Y-line
E
E’
rE
E
rY
C* + I*
45
0
o
Ye
Ye’
Figure 11 Multiplier effect
Y
1
Aggregate expenditure
(trillions of 1992 dollars)
The Multiplier
(Parkin)
o
45 line
9
8
7
6
5
0
e
c'
b'
a'
6
d
c
b
a
5
e' AE0
d'
A $0.5 trillion
increase in
investment...
AE1
…increases
real GDP by
$2 trillion
7
8
9
Real GDP (trillions of 1992 dollars)
2
The
Multiplier
Process
(Parkin)
2.0
1.5
1.0
0.5
0
1 2 3 4 5 6
Expenditure round
7 8 9 10 11 12 13 14 15
Increase in current round
3
Cumulative increase from previous rounds
Advanced
Advanced Level
Level
Macroeconomics
Microeconomics
Dr. Lam Pun Lee
Y-line
E
E’
E
45
0
o
Ye
Y1 Y2 Ye’
Y
Figure 14 The movement of expenditure multiplier 4
Previous
slide
1. Calculate the equilibrium level of income.
AE = C + I
AE = 40 + 0.75Y
AE = Y in equilibrium
40 + 0.75Y = Y
Y = 160
2. If I is increased by 10, calculate the new equilibrium
level of income.
AE = C + I = 50 + 0.75Y
AE = Y in equilibrium
50 + 0.75Y = Y
Y = 200
5
An autonomous change in
investment by 10 induces a larger change (40)
in equilibrium level of income.
Why is this so?
6
Rounds of
effects
Autonomous Induced change
change in I
in C
Change in Y
1st
$10
-
$10
2nd
-
$7.5
$7.5
3rd
-
$5.625
$5.625
4th
-
$4.21875
$4.21875
…
-
...
...
Total change:
$10
$30
$40
7
The Multiplier Process
(Miller)
Assumption: MPC = .8 or 4/5
Round
1 ($100 billion per
year increase in I)
2
3
4
5
.
.
.
All later rounds
Totals
Annual Increase
in Real
National Income
($ billions per year)
Annual Increase
in Planned
Consumption
($ billions per year)
Annual Increase
in Planned
Saving
($ billions per year)
100.00
80.00
64.00
51.20
40.96
.
.
.
163.84
80.000
64.00
51.200
40.960
32.768
.
.
.
131.072
20.000
16.000
12.800
10.240
8.192
.
.
.
32.768
500.00
400.00
100.0008
Slide 12-62
How does the Multiplier
work (P.13-7.2.2.2.)?
Any initial change in
spending by the government,
households, or firms creates
a chain reaction of further
spending
9
Y = $10 + $7.5 + $5.625 + …
= I + C + C + …
= I + cY + c2Y + …
= I + cI + c2I + …
= I (1 + c + c2 + …)
= I [1/(1-c)]
Multiplier (k) = Y / I = 1/(1-c)
10
One divided by one tenth equals
10
MULTIPLIER
.
1 .
1
X
1
10
10 =
1
=
10
11
If investment increases by $100,
with an MPC of 9/10, what effect
will this have on the economy?
The economy will grow by
$1,000 eventually
12
If investment declines by $100,
what’s the effect on the economy
with an MPC of 9/10?
The economy will shrink by
$1,000
13
Numerical example
I = 10
c = 0.75
k = 1/(1-c) = 4
E
Y = k I = 4*10 = 40
45 line
E = 50 + 0.75Y
E = 40 + 0.75Y
0
160 200
Y
14
Given:
C = 20 + 0.75Y
I = 20 + 0.1Y
1. Calculate the change in Y resulted from an
autonomous increase in I by $10.
2. Calculate the value of the multiplier.
15
1. Calculate the change in Y resulted from an
autonomous increase in I by $10.
When I = 20 + 0.1Y,
AE = C + I
When I = 30 + 0.1Y,
AE = C + I
AE = 40 + 0.85Y
AE = 50 + 0.85Y
AE = Y in equilibrium
AE = Y in equilibrium
40 + 0.85Y = Y
50 + 0.85Y = Y
Y = 266.67
Y = 333.33
Change in Y = 66.67
16
2. Calculate the value of the multiplier.
k = Change in Y / Change in I = 6.67
If I is an induced function, the size
of the simple Keynesian multiplier
will be greater. Why is this so?
