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AE1(C+Ig)[Basic Economy][Private(no G)&Closed(no X or M)]
Consumption
+80+80+80C=390
(AE1)470
(AE2)550
(AE3)630
+20 Xn+20 G
+20 Ig
S
Real GDP
45°45°
45°45°
AE
[C +
Ig
] (b
illion
s o
f d
ollars
)
o45
o
Consumption
C + Ig
Ig = $20 Billion
Equilibrium
370 390 410 430 450 470 490 510 530 550
Building the ModelAE[C+Ig] [“Basic” or “Simple” economy]
C =$450 Billion
$530
510
490
470
450
430
410
390
370 + 20 Ig
+80
S
Private Closed
GDP will increase by a “multiple” of 4 & that is why it is called the “multiplier”.
Real GDP
Multiplier-4
Con
su
mp
tion
Savin
g
o
o45
o
Consumption
S
C1
S
DI2 (Disposable Income)
Disposable Income
SAVING
SAVING
DISSAVING
DISSAVING
Change in (or QS)[Income change, movement from point to point]
So, the key to achange in QC(QS)
is a change in ?
Breakeven
DI1DI3
C2
S
Con
su
mp
tion
Savin
g
o
o45
o
C1
S1
Disposable Income
Disposable Income
C2
S2
Increase in Consumption (Decrease in Saving)[shift/whole curve/non-income]
Increases inconsumptionmeans…
Decreasein saving
May be caused by:Increase in wealthDecrease in PLExpect. PL incr.Expect. of positive YExpect. of shortagesDecrease in debt*Decrease in taxes
*Decrease in taxesincreases both C & S
I’ll buy more and save more.
Con
su
mp
tion
Savin
g
o
o45
o
C1
S0
Disposable Income
Disposable Income
C2
S2
Decrease in Consumption (Increase in Saving)[shift/whole curve/non-income]
Decreases inconsumptionmeans…
Increasein saving
May be caused by:Decrease in wealthIncrease in PLExpect. PL decreaseExpect. neg. future Y Increase in debt*Increase in taxes
*Increase in taxes decreases both C & S
.80 .85 .90 .95 1.0.986
.976
.972
.940
.907
.873
.869
.842
Canada
United States
Netherlands
United Kingdom
Germany
Italy
Japan
France
GLOBAL PERSPECTIVEAverage Propensities to Consume,
Selected Nations, 2000
NON-INCOME DETERMINANTS [Shifters]OF CONSUMPTION AND SAVING
• Wealth Increase or decrease in wealth
• Consumer Expectations
[about future availability, income, & prices]
• Household Debt• Increase/decrease in PL• Taxation increases/decreases
NominalInterest
Rate
RealInterest
Rate
AnticipatedInflation
-
12%
5%7%
Real Interest Rate[Nominal I.R. – inflation rate = Real I.R.]
=
Marginal Efficiency of Investment [MEI][If expected returns equal or exceed the real interest rate of interest, the firm will normally make the investment.]
30%
25%
20%
15%
10%
5%
[QID] Quantity of Investment Demanded (millions)
0 1 2 3 4 5 6
MEI = 27%
Renovate plant
$2 million
MEI=20%
Add newwing to factory$1 mil.
MEI=15%
Purchasemachines$1.5 mil.
MEI=12%
Acquireadditional
powerfacilities$1.5 mil.
MEI = 7%
Install computersystem $1 mil.
[One firm’s demandcurve for investment]
Change in QID[interest rate change, point to point movements]
Positive profit expectations and the real interest rate are the most important determinants of investment.
Drill Press - $1,000A. 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]
Single Firm
Investment (billions)
Exp
ecte
d r
ate
of
retu
rn,
r,
an
d in
tere
st
rate
, i
(perc
en
ts)
16
14
12
10
8%
6
4%
2
05 10 15 20 25 30 35 40 QID QID
Change in Quantity of Investment Demanded [QID](Interest rate change, point to point movement)
DI Firms will undertake all investments[additions to plant, equipment, inventory,and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest.
Monetary Policy – by loweringinterest rates, the Fed can increase Ig & employment.
[Inverse relationship between real interest rate and QID]
CHANGE [Shift] IN INVESTMENT [curve]
8%
QID1
I1 I2
QID2
Increase in Investment1. Positive profit expectations2. Scarcity of inventory3. Technology [innovation]4. Decrease in production costs5. Decrease in business taxes
INVESTMENT DEMAND & SCHEDULE
Exp
ecte
d r
ate
of
retu
rn,
r, a
nd
real in
tere
st
rate
, i (p
erc
en
ts)
Investm
en
t(b
illion
s o
f d
ollars
)Investment
(billions of dollars)
20
8
20
Real Domestic Product, GDP(billions of dollars)
DI
Ig
InvestmentDemand Curve
InvestmentSchedule
Ig independent of Y
20
20
Y1 Y2 Y3
In constructing the AE graph, Ig will be independent [not influenced]by income. Investment decisions are made months ahead.
