unit four national income and price determination unit four national income and price determination...

Unit FourNational Income and Price Determination

Unit FourNational Income and Price Determination

AP MacroeconomicsAP MacroeconomicsMr. Graham Mr. Graham

Do Now.

1. Why did economists originally devise the multiplier?

2. What happened to consumer and investment spending during the Great Depression?

3. Is it less likely for a depression to occur today? Why?

3

Module 16:Income and Expenditure

Module 16:Income and Expenditure

The Multiplier: An Informal Introduction

• 3 Simplifying Assumptions for this analysis (i.e. ceteris paribus conditions):

1. We assume that changes in overall spending (C and I) translate into changes in RGDP.

2. We assume there is no government spending and no taxes (i.e. “private”).

3. We assume that net exports are zero (i.e. “closed”).


$100 billion increase in investment spending

leads to increase in aggregate output (GDP)

leads to increase in disposable income

leads to a rise in consumer spending

Leads to an increase in aggregate output…

12-6

• How large is the total effect on aggregate output if we sum the effect from all these rounds of spending increases?

• Marginal Propensity to Consume (MPC)– The increase in consumer spending when

disposable income rises by $1


12-7

• Recall that there are two things you can do with disposable income…

• Marginal Propensity to Save (MPS)– The increase in household savings when

disposable income rises by $1

MPS = 1 - MPC


12-8

• Some relationships

– Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income (i.e. MPC + MPS = 1).


Complete Activity 24: “What Is An MPC?”

• Question– So…How can a $100 billion increase in investment

generate a $500 billion increase in equilibrium real GDP?

• Answer– The multiplier process


• It is possible that a relatively small change in investment can trigger a much larger change in real GDP


• The total effect of a $100 billion increase in investment spending, I, taking into account all the subsequent increases in consumer spending (and assuming no taxes and no international trade), is given by:


• Let’s consider a numerical example where the marginal propensity to consume is 0.6:


• We’ve described the effects of a change in investment spending, but the same analysis can be applied to any other autonomous change in aggregate spending.

• So the multiplier is:

• By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier

– The smaller the MPS, the larger the multiplier

– The larger the MPC, the larger the multiplier


Consumer Spending

• Consumption– Spending on new goods and services out of a

household’s current income

• Saving

– The act of not consuming all of one’s current income

– Whatever is not consumed out of disposable income is, by definition, saved.

Consumer Spending

• You can do only two things with income (in absence of taxes): consume it or save it

Consumption + Saving = Disposable Income

and

Saving = Disposable Income – Consumption

Investment and Consumption explained

http://www.khanacademy.org/humanities---other/finance/microeconomics-macroeconomics/v/investment-and-consumption

Consumer Spending

• Consumption choices have a powerful effect on the economy.

• What determines how much consumers spend?

Consumer Spending• The most important factor affecting a family’s

consumer spending is disposable income (DI).

• Consumption Function

– The relationship between amount consumed and disposable income

– A consumption function tells us how much people plan to consume at various levels of disposable income.

– Let’s first recall our understanding of slope.

Consumer Spending

Consumption Functionc = MPC x y + a

Where c is individual household consumer spending.

y is individual household current disposable income*.

a is a constant term—individual household autonomous consumer spending

MPC for an individual household as :

MPC = change in c / change in y

Consumption Function

Consumption Function

In reality, the actual data never fit the equation perfectly…

Aggregate Consumption FunctionAlthough Figure 16.3 shows a microeconomic

relationship, macroeconomists assume a similar relationship holds for the economy as a whole:

C = A + MPC x Y

Where C is (aggregate) consumer spending.

Y is (aggregate) disposable income*.

A is aggregate autonomous consumer spending.

12-23

Shifts of the Aggregate Consumption Function

• A change besides real disposable income will cause the consumption function to shift.

• Changes in Population

• Changes in Expected Future Disposable Income

• Changes in Expected Future Prices

• Changes in Aggregate Wealth

12-24

• Aggregate Wealth

– The stock of assets owned by a person, household, firm or nation

– For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash.

– Those who have accumulated a lot of wealth will, other things equal, spend more on goods and services than those who still need to save…


12-25


Do Now.• Which makes up a larger portion of the GDP?