17
Multiplier with induced I
1/mps-mpi
18
Figure 23-10 (Lipsey)
The Size of the Simple Multiplier
19
Relationship between MPC, MPS, and
the Spending Multiplier
MPS
Spending
Multiplier
.90
.80
.75
.67
.10
.20
.25
.33
10
5
4
3
.50
.33
.50
.67
2
1.5
MPC
20
E
S
S’
A
C
I
B
0
Y
Figure 12 The multiplier effects of autonomous
decrease in saving (= C rise)
21
E
S
I’
B
A
C
I
0
Y
Figure 13 The multiplier effects of autonomous
increase in investment
22
3-Sector & 4-Sector Models
The simple Keynesian model discussed
is a two-sector model, which includes
only firms and households. In this
section, we first add the government
sector and then the foreign trade sector
into our model. Lastly, we consider the
concepts of aggregate demand and
aggregate supply and how they are
related with the Keynesian model.
23
Next
slide
C
Household
S
Financial markets
Income
generated
Y
National expenditure
I
Government
T
National income
G
E
Firms
Payment for goods
and service
Figure 1 Three-sector national income model
24
The circular flow of income
Investment (I)
Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Government
expenditure (G)
BANKS, etc
GOV.
Net
Net
taxes (T)
saving (S)
25
E
Slope = c (1 – t)
C
a-cT*
0
Y
Figure 2(d) Consumption function in an 3-sector
income-expenditure diagram
26
Keynes and the Great Depression
• Keynes argued that prices and wages are not
sufficiently flexible to ensure the full employment
of resources
• Furthermore, Keynes argued that when resources
(especially labor) are not fully employed (due to a
lack of private investment expenditures), the
government could provide offsetting expenditures
as a means of stabilizing the economy
• Thus, Keynesian economics places emphasis on
planned expenditures and all its components
27
What is the GDP Gap (P.167.2.5.4. & Wong 2000: 104)?
The difference between
full employment real
GDP and actual real GDP
28
What is the Recessionary
AD Gap (P.16-7.2.5.4.)?
The amount by which
aggregate expenditures
fall short of the amount
required to achieve full
employment equilibrium
29
E
Y-line
G
E
DG
R
45
0
o
Ye
Yf
Y
Figure 2(a) Deflationary AD gap
30
W, J
The deflationary AD gap
W
J
O
Ye
Y
31
W, J
The deflationary AD gap
W
J
O
Ye
YF
Y
32
W, J
The deflationary AD gap
Deflationary AD gap
W
c
d
O
Ye
YF
J
Y
33
W, J
The deflationary AD gap
Deflationary AD gap
W
c
d
O
Ye
YF
J*
J
Y
34
What is the Keynesian
remedy for a Recessionary
AD Gap (P.16-7.2.5.5.)?
Increase autonomous
spending by the amount
of the recessionary AD
gap
35
What can the
Government do to close a
Recessionary AD Gap?
• Increase government
spending
• Lower taxes
• Raise transfer payments
36
Exhibit 2: U.S. Federal Budget Deficits
and Surplus Relative to GDP (P.17-7.2.6.1.2.)
1
1970
1975
1980
1985
1990
1995
2000
0
Percent of GDP
–1
–2
–3
–4
–5
–6
–7
Fiscal Year
Federal Budgets and Public Policy
Source: Developed based on budget figures in Economic Report of37
the President, February 1999.
3
What is an Inflationary AD
Gap (P.16-7.2.5.4.)?
The amount by which
aggregate expenditures
exceed the amount
required to achieve full
employment equilibrium
38
E
Y-line
E
F
IG
45
0
G
o
Ye
Yf
Y
Figure 2(b) Inflationary AD gap
39
W, J
The inflationary AD gap
W
J
O
Ye
Y
40
W, J
The inflationary AD gap
W
J
O
YF
Ye
Y
41
W, J
The inflationary AD gap
Inflationary AD gap
W
g
J
h
O
YF
Ye
Y
42
W, J
The inflationary AD gap
Inflationary AD gap
W
g
J
J*
h
O
YF
Ye
Y
43
What is the Keynesian
remedy for an Inflationary
AD Gap (P.16-7.2.5.5.)?
Reduce autonomous
spending by the amount
of the inflationary AD gap
44
How can the Government close
an Inflationary AD Gap?
