-Aggregate Demand: A schedule or curve that shows the amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level.
-In other words, AD = C + I + G + NX
-Graphing aggregate demand: A downward sloping curve with the price level on the Y-axis and real GDP (Y) on the X-axis.
-Demand for an individual good or service slopes downward because of the income effect and substitution effect. These don’t apply to the explanation of aggregate demand because we’re talking about price levels, not individual prices. (Substitution effect is based on a similar product being cheaper than another; doesn’t work if everything becomes cheaper when price levels fall. Income levels in general fall as well, so there is no income effect).
-Aggregate demand is downward sloping because of 3 effects: the real balances effect, the interest rate effect, and foreign purchases effect.[break]
Real Balances Effect
Real Balances Effect
-Rising price levels (inflation) decreases the purchasing power of assets with fixed dollar values like savings accounts, bonds, and annuities. This decreased purchasing power means that the public is now poorer, which leads to decreased consumption, which leads to a lower level of aggregate demand (AD (down) = C (down) + I + G + NX).[break]
Interest Rate Effect
Interest Rate Effect
-Assuming a fixed level of money supply, when price levels go up, the demand for money goes up (as people now need more dollars to purchase the same amount of goods). This increase in money demand leads to an increased interest rate. Higher interest rates means that firms now have a smaller portfolio of projects that have a high enough expected rate of return to borrow against, so they will undertake fewer projects and consequently have lower investment spending. At the same time, consumer related purchases that are dependent on interest levels (like buying a home or a car) also decrease because it is now more expensive to purchase the same good. This decrease in consumption and investment spending leads to a lower level of aggregate demand (AD (down) = C (down) + I (down) + G + NX).[break]
Foreign Purchases Effect
Foreign Purchases Effect
-When domestic price levels rise relative to foreign price levels, domestic goods become relatively more expensive and foreign goods become relatively cheaper. This leads to fewer domestic goods being exported and more foreign goods being imported, leading to decreased net exports which lower the level of aggregate demand (AD (down) = C + I + G + NX (down)).

#1 True/False: Reducing unemployment will shift an economy’s production possibilities curve outward.

Solution Show
#2 How would you graphically determine whether a country is operating at full employment or not?
Solution Show
#3 What does a straight line production possibilities curve imply?
Solution Show
#4 True/False: All else equal, if an economy is operating on the PPC, the only way for it to produce more of one good is to give up some of the other.
Solution Show
#5 A production possibilities curve shows the maximum amounts of two goods that can be produced under what assumptions?
Solution Show
#6 Why is the production possibilities curve typically concave to the origin (bowed out)? What does this imply about the opportunity cost?
Solution Show
Refer to this table for questions #7 to #14:
PPM PP - Table 1
#7 Refer to the above table. If the economy is producing at C, what is the opportunity cost of one more unit of X?
Solution Show
#8 Refer to the above table. If the economy is producing at point C, what is the opportunity cost of one more Y?
Solution Show
#9 Refer to the table above. If this economy has a total output of 0X and 20Y, what can we infer from this?
Solution Show
#10 Refer to the table above. What must happen in order for this economy to produce 8X and 18Y?
Solution Show
#11 Refer to the table above. Without changing the technology available, how might this economy achieve a total output beyond its PPC?
Solution Show
#12 Refer to the table above. Without graphing, how can we tell if the opportunity cost in this economy is increasing, decreasing, or constant?
Solution Show
#13 Refer to the table above. If you were to graph this PPC, what would the curve look like?
Solution Show
#14 Refer to the table above. At which production alternative will this economy produce at?
Solution Show
#15 Will an economy achieve faster economic growth by producing more consumer goods or more capital goods?
Solution Show
#16 All else equal, a sudden population decline will likely do what to a production possibilities curve?
Solution Show
#17 A new piece of machinery is invented that allows us to produce the same number of goods with fewer resources. What is this considered a change in and what will it do to the PPC?
Solution Show
#18 What does a convex PPC imply? Would this be likely in the real world?
Solution Show

