AP Macroeconomics
Unit 3: National Income and Price Determination
Spending & Saving
• Spending, also called consumption, and saving are part of
marginal analysis.
– Since consumption is the largest part of aggregate expenditures (C
being biggest portion of GDP) it is important to understand
marginal propensity to consume.
• How much of your income do you spend vs. how much do you save? If
you got $100, what percent would you spend and what percent would
you save?
– Can see propensity to consume or save with a consumption
schedule or a saving schedule (p. 161).
• There is also average propensity to consume and average
propensity to save.
APC = consumption / income
APS = savings / income
MPC and MPS
• Marginal propensity to consume (MPC) is
determined by ∆ consumption / ∆
income.
– On a graph, a steeper consumption line
means greater MPC.
• A shallower line means lower MPC.
• Marginal propensity to save (MPS) is
determined by ∆ savings / ∆ income.
• MPC and MPS are influenced by several
things:
– Wealth
• The more wealth a household has
accumulated the more of its current income
will be spent (p. 164).
• Though stock market prices do not directly
affect GDP, this Wealth Effect causing
increased MPC could be the result of an
increase in stock market prices. Why?
Determinants of MPC and MPS
• Expectations of future prices
• If you think prices will rise in the future you will
consume more today.
• Taxes
• Higher income taxes lower both consumption and
saving proportionately, and lower income taxes
increase consumption and saving proportionately.
– MPC and MPS are not altered.
• Higher sales taxes lower consumption.
• Higher capital gains taxes, the taxes on investment
profit, lower investment.
• Higher estate taxes, taxes on inherited property,
decrease savings.
• Debt
• When household debt gets too high MPC declines.
• Economists are worried about the increasing level of
college loan debt reducing MPC and weakening the
economy.
Marginal Propensity to Invest
• Most people spend most of their
wages in consumption. Businesses
and individuals, however, can invest
as well as consume or save.
• Marginal propensity to invest (spend
on capital; not necessarily invest in
the stock market) is influenced by
– Expected rate of return
• The higher the expected rate of return,
the greater the MPI.
– Real interest rate
• The higher the real interest rate (nominal
interest rate – inflation), the lower the
MPI.
– You don’t want to have to pay back that much
$.
MPI Continued
• The expected rate of return is also affected by:
– Operating costs
• The lower the operating costs, the higher the rate of return.
– Lower operating costs shift the demand curve for investment to the
right.
– Business taxes
• The lower the taxes, the higher the rate of return.
– Returns are considered to be after taxes
– Lower taxes shift the demand curve for investment to the right.
– Stock of capital
• The more capital you have, the lower the expected rate of
return by investing in new capital.
– Less stockpile of capital means more “bang for your buck” in investing
in new capital; demand curve for investment shifts to the right.
Marginal Propensities Continued
• Equilibrium GDP is the point where Consumption (C)
and Investment (I ) = Real Domestic Output.
G
– At this point (see page 173) there is no increase or decrease
in stockpiles of capital or consumer goods and
unemployment and prices are stable.
– The amount of Saving = The amount of Investment (I )
G
• More Saving than Investing = Decreasing employment and output.
• More Investing than Saving = Excess output and employment
(overproduction, likely leading to inflation).
• Unless a question specifically includes investment, only
consumption and saving are considered.
• MPC + MPS = 1
Marginal Propensities to Spend and Invest Affect Aggregate Expenditures
• Output and consumption are separate, so it is
possible to overconsume or underconsume.
• If aggregate expenditures (C+I+G+XN) exceed output
(AE is above 45 degree slope, or equilibrium slope),
then inventories are falling because more stuff is
being purchased than is being added to inventories.
• If AE is below the equilibrium line, inventories will
accumulate because less stuff is being purchased
than is being added to inventories.
• Equilibrium GDP is achieved when the AE line meets
the equilibrium line.
– The lines are not of equal slope because MPC < 1,
meaning that not all increases in income are spent
(become part of agg. expenditures).
– At lower levels of income (GDP2), people spend more
than their total income to make ends meet (resulting in
dissavings, or using up their savings), resulting in
“falling inventories.”
– At higher levels of income (GDP1), people do not have
to spend all of their income to purchase everything
they want, resulting in “accumulating inventories”
(savings).
