
• Monopolies and cartels that control the use of those resources 

INCREASE in Resource Price = SR shift to the RIGHT

DECREASE in Resource Price = SR shift to the LEFT

Productivity = Total Inputs / Total Outputs

• More productivity = Lower unit-production cost (SRAS shift to the right)
• Less Productivity = Higher unit-production cost (SRAS shift to the left)

Legal-Institutional Environment

• Taxes and Subsidies
• Taxes (money to government) on business increase per unit production cost (SRAS shift to the left)
• Subsidies (money from the government)  to businesses reduce per unit production cost (SRAS shift to the right)
• Government Regulation
• Government regulation creates a cost of compliance (SRAS shift to the left)
• Deregulation reduces compliance cost (SRAS shift to the right)

The AS/AD Model

The AS/AD Model: The equilibrium of AS and AD determine current output (Real GDP) and the price level

Full employment equilibrium: Exists where AD intersects SRAS and LRAS at the same point

Recessionary GDP: Exists when the equilibrium occurs below the full employment output

Inflationary GAP: Exists when equilibrium occurs beyond full employment output

Changes in AD

• Consumption
• An increase in Consumption results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decrease in Consumption results in:
• An AD shift to the left
• An decrease in Real GDP and Price Level
• A decrease in the unemployment rate
• A fall in the inflation rate
• Gross Domestic Investment
• An increase in Gross Domestic Investment results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Gross Domestic Investment results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate
• Government Spending
• An increase in Government Spending results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Government Spending results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate
• Net Exports
• An increase in Net Exports results in:
• An AD shift to the right
• An increase in Real GDP and Price Level
• A drop in the unemployment rate
• A rise in the inflation rate
• A decreases in Net Exports results in:
• An AD shift to the left
• A decrease in Real GDP and Price Level
• A rise in the unemployment rate
• A fall in the inflation rate

3 Ranges of the Aggregate Supply Curve

1. Horizontal/Keynesian: Includes only levels of Real output that are less than the full employment output.
• Implies that the economy is in a recession, therefore you have a decrease in real output
2. Vertical/Classical Range: The economy reaches its full capacity real output
3. Intermediate Range: There is an expansion of real output price level

Economics: Unit 3-Chapter 12: Fiscal Policy Options

Fiscal Policy: Changes in the expenditures or tax reserves of the federal government

2 Types of Fiscal Policy

• Taxes - Government can increase or decrease axes
• Spending - Government can increase or decrease spending

Fiscal policy is enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced Budget
• Revenues = Expenditures
• Budget Deficit
• Revenue is less then the expenditures
• Budget Surpluses
• Revenue is greater the the expenditures
• Government Deficit
• Sum of all deficits - Sum of all surpluses
• Government must borrow money when it runs a budget deficit
• Government borrows from:
• Individuals
• Corporations
• Financial Institutions
• Foreign Entities or Foreign Governments

When dealing with Fiscal Policy, their are 2 options:

1. Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surpluses
2. Non-Discretionary Fiscal policy (no action)

Discretionary vs. Automatic Fiscal Policy 

Discretionary Fiscal Policy: Increasing or decreasing taxes

Automatic Fiscal Policy: Unemployment compensation and marginal tax rates are examples that help mitigate the effects of recession and inflation

Contractionary vs. Expansionary Fiscal Policy

Contractionary Fiscal Policy - Policy designed to decrease aggregate demand 

• Strategy for controlling inflation
• Counters inflation
• Decreased government spending
• Increased taxes
• Notice that the unemployment rate increased: this means contractionary 

Expansionary Fiscal Policy - Policy designed to increase aggregate demand

• Strategy for controlling GDP (combating recession, and reducing unemployment)
• Counters recessions
• Increase government spending
• Decrease taxes
• Notice that the Price Level increased: this means expansionary

Automatic or Built in Stabilizer: Anything that increases the government budget deficit during a recession and increases its budget surplus during inflation without requiring action from policy makers.