– Consumption spending or investment spending

• Which drives the business cycle more? Why?

Investment Spending• Although consumer spending is much greater than

investment spending, booms and busts in investment spending tend to drive the business cycle.

Investment Spending• Planned Investment Spending

– Amount firms intend to invest during a given period.

– Depends on three principal factors:

• the interest rate

• the expected future level of real GDP

• the current level of production capacity

The Interest Rate and Investment Spending

• Planned Investment Spending is negatively related to the interest rate—investment projects are typically funded through borrowing.

• Higher interest rates will discourage borrowing.

• Lower interest rates will encourage borrowing.

Expected Future Real GDP and Investment Spending

• Planned Investment Spending is positively related to expected future real GDP.

– Higher expected real GDP and, in turn, expected sales for firms, will encourage an increase in planned investment spending.

– Lower expected real GDP and, in turn, expected sales for firms, will encourage an decrease in planned investment spending.

Current Production Capacity and Investment Spending

• Planned Investment Spending is negatively related to production capacity.

– Higher than necessary production capacity will discourage planned investment spending.

– Lower than necessary production capacity will encourage planned investment spending.

Inventories and Investment Spending

• Inventories

– Stocks of goods held to satisfy future sales.

• Inventory Investment—Value of change in total inventories held in the economy during a period.

– Firms, anticipating higher future sales, can increase their inventories as a form of investment spending.

Inventories and Unplanned Investment Spending

• Firms cannot always accurately predict sales

• Unplanned Inventory Investment

– Actual sales are more or less than expected, leading to unplanned decreases or increases in inventories.

Combining Consumption and Investment

• The equilibrium level of GDP is determined by the intersection of the aggregate expenditures schedule and 45-degree line

• At this output ($11T), C is $9T and I is 2T

• No levels of GDP above the equilibrium level are sustainable because C+I fall short.

• At the $12T GDP level, for example, C+I is only $11.5T; this underspending causes inventories to rise, prompting firms to readjust production downward, in the direction of the $11T output

Inventories and Unplanned Investment Spending

36

Module 17:Aggregate Demand:

Introduction and Determinants

Module 17:Aggregate Demand:


The Aggregate Demand Curve

• When a demand curve is derived, we are looking at a single product in one market only (Microeconomics).

• When the aggregate demand curve is derived, we are looking at the entire circular flow of income and product (Macroeconomics).

http://www.khanacademy.org/finance-economics/macroeconomics/v/aggregate-demand

Aggregate Demand Curve• Aggregate Demand Curve

– Shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world

– Depicts the relationship between real GDP demanded and the price level in the economy

– Slopes downward from left to right

Aggregate Demand Curve

Aggregate Demand Curve• Why is the AD curve downward sloping?

• What happens when the price level rises or falls?– The real-balance effect (or wealth effect)

– The interest rate effect

– The open economy effect

• The Real-Balance (a.k.a. Wealth) Effect

– There is an inverse relationship between the price level and real wealth

• As the price level increases, the purchasing power of money decreases and you spend less because of the negative wealth effect

• As the price level decreases, the purchasing power of money increases and you spend more because of the positive wealth effect


• The Interest Rate Effect

– There is a direct relationship between the price level and interest rates

• Increasing price levels indirectly increase the interest rate, which causes a reduction in borrowing/spending

• Decreasing price levels indirectly decrease the interest rate, which stimulates the economy


• The Open Economy Effect (a.k.a. Foreign Sector Substitution)

– There is an inverse relationship between the price level and net exports

• Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e. net exports fall).

• Lower price levels result in a greater desire for American-made goods (i.e. net exports rise)


Shifts in the Aggregate Demand Curve

• The AD curve will shift when the components of spending change (AD=C + I + G + X)

– Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right.

– Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left.

http://www.khanacademy.org/finance-economics/macroeconomics/v/shifts-in-aggregate-demand


• The AD curve will shift when the components of spending change (AD=C + I + G + X)

– Changes in Expectations

– Changes in Wealth

– Size of the Existing Stock of Physical Capital

– Fiscal Policy

– Monetary Policy

Determinants of Aggregate Demand

Do Now.