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.
NS 1-6
“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]
The 2000 Olympics resulted in $3 1/2 billion to Australia’s economy over a year’s time.The Texas-Oklahoma game brings $21 mil to D-FW.2005 Cotton Bowl brought $30 million to D-FW.Super Bowl brought $166 million to Houston.Fiesta Bowl for national title brought in $85 million.Big 12 Tournament brought $45 million to D-FW
OU
MT = MPC/MPSME = 1/MPS
MPC ME
.9 10
.8 5
.75 4
.60 2.5
.5 2
The larger the MPC, the smaller the MPS, and the greater the multiplier. This is the “simple multiplier”because it is based on a “simple model of the economy”.
Notice the 2nd round
with .9 versus .5
90%
50%
Super Bowl - $166 Million For Houston• $150 - Parking rates around the stadium
• $500-$600 per Super Bowl ticket
[$2,000-$6,000 on E-Bay for a seat]• $12,000 – cost of Super Bowl trophy
• $2.3 million – 30 second ad• $50,000 – Super Bowl Ring• 68,000 to each player on the winning team• $36,500 to each player on the losing team. • $3.35 million to the winning team• $2.59 million to the losing team• Hotels - $69 M; bars & restaurants-$27 M; entertainment-$15 M;
Government increases spending by $1 billion with a multiplier of 2
On new highwaysHighway workers buy new boatsBoat builders buy plasma TVsTV factory workers buy new carsAuto workers buy “wife beater shirts”Apparel workers spend $ on moviesMovie moguls spend money on Christina Agulera’s “Come On Over.”
Let’s Go To Padre Island and Party With The Multiplier
• During spring break, college students like to head to Padre Island. The “multiplier” is getting ready to work.
• With dollars in their pockets, the students spend money on food and drink, motel rooms, dance clubs, etc. These dollars raise total income there by some multiple of itself.
• College students buy pizzas, beer, and sodas. The people who sell these items find their incomes rising. They spend some fraction of their increased income, which generates additional income for others.
• If the students spend $8 million at Padre and the MPC is .60, then college students will increase income in Padre by $20 million.
• When the networks show scenes on the beach, the average person simply sees college students having a good time.
• But – economists see the multiplier at work, generating higher levels of income for many of the residents of Padre Island.
UT student
These areTexas A&M
studentsAt Padre.
Multiplier – As the money goes from one person, to another, to another…
NS 7 – 107. The APC indicates the percent of total income that will be (consumed/saved). 8. The MPC is the fraction of a change in income which is (spent/saved).9. The greater is the MPC, the (larger/smaller) the MPS, and the (larger/smaller) the multiplier.10. With a MPS of .4, the MPC will be (.4/.2/.6) and the multiplier will be (2/2.5/4).
Building [Simple economy to Complex economy]
[C+Ig] (private-closed)
[C+Ig+Xn] (private-open)
[C+Ig+G+Xn] (mixed-open)
“ME” = 4
ClosedPrivate
Private
Mixed Open
Open
390 470 550 630 Real GDP0
AE3 (C+Ig+G+Xn) (Complex Economy) [Open & mixed]
AE2 (C+Ig+Xn) (Open & Private) [X(40)-M(20)]
AE1(C+Ig)[Basic Economy][Private(no G)&Closed(no X or M)]
Notice that the injections are autonomous (independent) of Y
45°45°
Con
su
mp
tion
o45
o
Consumption
C1
F
SAVING
E
C2
S
How to figure the MPC & MPS [MPC = C/ Y] [MPS = S/ Y]
Disposable Income
B
C
D
A
H
Dissaving
MPC=? BC/EF
MPS=? CD/EF
S
200 400 1,000 bil. 0 N Q K
$1,000$700$400 J
P
I
HAE1[C+Ig]
Consumption
Real GDP
AE
[C+
Ig]
With Ig [C+Ig], the MPC is? PI/QK
The MPS is ? HI/QK
What income level represents “dissaving”? $200
Consumption will be equal to income at income level ? $400
Review
45°45°
NS 11-16
11. The APC is one at letter (A/B/C/D).12. The MPC is equal to (AE/OE or CB/AB). [moving from OE to OF]13. At income level “OF” the volume of saving is (CB/CD).14. Consumption will be equal to income at income level (OH/OE).