The Multiplier Effect
• Changes in expenditures cause changes in GDP. The size of
the change depends on the multiplier effect (p. 183). The
multiplier is determined by
∆ real GDP / initial ∆ in spending
• The multiplier effect exists because money flows through the
economy in multiple steps. For example, if MPC is 90% of
income, an initial investment of $100 does this
--------------------
MPC and MPS are affected by
multiple factors, including the
reserve requirement at banks
Multiplier and Marginal Propensities
• When raising or lowering taxes, interest rates, or reserve requirements
to stabilize or increase GDP the government must be aware of the
multiplier effect. To have the greatest effect a stimulus should occur
when MPS is lower.
• Multiplier = 1 / MPS, or 1/ 1-MPC
• Because the multiplier will not be static in real life and can change after
each additional transfer of money, the real life multiplier is called the
complex multiplier. In the United States is estimated to be about 2 (in
2002).
• The Spending Multiplier (above) is important in finding the Tax
Multiplier, which reveals how much spending will be generated by a
cut in taxes. Since not all of a tax cut will be spent, the amount of
money saved by the cut must be multiplied by the Spending Multiplier.
– SM = 1/MPS or 1/ 1-MPC
– TM = MPC (1/MPS)
Aggregate Demand Curve…Why is it Downward-Sloping?
• Real-Balances Effect: A higher price level means less consumption spending
because your $ is worth less (shift along the AD curve).
↑ Prices = ↓ output demanded because you have lower real income
• Interest-Rate Effect: Higher prices lead to lower real output demanded because
higher prices lead to higher interest rates (Bellringer 23).
↑ Prices = ↑ interest rates = less demand to buy things you must finance,
such as houses, cars, new capital.
• Foreign Purchases Effect: Higher prices lead to lower demand for U.S. exports,
thus reducing X and GDP.
N
• Foreigners like cheap U.S. goods; will buy domestic if imports become too expensive.
Determinants of Aggregate Demand
• Changes in prices lead to shifts along the AD curve.
• Shifts in the AD curve itself (AD shifters) include increased or
decreased spending:
– Consumer spending
• Affected by consumer wealth, expectations, indebtedness, and taxes (stuff from
Quiz 3 affecting consumption and MPC).
– Investment spending
• Affected by real interest rates and expected returns.
– Expected returns are influenced by future expectations of business conditions (p. 207),
technology, degree of excess capacity, and taxes.
– Degree of excess capacity means how much more output can be generated by your existing
capital. There is an inverse relationship between degree of excess capital and demand for
investment.
– Government spending
– Net EXport spending
Hmmm…C+I+G+XN …What did this equal again?
• Changes in stock prices do not affect AD.
Aggregate Supply
• Aggregate supply is what is produced by society
as a whole.
– The aggregate supply curve looks different than a
traditional supply curve, though.
– There is a horizontal range of supply that means
prices stay stable even as quantity supplied ↑
– This means a recession. Workers cannot get higher wages and
resource suppliers can’t charge higher prices. Firms can make
more without paying higher per-unit costs.
– The intermediate range (between “a” and “b”) is
where full employment begins to be reached by
various industries.
– Prices ↑ because workers can now demand higher wages.
– The vertical range is where full employment has
been reached. Production is at full capacity.
– Real output remains unchanged but individual firms can increase
or decrease output at the expense of rival (zero-sum game)
Determinants of Aggregate Supply
• Input prices
↑ Input prices = ↓ Aggregate supply
– Domestic resource availability
• Land
• Labor
– Wages and salaries make up about 75% of all business costs
• Capital
• Entrepreneurship
– Prices of imported resources
• If U.S. dollar appreciates the U.S. can buy more stuff from abroad,
meaning aggregate supply ↑. If the dollar depreciates the U.S. can only
afford less stuff from abroad, so aggregate supply ↓
Determinants of Aggregate Supply
• Market share/power
– The more powerful a supplier is the more it can shift the
aggregate supply curve (OPEC, monopolies, oligopolies)
•Large oligopolies like OPEC can cause supply shocks and cost- push
inflation by drastically raising prices, causing inflation and
unemployment to both increase.
• Productivity
•If productivity (efficiency) ↑ so does aggregate supply
• Laws and Taxes
Higher taxes = ↓ aggregate supply
Subsidies = ↑aggregate supply
Laws and regulations on business = ↓ aggregate supply
Equilibrium Price and Output
• Increasing aggregate demand will have little effect on
price levels in the horizontal range of aggregate supply.
