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AE[C+Ig+G] AD2 LRAS SRAS AE2[C+Ig+G] AE1[C+Ig] AD1 PL PL o 45 YR Y* Real GDP YR Y* Real GDP AE[C+Ig+G] AE1[C+Ig1] AE2[C+Ig2] LRAS SRAS AD1 AD2 PL PL o 45 Y* YI RGDP Y* YI Weaknesses [Limitations] of the AE Model • • • • • RGDP Does Not Show Price Level Changes Does not show Demand-Pull Inflation Does Not Deal With Cost-Push Inflation [Stagflation] It ignores premature demand-pull inflation [Inflation just before FE GDP] It does not allow for “self-correction” In this Chapter we will learn: 1. How changes in income affect consumption [& saving]. 2. About factors other than income that can affect consumption [like wealth or expectations] 3. How changes in real interest rates affect investment. 4. How factors other than the real interest rate can affect investment (like profit expectations or stock on hand). 5. Why changes in investment increase or decrease real GDP by a multiple amount due to the multiplier effect. [Simple [Basic] economy to Complex economy] [C + Ig] Private - closed Private-closed [C + Ig + Xn] Private-open [C+Ig+G+Xn] Private-open Mixed - open Mixed-open (AE3)630 (AE2)550 (AE1)470 C=390 +80 +80 +80 45° 0 390 470 550 630 Real GDP “ME” = 4 AE(C+Ig) AE3 (C+Ig+G+Xn) (Complex Economy) [Mixed-open] AE2 (C+Ig+Xn) (Private-open) [X(40)-M(20)] AE1(C+Ig)[Basic Economy][Private(no G)-Closed(no X or M)] S AE(C+Ig2) Consumption 500 AE(C+Ig1) 460 45° 460 YR 500 Real GDP Y* AE[C + Ig] Multiplier=4 (billions of dollars) AE[C+Ig] [“Basic” or “Simple” economy] C + Ig Private - Closed Consumption Equilibrium 470 Ig = $20 Billion 450 390 +20 +60 more 370 [increase 80] C =$450 Billion 45º o Real GDP GDP will increase by a “multiple” of 4 & that is why it is called the “multiplier”. 370 390 410 430 450 470 490 510 530 550 [Income change, movement from point to point] SAVING Consumption Consumption C2 Breakeven C1 DISSAVING DI2 Disposable Income S SAVING o DISSAVING o o DI3 DI1 Saving [Negative saving] 45 So, the key to a change in QC(QS) is a change in ? S Disposable Income Decrease in PL Expect. PL incr. Expect. of positive Y Expect. of shortages Decrease in debt *Decrease in taxes Consumption [shift/whole curve/non-income] C2 May be caused by: Increase in wealth C1 Saving *Decrease in taxes o increases both C & S I’ll buy more and save even more. o Increases in consumption means… 45 o Disposable Income S1 Decrease S2 in saving Disposable Income [shift/whole curve/non-income] May be caused by: o o Decreases in consumption means… 45 Disposable Income Increase S2 S in saving 0 Saving *Increase in taxes decreases both C & S Consumption Decrease in wealth Increase in PL Expect. PL decrease Expect. neg. future Y Increase in debt *Increase in taxes C1 C2 o Disposable Income Global Perspective Average Propensities to Consume Select Nations GDPs Average Propensities to Consume .80 .85 .90 .95 1.00 United States .963 Canada .958 United Kingdom .953 Japan .942 Germany .896 Netherlands .893 Italy France .840 .833 Source: Statistical Abstract of the United States, 2006 [Nominal I.R. – inflation rate = Real I.R.] - 2% 8% Nominal Interest Rate = - Inflation Premium = 6% Real Interest Rate Marginal Efficiency of Investment [MEI] [If expected returns equal or exceed the real interest rate of interest, the firm will normally make the investment.] [One firm’s demand curve for investment] MEI = 27% 30% Real Interest Rate 25% MEI=20% 20% MEI=15% 15% MEI=12% 10% 5% Add new wing to factory $1 mil. Renovate plant $2 million 0 1 2 MEI = 7% Acquire additional power facilities Install computer $1.5 mil. system $1 mil. Purchase machines $1.5 mil. 3 4 5 6 [QID] Quantity of Investment Demanded (millions) Real Interest Rates [MEI] Firms invest with their profits 25% & also borrow(5%) to invest.