© 2007 thomson south-western income and expenditures macro

© 2007 Thomson South-Western

Income and Expenditures

Macro


The Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS• Produce and sell

goods and services• Hire and use factors

of production

• Buy and consumegoods and services

• Own and sell factorsof production

HOUSEHOLDS

• Households sell• Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

• Firms sell• Households buy

MARKETSFOR

GOODS AND SERVICES



Disposable income (Yd) is …Money after taxes are paidYd = C + Savings (S)



Marginal Propensity to Consume (MPC) is …MPC = ∆ consumption/∆ disposable incomeAn increase in consumer spending when current

disposable income rises by $1The slope of the Consumption Function



Marginal Propensity to Save (MPS) is …MPS = ∆ savings /∆ disposable incomeAn increase in household savings when current

disposable income rises by $1



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 )



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?



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.



Abel now has $1000 from the sale and spends 80% ($800) on clothes at Alyssa’s boutique.



Alyssa now has $800 from the sale and spends 80% ($640) to fix her car at Pat’s garage.



Pat now has $640 from the sale and spends 80% ($512) on clothes at Brenna’s grocery store.



Brenna now has $512 from the sale and spends 80% ($409.60) with Kelly’s catering company.


Income and ExpendituresHow 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.



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)



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



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



A firm is considering building a new factory. This will

1. increase sales

2. require borrowing to fund the investment



• Expected Return on Investment =

Expected Economic Profit from the Factory

(Total Revenue – Total Cost)/ Investment Cost.



• The Market Interest Rate is …– The Cost of Investment

• Cost of borrowed funds• Cost of investing your own funds (no borrowing)



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


Income and ExpendituresSome 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.


Aggregate Demand

Aggregate Demand (AD) shows the…Relationship between Aggregate Price Level

and Quantity of Aggregate OutputDetermined by the Demand of households, firms,

government and the rest of the world.


Aggregate Demand

Aggregate Price Level is …The rising price level for ALL goods and services

in the economy.


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.


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.


Aggregate Demand

Shifts of the AD CurveShifts 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


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


Aggregate Demand

Monetary Policy is the use of …• Changes in the Money Q

– Increase/decrease of $$$$ in circulation

• Interest Rate• Federal Reserve controls


Aggregate Supply

Aggregate Supply (AS) shows the…Relationship between Economy-wide Production

andAggregate Price Level


Aggregate Supply

There are two AS curves.SRAS

Positive slope LRAS

Vertical at the level of potential GDP


Aggregate Supply

The reason the SRAS is positive is …P is rising faster than the Cost of the unit

The unit will be produced

SRASAggregate Price Level

Real GDP


Aggregate Supply

Sticky Prices– Do not rise or fall very quickly in response in a

change in demand.


Aggregate Supply

Shifts in SRASIncrease = producers willing to produce more

output at any price level


Real GDP


Aggregate Supply

Shifts in SRASDecrease = Q of Aggregate Output supplies falls at

any price level


Real GDP


Aggregate Supply

Shifts of the SRAS CurveShifts 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)


Aggregate Supply

LRASNominal wages adjust along with the price of

output. NO STICKY WAGES

LRAS

Yp

Aggregate Price Level

Real GDP


Aggregate Supply

SRAS to LRASWeak Economy. Recession. GDP Y1 < Yp

LRAS SRAS1 SRAS2

Y1 Yp


Real GDP


Aggregate Supply

What is expected to happen?

1. Weak labor market = falling D for labor.

2. Many Us.

3. Workers accept lower wages.

4. Nominal wages fall.

5. SRAS shifts right until current output = Yp.


Aggregate Supply

SRAS to LRASBooming Economy. GDP Y2 > Yp

SRAS2

LRAS SRAS1

Yp Y2


Real GDP


Aggregate Supply


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.


AD/ AS Equilibrium

Micro equilibrium

S

D

P

Q


AD/ AS EquilibriumMicro equilibrium Macro Equilibrium

S

D

P

Q

AggregateP Level

RealGDP

AD

SRAS

LRAS

Yp


AD/ AS Equilibrium

AggregateP Level

RealGDP

AD

SRAS

LRAS

P level above AD/SRAS intersection1. Surplus of aggregate output2. Prices fall

P level below AD/SRAS intersection1. Shortage of aggregate output2. Prices rise P2

P1

Yp


AD/ AS Equilibrium

AggregateP Level

RealGDP

AD1

SRASPessimism about future income/earning.1. AD shift left2. Aggregate Price Level falls.3. Real GDP falls.4. Recession.

Increase in consumer wealth.1. AD shift right2. Aggregate Price Level rises.3. Real GDP rises.

Ye

Pe

Demand shock is an event which shifts the AD Curve.

AD2

Y1

P1

AD3

Pe2

Y2


Long Run Equilibrium


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


AD/ AS Equilibrium

AggregateP Level

RealGDP

AD1

SRASCommodity prices increase.1. SRAS shift left2. Aggregate Price Level rise.3. Real GDP falls.4. Stagflation.

Technology increases labor productivity.1. SRAS shift right2. Aggregate Price Level fall.3. Real GDP rises.

Ye

Pe

Supply shock is an event which shifts the SRAS Curve.

SRAS2

Y1

Pe2

SRAS1

Pe1

Y2




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


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.


A C T I V E L E A R N I N G 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.

50


A C T I V E L E A R N I N G 2:

Answers

51

LRAS

YN

P

Y

AD2

SRAS2

AD1

SRAS1

P1

P3 C

P2

Y2

B

A

Event: boom in Canada

1. affects NX, AD curve

2. shifts AD right

3. SR equilibrium at point B. P and Y higher,U lower

4. Over time, PE rises, SRAS shifts left,until LR equilibrium at C.Y and U back at initial levels.



Output Gap = 100(Ye – Yp)/Yp

LR economy is self-correcting.

Shocks to AD affect aggregate output in the SR NOT in the LR.


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.



Government Budget and Total Spending GDP = C + I + G = NX Government MAJOR player in AD



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



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



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



Fiscal Policy Time Lags Recognition Lag Decision Lag Implementation Lag



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 Taxesa. Increase G directly affects AD, right shift, increasing real GDP

b. Increase in Transfer Payments or Decrease in Taxesa. Indirectly increase AD by increase



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 Taxesa. Decrease G directly affects AD, left shift, increasing real GDP, Reducing P

level

b. Decrease in Transfer Payments or Increase in Taxesa. Indirectly decrease AD by decreasing Yd.

b. Real GDP falls

c. Price Level falls


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)


Fiscal Policy and the MultiplierAn 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.


Fiscal Policy and the MultiplierA 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.



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)


Fiscal Policy and the MultiplierA 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.


Fiscal Policy and the MultiplierA 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.


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 inflationa. Taxes need to be raised or transfers need to be cut

b. Tm = .75(1 - .75) = 3.

c. $600B / 3 = $200B


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 recessiona. Spending increased with expansionary fiscal policy

b. M = 1/(1-.90) = 10

c. GDP needs to be increased by $1.5 Trillion

d. $1.5T/10 = $.15T or $150B



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 income and expenditures macro

Documents

thomson southwesternincome

aggregate spending

autonomous spending

savings disposable incomean

consumption fx

rounds of spending

households consumer

injection of new spending