Chapter 3: National Income: Where it Comes From and Where it Goes Continued CHAPTER 3 National Income

A closed economy, market-clearing model Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market DONE  DONE  Next  We’ve now completed the supply side of the model. CHAPTER 3 National Income

Demand for goods & services Components of aggregate demand: C = consumer demand for goods and services I = demand for investment goods G = government demand for goods and services (closed economy: no NX ) “g & s” is short for “goods & services” CHAPTER 3 National Income

Consumption, C We have seen earlier that consumption has the largest share of GDP (about 2/3) What are the determinants of consumption? We assume that the level of consumption depends on your “disposable income” CHAPTER 3 National Income

Consumption, C def: Disposable income is total income minus total taxes: Y – T. Consumption function: C = C (Y – T ) (Y – T )  C Again, we are using the short-hand notation that will appear throughout the remaining PowerPoints: X  Y means “an increase in X causes a decrease in Y.” Please feel free to edit slides if you wish to substitute other notation. CHAPTER 3 National Income

In addition to disposable income (Yd ), consumption depends on one’s tendency to consume def: Marginal propensity to consume (MPC) is the increase in C caused by a one-unit increase in disposable income: mpc=∆C/∆Yd 0 ≤ mpc ≤ 1: If Yd increases by $1, your consumption may increase at most by $1. Normally, it will increase by ~ 70 cents mpc = 0.7  mps (marginal propensity to save) = 1-mpc = 0.3 CHAPTER 3 National Income

The consumption function C = a + b(Y-T) a: autonomous consumption (The component of consumption that’s independent from your income) b: mpc CHAPTER 3 National Income

The consumption function Y – T C (Y –T ) The slope of the consumption function is the MPC. MPC 1 CHAPTER 3 National Income

Investment, I The investment function is I = I (r ), where r denotes the real interest rate Real vs. Nominal Interest Rate: Nominal interest rate is the interest rate that is reported: e.g. interest rate that the bank charges when you get a loan, interest rate on your credit card, etc. Real Interest Rate = Nominal Interest Rate – Inflation Rate CHAPTER 3 National Income

The real interest rate is the cost of borrowing the opportunity cost of using one’s own funds to finance investment spending.  A negative relationship between Investment demanded and interest rate So, r  I CHAPTER 3 National Income

Examples Ex: If a firm is trying to decide whether or not it should invest in a small $1 million factory, it compares the interest rate paid on the loan with the rate of return on investment. As interest rates increase, the chances of undertaking the investment ________. Ex: If the interest rate on your mortgage increases, the likelihood of buying a new house ________. CHAPTER 3 National Income

The investment function r I Spending on investment goods depends negatively on the real interest rate. I (r ) CHAPTER 3 National Income

Government spending, G G = govt spending on goods and services. G excludes transfer payments (e.g., social security benefits, unemployment insurance benefits). It might be useful to remind students of the meaning of the terms “exogenous” and “transfer payments.” CHAPTER 3 National Income

Notes  Transfer payments  Yd Even though transfer payments are not part of GDP (because the government does not spend that money to buy goods and services) they have an indirect effect on GDP through consumption:  Transfer payments  Yd If the transfer payments are financed by taxes no effect on Yd CHAPTER 3 National Income

Redefine disposable income as: Yd = Y – (T- transfer payments) From now on, “T-transfer payments” will be denoted by T. Assume government spending and total taxes are exogenous: CHAPTER 3 National Income

If G = T: balanced budget G > T: budget deficit (financed by borrowing from financial markets) G < T: budget surplus (can be used to pay existing debt) CHAPTER 3 National Income

U.S. Federal Government Surplus/Deficit, 1940-2004 Notes: 1. The huge deficit in the early 1940s was due to WW2: wars are expensive. 2. The budget is closed to balanced in the ’50s and ’60s, and begins a downward trend in the ’70s. 3. The early ’80s saw the largest deficits (as % of GDP) of the post-WW2 era, due to the Reagan tax cuts, defense buildup, and growth in entitlement program outlays. 4. The budget begins a positive trend in the early 1990s, and a surplus emerges in the late 1990s. There are several possible explanations for the improvement. First, President Bush (the first one) broke his campaign promise not to raise taxes. Second, the Clinton administration barely squeaked a deficit reduction deal through Congress (with Al Gore casting the tie-breaking vote in the Senate). And third, and probably most important, there was a swelling of tax revenues due to the surge in economic growth and the stock market boom. (A stock market boom leads to large capital gains, which leads to large revenues from the capital gains tax.) 5. The budget swings to deficit again in 2001, due to the Bush tax cuts and a recession. 6. Recently, the budget deficit has reached all-time highs, when measured in current dollars. As a percentage of GDP, though, the deficit does not seem quite as worrisome relative to the time period captured in this graph. Source of data: U.S. Department of Commerce, Bureau of Economic Analysis. CHAPTER 3 National Income