• Increasing AD will have normal effects on price levels in
the intermediate range of AS.
• Increasing AD will have extreme effects on price levels
in the vertical range of AS.
Changes in Equilibrium
• Things that increase Aggregate Demand (AD)
– Demand-pull inflation (you want more stuff)
• Starting in the intermediate range of AS, the multiplier effect is weakened.
• For any initial increase in AD, the resulting increase in real GDP will be smaller
the greater the increase in the price level.
– Means that there is an inverse relationship between a change in output and a change in
price level (if one is big, the other must be small)
• Things that decrease AD
– Recession and cyclical unemployment
• Real output is effected more than prices because of “sticky” pricing and
wages.
– Many employment contracts and union agreements say pay cannot be lowered.
– Companies will rarely lower prices because consumers will then expect more low prices.
– Cost-Push inflation (companies raise prices)
– A leftward shift in AD creates a recessionary gap.
Long Run AD-AS Equilibrium
• In the long run, changes in aggregate
demand and aggregate supply will
affect the other curve.
• Long run aggregate supply is a
vertical line, revealing a fixed long
run output that is independent of
price level or aggregate demand.
– Changes in short run aggregate supply
or aggregate demand will result in a
corresponding shift of the other curve,
restoring equilibrium with an
intersection on the vertical LRAS curve.
• Ex: An increase in aggregate demand can
only bring about a temporary increase in
output, since higher price levels eventually
translate into higher costs of production.
Long Run AD-AS Graph
Labor Productivity
• Real GDP = worker-hours x labor productivity
– Worker-hours influenced by the labor participation rate.
– As labor participation rate ↑ the
vertical LRAS (Long Run Aggregate
Supply) curve shifts to the right.
• Debate exists over increased inputs v. increased
productivity (quantity v. quality):
– Quantity and quality can be increased by investing in the
nation’s infrastructure (p. 329) and in human capital
through investment in education.
Other Determinants of LRAS
• Economies of scale also affect AS. Developed nations with
more large firms may have AS benefits because those firms
are more efficient.
– Remember from Micro: Buying in bulk, streamlining operations,
eliminating redundancy, consolidating, etc.
• Improved resource allocation affects AS. Societies get
better at allocating resources through the use of
comparative advantage and the elimination of
discrimination (p. 330), which violates comparative
advantage.
• Stable politics and lack of social restrictions. Nations that
are politically stable often have greater AS because
producers are more confident.
What Should be Done? Classical Economic
Theory
• Not all economists agree on how big of a
problem things like unemployment and inflation
are to a macro economy.
• Also, not all economists agree on how to fix
problems like unemployment or hyperinflation
when the occur.
• Classical Economists believe that prices and
wages in all markets are flexible and will bring
those markets to equilibrium without
government intervention.
– “The situation will fix itself.”
– The Circular Flow of Economic Activity will remain
in equilibrium (any money “leaked” through savings
will be compensated by increased investments).
– An increase in savings will have a proportional
decrease in interest.
– An increase in unemployment will cause a
proportional decrease in wages and prices.
Keynesian Economic Theory
• John Maynard Keynes was a liberal
economist whose belief that concepts like
sticky prices and wages required
government intervention in the economy
became popular during the Depression.
– The concept of “sticky” says that prices and
wages do not change freely and are instead
predisposed to certain movements, generally
upward, though prices more so than wages.
• Keynesians believe government actions
like raising or lowering government
spending (G) or raising or lowering taxes
(T) are necessary to affect aggregate
demand to achieve market equilibrium.
– Classical economists, by comparison, do not
believe in altering G and T and feel that the
new equilibrium is necessary.
Keynesians
believe in
active
government
efforts to
boost AD
Keynesians and Supply
• Keynesians believe that
surpluses (inflation) and
shortages are problematic and
must be dealt with.
• When there is too much
inflation or inventory (supply) a
Keynesian says producers will
produce less.
• Classical economists, on the
other hand, say supply
generates its own demand,
meaning a surplus is not a
problem.
– Say’s Law
Gov’t can alter Aggregate
Demand without raising
prices
Increased
Aggregate
Supply leads
to increased
Aggregate
Demand,
keeping prices
the same