-An economy is analogous to a complex machine; there are a lot of moving parts, many of which depend on each other. If one part breaks down, then the whole machine breaks down.
-This concept can easily be seen in the circular flow model.
-To keep things simple, we’ll look at a private closed economy so there are only two parts: households (consumers) and businesses (firms).
-There are two types of flows in this model: real flows (goods, services, and resources) and monetary flows (money).[break]
Real Flows
Real Flows
-Starting with households: Households are the keepers of resources (land, labor, capital, and entrepreneurial ability). They offer up their resources for use in the resource market.
-Businesses take the resources from the resource market and transforms them into goods and services, which they offer up in the product market.
-Households consume the goods and services from the product market.[break]
Monetary Flows
Monetary Flows
-Opposite of the real flows are the monetary flows, which is money that gets exchanged for the goods, services, and resources.
-Households spend their money in the product market to consume goods and services (consumption expenditures).
-The money that businesses get from offering goods and services in the product market is known as revenue.
-Businesses take the revenue that they get to pay for the costs of buying resources from the resource market.
-The money that is spent by businesses in the resource market translate into income for households.[break]
Circular Flow Diagram
Circular Flow Diagram
-Combing the two together gives you the circular flow diagram. With this you can easily see how one part of the economy is dependent on the other.
-For example, if households consumed less goods and services then businesses won’t make as much revenue which leads to them purchasing fewer resources which means less income for households which means fewer goods and services are consumed, so on and so forth.
-The opposite is also true: increased spending in one part would lead to increased spending in the other, cycling back and forth.

-Use our limited resources to produce a mix of goods and services.
-The production possibilities model shows us all the various combinations of output an economy can achieve.[break]
Simplifying Assumptions
-Two good economy: Keeps us from drawing crazy graphs and avoids tough mathematics while still getting the key concept across. We’ll say that there is a capital good and a consumer good.
-Fixed resources: The quality and amount of resources available to an economy (land, labor, capital, and entrepreneurial ability) do not change.
-Fixed technology: The productive efficiency of this economy does not change, i.e. they cannot produce more output using the same number of resources.
-Full employment: For now, this economy is utilizing all of its available resources to the best of its ability.
-Time period of one year: Economic analysis are meaningless without time frames attached to them. We’ll arbitrarily pick one year.
-Closed economy: No trading with others.[break]
Graphing the Model
Production Possibilities Model
-Taking our assumptions into account, we can create the productions possibilities curve (PPC).
-The PPC shows us all the different combinations of output we can have, given our resources and technology.
-The full employment of resources means that this economy can produce anywhere on the line.
-Note: We cannot tell with the given information what combination of goods will be produced; we only know the different combinations that could be produced. The actual mix of output will be determined by the society and their preference for consumer and capital goods.
-If we strip away the full employment assumption, i.e. an economy is not utilizing all of its available resources, then the point in which this economy will produce will lie somewhere inside the curve.
-It is not possible for an economy to produce outside of its production possibilities curve.
-Note the concave nature of the curve: as more and more consumer goods are produced, fewer and fewer capital goods are produced and vice versa. This is due to increasing opportunity costs.
PPM - Increasing Opportunity Costs
-For each successive unit of good X this economy wants to produce, it has to give up more and more units of good Y. For each successive unit of good Y this economy wants to produce, it has to give up more and more units of good X.
-This is because certain resources are better producing one thing than another. Some land is better suited for farming rice while other land is better suited for corn. Some people are better artists while others are better accountants. The more of one good or service that is produced, the fewer suitable resources there are to produce it, so it will take more resources to produce the next successive unit.
-The only way for an economy to produce more of one good without giving up some of the other is for it to be inside the PPC, in other words when this economy is not fully utilizing its resources.
PPM - Unemployment
-For example, in this case this economy can choose to produce more X, more Y, or more of both.
-As it was mentioned earlier, an economy cannot produce outside of its PPC. However, this does not mean that an economy is forever limited to its current output potential.
-Over time, the resources an economy has will change, as well as the technology available.
-If one or both of these factors change for the better, the PPC will shift to the right increasing the output potential.
-If one or both of these factors change for the worse, the PPC will shift to the left, decreasing the output potential.
-Another way for an economy to change its productive capabilities is by opening itself up to trade and specializing in production, but that’s a whole other subject on its own.

