Unit Four: Aggregate Model Topic: Aggregate Expenditures, Propensities and the Multipliers

Learning Targets 1.I will be able to explain the significance of the aggregate expenditures model and the impact of spending on the economy. 2.I will be able to explain the leakages and injections in the circular flow model. 3.I will be able to explain how GDP gaps occur in an economy.

Things to remember… Economic growth occurs when we have new and/or better resources. People who BORROW money like LOW interest rates. People who SAVE money like HIGH interest rates. Saved money becomes loans (which becomes investment). GDP = C + Ig + G (+ Xn) ↑ Ig => ↑ resources/capital stock => ↑ GDPr => economic growth (PPC shifts right)

Aggregate Expenditures Def: old-school model of the economy; is the basis of current economic theory; shows the total spending in the economy. AE = C + Ig + G (+ Xn) All factors are dependent on income/output in the economy.

Consumption C is the most sensitive to income (and interest rate) changes, but remains relatively stable. There will ALWAYS be some C in the economy (everyone has to buy food, shelter, etc.) EVEN IF there is LITTLE income. Households either CONSUME or SAVE; if they CONSUME more than their INCOME, they have DISSAVINGS. More dissavings at lower incomes; more savings at higher incomes.

Determinants of Consumption Disposable income Wealth Price level Interest rates

Propensities Def: what people usually do; inclinations. AVERAGE PROPENSITIES: APC = C / disposable income APS = S / disposable income APC + APS = 1

Practice 1.The APC is 0.7. What is the APS? 2.Total income = $100; total consumption = $80. a.What is the APC? b.What is the APS? 3.Total income = $100; total consumption = $120. a.What is the APC? b.What is the APS?

Propensities MARGINAL PROPENSITIES (what we do with extra income): MPC = Δ C / Δ disposable income MPS = Δ S / Δ disposable income MPC + MPS = 1

Practice 1.The MPC is 0.5. What is the MPS? 2.With an income of $1000, consumption is $800. With an income of $1200, consumption is $900. a.What is the MPC? b.What is the MPS?

Investment Components: additions to resource base; increase in inventories (unplanned); residential construction (houses); depreciation; education Interest rates determine the quantity of investment; businesses take out loans at LOWER INTEREST RATES in order to INCREASE investment (quantity of loanable funds demanded increases). Increases in investment => economic growth because resource base increases

Investment Ig varies the MOST and is the most UNSTABLE because of: –Interest rates change often because of fiscal and monetary policy, etc. –Taxes –Expectations of inflation, etc.

Government Expenditures and Net Exports Both are relatively stable. Remember: G revenue comes from taxes (T) Fiscal policy – gov’t use of taxing and spending to influence the economy.

The Multiplier Effect Def: a change in any component of AE leads to a larger change in total output (GDPr). Spending/Investment multiplier: use any time there is a change in C, Ig, or G. (Change in C, Ig or G) times the multiplier = the change in GDPr. Two ways to find the spending multiplier: 1 / MPS 1 / (1-MPC)

Practice 1.The MPS is 0.2. What is the value of the spending multiplier? 2.The MPC is 0.7. What is the value of the spending multiplier? 3.If the spending multiplier is 0.5, and spending increases by $100, then by how much will GDPr change?

The Multiplier Effect Tax multiplier: use when there is a change in lump-sum taxes. Change in taxes times tax multiplier = change in GDPr. Two ways to find the tax multiplier: -MPC / (1-MPC) -MPC/MPS REMEMBER THAT IT IS NEGATIVE!

Practice 1.The MPC is 0.8. What is the tax multiplier? 2.The MPC is 0.5. What is the tax multiplier? 3.If the tax multiplier is -3, and taxes increase by $100, then by how much will GDPr change?

Leakages and Injections LEAKAGES Def: things that “fall out” of spending in the economy. 1.Savings 2.Taxes 3.Imports INJECTIONS Def: things that “fall into” spending in the economy. 1.Investment 2.Government spending 3.Exports