ECO 121 Macroeconomics Lecture Seven Aisha Khan Section L & M Spring 2010 Aisha Khan Section L & M Lecture Seven

Recap Aggregate Model Consumption schedule Saving schedule Upward sloping with a slope = MPC Saving schedule Upward sloping with a slope = MPS

Investment Spending on new plants, capital equipment, machinery , inventories, construction Unstable spending Marginal benefits vs marginal costs Expected rate of return  marginal benefit Interest rate  marginal cost

Real interest rate (adjusted for inflation) Cost of investment Interest rate cost of borrowed funds Or the cost of investing your own funds If real interest rate > expected rate of return  investment should not be made

Investment demand schedule Inverse relationship between interest rate and investment Shifts : Greater expected returns  shift Investment schedule outwards

Investment demand curve Movements along the I demand curve depend on changes in the interest rate Shifts of the curve depend on Non-interest rate determinants of investment Changes in expected returns of a project due to non- interest rate determinants will shift the crve

Shifts of the Investment curve Acquisition, maintenance, and operating costs As costs fall  expected rate of return of a project rises  shifts I upwards Business taxes If government is considered  increase in taxes reduces expected profitability of investments  shifts I down

Stock of capital goods on hand Technological change More efficient technology  lowers production costs  increases expected returns  shifts I outwards/upwards Stock of capital goods on hand Extra stock  expected return falls  downwards Expectations Future expectations  higher expected returns  ?

Instability of Investment Durability Irregularity of innovation Variability of profits Variability of expectations

Multiplier Effect Multiplier = change in real GDP / initial change in spending

Aggregate Expenditures Model Chapter 9

Next? We have consumption and investment schedules Can now put them together to find GDP– true? GDP = C + I Therefore by the identity we can find the total output/income

Unplanned  in inventories Tendency of income/output Just for this example  investment is independent of income (fixed) Employ-ment levels GDP = DI C S I C+I Unplanned  in inventories Tendency of income/output 40 370 375 -5 20 395 -25  85 550 510 530 

Unplanned  in inventories Tendency of income/output Equilibrium GDP Employ-ment levels GDP = DI C S I C+I Unplanned  in inventories Tendency of income/output 40 370 375 -5 20 395 -25  45 390 410 -20 50 405 5 425 -15 55 430 420 10 440 -10 60 450 435 15 455 65 470 ~ 70 490 465 25 485  75 510 480 30 500 80 530 495 35 515 85 550

Graphical Analysis C+I C+I = GDP Aggregate expenditure C C+ I I = $20 billion C = $450 billion 45 GDP

Other features of GDP Savings = planned Investment Savings is a “leakage” from spending stream (therefore C not equal to GDP) Some output is planned for investment and not for consumption This investment spending replaces the leakage No unplanned changes in inventory Look at table again

Say’s Law “Supply creates its own demand”