1 Sect. 4 - National Income & Price Determination Module 16 - Income & Expenditure What you will learn: The nature of the multiplier The meaning of the aggregate consumption function How expected future income and aggregate wealth affect consumer spending The determinants of investment spending

Sect. 4 - National Income & Price Determination Module 16 - Income & Expenditure Marginal Propensity to Consume (MPC) - What is the increase in consumer spending when disposable income rises by $1 MPC = Change in Consumer Spending Change in Disposable income Ex: If consumer spending goes up by $6 billion when disposable income goes up by $10 billion MPC = = 0.6 ($.60 of every dollar of disp. income) $6B $10B

3 Marginal Propensity to Save (MPS) - The fraction of additional $1 of disposable income that is saved MPS = (1 - MPC) EX: =.4 ($.40 of every dollar) Autonomous Change in Aggregate Spending - An initial rise or fall in aggregate spending that is the cause of a series of income and spending changes Multiplier - The ratio of of total change in GDP caused by Autonomous Change in Consumer Spending 1 1 (1- MPC) MPS Ex: = = 2.5 X $100 billion = $250 billion =Multiplier = (1 -.6)

4 Consumption Function - Equation showing how a consumer household’s spending varies with disposable income c = a + MPC x Yd c - consumer spending a - autonomous consumer spending MPC - Marginal Propensity to Consume Yd - current household disposable income

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6 Consumption Function - Equation showing how a consumer household’s spending varies with disposable income c = a + MPC x Yd c - consumer spending a - autonomous consumer spending MPC - Marginal Propensity to Consume Yd - current household disposable income Autonomous Consumer Spending - Amount of money a household would spend if it had no disposable income

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8 Aggregate Consumption Function - For the economy as a whole - relationship between aggregate current disposable income and aggregate consumer spending C = A + MPC x YD Shifts in Ag. Consumption function 1) Change in Expected Future Disposable Income 2) Change in Aggregate Wealth

11 Aggregate Consumption Function - For the economy as a whole - relationship between aggregate current disposable income and aggregate consumer spending C = A + MPC x YD Shifts in Ag. Consumption function 1) Change in Expected Future Disposable Income 2) Change in Aggregate Wealth

12 Planned Investment Spending - Investment spending that businesses intend to undertake during a given period of time - effected by the interest rate Inventory Investment - Value of the change in inventories held in the economy in a given period of time Actual investment spending = Planned Investment Spending + Unplanned Inventory Investment

13 Module 17 - Aggregate Demand What you will learn: How the aggregate demand curve illustrates the relationship between aggregate price level and quantity of aggregate output demanded in the economy How the wealth effect and interest rate effect the aggregate demand curve What factors can shift the aggregate demand curve

14 Module 17 - Aggregate Demand Aggregate Demand - Aggregate Demand curve shows relationship between price level and quantity of aggregate output demanded

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16 Module 17 - Aggregate Demand Aggregate Demand - Aggregate Demand curve shows relationship between price level and quantity of aggregate output demanded Wealth Effect - Change in consumer spending caused by change in consumers’ purchasing power Interest Rate Effect - Change in investment and consumer spending caused by change in interest rates

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18 Shifts of Aggregate Demand Curve - Not a movement along the aggregate demand curve due to change in price level 1. Change in Expectations - If consumers and firms become more optimistic about future - aggregate demand increases (shifts right) - less optimistic and aggregate demand decreases (shifts left) 2. Change in Wealth - Change in the value of household assets changes aggregate demand Stock Mkt. crash decreased aggregate demand

19 3. Change in Existing Physical Capital - Investment spending depends on how much physical capital firms already have - Ex: housing market 4. Fiscal Policy - Govt. spending and taxation policies effect aggregate demand as it effects consumers’ disposable income 5. Monetary Policy - The Federal Reserve changes in the money supply and interest rates effects consumer and investment spending

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22 Module 18 - Aggregate Supply What you will learn: What factors can shift the aggregate supply curve Why the aggregate supply curve is different in the short run from the long run