(10%) 20% [A 20% cost of funds attract $100 billion of investment 15% 10% 5% I.R. DI (MEI) A 5% cost of funds attracts $200 bil. Ig 0 50 100 QID1 QID 150 200 250 QID2 Change in QID [interest rate change, point to point movements] Single Firm Positive profit expectations and the real interest rate are the most important determinants of investment. Drill Press - $1,000 A. Expected gross profits = $1,100 or a 10% return. [$100/$1,000 x 100 = 10%] [At 8%, invest in the drill; at 12%, don’t invest] B. Real interest rate [nominal interest rate-inflation] (percents) Expected rate of return, and interest rate, 10 r, 16 i (Interest rate change, point to point movement) DI Firms will undertake all investments [additions to plant, equipment, inventory, 14 and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest. 12 Monetary Policy – by lowering interest rates, the Fed can increase Ig & employment. 8% 6 4% 2 0 1 10 15 20 25 30 35 40 Investment (billions) QID QID [Inverse relationship between real interest rate and QID] Increase in Investment 1. 2. 3. 4. 5. I1 Positive profit expectations Scarcity of inventory Technology [innovation] Decrease in production costs Decrease in business taxes I2 8% QID1 QID2 Investment Investment Schedule Ig independent of Y DI Investment (billions of dollars) Expected rate of return, r, and real interest rate, i (percents) Demand Curve 8 20 Ig 20 20 20 20 Investment (billions of dollars) Y1 Y2 Y3 Real Domestic Product, GDP (billions of dollars) Ig on the AE graph will be independent [not influenced] by income. Investment decisions are forward-looking and made months ahead. “Closed” Closed and “private” [C+Ig] “Simple Economy” “Open” & “private” [C+Ig+Xn] “Open” & “mixed” [C+Ig+G+Xn] “Complex Economy” C+Ig Assumptions: No internat. trade or “G” ; no business saving; depreciation & NFFIEUS are 0; PL is constant [Keynesian] [GDP = DI] 1. The most important determinant of consumer spending is (wealth/indebtedness/income). 2. As aggregate income increases, consumption and saving both (increase/decrease). 3. The (consumption/saving) schedule shows how much households plan to consume at various income levels. 4. Dissaving occurs where consumption (exceeds/is less than) Y. 5. If the consumption schedule shifts upward [not caused by a tax change], the saving schedule will shift (upward/downward). 6. (The expectation of a recession/A change in consumer incomes/ An expected change in the price level) will not cause the consumption curve to shift. APC and APS APC - percentage of income (“Y”) consumed. APS – percentage of income (“Y”) saved. APC = C/Y(DI)=$48,000/$50,000 = .96 1 APS = S/Y(DI)= $2,000/$50,000 = .04 APC = C/Y=$52,000/$50,000 = 1.04 1 APS = S/Y= -$2,000/$50,000 = -.04 “Econ, Econ, APS=S/Y “High maintenance Econ teacher” What in the world is AE? AE=GDP APC=C/Y MPC, MPS, & the Multiplier ME=1/MPS MPC - % change in Y consumed. MPS - % change in Y saved. MPC = C/ Y = $750/$1,000 = .75 MPS = S/ Y = $250/$1,000 = .25 Multiplier [1/MPS]=1/.25=$1/.25 = “ME” of 4 [MPC is important for G in policy making decisions.] *The ME is the reciprocal of the MPS. The “ME” works like a concentric circle. $20 billion “G” [with ME of 4] 15 bil. 11.25 bil. 8.5 bil. MPC of 75% G spends $200 billion on the highways. Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 billion [$37.50 billion] and spend 75% or $112.50 billion on iPhones, etc. ME = 1/MPS, 1/.25 = $1/.25 = ME of 4 (billions ) ME is 4 & we are short of Y*[$860] by $60 billion AE[C+Ig+G] Equilibrium AE[C+Ig+G] AE[C+Ig] G = $15 Billion +60 Recess. Spending gap o Recessionary GDP Gap 45 o Recess. Gap 800 Yr “M” = 860 Y* Real GDP Y/ E = 60/15 = 4 Now, let’s look at the Tax Multiplier [MT] MT = -MPC/MPS, -.75/.25 = ME of -3 MT is -3 & we are short of Y*[$860] by $60 billion -3 x ? will close a $60 billion GDP gap? With this situation, [short of Y* by $60 bil.], we would need to decrease taxes by $20 billion, with a multiplier of -3. [-3 x -$20 = $60] MT = -MPC/MPS, -.75/.25 = MT of -3 (billions ) MT is -3 & we are short of Y*[$860] by $60 billion AE[C+Ig+G] Equilibrium AE[C+Ig+G] AE[C+Ig] +60 Recess. Spending gap o Recessionary GDP Gap 45 o Recess. Gap 800 Yr -3 x -$20 = $60 billion 860 Y* Real GDP ME and MT Let’s say that we have a Recessionary GDP [Output] Gap of $60 billion & the MPS is .50. Let’s correct the economy by first using: 1.) Government spending, and then using a 2.) Tax cut With a MPS of .50, what is the ME? 1/.5 = With a MPS of .50, what is the MT? -.5/.5 = - AE[C+Ig+G] Equilibrium AE[C+Ig] G = $30 Billion AE[C+Ig+G] (billions of dollars) ME = 1/MPS, 1/.50 = $1/.50 = ME of 2 ME is 2 & we are short of Y*[$860] by $60 billion Recess. Spending gap o Recessionary GDP Gap +60 45 o Recess. Gap 800 YR “M” = -2 x -$30 = $60 billion 860 Y* Real GDP Y/ E = 60/30 = 2 MT = -MPC/MPS, -.50/.50 = MT of -1 recessionary gap with a tax cut. MPS=.5 Recess. Spending gap o Recessionary GDP Gap AE[C+Ig+G] Equilibrium AE[C+Ig] AE[C+Ig+G] Now, let’s look at correcting this $60 billion (billions of dollars) MT is -1 & we are short of Y*[$860] by $60 billion +60 45 o Recess. Gap 800 YR -1 x -$60 = $60 billion 860 Y* Real GDP ME = 1/MPS, 1/.50 = $1/.50 = ME of 2 ME is 2 & we are beyond Y*[$840] by $40 billion AE [C+Ig+G] AE[C+Ig+G] (billions of dollars) 2 x -? [Decrease in G] = -40 o AE[C+Ig-G] Equilibrium Inflationary Spending gap=$20 B -40 45 o Inflat. Gap 840 Y* 880 Real GDP YI Inflationary GDP Gap MT = -MPC/MPS, -.50/.50 = MT of -1 MT is -1 & we are beyond Y*[$840] by $40 billion AE[C+Ig+G] Now, with a MT of 1, we would need a tax increase of how much to close the $40 bil. inflationary gap? (billions of dollars) AE [C+Ig+G] Equilibrium -40 -1 x ? [incre in T] = -40 $40 billion tax increase o AE[C+Ig+G] 45º Inflat. Gap 840 Y* 880 Real GDP YI Inflationary GDP Gap ME The ME is always positive. MPC .90 .80 .75 .60 .50 1/MPS 1/.10 1/.20 1/.25 1/.40 1/.50 = ME = 10 = 5 = 4 = 2.5 = 2 Reasons why the “Simple Multiplier” is not as strong as indicated. 1. Some spending will be on imports, reducing the size of the M. 2. It ignores PL changes which reduce the multiplier. 3. It ignores taxes which reduce the multiplier. MT The MT is always negative. MPC .90 .80 .75 .60 .50 -MPC/MPS = -MPC/.10 -MPC/.20 -MPC/.25 -MPC/.40 -MPC/.50 = = = = = MT -9 -4 -3 -1.5 -1 When the G gives a tax cut, the MT is smaller than the ME because a fraction [MPS] is saved and only the MPC is initially spent. So, the MT = -MPC/MPS. MBB Why is the MBB always “1”? 