• Cut government spending
• Increase taxes
• Reduce transfer payments
45
9. Keynes’ criticism of the classical theory was
that the Great Depression would not correct
itself. The multiplier effect would restore an
economy to full employment if
a. government would follow a “least
government is the best government”
policy.
b. government taxes were increased.
c. government spending were increased.
d. government spending were decreased.
c. Keynes’ prescription to cure the Great
Depression was for government to play an
active role rather than depend on the
classical theory that the price system will
46
eventually restore full employment.
10. The equilibrium level of real GDP is $1,000
billion, the full employment level of real
GDP is $1,250 billion, and the marginal
propensity to consume (MPC) is 0.60. The
full-employment target can be reached if
government spending is increased
a. by $60 billion.
b. by $100 billion.
c. by $250 billion.
d. by $25 billion.
b. Change in real GDP required = spending
multiplier x change in government spending
(G). Rewritten,
G = 1/(1 - 0.60) x ($1,250 - $1,000)
G x 2.5 = $250
47
G = $100 billion.
E
Y-line
E
45
0
o
Yf = Ye
Y
Figure 2(c) Equilibrium income equals
potential income
48
Does the equilibrium yield full
employment?
Not necessarily, according to
Keynes. We could move toward
a less than full employment
equilibrium.
49
What can we do if the
economy is moving toward
less than full employment?
We use our fiscal policies
to shift the equilibrium to
a point of GDP that gives
us full employment.
50
What is Fiscal Policy? (P.16-7.2.6. & Wong
2000: 137)
• Fiscal policy is the deliberate
manipulation of government
purchases, transfer payments, taxes,
and borrowing in order to influence
macroeconomic variables such as
employment, the price level, and
the level of GDP
51
What is a Discretionary
Fiscal Policy (P.16-7.2.6.1. & Wong 2000: 139)?
The deliberate use of changes
in government spending,
transfer payments, taxes and
borrowing to alter aggregate
demand and stabilize the
economy
52
Discretionary Fiscal Policy
(P.16-7.2.6.1. & Wong 2000: 139)
= The discretionary changes in
government expenditures and/or
taxes in order to achieve certain
national economic goals
Slide 13-8
• High employment
• Price stability
• Economic growth
• Level of GDP
• Improvement of international payments
53
balance
Why is Government spending
considered an Autonomous
Expenditure (Wong 2000: 94)?
Because Government
spending is primarily the
result of a political
decision made
independent of the level
of national output.
54
What are examples of
Expansionary Fiscal Policy
(P.16-7.2.6.1.1.)?
• Increase government
spending
• Decrease taxes
• increase government
spending and taxes equally
55
The Effect on GDP of an Increase in
Government Spending
$
45o
C+I+G’
C+I+G
G
Simple government expenditures multiplier =
GDP/G = 1/(1-MPC)
GDP
Real GDP
56
The Effect on GDP of a Decrease
in Lump-sum Taxes
$
45o
C’+I+G
C+I+G
Simple tax multiplier =
GDP/T = -MPC/(1-MPC)
GDP
Real GDP
57
Planned Spending
Shifting the aggregate demand curve
upward
C2 + I2 + G2
C1 + I1 + G1
less than full employment
full employment
45o
Real GDP
58
How can we shift the aggregate
demand curve upward?
We can use fiscal policies to
• lower taxes
• increase government
spending
59
E
Y-line
E’
E
45
0
o
Ye
Yf
Y
Figure 3(a) Expansionary fiscal policy
60
What is a Cyclical Deficit & a
Structural Deficit (P.16-7.2.6.1.4.)?
• The part of the deficit that
varies with the business cycle
is a Cyclical Deficit.
• The part of the deficit that is
independent of the business
cycle is a Structural Deficit.
C:\My Documents\Econppt\Macro\HLch27GovtSpending.ppt
61
What are examples of
Contractionary Fiscal Policy
(P.16-7.2.6.1.1.)?
• Decrease government
spending
• Increase taxes
62
E
Y-line
E
E’
45
0
o
Yf
Ye
Y
Figure 3(b) Contractionary fiscal policy
63
E
Y-line
c rT*
C+I+G
rG*
45
0
Figure 4
o
Y
rY
A balance-budget increase in G and T will have
an expansionary effect on the economy
64
What is the Tax Multiplier
(P.15-7.2.4.3.=Wong 2000: 101)?
The change in aggregate
demand (total spending)
resulting from an initial
change in taxes
65
What is the Balanced
Budget Multiplier (P.157.2.4.3.)?
