Building
[Simple [Basic] economy to Complex economy]
[C + Ig]
Private - closed
[C + Ig + Xn] Private-open
[C+Ig+G+Xn]
…added foreign trade
Mixed - open
Added gov spending
S AE3 (C+Ig+G+Xn) (Complex Economy) [Mixed-open]
(AE3)630
(AE2)550
(AE1)470
Consumption
C=390
+80 +80 +80
45°
0 390 470 550 630 Real GDP
“ME” = 4
AE(C+Ig)
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)
AE(C+Ig1)
45°
460
YR
500 Real GDP
Y*
Building the
Model
S
$530
Private - Closed
510
C + Ig
Consumption
490
Equilibrium
470
AE[C + Ig]
Multiplier=4
(billions of dollars)
AE[C+Ig] [“Basic” or “Simple” economy]
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
+80
45
o
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
Change in QC (or QS)
Consumption
[Income change, movement from point to point]
DISSAVING
SAVING
Consumption
C2
Breakeven
So, the key to a
change in QC(QS)
is a change in ?
C1
o
45
o DI3 DI1
DI2
(Disposable Income)
S
Saving
[Negative saving]
S
SAVING
o
DISSAVING
S
Disposable Income
NON-INCOME DETERMINANTS [Shifters]
OF CONSUMPTION AND SAVING
 Wealth
Increase or decrease in wealth
 Increase/decrease in PL
Taxation increases/decreases
Consumer Expectations
[about future availability, income, & prices]
 Household Debt
Increase in Consumption (Decrease in Saving)
[shift/whole curve/non-income]
C2
C1
Increase in wealth
Decrease in PL
Expect. PL incr.
Expect. of positive Y
Expect. of shortages
Decrease in debt
*Decrease in taxes
Consumption
May be caused by:
Saving
*Decrease in taxes
o
increases both C & S
I’ll buy more and
save even more.
Increases in
consumption
means…
o
45
Disposable Income
Decrease
S1
S2 in saving
o
Disposable Income
Decrease in Consumption (Increase in Saving)
[shift/whole curve/non-income]
Decrease in wealth
Increase in PL
Expect. PL decrease
Expect. neg. future Y
Increase in debt
*Increase in taxes
o
Saving
*Increase in taxes
decreases both C & S
C1
C2
Consumption
May be caused by:
o
Decreases in
consumption
means…
45
Disposable Income
Increase
S2
S in saving
0
o
Disposable Income
GLOBAL PERSPECTIVE
Average Propensities to Consume [C/Y],
Selected Nations, 2000
.80
Canada
.85
.90
.95
United States
Netherlands
.976
.972
United Kingdom
.940
Germany
.907
Italy
1.0
.986
.873
Japan
.869
France
.842
[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)
[MEI]
Firms invest with their profits
Real Interest Rates
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; at 12%, don’t invest]
B. Real interest rate [nominal interest rate-inflation]
Change in Quantity of Investment Demanded [QID]
(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]
CHANGE [Shift] IN INVESTMENT [curve]
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 DEMAND & SCHEDULE
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
20
8
Ig
20
20
20
20
Investment
(billions of dollars)
Y1
Y2
Y3
Real Domestic Product, GDP
(billions of dollars)
In constructing the AE graph, Ig will be independent [not influenced]
by income. Investment decisions are 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”
?
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 = “M” of 4
[MPC is important for G in policy making decisions.]
*The ME is the reciprocal of the MPS.
The “M” works like a concentric circle.
The First Round of Government
Spending Causes The Biggest Splash
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 bil. [$37.50 bil.]
& spend 75% or $112.50 bil. on iPod Videos, 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.
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
860
Y*
Real GDP
ME = 1/MPS, 1/.50 = $1/.50 = ME of 2
(billions of dollars)
ME is 2 & we are short of Y*[$860] by $60 billion
AE[C+Ig+G]
Equilibrium
AE[C+Ig]
AE[C+Ig+G]
G = $30 Billion
+60
Recess. Spending gap
o
Recessionary GDP Gap
45
o
Recess. Gap
800
YR
“M” =
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
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
Recess. Spending gap
o
Recessionary GDP Gap
45
o
Recess. Gap
800
YR
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 -? = -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
1 x -? = -40
$40 billion
tax increase
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]
o
AE[C+Ig+G]
Equilibrium
-40
45
o
Inflat. Gap
840
Y*
880 Real GDP
YI
Inflationary GDP Gap
ME [Change in G, Ig, or Xn] = 1/MPS
MPC
.90
.80
.75
.60
.50
1/MPS = ME
1/.10
= 10
1/.20
= 5
1/.25
= 4
1/.40
= 2.5
1/.50
= 2
MT [Change in Taxes] = MPC/MPS
MPC
.90
.80
.75
.60
.50
= MT
MPC/.10
=
9
MPC/.20 =
4
MPC/.25 =
3
MPC/.40 = 1.5
MPC/.50 =
1
MPC/MPS
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.
