A Quick Review in the Movies!!!

UNIT 3

NATIONAL INCOME AND PRICE DETERMINATION

Why do cities want the Superbowl? Because an initial change in spending will set off a spending

chain that is magnified throughout the economy.Example: • Bobby spends $100 on Jason’s product• Jason now has more income so he buys $100 of Nancy’s product• Nancy now has more income so she buys $100 of Tiffany’s product. • The result is an $300 increase in consumer spending

The Multiplier Effect shows how spending is magnified in the economy.

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Marginal Propensity to Consume (MPC)•How much people consume rather than save when there is an change in income. •It is always expressed as a fraction (decimal).

MPC= Change in Consumer Spending Change in IncomeExample:Consumer spending goes up by 6 billionDisposable income goes up by 10 billionWhat is the MPC? Means? 4

Marginal Propensity to Save (MPS)

MPS= Change in Saving Change in Income

•How much people save rather than consume when there is an change in income.

•It is always expressed as a fraction (decimal)

Or….

MPS=1-MPC5

Why is this true?Because people can either save or consume

The new disposable income they receive

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MPC + MPS = 1-----------------------

MPS = 1 - MPC

Practice Problems

The Multiplier

It’s a simple concept…

The Multiplier in the real world…

The federal government recently enacted the American Recovery and Reinvestment Act of 2009. This “stimulus package” of $787 billion was intended to spark job growth to reverse the worst recession since the Great Depression. How was this supposed to work?The short answer is that $1 of spending in one area of the economy multiplies into more than $1 of spending throughout the economy

Autonomous Change in Aggregate Spending

• This is the initial change in aggregate spending before real GDP rises. It is the cause, not the result, of the chain reaction.

• The multiplier is the ratio of the total change in real GDP caused by AAS. Multiplier = change in real GDP

change in AAS

The size of the multiplier will depend on the MPC. The higher the MPC the higher the multiplier.

{In other words, the more money spent the greater the impact the multiplier will have}

What do you need to know and understand how the multiplier

works?

How is Spending “Multiplied”?

Change inGDP = Multiplier x Initial Change

in Spending

Assume the MPC is .5 for everyone •Assume that when the Super Bowl comes to town there is an increase of $100 in Ashley’s restaurant.•Ashley now has $100 more income. •She saves $50 and spends $50 at Carl’s Salon•Carl now has $50 more income•He saves $25 and spends $25 at Dan’s fruit stand•Dan now has $25 more income.

This continues until every penny is spent or saved

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or

• Multiplier = Change in GDP Change in Spending

*** I just made an algebraic change

If the MPC is .5 how much is the multiplier?

Change inGDP = Multiplier x initial change

in spending

SimpleMultiplier

= or 1

MPS

1

1 - MPC

•If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? •How much will a decrease of $3 in spending decrease GDP?

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The Multiplier EffectPractice calculating the spending multiplier

SimpleMultiplier

= or 1

MPS

1

1 - MPC

1. If MPC is .9, what is multiplier?2. If MPC is .8, what is multiplier?3. If MPC is .5, and consumption increased $2M.

How much will GDP increase?4. If MPC is 0 and investment increases $2M.

How much will GDP increase?Conclusion: As the Marginal Propensity to

Consume falls, the Multiplier Effect is less 16

Did the stimulus help or hurt the economy.

APE 21

APE 21

APE 21

Smaller

The increase in GDP would be smaller if they held more money.

If we all spent ALL of our income or our change the spending multiplier would be infinite..

APE 21

APE 21

-.90/.10= -9.0-.80/.20= -4.0-.75/.25= -3.0

APE 21

-4 (-.80/.20)

3 (1/.33)

-3 (-.75/.25)

If people begin to worry about their jobs and/or their wealth (stocks, housing prices, etc) they will hold more money which decreases the multiplier.

APE 21

If the multiplier is 5 the MPC is .80.Tax multiplier= -.80/.20=-4

APE 21

MPC=Change in consumption/change in incomeMPC=75/100=.75

Marginal Propensity to ConsumeThe consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income.

Two factors can change Aggregate Consumption Function

• 1. Changes in expected future disposable income

• 2. Changes in aggregate wealth

Duffka School of Economics

Investment SpendingConsumer spending is much larger than investment spending, but booms and busts in investment spending tend to drive the business cycle.

Most recessions originate as a fall in investment spending.

• Planned Investment is what firms intend to undertake in a given period but it will depend on three (3) factors:

• 1- interest rates• 2-expected future GDP• 3- current level of

production capacity

Investment SpendingInvestment Spending

Investment demand handout

Inventories• Increase in inventories =investment spending

• Higher than anticipated inventories due to a unplanned decrease in sales is known as unplanned inventory investment.

• Investment (I) = I unplanned + I planned