An equal change in
government spending and
taxes, which changes
aggregate demand by the
amount of the change in
government spending
66
What is a Countercyclical
Fiscal Policy (P.16-7.2.6.1.3.)?
Changes in taxes or
government spending
designed to counteract a
boom or recession.
C:\My Documents\Econppt\Macro\HLch27GovtSpending.ppt
67
What are limitations to
Countercyclical Policies?
Timing Problems – there are
the lags of recognition,
decision, and action
Irreversibility – government
policies tend to become
entrenched
68
Fiscal Policy: problems
• Time lags (P.18-7.2.6.3.1.)
– Recognition Time Lag
• The time required to gather information about the
current state of the economy
– Action Time Lag
• The time required between recognizing an economic
problem and putting policy into effect
– Particularly long for fiscal policy
– Effect Time Lag
• The time it takes for a fiscal policy to affect the
economy
69
Slide 13-39
Discretionary Fiscal Policy
in Practice
• Fiscal policy time lags are long.
A policy designed to correct a
recession may not produce results
until the economy is experiencing
inflation.
• Fiscal policy time lags are variable
in length (1–3 years). The timing of
the desired effect cannot be predicted.
Slide 13-42
70
What are Automatic Stabilizers?
(P.17-7.2.6.2. & Wong 2000: 138)
Forces that reduce the size
of the expenditure
multiplier and diminish the
impact of spending shocks
71
What is an Automatic
Stabilizer (P.17-7.2.6.2. & Wong 2000: 138)?
• Government expenditures and tax
revenues that automatically change
levels in order to stabilize an
economic expansion or contraction
• Structural features of government
spending and taxation that smooth
fluctuations in disposable income
over the business cycle
72
Automatic Stabilizers
• Changes in government spending and
taxation that occur automatically without
deliberate action of government
• Examples:
–Progressive income tax system with its
increasing marginal income tax rates
–Unemployment compensation
–Welfare spending
–Transfer payments
73
Slide 13-43
What are some examples of
Stabilizers?
• Transfer payments that increase and
decrease with changes in the economy
• Income (proportional/progressive) taxes
that rise and fall with income
How do automatic stabilizers affect spending
shocks?
• They smooth out the ups and downs of the
economy.
74
Automatic Stabilizers
Government Transfers
and Tax Revenues
Unemployment
compensation and welfare
Tax
revenues
Budget surplus
Budget
deficit
The automatic changes tend
to drive the economy back
toward its full-employment
output level
0
Y2
Y1
Real GDP per Year
($ trillions)
Slide 13-44
75
Automatic Stabilizers
Government Transfers
and Tax Revenues
Unemployment
compensation and welfare
Tax
revenues
Budget surplus
Budget
deficit
0
Y2
Figure 13-6 Slide 13-45
Yf
Real GDP per Year
($ trillions)
Y1
76
C
Household
National income
S
National expenditure
Financial markets
I
Government
T
Foreign markets
G
X
Y
Income
generated
Firms
E
M
Payment for goods
and service
Figure 5 Four-sector national income model
77
The circular flow of income
INJECTIONS
Export
expenditure (X)
Investment (I)
Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Government
expenditure (G)
BANKS, etc
Net
saving (S)
GOV.
ABROAD
Import
Net
expenditure (M)
taxes (T)
WITHDRAWALS
78
E
Y-line
E = C + I + G + (X - M)
(a)
0
45
o
Y
Ye
E
S+T+M
(b)
I+G+X
0
Y
Figure 6 Determining the equilibrium
income of an open economy
Ye
79
P
AD
0
Q
Figure 7 Aggregate demand curve
80
P
AS
0
Qf
Q
Figure 8(a) Keynesian (kinked) aggregate supply
curve
81
P
AS
0
Qf
Q
Figure 8(b) Upward-sloping aggregate supply curve
82
P
AS
0
Qf
Q
Figure 8(c) Classical aggregate supply curve
83
P
AS
Pe
AD
0
Qe
Q
Figure 9 Equilibrium of aggregate demand
and supply
84
P
AS
Qf
0
DG
AD
Q
Figure 10(a) Unemployment equilibrium
85
P
AS
AD
Qf
0
IG
Q
Figure 10(b) Over-employment equilibrium
86
P
AS
AD
0
Qf
Q
Figure 10(c) Full employment equilibrium
87
Advanced
Advanced Level
Level
Macroeconomics
Microeconomics
(a) P
(b)
AS
•
•
P
AS
AD’
•
AD
0
If P
Q
Qf
•
AD’
AD
Q
0
If P unchanged
(c)
P
AS
Figure 11
Multiplier effect with
changing price level
•
•
0
Qf
AD’
AD
Q
88
Previous
slide
The paradox of thrift:
An attempt to save more may
lead to lower income and no
actual increase in saving if
everybody do the same.
