Income and Expenditures
Macro
© 2007 Thomson South-Western
The Circular-Flow Diagram
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Revenue
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Income and Expenditures
Disposable income (Yd) is …
Money after taxes are paid
Yd = C + Savings (S)
© 2007 Thomson South-Western
Income and Expenditures
Marginal Propensity to Consume (MPC) is …
MPC = ∆ consumption/∆ disposable income
An increase in consumer spending when current
disposable income rises by $1
The slope of the Consumption Function
© 2007 Thomson South-Western
Income and Expenditures
Marginal Propensity to Save (MPS) is …
MPS = ∆ savings /∆ disposable income
An increase in household savings when current
disposable income rises by $1
© 2007 Thomson South-Western
Income and Expenditures
The Consumption Function is …
– An equation: c = a + MPC * yd
•
A = autonomous consumption (y-intercept)
– Shows how a households consumer spending (c )
varies with the household’s current disposable
income ( Yd )
© 2007 Thomson South-Western
Income and Expenditures
Let’s assume that everyone in the economy
spends 80% of every additional dollar of new
disposable income. What would happened if
there was an injection of new spending into the
economy?
© 2007 Thomson South-Western
Income and Expenditures
Whit is a chicken farmer in the local community.
Suppose White decides to spend $1000 on some
chicken coops at Abel’s farm supply shop. This
money now starts to be circulated around the
economy.
© 2007 Thomson South-Western
Income and Expenditures
Abel now has $1000 from the sale and spends
80% ($800) on clothes at Alyssa’s boutique.
© 2007 Thomson South-Western
Income and Expenditures
Alyssa now has $800 from the sale and spends
80% ($640) to fix her car at Pat’s garage.
© 2007 Thomson South-Western
Income and Expenditures
Pat now has $640 from the sale and spends 80%
($512) on clothes at Brenna’s grocery store.
© 2007 Thomson South-Western
Income and Expenditures
Brenna now has $512 from the sale and spends
80% ($409.60) with Kelly’s catering company.
© 2007 Thomson South-Western
Income and Expenditures
How much money was spent after 5 rounds of
spending?
$2,361.60 – more than DOUBLE of the original
injection!
Continuing on until someone tried to spend 80% of
nothing, Whit’s initial $1000 would have multiplied to
$5000 in income/spending.
© 2007 Thomson South-Western
Income and Expenditures
The Spending Multiplier is …
 A ratio of
 Total change in real GDP
 Caused by
 An autonomous change in Aggregate Spending to the
size of that autonomous spending.

M = 1/(1 – MPC)
© 2007 Thomson South-Western
Income and Expenditures
Shifts of the Aggregate Consumption Function
– Changes in Expected Future Disposable Income
• A college student will graduate in May. She already has
a job lined-up once she graduated.
• Consumption f(x) moves????
• UP
© 2007 Thomson South-Western
Income and Expenditures
Shifts of the Aggregate Consumption Function
– Changes in Aggregate Wealth
• Wealth is accumulated assets
– House, car, stocks, savings account
• You own stock and the stock market declines
• The Consumption f(x) moves ???
• DOWN
© 2007 Thomson South-Western
Income and Expenditures
A firm is considering building a new factory.
This will
1. increase sales
2. require borrowing to fund the investment
© 2007 Thomson South-Western
Income and Expenditures
• Expected Return on Investment =
Expected Economic Profit from the Factory
(Total Revenue – Total Cost)/ Investment Cost.
© 2007 Thomson South-Western
Income and Expenditures
• The Market Interest Rate is …
– The Cost of Investment
• Cost of borrowed funds
• Cost of investing your own funds (no borrowing)
© 2007 Thomson South-Western
Income and Expenditures
The factory will only be built if the firm expects a …
1. Rate of Return > Cost of the $$$ borrowed
Higher Interest Rate means Fewer Projects =
Lower Investment Spending.
Interest Rate
Investment Spending
© 2007 Thomson South-Western
Income and Expenditures
Some Factors Increase Investment Spending
at Any Interest Rate
1. Expected Future Real GDP
A firm believes that the economy is going to vastly
improve within the next year.
2. Production Capacity
A firm is near production capacity with an
expectation of strong real GDP in the future.
© 2007 Thomson South-Western
Aggregate Demand
Aggregate Demand (AD) shows the…
Relationship between Aggregate Price Level
and
 Quantity of Aggregate Output
Determined by the Demand of households, firms,
government and the rest of the world.
© 2007 Thomson South-Western
Aggregate Demand
Aggregate Price Level is …
The rising price level for ALL goods and services
in the economy.