-Aggregate Expenditures: The sum of the total spending in the economy.
-AE = C + I + G + NX
-Slope of the aggregate expenditures line is the marginal propensity to consume (MPC).
-The curve shows for any given level of income, what we as an economy are willing to consume.
-Savings is the leakage that causes AE to be less than GDP.
Aggregate Expenditures
-The equilibrium is where spending is equal to output. In other words, we as an economy consume what we produce.
-That’s where the significance of the 45 degree line comes in. At every point on the line, Y = X, so in this case the 45 degree line shows where spending is equal to income.
Aggregate Expenditures 2
-This is a short run model, so prices are sticky (they do not change). So instead of react to changing prices, firms react to changing inventory levels.
-If aggregate expenditures is greater than income (Y1, AE1), then spending is greater than production. We are buying more than we make. Firms will have to sell off their inventory, reducing inventory. Firms will react by hiring more workers and increasing output.
-If aggregate expenditures is less than income (Y2, AE2), then spending is less than production. We are buying less than we make. Firms will have to add on to their inventory, increasing inventory. Firms will react by laying off workers and decreasing output.

-The multiplier effect: a small change in spending will yield a much larger change in GDP.
-If someone increased their spending by $1, the economy’s GDP would increase by more than $1.
-To understand the logic behind this, let’s take a look at an example.[break]
Multiplier Effect Rationale

-Suppose a firm decided to increase their investment spending by $5.00. Let’s say that they chose to put that $5.00 towards constructing a new building. That means a construction worker is going to get $5.00 in income that he didn’t have before (change in income).
-Of this new $5.00, this construction worker is going to spend some of it and save some of it. If his marginal propensity to consume is 0.80, then of this new $5.00, he will spend $4.00 (change in consumption) and save $1.00 (change in savings).
-Suppose this construction worker takes the $4.00 and spends it at the liquor store down the street from his house. That means that the store owner now has an extra $4.00 in income that he didn’t have before.
-The store owner is going to spend 80% of it ($3.20) and save 20% of it ($0.80).
-The $3.20 that the store owner spends is going to turn into someone else’s income, which in turn leads to more spending which leads to more income.
-If we execute this over many transactions and sum all the numbers, we find that in this scenario, a $5.00 initial increase in spending will lead to a total of a $25.00 change in income, aka GDP.
-The reason why the multiplier effect exists is because one person’s spending is another person’s income
-Opposite scenario: If spending was cut by $5, GDP decreases by $25.[break]
-MPC + MPS = 1
Multiplier = \frac{1}{1-MPC} or Multiplier = \frac{1}{MPS}
-Change in GDP = Multiplier  x Initial Change in Spending
-Multiplier = Change in GDP / Initial Change in Spending

-To economists, there really only two things you can do with your money: spend it or save it.
-In other words, Disposable Income = Consumption + Savings
-If your disposable income changes, then your consumption, savings, or a combination of both will change.
-We use the terms marginal propensity to consume and marginal propensity to save to analyze this topic.
-In economics, the word marginal means ‘change in’ or ‘addition to’. Propensity refers to the tendency for something to happen.
-So the marginal propensity to consume/save just refers to how we would alter our spending/savings when our income changes.
-The marginal propensity to consume (MPC) is the rate that consumption will change for a given change in disposable income. In other words, MPC = Change in Consumption / Change in Disposable Income.
-The marginal propensity to save (MPS) is the rate that savings will change for a given change in disposable income. In other words, MPS = Change in Savings / Change in Disposable Income.

Types of Unemployment
-We generally classify unemployment into one of three categories: frictional, structural, and cyclical.
Frictional Unemployment: Works are “between jobs.” Might voluntarily be moving from one job to the next. Might have been fired. Might have been laid off due to seasonal demand, etc.
Structural Unemployment: Caused by a change in demand for labor. Could be due to a change in demand for skills. Could be caused by a change in geography as firms move locations.
-The difference between frictional and structural unemployment isn’t always clear cut. The key difference is that frictionally unemployed workers have marketable skills and either live in areas where jobs exists or are able to move to areas where they do. Structurally unemployed workers find it hard to obtain new jobs without retraining, gaining additional education, or relocating.
Cyclical Unemployment: Caused by a decline in total spending. Follows the business cycle.
-It is impossible to have zero frictional unemployment and structural unemployment because firms are always changing and people are always quitting their jobs or getting fired. So when we say that the economy is full employed, we don’t mean that the unemployment rate is at 0%, we mean that there is zero cyclical unemployment.
-Full employment does not equal 100% employment.
-When an economy is operating at its full employment rate (or natural rate of unemployment) it is producing its potential output. [break]
Calculating the Unemployment Rate

-Employment Rate = \frac{\&hash;\ Employed}{Labor Force} \times 100\%

-Unemployment Rate = \frac{\&hash;\ Unemployed}{Labor Force} \times 100\%
-Alternatively, Unemployment Rate = 1 – Employment Rate
-Labor Force = Unemployed + Employed
-According to the Bureau of Labor Statistics, you are not considered part of the labor force if you are not looking for work, if you’re under 16, or if you’re institutionalized.
-A discouraged worker is someone who used to be employed, became unemployed, and then became discouraged from looking for work after not being able to find a job for a while. Once they are no longer looking for work, they are no longer considered unemployed. [break]
Total Population: 250 million
Number of People Not in the Labor Force: 150 million
Number of People Employed: 130 million
Number of People Unemployed: 20 million

Using the above information, calculate the labor force and the unemployment rate.