Saving is a virtue for the
individual, but may not be good
for the society as a whole!
89
Case 1
When you want to save more by decreasing
autonomous consumption and others follow
what you did, the saving function shifts
upwards. The national income is decreased.
The level of saving remains the same.
S
S’ = -a’ + sY
S = -a + sY
I = I*
Ye’ Ye
Y
90
Case 2
If investment is an induced function, how will an
upward shift in saving function affect the level of
equilibrium income and saving? Show your answer
in the following diagram?
S
S’ = -a’ + sY
S = -a + sY
I = I* + iY
S
S’
Ye’
Ye
Y
91
Resolution:
The amount of investment is independent of the rate
of interest and the amount of saving. An increase in
saving leads to an accumulation of unintended
inventory and then output and income will fall.
Rate of interest (r)
D = investment
S = saving
S, I
S’
S
S’
I
Ye’
Loanable funds for investment
Ye
Y
92
Would the paradox still arise
if investment is negatively
related to the rate of interest?
93
Annual Percentage Changes in U.S. Real GDP,
Real Consumption, and Real Investment
30.0
Investment
20.0
15.0
GDP
10.0
Consumption
5.0
–10.0
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
–5.0
1962
0.0
1960
Annual percentage change
25.0
Year
–15.0
–20.0
Source: Based on annual estimated found in Survey of Current Business, U.S. Department of Commerce, 77 (August 1997)
and 79 (January 1999).
94
Why does the Consumption
Function Shift (P.20-7.3.1.1.)?
• Expectations
• Wealth
• Price level
• Interest rate
28
95
How do Expectations affect the
Consumption (P.22-7.3.1.1.10)?
Consumers expectations of
things to happen in the
future will affect their
spending decisions today
29
96
How does Wealth affect the
Consumption (P.20-7.3.1.1.5)?
Holding all other factors
constant, the more wealth
households accumulate,
the more they spend at
any current level of
disposable income
30
97
How does the Price Level
affect the Consumption
(P.21-7.3.1.1.6)?
Any change in the general
price level shifts the
consumption schedule by
reducing or enlarging the
consumers purchasing power
31
98
How does the Interest Rate
affect the Consumption
Function (P.21-7.3.1.1.8)?
A high interest rate will
discourage people from
borrowing money and a low
interest rate will encourage
people to borrow money
32
99
According to Keynes, what
determines the level of
Investment?
Expectations of future
profits is the primary
factor, the interest rate is
the financing cost of any
investment proposal
36
101
7.4.3. How do Expectations
affect Investment?
Business people are quite
susceptible to moods of
optimism and pessimism
41
102
How do Business Taxes
affect Investment?
Business decisions
depend on the expected
after-tax rate of profit
45
106
Can the government maintain a
permanent budget deficit? What would
you need to know about the future path
of interest rates and GDP growth rates
to be able to answer this question?
8.
• It depends. The government can
(cannot) maintain a permanent budget
deficit if the interest rate is lower
(higher) than the GDP growth rate.
107
Countercyclical fiscal policy
• Argues that increasing government
spending or reducing taxes during a
recession would mitigate the recession
–Suggested by Keynes in 1930s
(Keynesian policy)
• Rationale now for “fiscal stimulus”
package in Japan
• Discretionary versus automatic
108
Effect of the economy
on the budget deficit
• Budget deficit is cyclical
–Deficit rises in recessions
–Deficit falls during recoveries
and expansions
• To see the reason look at tax
revenues and expenditures
109
Government tax revenues depend
on the state of the economy
• when real GDP grows more rapidly,
proportional tax revenues rise
–more people working, higher
incomes
–people move into higher tax
brackets
110
Expenditures also depend on the economy
• When real GDP grows more rapidly, as in
a recovery, expenditures such as transfer
payments grow less rapidly
• When real GDP grows less rapidly or falls,
as in a recession, expenditures grow more
rapidly
– unemployment compensation rises
– welfare payments go up
– more people retire, increasing social
security payments
111
Net effect of real GDP on deficit
•
deficit = government spending
- tax revenue
•thus in a recession the
deficit will rise, and in a
recovery the deficit will fall
• Fill in P.17 table
112
The structural deficit
• The structural deficit is the deficit that
would exist if real GDP = potential GDP
• Also called full employment deficit
• Purpose is to take out (control for) the
effects of economic fluctuations in real
GDP on the deficit
• Changing structural deficit requires
– change in tax laws, size of government,...