23 Module 18 - Aggregate Supply Aggregate Supply - Aggregate supply curve shows the relationship between price level and aggregate output supplied Sticky Wages - Nominal wages that are slow to rise and fall as the economy rises and falls - Short-run Aggregate Supply Curve - Relationship between price level and output during a period when most production costs are fixed

Shifts of the Short-run Aggregate Supply Curve - Not a movement along the aggregate supply curve due to change in price level 1. Change in Commodity Prices - Goods used in production (inputs) and represent a significant production cost - input costs can change quickly and significantly 2. Change in Nominal Wages - Another significant production cost 3. Change in Productivity - Workers produce more with the same inputs - usually due to technological advances

The Long-Run Aggregate Supply Curve - Shows relationship between price level and aggregate output supplied if all prices were fully flexible (wages, inputs, sale price) - shows potential aggregate output

The Long-Run Aggregate Supply Curve - Shows relationship between price level and aggregate output supplied if all prices were fully flexible (wages, inputs, sale price) - shows potential aggregate output Short Run to Long Run - Short-run aggregate supply can be above or below potential output but over time it will equal long-run potential output

The Long-Run Aggregate Supply Curve - Shows relationship between price level and aggregate output supplied if all prices were fully flexible (wages, inputs, sale price) - shows potential aggregate output Short Run to Long Run - Short-run aggregate supply can be above or below potential output but over time it will equal long-run potential output

Module 19 - Equilibrium in Aggregate Demand / Supply What you will learn: The difference between short-run and long-run macroeconomic equilibrium The effects of demand shocks and supply shocks How to determine if an economy is experiencing a recessionary gap or an inflationary gap and how to calculate the size of the output gaps

35 Module 19 - Equilibrium in Aggregate Demand / Supply AD - AS Model - The aggregate Demand and Supply curves used together to analyze economic fluctuations

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37 Module 19 - Equilibrium in Aggregate Demand / Supply AD - AS Model - The aggregate Demand and Supply curves used together to analyze economic fluctuations Demand / Supply Shock - An event that shifts the aggregate demand or supply curves left or right Shifts of Aggregate Demand: Short-Run - As the short-run demand curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level and GDP increase - Shift Left = ag price level and GDP decrease

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39 Module 19 - Equilibrium in Aggregate Demand / Supply AD - AS Model - The aggregate Demand and Supply curves used together to analyze economic fluctuations Demand / Supply Shock - An event that shifts the aggregate demand or supply curves left or right Shifts of Aggregate Demand: Short-Run - As the short-run demand curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level and GDP increase - Shift Left = ag price level and GDP decrease

40 Shifts of Aggregate Supply: Short-Run - As the short-run supply curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level decrease and GDP increase - Shift Left = ag price level increase and GDP decrease

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42 Shifts of Aggregate Supply: Short-Run - As the short-run supply curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level decrease and GDP increase - Shift Left = ag price level increase and GDP decrease Stagflation - The combination of inflation (rising price level) and falling output - Leads to rising unemployment and rising prices

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44 Shifts of Aggregate Supply: Short-Run - As the short-run supply curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level decrease and GDP increase - Shift Left = ag price level increase and GDP decrease Stagflation - The combination of inflation (rising price level) and falling output - Leads to rising unemployment and rising prices Long-Run Macro Equilibrium - The economy is in long-run equilibrium when the point of short-run equilibrium is on the long-run supply curve

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46 Shifts of Aggregate Supply: Short-Run - As the short-run supply curve shifts it leads to a new equilibrium price level and output level - Shift Right = ag price level decrease and GDP increase - Shift Left = ag price level increase and GDP decrease Stagflation - The combination of inflation (rising price level) and falling output - Leads to rising unemployment and rising prices Long-Run Macro Equilibrium - The economy is in long-run equilibrium when the point of short-run equilibrium is on the long-run supply curve

Recessionary Gap - When aggregate output is below potential output - initiated by a negative demand shock