1/ -MPC/ + MPS MPS = 1- MPC/MPS = MPS/MPS = “1” Let’s say the MPC is .90 1/ -.90/ 1- .90/ .10/ + = = .10 .10 .10 .10 = “1” Or, Let’s say the MPC is .75 1/ -.75/ 1- .75/ .25/ + = = .25 .25 .25 .25 = “1” Notice the 2nd round with MT=-MPC/MPS .9 [10] versus .5 [2] MBB=1 G ME=1/MPS 2 Round at .9 90% -9 1 .9 2 Round at .510 50% nd nd .8 .75 .60 .5 5 -4 1 When Arlington gets the Super Bowl in 2012, it will have an estimated economic impact of $419 million. 200,000 people will visit the area. 2008 Final Four in San Antonio brought 57,000 4 -31 The visitors[$223 per day], $47 M in 4 days & $120 M trickle effect. The Texas-Oklahoma game brings $34 mil to D-FW. 2.5 -1.5 1 2007 Cotton Bowl brought $30 million to D-FW. Super Bowl brought $336 million to Houston. Fiesta Bowl for national title brought in $85 million. 2 -1 1 Big 12 Tournament brought $45 million to D-FW The larger the MPC, the smaller the MPS, and the greater the multiplier. This is the “simple multiplier” because it is based on a “simple model of the economy”. OU • $150 - Parking rates around the stadium • $500-$600 per Super Bowl ticket [$2,000-$6,000 on E-Bay for a seat] • $12,000 – cost of Super Bowl trophy Reliant Stadium • $2.3 million – 30 second ad • $50,000 – Super Bowl Ring • 68,000 to each player on the winning team • $36,500 to each player on the losing team. • $3.35 million to the winning team • $2.59 million to the losing team • Hotels - $69 M; bars & restaurants-$27 M; entertainment-$15 M; transportation-$15 M; and retail sales-$41 M Government increases spending by $1 billion with a multiplier of 2 $1,000.00 On new highways 500.00 Highway workers buy new boats 250.00 Boat builders buy plasma TVs 125.00 TV factory workers buy new cars 62.50 Auto workers buy “wife beater shirts” 31.25 Apparel workers spend $ on movies 15.625 Movie moguls spend money on Christina 7.8125 Agulera songs. 3.90625 1.953125 “What A Girl .9765625 Wants.” .48828125 .244140625 .1220703125 .06103515625 .030517578125 .015258789062 $2,000,000,000 [Increased by a multiple of 2] Let’s Go To Padre Island and Party With The Multiplier UT student These are Texas A&M students at Padre. • During spring break, college students like to head to Padre Island. • • • • • The “multiplier” is getting ready to work. With dollars in their pockets, the students spend money on food and drink, motel rooms, dance clubs, etc. These dollars raise total income there by some multiple of itself. College students buy pizzas, beer, and sodas. The people who sell these items find their incomes rising. They spend some fraction of their increased income, which generates additional income for others. If the students spend $8 million at Padre and the MPC is .60, then college students will increase income in Padre by $20 million. When the networks show scenes on the beach, the average person simply sees college students having a good time. But – economists see the multiplier at work, generating higher levels of income for many of the residents of Padre Island. If business activity slows, then sales of houses and autos decrease. Home construction workers and auto workers get laid off. Auto companies cancel their orders for steel and steel workers laid off. Furniture sales are down so some of the furniture workers are laid off. Laid off people don’t buy new clothes or cars so more lay-offs. They also don’t eat out as much so some restaurant workers laid off. Company profits are down, depressing stock prices, making people poorer, so they buy even less. And so it goes, the multiplier in reverse. NS 7 – 10 7. The APC indicates the percent of total income that will be (consumed/saved). 