© 2007 Thomson South-Western
Aggregate Demand
Why does the AD curve slope downward?
The Wealth Effect
price level =
consumer spending = Q demand
Consumers ‘feel more wealthy’.
Downward movement along
the AD curve.
© 2007 Thomson South-Western
Aggregate Demand
Why does the AD curve slope downward?
The Interest Rate Effect
price level =
interest rate = Q demand
Greater spending on investments.
Increasing real GDP along the AD curve.
© 2007 Thomson South-Western
Aggregate Demand
Shifts of the AD Curve
Shifts in AD Curve
Changes In
AD Right
AD Left
Expectations
Optimistic about future
Pessimistic about future
Wealth
Increased wealth =
increased consumer
consumption
Decreased wealth =
decreased consumer
consumption
Size of Existing Stock of
Physical Capital
Need more stock to meet
demand
Have enough stock to meet
demand
Fiscal Policy
Increase G in GDP
Decrease G in GDP
Monetary Policy
Increase $$$ in circulation
= higher I and C in GDP
Decrease $$$ in circulation
= lower I and C in GDP
© 2007 Thomson South-Western
Aggregate Demand
Fiscal Policy is the use of …
• Use of Government Spending
– Purchase of final goods/services
– Government transfers
• Tax Policy
• Congress and the President control
© 2007 Thomson South-Western
Aggregate Demand
Monetary Policy is the use of …
• Changes in the Money Q
– Increase/decrease of $$$$ in circulation
• Interest Rate
• Federal Reserve controls
© 2007 Thomson South-Western
Aggregate Supply
Aggregate Supply (AS) shows the…
Relationship between Economy-wide Production
and
Aggregate Price Level
© 2007 Thomson South-Western
Aggregate Supply
There are two AS curves.
SRAS
Positive slope
LRAS
Vertical at the level of potential GDP
© 2007 Thomson South-Western
Aggregate Supply
The reason the SRAS is positive is …
P is rising faster than the Cost of the unit
The unit will be produced
Aggregate
Price Level
SRAS
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
Sticky Prices
– Do not rise or fall very quickly in response in a
change in demand.
© 2007 Thomson South-Western
Aggregate Supply
Shifts in SRAS
Increase = producers willing to produce more
output at any price level
Aggregate
Price Level
SRAS
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
Shifts in SRAS
Decrease = Q of Aggregate Output supplies falls at
any price level
Aggregate
Price Level
SRAS
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
Shifts of the SRAS Curve
Shifts in SRAS Curve
Changes In
SRAS Right
SRAS Left
Commodity Prices
Decrease in Commodity
Prices
Increase in Commodity
Prices
Nominal Wages
(Current Price of Labor)
Wages decrease
Wages Increase
Productivity
Decrease in Productivity
Increased Productivity
(tools/technology)
© 2007 Thomson South-Western
Aggregate Supply
LRAS
Nominal wages adjust along with the price of
output.
NO STICKY WAGES
Aggregate
Price Level
LRAS
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
SRAS to LRAS
Weak Economy.
Aggregate
Price Level
LRAS
Y1 Yp
Recession.
GDP Y1 < Yp
SRAS1
SRAS2
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
What is expected to happen?
1.
2.
3.
4.
5.
Weak labor market = falling D for labor.
Many Us.
Workers accept lower wages.
Nominal wages fall.
SRAS shifts right until current output = Yp.
© 2007 Thomson South-Western
Aggregate Supply
SRAS to LRAS
Booming Economy.
Aggregate
Price Level
GDP Y2 > Yp
SRAS2
LRAS
Yp
SRAS1
Y2
Real GDP
© 2007 Thomson South-Western
Aggregate Supply
What is expected to happen?
1. Strong labor market = rising D for labor.
2. Few Us.
3. Employers are scrambling to find scarce
resources.
4. Nominal wages rise.
5. SRAS shifts left until current output = Yp.
© 2007 Thomson South-Western
AD/ AS Equilibrium
Micro equilibrium
P
S
D
Q
© 2007 Thomson South-Western
AD/ AS Equilibrium
Micro equilibrium
Macro Equilibrium
Aggregate
P Level
P
LRAS
SRAS
S
D
AD
Q
Yp
Real
GDP
© 2007 Thomson South-Western
AD/ AS Equilibrium
Aggregate
P Level
LRAS
P level above AD/SRAS intersection
1. Surplus of aggregate output
2. Prices fall
SRAS
P1
P level below AD/SRAS intersection
1. Shortage of aggregate output
2. Prices rise
P2
AD
Yp
Real
GDP
© 2007 Thomson South-Western
AD/ AS Equilibrium
Demand shock is an event which shifts the AD Curve.
