# Unit 3: Aggregate Supply & Demand

Feb 24, 2016

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Unit 3: Aggregate Supply & Demand . Consumption Function. Development John Maynard Keynes originated idea Measures economic performance of an economy Focuses on the relationship b/w Consumption & Savings Simplifications Private/closed economy (no int’l influence & gov’t ignored) - PowerPoint PPT Presentation

#### di total income level

Unit 1: Introduction to Economics & Market Systems

Unit 3: Aggregate Supply & Demand

Consumption FunctionDevelopmentJohn Maynard Keynes originated idea Measures economic performance of an economyFocuses on the relationship b/w Consumption & Savings

Simplifications Private/closed economy (no intl influence & govt ignored) C + IgAssume that all saving is personal Depreciation & net foreign factor = 0 Reminder: w/ no govt or foreign trade, GDP = NI = PI = DI (all the same!) Recheck blue is it correct???

In other words, businesses arent saving they are spending Depreciation means that gross investment & net investment (amount of money spent on capital assets i.e. machinery, equipment, tech) & are the same If \$100 billion of output is produced as GDP, households will have exactly \$100 billion to consume or save as DI 2Consumption FunctionToolsTheory assumes that the level of output & employment depend directly on the level of aggregate expenditures Changes in output reflect changes in agg. spending ConsumptionThe most important determinant of consumer spending is DI (income) 45 angle represents all points where consumer spending equals DI (1:1) 45 line represents zero savings If DI increases, both consumption & savings will increase Businesses will only produce at the level that ppl are willing to consume (& thus profit) if ppl stop spending, output & employment fall and vice versa Determinant: your spending level is determined most significantly by your income Anything not spent is saved, so DI = C + SThis is the reason for the 45 degree line 3Consumption FunctionToolsConsumption Schedule Historically, households spend a larger proportion of small income than of a larger incomeBreakeven: C = DI total income level when H consume all income Dissavings occurs at low levels where consumption exceeds income & households must borrow (credit cards)4Consumption FunctionToolsNon-income Determinants of Consumption & Saving WealthExpectationsHousehold DebtTaxation Shifts & Stability Consumption & saving schedules will shift in opposite directions UNLESS caused by a tax change Consumption & saving schedules are generally stable unless deliberately shifted by govt action Non-income: DI is the main one, but other factors can affect whether ppl save or spendWealth: Greater wealth, greater their consumption (shift up) and less saved (down) you typically save to accumulate wealth, but when your wealth increases for other reasons, you tend to spend more Expectations: expecting higher prices tomorrow increases more spending & less saving now; lower income tomorrow decreases spending & increases saving nowHousehold debt: increasing your debt leads to more spending; if debt is too high then consumption might decrease to pay off debts Taxation: increase in taxes decreases saving & spending; lower taxes increases both 5451:1DissavingsSavingsBreak EvenDIConsumptionConsumption Function\$500\$500DissavingsSavingsBreak EvenDISavingsSavings FunctionMarginal Propensity to Consume & Save MPC: what effect a Income has on amount CMPC = change in consumption change in income

MPS: what effect a Income has on amount SMPS = change in saving change in income

MPC + MPS = 1

Marginal propensity to consume(MPC) is a fancy economic measure that shows how much more youre likely to spend when your income goes up. If the United States average MPC is 90%, then for every extra dollar you earn (or are given) as an average American, you are likely to spend 90 cents of it as disposable income. And if youve paid any attention to our national savings rate recently, you might come to the conclusion that as a society weve been dancing right on the 99% MPC line. (That is, we spend 99% of every extra dollar we bring home.)

http://www.getrichslowly.org/blog/2009/04/09/economic-stimulus-and-the-marginal-propensity-to-consume/ 8Marginal Propensity to Consume & Save Calculate MPC/MPSIf disposable income changes from \$10,000 to \$12,000 and consumption changes from \$9,000 to \$10,000: What is MPC? What is MPS?

Why do MPC & MPS always equal 1?

MPC & MPSLevel of output & income(NNP=DI)(1)Consumption(2)Saving(1)-(2)(3)MPC(2)/(1)(4)MPS(3)/(1)(5)\$12,000\$12,100-100.90.113,00013,00009/101/1014,00013,800200.8.215,00014,500500.7.316,00015,100900.6.4The Multiplier EffectWhy do cities want the Superbowl in their stadium? An initial change in spending will set off a spending chain that is magnified in the economy.