8. The MPC is the fraction of a change in income which is (spent/saved). 9. The greater is the MPC, the (larger/smaller) the MPS, and the (larger/smaller) the multiplier. 10. With a MPS of .4, the MPC will be (.4/.2/.6) and the multiplier will be (2/2.5/4). Multiplier – As the money goes from one person, to another, to another… [From “Simple” to “Complex” economy] [C+Ig] Private Closed (private-closed) [C+Ig+Xn] Private Open (private-open) [C+Ig+G+Xn] “ME” = 4 Mixed Open (mixed-open) S AE3 (C+Ig+G+Xn) (Complex Economy) [Mixed-open] (AE3)550 AE21)470 )470 ((AE C=390 AE1(C+Ig)[B asic(Private-open) Economy][Private (no G)-Closed(no X or M)] AE2 (C+Ig+Xn) [X(10)-M(10)] +20 G Consumption +20 Ig + Xn +80 +80 45º 0 390 470 550 Real GDP Injections Leakages 1. Investment [20]= 1. Saving[20] Notice that the injections are 2. Exports [10]= 2. Imports[10] autonomous (independent) of Y 3. Government [20]= 3. Taxes [20] How to figure the MPC & MPS Consumption [MPC = C/ Y] [MPS = S D S/ Y] SAVING Consumption C2 C A C1 Dissaving o MPC=? BC/EF[or AB] B MPS=? CD/EF 45 H E F Disposable Income [C+Ig] AE $1,000 $700 $400 $100 H AE1[C+Ig] Consumption I J P o 45 200 400 0 N Q 1,000 bil. Real K GDP Consumption will be equal to income at income level ? $400 With Ig [C+Ig], the MPC is? PI/QK The MPS is ? HI/QK What income level represents “dissaving”? $200 Consumption D 1,000 Consumption 700 A 400 45 0 C B o 200 400 1,000 F H E Income 11. The APC is one at letter (A/B/C/D). 12. The MPC is equal to (AE/OE or BC/EF[or AB]). [moving from OE(400) to OF(1,000)] 13. At income level “OF” the volume of saving is (CB/CD). 14. Consumption will be equal to income at income level (OH/OE). 15. The economy is dissaving at income level (OH/OF). 16. The MPS is (CD/EF or CB/EF). [moving from OE to OF] An Increase in G of $20B is more expansionary than a decrease in T of $20 B [If the MPC is .75, ME is 4 but the MT is only 3] AE AE2(C+Ig+G) AE1(C+Ig) +80 YR F* 500 580 Incr G spending by $20 bil. “ME” of 4 [1/.25] [20 x 4 = $80] Let’s see, anyone’s spending (G,Ig, or Xn) becomes someone else’s income, so there will be an increase in “C”. AE AE2 AE1 “Big 12” Tournament brings $45 million to the DFW economy. AAC “Tax cut” of $20 billion “MT” = -3 [-.75/.25] x -20 = $60 +60 YR 560 Y* 500 580 [Need a 25% larger “Tax cut” to get to $580] “Tax cut of -$25.67 billion x -3 = $80] Increase in G of $40 Billion with MPS of .5 1st Round = $40 billion spent on the highways 2nd Round=$20 billion on motorcycles The multiplier is the multiple in which an initial change in aggregate spending will alter total spending after an infinite # of spending cycles. Total spending change = M X new spending injection. 3rd Round, only $10 billion spent on corvettes Decrease in Taxes of $40 B with MPS of .5 With MPS of .50, $20 is saved & & only $20 bil is spent 1st round. Leakage of 50% [saving of $20 bil.] in the first round 2nd Round: only $10 bil. is spent. 