Aggregate
P Level
Pessimism about future income/earning.
1. AD shift left
2. Aggregate Price Level falls.
3. Real GDP falls.
4. Recession.
Increase in consumer wealth.
1. AD shift right
2. Aggregate Price Level rises.
3. Real GDP rises.
SRAS
Pe2
Pe
P1
AD3
AD1
Y1 Ye
AD2
Y2 Real
GDP
© 2007 Thomson South-Western
Long Run Equilibrium
What is expected to happen?
Recessionary Gap is the amount that GDP fall below potential output.
1. Output gap is negative
2. Weak economy
3. U rises
4. Nominal wages fall
5. SRAS shifts right
6. GDP begins to rise
7. GDP reaches Yp = LR equilibrium
8. P level has fallen further
© 2007 Thomson South-Western
AD/ AS Equilibrium
Supply shock is an event which shifts the SRAS Curve.
Aggregate
P Level
Commodity prices increase.
1. SRAS shift left
2. Aggregate Price Level rise.
3. Real GDP falls.
4. Stagflation.
Technology increases labor productivity.
1. SRAS shift right
2. Aggregate Price Level fall.
3. Real GDP rises.
SRAS1
SRAS
Pe1
Pe
Pe2
SRAS2
AD1
Y1 Ye
Y2
© 2007 Thomson South-Western
Real
GDP
Long Run Equilibrium
What is expected to happen?
Inflationary Gap is the amount that GDP rises above potential output.
1. Output gap is positive
2. Booming economy
3. U falls
4. Nominal wages rise
5. SRAS shifts left
6. GDP begins to falls
7. GDP reaches Yp = LR equilibrium
8. P level has increased further
© 2007 Thomson South-Western
Economic Fluctuations
• Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift changes
Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR equilibrium to new LR
equilibrium.
© 2007 Thomson South-Western
ACTIVE LEARNING
2:
Exercise
• Draw the AD-SRAS-LRAS diagram
for the U.S. economy, starting in a long-run
equilibrium.
• A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.
49
© 2007 Thomson South-Western
ACTIVE LEARNING
2:
Answers
Event: boom in Canada
P
1. affects NX, AD curve
LRAS
SRAS2
2. shifts AD right
3. SR equilibrium at point B.
P and Y higher,
U lower
P3
4. Over time, PE rises,
SRAS shifts left,
until LR equilibrium at C.
Y and U back
at initial levels.
P1
C
SRAS1
B
P2
A
AD2
AD1
YN
Y2
Y
50
© 2007 Thomson South-Western
Long Run Equilibrium
Output Gap = 100(Ye – Yp)/Yp
LR economy is self-correcting.
Shocks to AD affect aggregate output in the SR NOT in the LR.
© 2007 Thomson South-Western
Economic Policy and AD/AS
Fiscal Policy is …
 Conducted by the executive and legislative branches of the government.
 Combination of spending and taxation to stabilize an economy.
© 2007 Thomson South-Western
Economic Policy and AD/AS
Government Budget and Total Spending
 GDP = C + I + G = NX
 Government MAJOR player in AD
© 2007 Thomson South-Western
Economic Policy and AD/AS
Government Budget and Total Spending





GDP = C + I + G = NX
Government indirectly affects consumer spending – HOW?
Taxes and Transfer Payments
What equation show us this?
Yd = Y – taxes + transfers = C + S or
 C = Yd – S
 What happens when Yd increases?
 C increases
 How can the government increase Yd?
 Cut taxes
 Increase Transfer Payments
© 2007 Thomson South-Western
Economic Policy and AD/AS
Expansionary Fiscal Policy
 Example of a Recessionary Gap
 Fiscal policy should try to shift AD right
 Expansionary Fiscal Policy takes one of three form:
 An increase in government purchases of g/s
 A cut in taxes
 An increase in government transfers
© 2007 Thomson South-Western
Economic Policy and AD/AS
Contractionary Fiscal Policy
 Example of a Inflationary Gap
 Fiscal policy should try to shift AD left
 Expansionary Fiscal Policy takes one of three form:
 A decrease in government purchases of g/s
 An increase in taxes
 A decrease in government transfers
© 2007 Thomson South-Western
Economic Policy and AD/AS
Fiscal Policy Time Lags
 Recognition Lag
 Decision Lag
 Implementation Lag
© 2007 Thomson South-Western
Economic Policy and AD/AS
Scenario 1: The economy is currently experiencing a recessionary gap.