U.S. Federal Government Debt, 1940-2004 Fact: In the early 1990s, about 18 cents of every tax dollar went to pay interest on the debt. (Today it’s about 9 cents.) A later chapter will give more details, but for now, tell students that the government finances its deficits by borrowing from the public. (This borrowing takes the form of selling Treasury bonds). Persistent deficits over time imply persistent borrowing, which causes the debt to increase. After WW2, occasional budget surpluses allowed the government to retire some of its WW2 debt; also, normal economic growth increased the denominator of the debt-to-GDP ratio. Starting in the early 1980s, corresponding to the beginning of huge and persistent deficits, we see a huge increase in the debt-to-GDP ratio, from 32% in 1981 to 66% in 1995. In the mid 1990s, budget surpluses and rapid growth started to reduce the debt-to-GDP ratio, but it started rising again in 2001 due to the economic slowdown, the Bush tax cuts, and higher spending (Afghanistan & Iraq, war on terrorism, 2002 airline bailout, etc). Students are typically shocked when they realize how much extra we are paying in taxes just to service the debt; if it weren’t for the debt, we’d either pay much lower taxes, or have a lot of revenue available for other purposes, like financial aid for college students, AIDS and cancer research, national defense, Social Security reform, etc. Source of data: U.S. Dept of Commerce Bureau of Economic Analysis. CHAPTER 3 National Income

CHAPTER 3 National Income

Central Government Budget Deficit (% of GDP) CHAPTER 3 National Income

Public Sector Debt Stock (Gross, % of GDP) CHAPTER 3 National Income

Aside Fiscal policy: The government’s policy to adjust its spending G and taxation T to manipulate the level of output. Note: G  or T   Y  : expansionary policy G  or T   Y  : contractionary policy In this chapter we don’t try to explain fiscal policy. We take G and T as given (exogenous variables). We want to see the impact of these variables on C, I, r (endogenous variables). CHAPTER 3 National Income

The market for goods & services Aggregate demand: Aggregate supply: Equilibrium: The real interest rate adjusts to equate demand with supply. Note the only variable in the equilibrium condition that doesn’t have a “bar” over it is the real interest rate. When the full slide is showing, before you advance to the next one, you might want to note that the interest rate is important in financial markets as well, so we will next develop a simple model of the financial system. CHAPTER 3 National Income

The loanable funds market A simple supply-demand model of the financial system. One asset: “loanable funds” Loanable funds are funds available for borrowing/lending demand for funds: investment supply of funds: saving “price” of funds: real interest rate CHAPTER 3 National Income

Demand for funds: Investment The demand for loanable funds… comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the “price” of loanable funds (cost of borrowing). CHAPTER 3 National Income

Loanable funds demand curve I The investment curve is also the demand curve for loanable funds. I (r ) CHAPTER 3 National Income

Supply of funds: Saving The supply of loanable funds comes from savings: Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it does not spend all the tax revenue it receives. CHAPTER 3 National Income

Types of saving private saving (Sp) = (Y – T ) – C public saving (Sg) = T – G national saving, S = Sg+ Sp S = private saving + public saving = (Y –T ) – C + T – G S = Y – C – G After showing definition of private saving, - give the interpretation of the equation: private saving is disposable income minus consumption spending - explain why private saving is part of the supply of loanable funds: Suppose a person earns $50,000/year, pays $10,000 in taxes, and spends $35,000 on goods and services. There’s $5000 remaining. What happens to that $5000? The person might use it to buy stocks or bonds, or she might put it in her savings account or money market deposit account. In all of these cases, this $5000 becomes part of the supply of loanable funds in the financial system. After displaying public saving, explain the equation’s interpretation: public saving is tax revenue minus government spending. Notice the analogy to private saving – both concepts represent income less spending: for the private household, income is (Y-T) and spending is C. For the government, income is T and spending is G. CHAPTER 3 National Income

EXERCISE: Calculate the change in saving Suppose MPC = 0.8 and MPL = 20. For each of the following, compute ΔS : a. ΔG = 100 b. ΔT = 100 c. ΔY = 100 d. ΔL = 10 This problem reinforces the concepts with concrete numerical examples. It’s also a good way to break up the lecture and get students actively involved with the material. CHAPTER 3 National Income

Answers CHAPTER 3 National Income First, in the box at the top of the slide, we plug the given value for the MPC into the expression for S and simplify. Then, finding the answers is straightforward: just plug in the given values into the expression for S. CHAPTER 3 National Income

Loanable funds supply curve S, I National saving does not depend on r, so the supply curve is vertical. At the end of this chapter, we will briefly consider how things would be different if Consumption (and therefore Saving) were allowed to depend on the interest rate. For now, though, they do not. CHAPTER 3 National Income

Loanable funds market equilibrium S, I I (r ) Equilibrium real interest rate Equilibrium level of investment CHAPTER 3 National Income

The special role of r Eq’m in L.F. market Eq’m in goods market r adjusts to equilibrate the goods market and the loanable funds market simultaneously: If L.F. market in equilibrium, then Y – C – G = I Add (C +G ) to both sides to get Y = C + I + G (goods market eq’m) Thus, This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined. Explain that the symbol  means each one implies the other. The thing on the left implies the thing on the right, and vice versa. More short-hand: “eq’m” is short for “equilibrium” and “LF” for “loanable funds.” Eq’m in L.F. market Eq’m in goods market CHAPTER 3 National Income