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, and MPC), you will be given
two and if you know two 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
Recessionary spending gap
E2
AE1
E1
AE3
E3
500
Recessionary Inflationary
GDP gap
GDP gap
3. Except for 6, 9, 15, & 18, you will increase
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 = $420.
The Multiplier & Equilibrium GDP
[Give the correct equilibrium GDP [start from $500] using the ME, MT, MBB]
MT = MPC/MPS [Chg in T ] MBB = 1 [G&T ]
ME=1/MPS [chg in G, Xg, or Xn]
Inflationary
Spending gap
AE
E2
E1
Chg in
Equilibrium GDP
MPC
[So MPS &
ME, MT, & MBB]
Change in
Expenditures
[+G] 1. ME = ____
560
[-T]
2. MT = ____
548
[+G&T] 3. MBB =____
512
1
60 Y with ME
____
48
____Y with MT
12
____Y with MBB
$12
.80
ME__
5
4
MT___
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
40
___ Y with ME
20 with MT
____Y
20 with MBB
____Y
45°
Recessionary $500
Spending gap
700
[+G] 1. ME = ____
[-T]
2. MT = ____
650
[+G&T] 3. MBB =____
550
2
$200 Y with ME
150
_____Y with MT
50 with MBB
_____Y
$50
.75
4
ME__
3
MT___
1
MBB___
2
ME__
1
MT___
MBB___
1
$20
.50
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 with MBB
___Y
$10
__
.9 ME10
9
?
MT___
1
MBB___
[+G] 1. ME = ____
550
[-T]
2. MT = ____
530
[+G&T] 3. MBB =____
520
[+G] 1. ME = ____
600
[-T]
2. MT = 550
____
[+G&T] 3. MBB =____
550
4
Here
are5 a
few
helpers…
7
8
try the rest
on your own
___ Y with ME
50
____Y
30 with MT
____Y
20 with MBB
100
___ Y with ME
50 with MT
____Y
____Y with MBB
50
.60
$20
2.5
ME__
1.5
MT___
1
MBB___
[+G] 1. ME = ____
575
[-T]
2. MT = ____
560
[+G&T] 3. MBB =____
515
___
75 Y with ME
____Y
60 with MT
15 with MBB
____Y
$15
6
-40
___ Y with ME
-35
____Y with MT
____Y
-5 with MBB
.50
87.5
ME__
2
MT___
1
MBB___
1
$50
[+G] 1. ME = ____
900
[-T]
2. MT = 800
____
[+G&T] 3. MBB =____
600
___
400 Y with ME
____Y with MT
300
____Y with MBB
100
.80
ME__
5
MT___
4
MBB___
1
[-G] 1. ME = 460
___
465
[+T] 2. MT =___
[-G&T]3.MBB=___
495
-$5
[-G] 1. ME =___
300
[+T] 2. MT =___
320
[-G&T]3.MBB=___
480
9
-200
___ Y with ME
____Y with MT
-180
____Y with MBB
-20
.9
.75
$100
ME__
4
MT___
3
1
MBB___
ME__
8
7
MT___
MBB___
1
-$20
ME__
10
MT___
9
MBB___
1
[+G] 1. ME =512.5
____
[-T]
2. MT =507.5
____
[+G&T] 3. MBB =____
505
[+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
Here are a few
helpers… try the rest
on your own
10
__._ Y with ME
125
_.___Y
with MT
75
__
50 with MBB
.60
ME__
2.5
MT___
1.5
1
MBB___
$5
[+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
11
40 Y with ME
___
38 with MT
____Y
____Y
with MBB
2
?
$2
$15
ME__
4
MT___
3
MBB___
1
ME__
20
19
MT___
1
MBB___
___
200 Y with ME
____Y with MT
100
____Y with MBB
100
.75
.50
$100
50 Y with ME
___
40 with MT
____Y
____Y
10 with MBB
.95
[+G] 1. ME = ____
700
[-T]
2. MT = 600
____
[+G&T] 3. MBB =____
600
14
12
ME__
2
MT___
1
1
MBB___
$10
?
ME__
5
4
MT___
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
87.5
ME__
8
7
-$10 MT___
MBB___
1
[+G] 1. ME = ____
625
[-T]
2. MT = ____
600
[+G&T] 3. MBB =____
525
16 125
___ Y with ME
532
[+G] 1. ME = ____
[-T]
2. MT = 524
____
[+G&T] 3. MBB =____
508
17
100
____Y with MT
25 with MBB
____Y
$25
18 -100
___ Y with ME
____Y with MT
-90
____Y with MBB
-10
.75
.80
ME__
5
MT___
4
1
MBB___
32 Y with ME
___
24 with MT
____Y
8 with MBB
____Y
[-G] 1. ME = ___
400
410
[+T] 2. MT =___
[-G&T]3.MBB=___
490
$8
4
ME__
3
MT___
1
MBB___
.9
-$10
ME10
__
9
MT___
1
MBB___