List two fiscal policy options that would move the economy closer to
potential real GDP. Describe how your policy would achieve the
desired results.
a. Increase G, increase Transfer Payments, or Decrease Taxes
a.
b.
Increase G directly affects AD, right shift, increasing real GDP
Increase in Transfer Payments or Decrease in Taxes
a.
Indirectly increase AD by increase
© 2007 Thomson South-Western
Economic Policy and AD/AS
Scenario 2: The economy is currently at a level of output that exceeds
potential GDP (Yd). List two fiscal policy options that would move the
economy closer to potential real GDP. Describe how your policy would
achieve the desired results.
a. Decrease G, Decrease Transfer Payments, or Increase Taxes
a.
b.
Decrease G directly affects AD, left shift, increasing real GDP, Reducing P
level
Decrease in Transfer Payments or Increase in Taxes
a.
b.
c.
Indirectly decrease AD by decreasing Yd.
Real GDP falls
Price Level falls
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
Spending Multiplier –
 When C or I increase by $1, eventually it would multiply into more dollars of
spending and income and rea DGP
 Multiplier size depends on the MPC
 Spending Multiplier = 1/(1-MPC)
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
An Injection of Government (G) Spending
Example: Suppose the government is experiencing a recessionary gap.
Current output is $500 billion below potential GDP (Yp) and
unemployment is beginning to rise. Does the government need to
inject $500 of new G into the economy to return to full employment?
NO!
If MPC =.90, the Spending Multiplier:
M = 1/.10 = 10
So, an increase of G = $50B will eventually multiply to a 10 *
$50B = $500B positive shift of AD to the right.
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
A Reduction of Government (G) Spending
Example: Suppose the government is experiencing an inflationary
gap. Current output is $800B above potential GDP(Yp) and inflation is
starting to hurt the economy.
If MPC =.75, the Spending Multiplier:
M = 1/.25= 4
So, a decrease of G = $200B will eventually multiply to a 4 *
$200B = $500B negative shift of AD to the left.
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
Government Transfers and Taxes–
 Indirectly affects real GDP because it 1st impacts Consumer Disposable Income
(Yd)
 WHY?
 Consumers save some of every new dollar of Yd
 New saved Yd $ cannot multiply into additional spending and income.
 Tm = MPC * M or MPC/(1 – MPC)
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
A Tax Decision
Example: Suppose the government decides to lower income taxes by a
lump-sum of $1000.
MPC = .90
Americans get $1000 back into their pockets
– Spend 90% = $900
– Save 10% = $100
• $900 of new spending will multiply by 10
– M=1/.90 = 10
So, a $1000 tax cut will eventually multiply into $9000 of
additional real GDP.
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
A Transfer Payment Decision
Example: Suppose the government decides to increase transfer
payments by a lump-sum of $500.
MPC = .80
Americans receive $500 more Yd.
– Spend 80% = $400
– Save 20% = $100
• $400 of new spending will multiply by 5
– M=1/.80 = 5
So, an increase of transfers will eventually multiply into
$2000 of additional real GDP.
© 2007 Thomson South-Western
Economic Policy and the Multiplier
Scenario 1: Real GDP is currently $600B above potential GDP and
price inflation is beginning to dominate the headlines. How could the
government adjust taxes or transfers to return the economy to full
employment? How large would this lump-sum adjustment need to be?
Assume the MPC = .75.
a. Economy is suffering inflation
a.
b.
c.
Taxes need to be raised or transfers need to be cut
Tm = .75(1 - .75) = 3.
$600B / 3 = $200B
© 2007 Thomson South-Western
Economic Policy and the Multiplier
Scenario 2: Current Real GDP is $6 trillion and potential GDP is
$7.5trillion. The government is prepared to pass a spending package to
return the economy to full employment. What kind of spending package
should be passed? How big does it need to be? Assume that the MPC =
.90.
a. Economy is in a recession
a.
b.
c.
d.
Spending increased with expansionary fiscal policy
M = 1/(1-.90) = 10
GDP needs to be increased by $1.5 Trillion
$1.5T/10 = $.15T or $150B
© 2007 Thomson South-Western
Fiscal Policy and the Multiplier
Discretionary Fiscal Policy and the Progressive Tax System
 Progressive Tax System is a form of Automatic Stabilizer.
 Automatic Stabilizers (non-discretionary fiscal policy) are …





Government spending and taxation rules
Affect Fiscal Policy
Automatically expansionary when the economy contracts
Automatically contractionary when the economy expands
Do not require any deliberate action by policy makers
© 2007 Thomson South-Western