• Watch this video:– http://www.criticalcommons.org/Members/fsusta

vros/clips/stossel-2007-oil-supplies

– What will happen to the world economy if the supply oil decreases significatly?

http://www.criticalcommons.org/Members/fsustavros/clips/stossel-2007-oil-supplies

http://www.criticalcommons.org/Members/fsustavros/clips/stossel-2007-oil-supplies

49

Module 18:Aggregate Supply:


Module 18:Aggregate Supply:


Aggregate Supply Curve• Economists like to look at aggregate supply in

two different ways:– The short run refers to the period of time in which

firms haven’t yet made price changes in response to an economic shock

– The long run refers to the period of time after which firms have made all necessary price changes in response to an economic shock

• The shape of the AS curve depends on whether one is looking at a long-run AS (LRAS) curve or a short-run (SRAS) curve

Short-Run Aggregate Supply Curve

• Short-Run Aggregate Supply Curve

– Shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run (i.e. the time period when many production costs can be taken as fixed).

– Slopes upward from left to right

http://www.khanacademy.org/finance-economics/macroeconomics/v/short-run-aggregate-supply


• Why is the SRAS upward sloping?

• What happens when the price level rises or falls?

– Misperception Theory

– “Sticky Wages”


Profit = Price – Production Cost

•The Misperception Theory

– As the price level increases, individual markets’ producers may “misperceive” the rising prices as specific to their industry.

•Sticky Prices

– As the price level increases, production costs, particularly wages, are temporarily “sticky” (unions, contracts, etc.)

Shifts in the Short-Run Aggregate Supply Curve

• The SRAS curve will shift when producers reduce the quantity of aggregate output they are willing to produce at any given aggregate price level

– Changes in Commodity Prices

– Changes in Nominal Wages

– Changes in Productivity

Determinants of Short-Run Aggregate Supply

Shifts in the Aggregate Supply Curve

Long-Run Aggregate Supply Curve

• Long-Run Aggregate Supply Curve

– Shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the long-run

– Production costs, including wages, are fully flexible (unions, contracts, etc.).

– In the long run, the aggregate price level has no effect on the quantity of aggregate output supplied.

– Fixed, vertical line.

http://www.khanacademy.org/finance-economics/macroeconomics/v/long-run-aggregate-supply


• It represents the economy’s potential output

– is the level of real GDP the economy would produce if all prices, including nominal wages, were flexible.

– Drawn above the point on the horizontal axis that represents the full-employment output.

– In reality, the actual level of real GDP is almost always either above or below potential output, but it is still an important number because it defines the trend around which actual aggregate output fluctuates from year to year.

Shifts in the Long-Run Aggregate Supply Curve

• The LRAS curve will shift when we experience the factors attributed to long-run economic growth:

– Increases in the quantity of resources (i.e. land, labor, capital, and entrepreneurship)

– Increases in the quality of resources (i.e. education)

– Technological progress

Shifts in the Long-Run Aggregate Supply Curve

From the Short-Run to the Long-Run

• As we saw earlier, the economy normally produces more or less than potential output.

• So the economy is normally on its short-run aggregate supply curve—but not on its long-run aggregate supply curve.

From the Short-Run to the Long-Run

We’ll examine in Module 19 how and why shifts of the SRAS curve will return economy to potential output in the long run.

66

Module 19:Equilibrium in the

AD/AS Model

Module 19:Equilibrium in the

AD/AS Model

AD-AS Model

• To understand the behavior of the economy, we must put the aggregate supply curve and the aggregate demand curve together.

• The result is the AD-AS Model—the basic model we use to understand economic fluctuations.

Short-Run Macroeconomic Equilibrium

• Short-Run Macroeconomic Equilibrium (ESR)– the quantity of aggregate output supplied is equal to

the quantity demanded.

• Short-Run Equilibrium Aggregate Price Level (PE)– the aggregate price level in the short-run

macroeconomic equilibrium.

• Short-Run Equilibrium Aggregate Output (YE)– the quantity of aggregate output produced in the

short-run macroeconomic equilibrium.


• Our microeconomic logic applies here as well…

If the aggregate price level is above its equilibrium

the quantity of aggregate output supplied exceeds the quantity of aggregate output demanded

leads to a fall in the aggregate price level

and pushes it toward its equilibrium level.


