tco 6 given a change in government purchases (g) or net taxes (t), and the marginal propensity to...
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TCO 6
Given a change in government purchases (G) or net taxes (T), and the Marginal Propensity to Consume (MPC) of the economy, analyze the effects of these fiscal policies on equilibrium real GDP.
• Describe and graph a consumption function.• Calculate marginal propensity to consume and
save (MPC and MPS) and interpret them.• Explain how the economy’s macroeconomic
equilibrium is reached.
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Consumption
• Consumption is the nation’s expenditures on all final goods and services produced during the year at market prices– Consumption was almost $2 trillion
dollars in 2002• $2,000,000,000,000• $2,000 billion• $2.0 trillion
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Four Parts of GDP
• Consumption ------------ C• Investment ---------------- I• Government -------------- G• Net exports --------------- Xn
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Consumption
• Americans spend over 95% of their income after taxes– The total of everyone’s expenditures is
called consumption• Consumption is designated by the letter C
• C is the largest sector of GDP– Now C is just over two-thirds of GDP
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Consumption
• The consumption functions states– As income rises, consumption (C) rises, but
not as quickly– Therefore, consumption varies with
disposable income (DI)• DI increases . . . C increases but by a smaller
amount
• DI decreases . . . C decreases but by a smaller amount
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Saving
• Saving is NOT spending• The more we spend, the less we save• A low savings rate leads to a low
productivity growth rate– Without savings ($) to invest in NEW plant and
equipment, we cannot raise our productivity fast enough!
• Savings includes personal saving, business saving, and a government surplus (if they have one)
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Marginal Propensityto Consume (MPC)
MPC = CHANGE in Consumption
CHANGE in Income
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Graphing the Consumption Function
If Consumption rose at the same rate as Disposable Income, a graph of this function would be a 45 % line.
Disposable income ($)
45û
1,000
1,000
2,000
3,000
2,000 3,000
31
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Graphing the Consumption Function
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
DI C S
3000 1750 ?
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
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Graphing the Consumption Function
DI C S
3000 1750 1250
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line.
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Graphing the Consumption Function
DI C S
3000 1750 1250
2000 1440
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250
2000 1440 560
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560
1000 1000
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560
1000 1000 0
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is “0” at 1000 DI because there is NO distance between the C line and the 45 degree line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0
0 625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0
0 625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
When DI is “0” the level of Consumption is called Autonomous Consumption (AC)
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Graphing the Consumption Function
DI C S
3000 1750 1250 2000 1440 560 1000 1000 0
0 625 -625
Disposable income ($)
45û
C
1,000 2,000 3,0001,000
1,000
2,000
3,000
Saving is the vertical distance between the “C” line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line
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The Determinants of Saving
• There is no single reason why people save
• Some spend virtually all of their disposable income
• Some spend more than they earn• Americans now save less than 5 percent
of disposable income• Americans used to save 7 - 10 percent of
disposable income
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Investment
• “Investment” is the thing that really makes our economy go and grow!
• Investment is any NEW:– Plant and equipment
• Investment is:– Additional inventory
• Investment is any NEW– Residential housing
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Inventory Investment
Includes only net change
Date Level of Inventory
Jan. 1, 2003 $120 million
July 1, 2003 145 million
Dec. 31, 2003 130 million
Started the year with $120 million
Ended the year with 130 million
Net change is a (+) 10 million
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Investment in Plant and Equipment
• Investment in plant and equipment is more stable than inventory– Even in bad years companies will still
invest a substantial amount in new plant and equipment
• This is mainly because old and obsolete factories, office buildings, and machinery must be replaced
– This is the depreciation part of investment
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Residential Construction
• Involves replacing old housing as well as adding to it
• Fluctuates considerably from year to year• Mortgage interest rates play a dominant
role
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Investment• Investment is the most volatile sector in
our economy
GDP = C + II + G + Xn• Fluctuations in GDP are largely
fluctuations in investment
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Gross Investment versus Net Investment
• In the equation GDP = C + I + G + Xn
• The “I” represent gross investment• Gross investment - depreciation = net investment
– Depreciation is taking into account for the fact that plant & equipment wear out and houses deteriorate
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• In the equation GDP = C + I + G + Xn
• the “I” represent Gross Investment• Gross Investment - Depreciation = Net Investment
– depreciation is taking into account for the fact that plant & equipment wear out and houses deteriorate.