Recessionary Gap - When aggregate output is below potential output - initiated by a negative demand shock Inflationary Gap - When aggregate output is above potential output - initiated by a positive demand shock

Recessionary Gap - When aggregate output is below potential output - initiated by a negative demand shock Inflationary Gap - When aggregate output is above potential output - initiated by a positive demand shock Output Gap - The difference between actual aggregate output and potential output Output Gap = x 100 If positive = Inflationary Gap If negative = Recessionary Gap Actual Output - Potential Output Potential Output

Recessionary Gap - When aggregate output is below potential output - initiated by a negative demand shock Inflationary Gap - When aggregate output is above potential output - initiated by a positive demand shock Output Gap - The difference between actual aggregate output and potential output Output Gap = x 100 If positive = Inflationary Gap If negative = Recessionary Gap Current Output - Potential Output Potential Output

Module 20 - Economic Policy & the AD - AS Model What You Will Learn How the AD-AS model is used to formulate policy Why fiscal policy is an important tool for managing economic fluctuations Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy

Module 20 - Economic Policy & the AD - AS Model Stabilization Policy - Government policy to reduce the severity of recessions and expansions - counteract strong economic shocks Fiscal Policy - Govt. use of taxing and spending to influence the economy - Expand or slow economic growth John Maynard Keynes - Believed that self correcting economy could take too long - govt. should impose fiscal policy to help economy return to potential

Fiscal Policy

Module 20 - Economic Policy & the AD - AS Model Stabilization Policy - Government policy to reduce the severity of recessions and expansions - counteract strong economic shocks Fiscal Policy - Govt. use of taxing and spending to influence the economy - Expand or slow economic growth John Maynard Keynes - Believed that self correcting economy could take too long - govt. should impose fiscal policy to help economy return to potential

Module 20 - Economic Policy & the AD - AS Model Stabilization Policy - Government policy to reduce the severity of recessions and expansions - counteract strong economic shocks Fiscal Policy - Govt. use of taxing and spending to influence the economy - Expand or slow economic growth Expansionary Fiscal Policy - Attempts to increase aggregate demand to return to potential output (counter negative demand shock) - involves combination of increasing govt. spending / cutting taxes

Module 20 - Economic Policy & the AD - AS Model Stabilization Policy - Government policy to reduce the severity of recessions and expansions - counteract strong economic shocks Fiscal Policy - Govt. use of taxing and spending to influence the economy - Expand or slow economic growth Expansionary Fiscal Policy - Attempts to increase aggregate demand to equal potential output - involves combination of increasing govt. spending / cutting taxes Expansionary Policy

Contractionary Policy - Attempts to decrease aggregate demand to return to potential output (counter positive demand shock) - involves combination of decreasing govt. spending / raising taxes

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Contractionary Policy - Attempts to decrease aggregate demand to return to potential output (counter positive demand shock) - involves combination of decreasing govt. spending / raising taxes Contractionary Policy Lags in Fiscal Policy - Due to the time it takes to initiate fiscal policy, the economy might have recovered before the policy takes effect - can make the situation worse

Module 21 - Fiscal Policy & the Multiplier Why fiscal policy has a multiplier effect How the economy is influenced by automatic stabilizers

Module 21 - Fiscal Policy & the Multiplier Multiplier Effect of Increase in Govt. Spending - Determine how much an increase in govt. spending will actually increase aggregate output (GDP) Ex: With a multiplier of 2, Govt. spending of $50 billion would increase aggregate output by $100 billion Multiplier Effect of Changes in Govt. Taxes - A tax cut will have a smaller effect on aggregate output because the MPC will cause spending to be less than the tax cut - a tax increase will function the same way to slow an expansion

Automatic Stabilizers - Taxes and transfer payments make fiscal policy automatically expansionary during economic contractions and contractionary during expansions Discretionary Fiscal Policy - Policy that is the result of deliberate govt. actions rather than by automatic stabilizers Ex: New Deal programs of the Great Depression

72 The End