3rd Round only $5 bil. is spent. Balanced Budget Multiplier (“1”) $20 G $20 T [Increase G & T by $20 billion] ME of 2 & MT of -1 ME of “2” [So MT is -“1”] AE2[C+Ig] AE1[C+Ig] AE “G” [+20] 40 -20 “T” ME of 5 & MT of 4 ME of “5” [So MT is -“4”] “G” [+20] -80 +$20 $600 $620 100 “T” ME of 10 & MT of 9 MBB = 1 x G 1 x $20 ME of “10” “G” [+20] -180 [So MT is -“9”] 200 “T” 1993 Macro Free Response Long Question 1. Suppose that the following conditions describe the current U.S. economy. - The unemployment rate is 5% - Inflation is 2% - Real GDP is growing at the rate of 3% I. First assume that the federal government increases its spending and increases taxes so as to maintain a balanced budget. Using AD/AS analysis, explain the short-run effects of these policies on each of the following. (a) Output/employment (b) The price level (c) Interest rates PL With G&T increased by the same amount, & since 1st round G is not subject to the MPS but T is, this 3% would result in an “expansionary fiscal policy” and 2% increase GDP by the same amount as the equal increase in G and T, which would increase AD. LRAS SRAS D1 D2 5% 4.8% RGDP This increase in AD would increase GDP, employment and price level. The increase in price level *increases demand for money and this increases interest rates. Balanced Budget Multiplier [$20 billion] [“T” affects AD indirectly thru “C”; “G” affects AD directly] Net Change in GDP = The increase in “T” means we would have consumed $15 and kept $5 in our pockets. Sa= -$5 T The increase in “G” flows directly into the economy. +$20 GDP= -$60 $20 Ca= -$15 GDP =$80 MT = -MPC/MPS = -.75/.25=-3 So, -3 x $20 = -$60 AS AD1AD2 PL $470 billion $490 billion G $20 ME = 1/MPS ME = 1/.25 = 4 So, 4 x $20 = $80 The ME, MT, & MBB Multipliers ME [C, Ig, G, or Xn] = 1/MPS = 1/.25 = 4 So, G increase of $20 bil. will incr Y by $80 bil. [+$20x4=$80] And a G decrease of $20 bil. will decrease Y by $80 bil. [-$20x4=-$80 bil.] MT = -MPC/MPS = -.75/.25 = -3 So, T decrease of $20 bil. will incr Y by $60 bil. [-$20 x-3=$60] And a T increase of $20 bil. will decr Y by $60 bil. [+$20x-3=-$60] MBB = 1 X ( G) So, an increase in G&T of $20 bil. will incr Y by $20 bil. [1X$20=$20] And a decrease in G&T of $20 bil. will decr Y by $20 bil.[1X-$20=-$20] Any increase in expenditures x the M will increase GDP.. Any decrease in expenditures x the M will decrease GDP. 1. INSTRUCTIONS FOR THE NEXT FOUR AE SLIDES We will start at $500 equilibrium GDP on each. Inflationary spending gap 2. Of the three items (equilibrium GDP, change in expenditures, & MPC), you will be given two and if you know 2 you can always figure out the 3rd. For instance, if you knew that equilibrium GDP increased by $400 and the multiplier was 4, then the change in expenditures was obviously $100. AE2 AE E2 AE1 E1 AE3 E3 500 Recessionary spending gap Recessionary Inflationary GDP gap 3. Except for 6, 9, 15, & 18, you will increase GDP gap equilibrium GDP above $500, because there is an increase in G, or a decrease in T, or an equal increase in G&T. Ex: With MPC of .75 & therefore a ME of 4, an increase in G of $20 means +$20 x 4 = $580 4. On questions 6, 9, 15, & 18, you will decrease equilibrium GDP below $500 because you are either decreasing G, increasing T, or there is an equal decrease in G & T. Ex: With MPC of .75 & therefore a ME of 4, a decrease in G of $20 means -$20 x 4 = -$80; so ends up at $420. The Multiplier & Equilibrium GDP [Give the correct equilibrium GDP [start from $500] using the ME, MT, MBB] ME=1/MPS [chg in G, Xg, or Xn] MT = -MPC/MPS [Chg in T ] MBB = 1 X[ G ] Inflationary Spending gap AE E2 E1 Chg in Equilibrium GDP Change in Expenditures MPC [So MPS & ME, MT, & MBB] [+G] 1. ME = ____ 560 [-T] 2. MT = ____ 548 [+G&T] 3. MBB =____ 512 1 60 Y with ME ____ 48 with MT ____Y 12 with ____Y MBB ______ $12 ME__ 5 ______ -$12 -4 MT___ .80 $12 ______ MBB1 ___ ME’s [G,Ig,Xn] MPC M .90 = 10 .87.5= 8 .80 = 5 .75 = 4 .60 =2.5 .50 = 2 540 [+G] 1. ME = ____ S [-T] 2. MT = ____ 520 AE1 520 AE2 [+G&T] 3. MBB =____ AE3 E3 45° Recessionary $500 Spending gap 700 [+G] 1. ME = ____ [-T] 2. MT = ____ 650 [+G&T] 3. MBB =____ 550 2 $200 Y with ME _____Y with MT 150 50 with MBB _____Y ______ $50 ______ -$50 ______ $50 .75 ME__ 4 MT___ -3 MBB___ 1 40 ___ Y with ME 20 with MT ____Y 20 with MBB ____Y ______ $20 2 ME__ ______ -1 -$20 .50 MT___ MBB___ 1 $20 ______ MT’s MPC M .90 = -9 .87.5= -7 .80 = -4 .75 = -3 .60= -1.5 .50 = -1 [+G] 1. ME = ____ 600 [-T] 2. MT = ____ 590 510 [+G&T] 3. MBB =____ 3 $100 Y with ME 90 ___Y with MT 10 ___Y with MBB ______ $10 ______ -$10 $10 ______ __ .9 ME10 -9 ? MT___ 1 MBB___ [+G] 1. ME = ____ 550 [-T] 2. MT = ____ 530 [+G&T] 3. MBB =____ 520 4 ___ Y with ME 50 ____Y 30 with MT ____Y 20 with MBB .60 ______ $20 ME__ 2.5 ______ -$20 MT___ -1.5 ______ $20 MBB___ 1 [+G] 1. ME = ____ 575 [-T] 2. MT = ____ 560 [+G&T] 3. MBB =____ 515 7 ___ 75 Y with ME ____Y 60 with MT 15 with MBB ____Y .80 ______ $15 ME__ 5 ______ -$15 MT-4 ___ ______ $15 MBB___ 1 [+G] 1. ME = ____ 600 [-T] 2. MT = 550 ____ [+G&T] 3. MBB =____ 550 5 100 ___ Y with ME 50 with MT ____Y ____Y with MBB 50 $50 ______ ? ______ -$50 ______ $50 .50 ME__ 2 MT___ -1 MBB___ 1 [+G] 1. ME = ____ 900 [-T] 2. MT = 800 ____ [+G&T] 3. MBB =____ 600 8 ___ Y with ME 400 ____Y with MT 300 ____Y with MBB 100 .75 ______ $100 ME__ 4 ______ MT___ -$100 -3 ______ MBB___ $100 1 [-G] 1. ME = 460 ___ 465 [+T] 2. MT =___ [-G&T]3.MBB=___ 495 6 -40 ___ Y with ME -35 ____Y with MT ____Y -5 with MBB -$5 ______ ______ $5 ______ -$5 87.5 ME__ 8 -7 MT___ MBB___ 1 [-G] 1. ME =___ 300 [+T] 2. MT =___ 320 [-G&T]3.MBB=___ 480 9 ___ Y with ME -200 -180 ____Y with MT ____Y with MBB -20 .9 ______ -$20 ME__ 10 ______ $20 MT___ -9 ______ -$20 MBB___ 1 [+G] 1. ME = ____ 625 [-T] 2. MT = ____ 575 [+G&T] 3. MBB =____ 550 ___ Y with ME 10 125 ____Y 75 with MT ____Y 50 with MBB _____ $50 _____ -$50 _____ $50 .60 ME__ 2.5 MT-1.5 ___ 1 MBB___ [+G] 1. ME = ____ 560 [-T] 2. MT = ____ 545 [+G&T] 3. MBB =____ 515 13 ___ 60 Y with ME ____Y 45 with MT 15 with MBB ____Y _____ $15 _____ -$15 _____ $15 .75 ME__ 4 MT___ -3 MBB___ 1 [+G] 1. ME = ____ 540 [-T] 2. MT = 538 ____ [+G&T] 3. MBB =____ 502 [+G] 1. ME = 550 ___ 540 [-T] 2. MT =___ [+G&T]3.MBB=___ 510 11 ___ 40 Y with ME 12 ___ 50 Y with ME 38 with MT ____Y ____Y 2 with MBB ?_____ $2 _____ -$2 _____ -$2 .95 ME__ 20 MT-19 ___ 1 MBB___ [+G] 1. ME = ____ 700 [-T] 2. MT = 600 ____ [+G&T] 3. MBB =____ 600 14 ___ 200 Y with ME ____Y with MT 100 ____Y with MBB 100 ? .50 $______ 100 ME__ 2 -$______ 100 MT___ -1 1 $______ 100 MBB___ 40 with MT ____Y ____Y 10 with MBB ? _____ .80 $10 ME__ 5 _____ -$10 MT___ -4 _____ $10 MBB___ 1 [-G] 1. ME =___ 420 [+T] 2. MT =___ 430 [-G&T]3.MBB=___ 490 15 -80 Y with ME ___ ____Y with MT -70 ____Y with MBB -10 ______ -$10 ______ $10 ______ -$10 87.5 ME__ 8 MT___ -7 MBB___ 1 [+G] 1. ME = ____ 625 [-T] 2. MT = ____ 600 [+G&T] 3. MBB =____ 525 16 125 ___ Y with ME 100 ____Y with MT 25 with MBB ____Y .80 _______ $25 ME__5 _______ MT-4 -$25 ___ _______ $25 MBB___ 1 532 [+G] 1. ME = ____ [-T] 2. MT = 524 ____ [+G&T] 3. MBB =____ 508 [-G] 1. ME = ___ 400 410 [+T] 2. MT =___ [-G&T]3.MBB=___ 490 17 ___ 32 Y with ME 18 -100 ___ Y with ME 24 with MT ____Y 8 with MBB ____Y .75 _______ $8 ME__ 4 _______ -$8 MT___ -3 _______ $8 MBB___ 1 ____Y with MT -90 ____Y with MBB -10 .9 _______ -$10 ME10 __ _______ $10 MT___ -9 _______ -$10 MBB___ 1 U.S. Consumption and Income $7000 2000 CONSUMPTION (billions) 6000 5000 4000 3000 2000 1000 45° 0 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 Actual consumer spending [so, gives us APC] C = YD $1000 2000 3000 4000 5000 6000 7000 DISPOSABLE INCOME (billions of dollars per year) The Consumption Function: How large we expect the basic flow of consumer spending to be at different levels of GDP (income) C/Y = $4,425/$4,800 = 92% 1993 Saving = $375.0 billion “C” = $4,425 “S” = $375 1929 – Saving = $4 bil. 1933 – Dissaving 1944 – Saving = 20% = Equilibrium GDP [$470] 530 (C + Ig = GDP) Consumption (billions of dollars) 510 Equilibrium Point 490 470 C + Ig C 450 430 410 390 C = $450 Billion 370 45° 370 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) (2) Real Domestic (3) (5) (6) Output Con(1) (4) Investment Aggregate (and sumpEmploy- Income) tion Saving (S) (Ig) Expenditures ment (GDP=DI) (C) (1-2) (C+Ig) (7) (8) MPC MPS …in Billions of Dollars (1) 40 $370 $375 $-5 20 $395 .75 .25 (2) 45 390 390 0 20 410 .75 .25 (3) 50 410 405 5 20 425 .75 .25 (4) 55 430 420 10 20 440 .75 .25 (5) 60 450 435 15 20 455 .75 .25 (6) 65 470 450 20 20 470 .75 .25 (7) 70 490 465 25 20 485 .75 .25 (8) 75 510 480 30 20 500 .75 .25 (9) 80 530 495 35 20 515 .75 .25 (10) 85 550 510 40 20 530 .75 .25 Leakage (S of $20 B) = Injection (Ig of $20 B) At Equilibrium, Any Injections = Any Leakages Injections = Leakages C+Ig Ig(20) = S(20) = S(20)+ M(10) [Private-closed] C+Ig+Xn Ig(20)+X(10) [Private-open] C+Ig+G+Xn Ig(20)+G(20)+X(10) = S(20)+T(20)+M(10) [Mixed-open] = Autonomous v. Induced Investment So Ig is said to be “forward looking”, based more on profit expectations, rather than current income. Investment induced by income (dependent” or “stimulated by Y” Autonomous Investment “Independent of” or “not stimulated by Y” Autonomous-independent of [not stimulated] by income Induced - ”dependent” [stimulated] by income Percentage Change 40 30 Gross Investment 20 10 GDP 0 -10 -20 -30 R R 1971 1975 1979 R1983 R R1995 1987 1991 Year 1999 R 2003 • Durability – Capital has a long life-span, therefore once it is built there is no immediate need for further investment. • Irregularity of Innovation – Innovation does not proceed in a smooth linear fashion, instead there are bursts of innovation followed by periods of relative stability. • Variability of Profits – Profitability is subject to the forces of competition, cyclical changes in the economy, & human management decisions. • Variability of Expectations – Political, social & natural phenomenon shape our positive and negative expectations of the future. Inflation and the Multiplier [4] Full Multiplier Effect Price Level AD1 AD2 AS AD3 +20 +20 Reduced Multiplier Effect Due to Inflation P2 P1 + 80 bil. M(4) = Y/ E [80] [20] GDP1 + 40 bil. GDP2 GDP3 M(2) = Y/ E [40] [20] [MPS=.20] the multiplier at work... $5 billion initial direct increase in spending AS AD1 AD 2 Full $25 billion increase in AD Price level +5 PL1 $475 500 Real GDP (billions) $5 billion initial direct increase in spending Price level AD1 AD2 +5 Reduced AS Multiplier Effect Due to Inflation ME = 4 20/5=4 PL2 PL1 $20 billion $25 billion 520 $500 Real GDP (billions) ME = 5 25/5=5 525