113
4. The government budget deficit is
a) A stock variable.
b) A flow variable.
c) Neither a flow nor a stock variable.
d) Always increasing over time.
Answer: b
114
Countercyclical fiscal policy
• Argues that increasing government
spending or reducing taxes during a
recession would mitigate the recession
–Suggested by Keynes in 1930s
(Keynesian policy)
• Rationale now for “fiscal stimulus”
package in Japan
• Discretionary versus automatic
115
Fiscal Policy (P.16-7.2.6.)
• There was no such thing as fiscal policy until
John Maynard Keynes invented it in the
1930s
– He maintained that
• The only way out of the Depression was
to boost aggregate demand by
increasing government spending
• If we ran a big enough budget deficit, we
could jump-start the economy and, in
effect, spend our way out of the
depression
116
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12-4
The Public Debt (P.18-7.2.6.3.3.)
• Differentiating between the Deficit and
the Debt
– The deficit occurs when government spending is
greater than tax revenue
– The debt is the cumulative total of all the budget
deficits less any surpluses
• Suppose that our deficit declined one year from $200
billion to $150 billion
• The national debt would still go up by $150 billion
• So every year that we have a deficit – even a declining
one – the national debt will go up
117
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12-48
The Public Debt
• Is the national debt a burden that will have
to be borne by future generations?
– As long as we owe it to ourselves, the answer is
no
– If we did owe it mainly to foreigners (in 4-sector
model), and if they wanted it paid off, it could be
a great burden
– In the future, even if we never pay back one
penny of the debt, our children and our
grandchildren will have to pay hundreds of
billions of dollars in interest. At least to that
degree, the public debt will be a burden to
future generations
118
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-50
The Public Debt
National Debt, 1975-2000
6
5
4
3
2
1
0
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Economic Report of the President, 2000
119
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12-49
The Automatic Stabilizers
• The automatic stabilizers protect us
from the extremes (peak & trough)
of the business cycle
– Personal Income and Payroll Taxes
• During recessions, tax receipts decline
• During inflations, tax receipts rise
– Personal Savings
• During recessions, saving declines
• During prosperity, saving rises
120
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12-27
The Automatic Stabilizers
–Credit Availability
–Credit availability helps get us
through recessions
–Unemployment
Compensation
–During recessions more people
collect unemployment benefits
121
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12-28
The Automatic Stabilizers
–The Corporate Profits Tax
• During recessions, corporations
pay much less corporate income
taxes
–Other Transfer Payments
• Welfare (or public assistance)
payments, Medical aid payments,
and food stamps rise during
recessions
122
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12-29
•Consumption and Investment
Consumption and investment are two important
aggregates in macroeconomic models. An
autonomous change in one of them will cause the
level of national income to change, via the multiplier
effect. In this lesson, we take a closer look at
consumption and investment. Firstly, we consider
possible determinants of consumption demand
other than the one (i.e. income) in the simple
Keynesian model. Secondly, we examine two
hypotheses of consumption demand which are
used to explain the empirical data: the permanent
income hypothesis and the life-cycle hypothesis.
Lastly, we turn our attention to determinants of
123
investment.
Consumption
7.3.1.3.
C
Slope = MPC = APC
0
Income (years)
Figure 3 Permanent-income hypothesis
124
$
7.3.1.2.
Income stream
C
0
Age
Figure 4 Life-cycle income, consumption
and saving
125
Consumption
7.3.1.2.
C
Slope = MPC = APC =1
0
Permanent income
Figure 5 Life-cycle hypothesis
126
7.3.1.1.11.