Labor Force = Employed + Unemployed = 130 million + 20 million = 150 million
(Can also take Total Population – Number of people Not in the Labor Force)

Unemployment Rate = \frac{20\ million}{150\ million} \times 100\% = 13.33% [break]
Problems with This Measure of Unemployment
-A few problems arise with the way the Bureau of Labor Statistics measures unemployment.
-It is potentially understated because the statistic excludes people who hold part time jobs.
-It is potentially understated because it excludes workers who are under 16 years of age.
-Changes in the unemployment rate can come about without any actual changes in the total number of jobs. For example, suppose that this month there is currently a labor force of 100,000, with 95,000 people employed (5% unemployment rate). 18,750 discouraged workers hear about this low unemployment rate and become inspired to look for work again. Suppose the total number of jobs in the economy stays fixed at 95,000. Then the next month, the reported unemployment rate will jump up to 20% (= 1 - \frac{95,000}{118,750} \times 100\%). While the absolute number of jobs have not changed, this sudden increase in the unemployment rate makes the economy look worse than it really is, which can cause people to panic.
-It is also easy to imagine a scenario where the number the total number of jobs does not change, but the number of people who are actually looking for work, decrease, causing the unemployment rate to drop, making the economy look better than it really is.

-Let’s begin by making a general assumption: It is better to consume something now than it is to wait and consume it later. For example, if you are given the option of receiving $1000 now or $1000 five years from now, chances are that you’d take the money now.
-In economics, there are really only two things you can do with your money: spend it or save it. Should you decide to save your money, you are delaying your ability to consume it now.
-In return for delaying your consumption now, you would want to be compensated by being able to consume more later.
-When we’re talking about money, this compensation takes place in the form of interest.[break]
Compound Interest
-There are several different forms of interest. We’ll focus on compound interest.
-Compound interest pays you not only based on your principle amount (the money you start with), but also on any interest you have earned. In other words, compound interest pays you interest on interest.[break]
Suppose you have $500 that you put into the bank. The bank is going to pay you 5% interest, compounded every year. Let t = time in years.

Compound Interest Example

So on and so forth.

-There’s a pattern here. As long as we know the amount of money we start with and the interest rate, we can calculate the amount of money we can expect to have for any given year.[break]
Future Value Formula
Let i = interest rate
Let t = time in years
Let $X = principle amount of money we start with
Let FVt = future value of the starting principle ($X) after t years

Future Value Proof

-From this we can generalize that when t = n, FVn = $X(1+i)n. (Not the strictest of proofs, but I’m not a mathematician).
-We refer to this formula as the future value formula because it helps us calculate the value of money in the future. (We economists are a pragmatic bunch).[break]
Present Value Formula
-With the future value formula we can found out what our money will be worth for a given interest rate after t years. In other words, we can calculate money going forwards in time.
-Let’s reverse the process to find out how much money needs to be saved now for a given interest rate in order to have a specific amount of money later.[break]
Present Value Proof
Suppose you want to figure out how much money you need to save now at a 7% interest rate compounded yearly to have $5,000 four years from now:
i = 7%
t = 4 years
PV4 = The present value of $5000 four years from now

Present Value Example
So if we save $3814.48 at 7% interest compounded yearly, four years from now we will have $5,000.

-If we take the present value formula and start plugging in numbers into it, we can come to an interesting conclusion.

-Let’s see what happens to the present value of a dollar over time at some interest rate. For this example, we’ll use 5%. (It doesn’t really matter what we pick; the end result will still be the same.)

Dollar Today

-From this we can gather that PV0 > PV1 > PV2 > PV3 > … > PVn.
-In non-mathematical terms, this means that a dollar today is worth more than a dollar tomorrow.
-This conclusion has implications that are widespread throughout all of economics and finance and will be something that we’ll explore more in the future.