– Start the year with 10 machines– bought -----------> 6 machines (gross investment)– worn out/obsolete - 4 machines (depreciation)– end the year with 12 machines– actual gain of ---> 2 machines (net investment)
Investment
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Determinants of the Level of Investment
• Sales outlook
• Capacity utilization rate
• Interest rate
• Expected rate of profit (ERP)
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The Interest Rate
• You won’t invest if interest rates are too high
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
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The Interest Rate
• You won’t invest if interest rates are too high
Interest rate = The interest paid / The amount borrowed
X = $120
$1000
X = .12 = 12 %
Assume you borrowed $1000 for one year and paid $120 interest. What was the interest rate?
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Expected Rate of Profit-ERP
ERP = -------------------------------------------
Expected Profits
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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ERP = -------------------------------------------
Expected Profits
Money Invested
ERP = -------------------------------------------$1,650
$10,000
ERP = .165 = 16.5 %
How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?
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Disposable income ($)
45û
C
1,000
1,000
2,000
3,000
2,000 3,000Disposable income ($)
45û
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
To keep things simple so we can read the graph we’re going to assume the level of investment stays the same for all levels of income.
Graphing the C + I Line
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Disposable income ($)
45û
C
1,000
1,000
2,000
3,000
2,000 3,000Disposable income ($)
45û
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
How much is I when disposable income is 1000, 2000, and 3,000?
The C line and the C+I line are parallel. Therefore I is about 480 at every level of disposable income.
Graphing the C + I Line
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Total Saving
• Every economy depends on saving for capital formation
• Individual saving + business saving + government saving = Total Saving– Declines in household saving has been
offset somewhat since 1993 by a sharp rise in government saving and business saving
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Introduction: The Growing Economic Role of Government
• Most of the growth over the past seven decades was due to the Depression and World War II
• Since 1945 the roles of government at the federal, state, and local levels have expanded– The seeds of that expansion were sown during
the Roosevelt administration• The government exerts four basic influences
– It spends more than $3.0 trillion – It levies even more in taxes– It redistributes hundreds of billions of dollars– It regulates the economy
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State and Local Government Spending
• Main expenditures– Education– Health– Welfare
• Spending is a little more than half the level of federal spending
• Police protection and prisons are now straining state and local budgets
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Government Purchases versus Transfer Payments
• The federal, state, and local governments spends over $3.0 trillion a year– GDP = C + I + G + Xn– Approximately half are “transfer payments”
• The largest transfer payment is social security
• These payments end up in the “C” part GDP– Approximately half are “government
purchases”• The largest government purchase is defense• These end up in the “G” part of GDP
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Graphing the C + I + G + Xn Line
Disposable income ($)
45û
2,000 3,0001,000
1,000
2,000
C
3,000
C +I+G
C +I
To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income
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Graphing the C + I + G + Xn Line
Disposable income ($)
45û
2,000 3,0001,000
1,000
2,000
C
3,000
C +I+G
C +I
How much is G?
Answer: 400
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The Average Tax Rate and the Marginal Tax Rate
Income Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate
This is a hypothetical illustration
0 - $100 0 % $ 0 $ 0 0.0 %
$101 - $200 10 % $10
Additional Taxes Paid ( $10)
MTR = --------------------------------
Additional Taxable Income ($100)
The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned
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Types of Taxes
• Direct tax– A tax with your name on it
• Indirect tax– A tax on things
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Types of Taxes
• Progressive taxes– Places a greater burden on those best able to
pay and little or no burden on the poor• Proportional taxes
– Places an equal burden on the rich, the middle class, and the poor
• Regressive taxes– Places a heavier burden on the poor than on
the rich
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The Basis for International Trade
• The basis for international trade is that a nation can import a particular good or service at a lower cost than if it were produced domestically– In other words, if you can buy it cheaper than you
can make it you buy it– This maxim is true for individuals and nations– This is called specialization and exchange
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A Summing Up: C + I + G + Xn
Net exports = Xn
Xn = Exports - Imports
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45û
8,000
10,000
8,000 10,000
6,000
6,000
4,000
4,0002,000
2,000
C +I +G
Disposable income ($)
45û
8,000
10,000
8,000 10,000
6,000
6,000
4,000
4,0002,000
2,000
C +I +G
Disposable income ($)
C +I +G +Xn
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.
C + I + G + Xn