• Ex. Transfer Payments, Social Security

3 Tax Systems

• Progressive Tax System: The average tax rate that rises with GDP
• Proportional Tax System: The average tax rate remains constant as GDP changes
• Regressive Tax System: The average tax rate falls with GDP

Economics: Unit 3-Chapter 10: The Spending Multiplier

Consumption and Savings

Disposable Income (DI): Income after taxes or net income 

• DI = Gross Income - Taxes

With disposable income, you can either: 

• Consumer (spend money on goods and services)
• Save (not spend money on goods and services)

Consumption

• Households Spending
• The ability to consume is constrained by 
• The amount of disposable income
• The propensity to save
• Do households consume if DI is equal to 0?
• Autonomous Consumption
• Dissolving
• APC = C/DI, percent of disposable income that is spent

Saving

• Households 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
• APS = S/DI, percent that is not spent

APC and APS

The Average propensity to Consume/Save

APC + APS = 1

1 - APC = APS

1 - APS = APC

If APC is greater than I, than it is disaving

If APS is negative, then you are dissaving

MPC and MPS

Marginal propensity to Consume

• Change in Consumption/Change in Disposable Income
• The percent of every extra dollar earned that is spent

Marginal Propensity to Save

• Change in Savings/Change in Disposable Income
• The percent of every extra dollar earned that is saved

MPC + MPS = 1

1 - MPC = MPS

1 - MPS = MPC

Determinants of Consumption and Savings

• Wealth
• Expectations
• Household Debt
• Taxes

The Spending Multiplier Effect

The Spending Multiplier Effect: An initial change in Spending (C, Ig, G, or Xn) causes a larger change in aggregate spending or aggregate demand (AD)

• Multiplier = Change in AD/Change in Spending
• Multiplier = Change in Aggregate Demand/Change in (C, I, G, Xn)
• Why does this happen?
• Expenditures and income flow continuously which sets off a spending increase int he 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 positive when their is an increase in spending and negative when their 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: its negative)
• -MPC/(1 - MPC) or -MPC/MPS
• If their is a tax-cut, then the multiplier is positive, because their is more money in the circular flow

Problem Solving Steps:

1. Calculate the MPS and MPC
2. Determine which multiplier to use and whether it is positive or negative
3. Calculate the spending and/or tax multiplier
4. Calculate the change in AD

Economics: Unit 3-Classical vs. Keynesian

Classical vs. Keynesian Debate

Modern Followers:

• Classical: Adam Smith
• Keynesian:
• John B. Say
• John Maynard Keynes
• Neo-Keynesians

Say's Law

• Classical:
• Supply creates its own demand
• Production equals income, which equals spending
• Under-spending is unlikely
• Keynesian: 
• Depression deputes Say's Law
• Demand creates its own supply
• Under-spending persists

Saving and Investment

• Classical:
• From Households to Business
• Invest = Savings
• Spending
• Keynesian:
• Savings does NOT equal investment (different motivations)
• Savings
• Future needs
• Precaution
• habit
• Income level
• Interest rate
• Investment
• Interest rate
• Rate of Profit
• Expectations

Lonable Market

• Classical

• Keynesian:
• Investment savings from cash, checking accounts
• Lending creates money, therefore money supply increases
• Inflation and Unemployment are unstable

Wage/Price Flexibility

• Classical 

• Keynesian:
• Inflexible downward
• Not very competitive

Output and Employment

• Classical: 
• Aggregate Supply determine output and employment
• Keynesian: 
• Aggregate Demand determine output and employment

Unemployment:

• Classical:
• Rarely exists due to price wage flexibility
• The causes are external like war or famine
• Keynesian:
• Usually exists
• Causes are external like war or famine
• Or internal where investment is not equal to savings

Aggregate Demand (AD)

• Classical:
• AD determines the price level
• AD is reasonably stable if the money supply is stable
• Keynesian:
• AD changes dues to the determinants (C, G, Ig, Xn)
• AD is unstable even if money supply is stable, due to fluctuation in spending

Basic Equation

• Classical: 
• MV = P (Price) * Q (Quantity)
• Used from 1965 to 1972
• Keynesian
• GDP = G + C + Ig + Xn
• Used from 1973 to the present

Role of the government

• Classical
• lassie fair 
• Economy is self regulated
• Keynesian
• Fiscal policy (tax and spend)
• Economy is not self regulated)

Inflation

• Classical: caused by to much money
• Keynesian: Caused by to much demand

How long is the short run?

• Classical: A very short time
• Keynesian: A very long time

Emphasis Today

• Classical: Microeconomics
• Keynesian: Macroeconomics