• Our microeconomic logic applies here as well…

If the aggregate price level is below its equilibrium

the quantity of aggregate output supplied is less than the quantity of aggregate output demanded

leads to a rise in the aggregate price level

and pushes it toward its equilibrium level.


• Demand Shock: an “event” that shifts the aggregate demand curve:

– Changes in Expectations

– Changes in Wealth

– Size of the Existing Stock of Physical Capital

– Fiscal Policy

– Monetary Policy

Shifts of Aggregate Demand: Short-Run Effects

Shifts of the SRAS Curve

• Supply Shock: an “event” that shifts the aggregate supply curve:

– Changes in Commodity Prices

– Changes in Nominal Wages

– Changes in Productivity

Shifts of the SRAS Curve

Long-Run Macroeconomic Equilibrium

• Now suppose that for some reason AD falls and the AD curve shifts leftward to AD₂

• Recessionary Gap

– The gap that exists whenever equilibrium real GDP per year is less than full-employment real GDP as shown by the position of the LRAS curve


• In the face of high unemployment, nominal wages eventually fall, as do any other sticky prices, ultimately leading producers to increase output

• As a result, SRAS gradually shifts to the right.

• Eventually, SRAS₁ reaches its new position at SRAS₂, bringing the economy to equilibrium at E₃

• Back at potential output Y₁ but at a lower aggregate price level, P₃, reflecting a long-run fall in the aggregate price level.


• Now suppose that AD rises and the AD curve shifts leftward to AD₂

• Inflationary Gap

– The gap that exists whenever equilibrium real GDP per year is greater than full-employment real GDP as shown by the position of the LRAS curve


• In the face of low unemployment, nominal wages eventually rise, as do any other sticky prices, ultimately leading producers to decrease output

• As a result, SRAS gradually shifts to the left.

• Eventually, SRAS₁ reaches its new position at SRAS₂, bringing the economy to equilibrium at E₃

• Back at potential output Y₁ but at a higher aggregate price level, P₃, reflecting a long-run rise in the aggregate price level.


• So in the long-run, the economy is self-correcting

– Shocks to aggregate demand affect aggregate output in the short-run but not in the long-run.


Do Now.

• Explain the difference between SRAS and LRAS• Define: recessionary gap, inflationary gap• What is the main idea behind government

stabilization of the economy? • To what extend do you feel the government

should regulate the economy?

89

Module 20:Economic Policy and

the AD/AS Model

Module 20:Economic Policy and

the AD/AS Model

Macroeconomic Policy

• We said earlier that the economy is self-correcting in the long-run– Most macroeconomists believe, however, that

the process takes a decade or more.– During recessions, the economy can suffer an

extended period of depressed aggregate output and high unemployment before it returns to normal.

Stabilization Policy

• “In the long run we are all dead” –John Maynard Keynes

• Keynes recommended we do not wait for “self-correction”…

• The government should step in to increase aggregate demand and ward off recessions and depressions


Under active stabilization policy, the U.S. economy returned to

potential output in 1996 after a 5-year recessionary gap

Under active stabilization policy, the U.S. economy returned to

potential output in 2001 after a 4-year inflationary gap

Recall:The

(Expanded) Circular-

Flow Diagram

Funds flow into the government in the form of taxes and government borrowing;

Funds flow out in the form of government purchases of goods and services and government transfers to households.

The Government Budget

Inflows Outflows


• Let’s recall the basic equation of national income accounting:

GDP = C+ I + G + X

• The government directly controls G.

• The government indirectly influences C

– Increase/Decrease in Taxes

– Decrease/Increase in Transfers

Decrease/Increase Disposable Income

Fiscal Policy

• The discretionary changes in government expenditures and/or taxes…

• The automatic changes in transfer payments…

In order to achieve certain national economic goals such as:

– High employment (low unemployment)

– Price stability

– Economic growth

Expansionary Fiscal Policy

• Fiscal policy that increases aggregate demand:– an increase in

government purchases of goods and services

– a cut in taxes– an increase

government transfers

Contractionary Fiscal Policy

• Fiscal policy that decreases aggregate demand:– an reduction in

government purchases of goods and services

– an increase in taxes– a reduction in

government transfers

• Questions

– Would the increase/decrease in government spending equal the size of the gap?