Example:A Seahawks fan spends \$120 on dinner at Johns diner.Johns income has increased by \$120. John spends \$100 on a new bench from Carols furniture shop. Carol spends \$80 on wood from Dans lumber yard. Dan spends \$50 on lunch at Sharons restaurant

The Multiplier Effect shows how spending is magnified in the economy & doesnt end at the initial purchase/investment.

Multiplier Multiplier EffectAny increase in spending will result in an even larger increase in GDP due to the fact that every \$ spent is spent again multiple times. Increases in spending can come from either government (G) or businesses (Ig)Any money spent is someone elses income & thus subject to spending. Contingent on MPC & MPS WHY? Limiting factor of multiplier is MPS Multiplier = 1/MPS or 1/(1-MPC)Larger the MPC, larger the multiplier

Multiplier What is the multiplier if the MPC is equal to ? 1 / (1 - 0.75) = 4

What is the multiplier if the MPC is equal to 9/10? 1 / (1 - 0.9) = 10

What is the multiplier if the MPS is 1/5? 1 / 0.2 = 513Multiplier Multiplier EffectMultiplier is used to calculate how any change in spending will change total spending (AD) or income (GDP) Spending x Multiplier = AD/GDPGeorge Bush, in an effort to increase GDP during a recession, proposed a stimulus package which provided every American family with \$200 more of disposable income. The marginal propensity to consume at that point in time was 0.75.

Calculate the multiplier and identify how much more spending this would generate per family. 1/0.25 = 4 4 x 200 = \$800

Multiplier Would the multiplier be larger or smaller if people saved more of their additional income? (MPS = .25 vs. .3) Smaller ( 4 vs. 3.33)What would happen to the multiplier if people saved all of their income? It would be 1 & thus spending doesnt multiply (Multiplier = 1/1)What would happen if people spent all of their income? It would be infinite & thus spending would be replicated for every transaction (Multiplier = 1/0)

Multiplier If the multiplier were 4, how much money would the govt spend to increase aggregate demand by \$1 million? \$250,000( spending x 4 = 1,000,000 )

If the govt needed to cut AD by \$2 million and the multiplier were 4, how much would govt spending have to be reduced? \$500,000 ( spending x 4 = 2,000,000 )

16Multiplier How does the multiplier explain why changes in investment spending cause large fluctuations in GDP? Because increases in investment cause endogenous increases in consumption, the ultimate increase in GDP is larger than the initial investmenti.e. minor injections/leakages cause even greater growth of GDP (\$1 M injection can yield growth of \$5 M)growing from within 17If disposable income changes from \$15,000 to \$19,000 and saving changes from \$10,000 to \$11,000:

MPS: .25

MPC: .75

The MULTIPLIER: 4

MPS/MPC & MultiplierMPS: .25, MPC: .75, Mult.: 418If disposable income changes from \$15,000 to \$16,000 and consumption changes from \$10,000 to \$10,750:

MPS: .25

MPC: .75

The MULTIPLIER: 4

MPS/MPC & MultiplierMPS: .25, MPC: .75, Mult.: 4

19Interest Rates & Investment DemandWhat is investment? Investment decisions made using cost/benefit analysis. Benefit = expected rate of return (r)Cost = interest rates the cost of money (i)make sure i is adjusted for inflationRules: If expected return real interest INVEST If expected return < real interest DO NOT

Investment is expenditures on new plants (factories), capital equipment (machinery), technology, homes, inventories (goods sold by producers). Expected rate of return: you invest in a new piece of machinery that costs \$1000 and expect it get \$1200 of production out of it in the next year profit of \$200 (200/1000 = 0.2% rate of return)

20Interest Rates & Investment DemandWhy is the ID downward sloping?

Inverse relationship the lower the real interest rate, the greater the business investment b/c theyll receive a higher return on their investment When interest rates are high, fewer investments are profitable If in this example, the real interest rate is 5%, all investments with a expected return higher than 5% will be undertaken. If in this example, the real interest is 3%, all investments with an expected return higher than 3% will be undertaken you would naturally expect more investments to have a return above 3% than 5%, hence downward slope.

21Shifts in Investment DemandCost of ProductionLower costs shift ID Higher shifts ID

Technological ChangeNew technology shifts ID

Stock of Capital Low on capital shifts ID High shifts ID

Expectations Positive expectations shifts ID Negative shifts ID More incentive to invest in capital - High on stock means there is less incentive to invest

22Interest Rates & Investment Demand

The real interest rate is 2%. What is investment at that level? 23Investment ScheduleinvestmentGDP = DI\$2 TIf real interest rate was 2%, we would assume that businesses are investing \$2T at all levels of output.

The amount invested is very unstable/volatile, however, and inves

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