C
Slope = MPC
rC
C
rYd
rC
rYd
0
Yd
Figure 6 Change in income distribution
127
E
0
E
Ye’
(a)
Ye
S’
S’
S
I
S
Yf Y
I
0
Ye’
Ye
Yf
(b)
Figure 9 The paradox of thrift
128
Y
Interest rate
E
S
S’
S
I’
S’
I
0
Ye
Yf
I
0
Loanable fund for
investment
(a)
(b)
Figure 10 The effect of increased saving
129
on investment
Y
Discretionary Policy and
Permanent Income
• Permanent income is income that
individuals expect to receive on
average over the long run
• To the extent that consumers base
spending decisions on their permanent
income, attempts to fine-tune the
economy through discretionary fiscal
policy will be less effective
130
Permanent Income Hypothesis
(Milton Friedman) 7.3.1.3.
• People gear their consumption to
their expected lifetime average
earnings more than to their current
income
– Apparently there are quite a few deviations
from the behavior predicted by the
permanent income hypothesis
131
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5-49
7.3.1.2. Figure 8.6a Life-cycle
consumption, income, and saving
132
7.4 Investment (P. 23)
• “Investment” is the thing that really
makes our economy go and grow!
• Investment is any NEW
– Plant and equipment
• Investment is any NEW
– Additional inventory
• Investment is any NEW
– Residential housing
133
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6-14
Investment in Plant and Equipment,
1960-2000 (in 1987 dollars)
1200
1100
1000
900
800
700
600
500
400
300
200
100
1960
1965
1970
1975
1980
1985
1990
1995
2000
There has been a strong upward trend in this investment sector over the last four
decades. Note the periodic downturns, especially during recession years 134
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6-20
Inventory Investment, 1960-2000 (in
billions of 1987 dollars)
75
50
25
0
Ð25
1960
1965
1970
1975
1980
1985
1990
1995
2000
This is the most volatile sector of investment. Note that investment
was actually negative during three recessions
135
6-18
Copyright Ó2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Residential Construction
• Involves replacing old housing as
well as adding to it
• Fluctuates considerably from
year to year
• Has mortgage interest rates play
a dominant role
136
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6-21
Investment
• Investment is the most volatile sector in
our economy
– GDP = C + I + G + Xn
• Fluctuations in GDP are largely
fluctuations in investment
• Recessions are touched off by declines in
investment
• Recoveries are brought about by rising
investment
137
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6-22
Determinants of the Level of
Investment
• Interest rate
• Sales outlook
• Expected rate of profit
• Technological change
• Business taxes
• Autonomous reasons
138
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6-31
7.4.2. The Interest Rate
• You won’t invest if interest rates (cost)
are higher than MEC (benefit)
Interest rate = The interest paid / The amount borrowed
Assume you borrow $1000 for one year @ 12 %, how
much interest do you pay?
.12 =
X
$1000
X = $120
139
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6-35
You Won’t Invest
If Interest Rates Are Too High
• In general, the lower the interest rate, the
more business firms will borrow
• To know how much they will borrow and
whether they will borrow, you need to
compare the interest rate with the
expected rate of profit
• Even if they are investing their own
money they need to make this
comparison
140
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6-39
7.4.3. The Sales Outlook
• You won’t invest if the sales outlook
is bad
• If sales are expected to be strong the
next few months the business is
probably willing to add inventory
• If sales outlook is good for the next
few years, firms will probably
purchase new plant and equipment
141
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6-32
Expected Rate of Profit
(ERP)
Expected Profits
ERP = ------------------------------------------Money Invested
How much is the ERP on a
$10,000 investment if you
expect to make a profit of
$1,650?
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142
6-37
How much is the ERP on a
$10,000 investment if you expect
to make a profit of $1,650?
Expected Profits
ERP = ------------------------------------------Money Invested
$1,650
ERP = ------------------------------------------$10,000
ERP = .165 = 16.5 %
143
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6-38
Why Do Firms Invest?
• Firm’s will only invest if the
expected profit rate is “high enough”
• Firms invest when
– Their sales outlook is good
– Their expected profit rate is high
• Even if firm’s invest their own
money, the interest rate is still a
consideration
144
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6-40
C + I + G + Xn
10,000
10,000
C+I+G
8,000
C+I+G
8,000
C + I + G + Xn
6,000
6,000
4,000
4,000
2,000
2,000
45û
45û
2,000
4,000
6,000
8,000
Disposable income ($)
10,000
2,000
8,000
6,000
4,000
Disposable income ($)
10,000
Why is the C + I + G + Xn line lower than the C + I + G line?
Answer: It is lower because net exports (Xn) are negative
8-8
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145