– What impact would expansionary/contractionary fiscal policy have on the price level?

Expansionary and Contractionary Fiscal Policy

Fiscal Policy Analysis

Indicate whether each of the following actions of the government is expansionary or contractionary:

1.The government cuts personal income taxes.2.The government increases its orders for a new missile defense system.3.The government eliminates tax incentives for business.4.In response to world pressure, the government drops its order for new missiles.5.The government increases personal income taxes in response to a budget deficit.

Videos

• http://www.youtube.com/watch?v=1qhJPqyJRo8

• http://www.youtube.com/watch?v=7rpvxZphZZc

http://www.youtube.com/watch?v=1qhJPqyJRo8

http://www.youtube.com/watch?v=1qhJPqyJRo8

http://www.youtube.com/watch?v=7rpvxZphZZc

http://www.youtube.com/watch?v=7rpvxZphZZc

Fiscal Policy AnalysisIndicate how you would solve the problems below using fiscal policy:

1.The national unemployment rate has increased by 1 percent for the last three years.2.Inflation has been steadily on the rise, increasing 2 percent for the last three quarters.3.The overall consumer confidence is falling.4.Consumer sales continue to grow, and businesses continue to produce more goods to meet the stronger demand.5.Inflation continues to grow, and unemployment remains at a high rate.

Do Now.

• Watch this video: • http://www.criticalcommons.org/Members/fs

ustavros/clips/fight-of-the-century-keynes-vs-hayek-round-two

http://www.criticalcommons.org/Members/fsustavros/clips/fight-of-the-century-keynes-vs-hayek-round-two



104

Module 21:Fiscal Policy and the Multiplier

Module 21:Fiscal Policy and the Multiplier

Fiscal Policy

• Fiscal policy can be used to increase/decrease aggregate demand by…

– Increasing/decreasing government spending

– Increasing/decreasing taxes

– Increasing/decreasing transfer payments

• Which fiscal policy option has a greater impact on an economy? Why?

http://www.reffonomics.com/textbook2/macroeconomics2/monetaryandfiscalpolicy/governmentspendingvsincreasetaxes.swf

Multiplier Effects: Government Spending

• We learned in Module 16 about the concept of the multiplier.

• An increase in government spending is an example of an autonomous increase in aggregate spending.

• Therefore, any change in government spending will lead to an even greater change in real GDP.

Government decides to spend $50 billion building bridges and roads.

The government’s purchases of goods and services will directly increase total spending on final goods and services by $50 billion.

The firms producing the goods and services purchased by the government will earn revenues that flow to households in the form

of wages, profit, interest, and rent.

Increase in disposable income leads to rise in consumer spending.

Rise in consumer spending, in turn, will induce firms to increase output, leading to a further rise in disposable income, which will

lead to another round of consumer spending increases, and so on.



• Government increases spending by $50 billion.• MPC is .5• Multiplier:

Multiplier Effects: Tax Cuts and Transfers

• Government hands out $50 billion in (lump-sum) tax cuts or transfers.

• MPC is .5 (i.e. households only consume half of those first tax cuts or transfers).

Taxes: Automatic Stabilizers?• In reality, the great majority of tax revenue is

raised via tax rates that are changed proportionately to changes in real GDP.

• In a recessionary gap:

– Incomes and profits fall when business activity slows down, and the government’s tax revenues drop as well.

– Some economists consider this an automatic tax cut, which therefore stimulates aggregate demand

Taxes and the Multiplier• Taxes reduce the effect of the multiplier.

– The government siphons off some of any increase in real GDP at each stage of the multiplier process.

– As a result, the increase in consumer spending is smaller than it would be if taxes weren’t part of the picture.

What Do We Really Know About Fiscal Policy?

• Fiscal policy during abnormal times

– Fiscal policy can be effective

– The Great Depression—fiscal policy may be able to stimulate aggregate demand

– Wartime—during World War II real GDP increased dramatically

What Do We Really Know About Fiscal Policy?

• Fiscal policy during normal times

– Congress ends up doing too little too late to help in a minor recession

– Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty

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