15. The economy is dissaving at income level (OH/OF).16. The MPS is (CD/EF or CB/EF).
[moving from OE to OF]
Consumption
Con
su
mp
tion
Income0 H E F
AB
C
D
45°45°
YR F* 500 580
An Increase in G of $20B is more expansionary than a decrease in T of $20 B
[If the MPC is .75, ME is 4 but the MT is only 3]
AE
AE
+80
YR Y*500 580
+60+20T
AE1(C+Ig)AE2(C+Ig+G)
AE1
AE2
Incr G spending by $20 bil.“ME” of 4 [1/.25]
[20 x 4 = $80]
“Tax cut” of $20 billion“MT” = 3 [.75/.25] x 20 = $60
[Need a 25% larger “Tax cut” to get to $580]“Tax cut of $25.67 billion x 3 = $80]
Let’s see, anyone’s spending (G,Ig, or Xn) becomes someone else’s income, so there will be an increase in “C”.
+20G
S
S
560
“Big 12” Tournament brings $45million to the DFW economy.
AAC
Increase in G of $40 Billion with MPS of .5
1st Round = $40 billion spent on the highways
2nd Round=$20 billion on motorcycles
3rd Round,only $10 billion spent on corvettes
The multiplier is the multiple in which an initial change in aggregate spending will alter total spending after an infinite # of spending cycles.
Total spending change = M X new spending injection.
Decrease in Taxes of $40 B with MPS of .5
With MPS of .50, $20 is saved & & only $20 bil is spent 1st round.
2nd Round: only$10 bil. is spent.
3rd Round
only $5 bil.is spent.
Leakage of 50%[saving of $20 bil.]in the first round
ME of “10” [So MT is “9”]
[+20]
ME of “5” [So MT is “4”]
[+20]
ME of “2” [So MT is “1”]
[+20]
Balanced Budget Multiplier (“1”)$20 G $20 T
$600 $620
S
+20 G&T
AE1[C+Ig]AE2[C+Ig]
[Increase G & T by $20 billion]
40“G”“T”-20
“G”
“G”
“T”
“T”
100
200
-80
-180
AE
ME of 2 & MT of 1
+$20
ME of 5 & MT of 4
ME of 10 & MT of 9
Balanced Budget Multiplier [$20 billion][“T” affects AD indirectly thru “C”; “G” affects AD directly]
GDP = $80
Net Change in GDP = The increase in “T” means we would have consumed $15 and kept $5 in our pockets.
The increase in “G” flows directly into the economy.
ME = 1/MPS
ME = 1/.25 = 4
So, 4 x $20 = $80
G $20
MT = MPC/MPS=.75/.25=3So, 3 x -$20 = -$60
GDP = -$60
Ca= -$15
Sa= -$5
T $20
$470 billion
AS
AD1
$490 billion
PL
AD2
+$20
The ME, MT, & MBB MultipliersME[G, Ig, or Xn] = 1/MPS = 1/.25 = 4So, G increase of $10 bil. will incr Y by $40 bil. [$10x4=$40]And a G decrease of $10 bil. will decrease Y by $40 bil. [-$10x4=-$40 bil.]
MT = MPC/MPS = .75/.25 = 3So, T decrease of $10 bil. will incr Y by $30 bil. [$10 x 3=$30]And a T increase of $10 bil. will decr Y by $30 bil. [-$10x3=-$30]
MBB = 1So, an increase in G&T of $10 bil. will incr Y by $10 bil. [$10x1=$10]
And a decrease in G&T of $10 bil. will decr Y by $10 bil.[-$10x1=-$10]
Any increase in expenditures x the M will increase GDP.Any decrease in expenditures x the M will decrease GDP.
1. We will start at $500 equilibrium GDP on each.
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.
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 = $5804. 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.
INSTRUCTIONS FOR THE NEXT FOUR AE SLIDES
AE
E1
E3
E2AE2
AE1
AE3
500Recessionary spending gap
Inflationary spending gap
Recessionary
GDP gap
InflationaryGDP gap
$10ME__MT___MBB___
$100 Y with ME
___Y with MT
___Y with MBB
19010
.9?
10
1 9
$200 Y with ME
_____Y with MT
_____Y with MBB
15050
____ Y with ME
____Y with MT
____Y with MBB
___ Y with ME
____Y with MT
____Y with MBB
124860
$12 $50
$20Change in Expenditures
MPC[So MPS &ME, MT, & MBB]
Chg inEquilibrium GDP
The Multiplier & Equilibrium GDP
[Give the correct equilibrium GDP [start from $500] using the ME, MT, MBB]