© 2007 Thomson South-Western Income and Expenditures Macro

© 2007 Thomson South-Western The Circular-Flow Diagram Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES

© 2007 Thomson South-Western

Income and Expenditures  Disposable income (Y d ) is …  Money after taxes are paid  Y d = C + Savings (S)

© 2007 Thomson South-Western Income and Expenditures  Marginal Propensity to Consume (MPC) is …  MPC = ∆ consumption/∆ disposable income  An increase in consumer spending when current disposable income rises by $1  The slope of the Consumption Function

© 2007 Thomson South-Western Income and Expenditures  Marginal Propensity to Save (MPS) is …  MPS = ∆ savings /∆ disposable income  An increase in household savings when current disposable income rises by $1

© 2007 Thomson South-Western Income and Expenditures The Consumption Function is … –An equation: c = a + MPC * y d A = autonomous consumption (y-intercept) –Shows how a households consumer spending (c ) varies with the household’s current disposable income ( Y d )

© 2007 Thomson South-Western Income and Expenditures Let’s assume that everyone in the economy spends 80% of every additional dollar of new disposable income. What would happened if there was an injection of new spending into the economy?

© 2007 Thomson South-Western Income and Expenditures Whit is a chicken farmer in the local community. Suppose White decides to spend $1000 on some chicken coops at Abel’s farm supply shop. This money now starts to be circulated around the economy.

© 2007 Thomson South-Western Income and Expenditures Abel now has $1000 from the sale and spends 80% ($800) on clothes at Alyssa’s boutique.

© 2007 Thomson South-Western Income and Expenditures Alyssa now has $800 from the sale and spends 80% ($640) to fix her car at Pat’s garage.

© 2007 Thomson South-Western Income and Expenditures Pat now has $640 from the sale and spends 80% ($512) on clothes at Brenna’s grocery store.

© 2007 Thomson South-Western Income and Expenditures Brenna now has $512 from the sale and spends 80% ($409.60) with Kelly’s catering company.

© 2007 Thomson South-Western Income and Expenditures How much money was spent after 5 rounds of spending? $2, – more than DOUBLE of the original injection! Continuing on until someone tried to spend 80% of nothing, Whit’s initial $1000 would have multiplied to $5000 in income/spending.

© 2007 Thomson South-Western Income and Expenditures The Spending Multiplier is …  A ratio of  Total change in real GDP  Caused by  An autonomous change in Aggregate Spending to the size of that autonomous spending.  M = 1/(1 – MPC)

© 2007 Thomson South-Western Income and Expenditures Shifts of the Aggregate Consumption Function –Changes in Expected Future Disposable Income A college student will graduate in May. She already has a job lined-up once she graduated. Consumption f(x) moves???? UP

© 2007 Thomson South-Western Income and Expenditures Shifts of the Aggregate Consumption Function –Changes in Aggregate Wealth Wealth is accumulated assets –House, car, stocks, savings account You own stock and the stock market declines The Consumption f(x) moves ??? DOWN

© 2007 Thomson South-Western Income and Expenditures A firm is considering building a new factory. This will 1. increase sales 2. require borrowing to fund the investment

© 2007 Thomson South-Western Income and Expenditures Expected Return on Investment = Expected Economic Profit from the Factory (Total Revenue – Total Cost)/ Investment Cost.

© 2007 Thomson South-Western Income and Expenditures The Market Interest Rate is … –The Cost of Investment Cost of borrowed funds Cost of investing your own funds (no borrowing)

© 2007 Thomson South-Western Income and Expenditures The factory will only be built if the firm expects a … 1. Rate of Return > Cost of the $$$ borrowed Higher Interest Rate means Fewer Projects = Lower Investment Spending. Interest RateInvestment Spending

© 2007 Thomson South-Western Income and Expenditures Some Factors Increase Investment Spending at Any Interest Rate 1. Expected Future Real GDP A firm believes that the economy is going to vastly improve within the next year. 2. Production Capacity A firm is near production capacity with an expectation of strong real GDP in the future.

© 2007 Thomson South-Western Aggregate Demand  Aggregate Demand (AD) shows the…  Relationship between Aggregate Price Level and  Quantity of Aggregate Output  Determined by the Demand of households, firms, government and the rest of the world.

© 2007 Thomson South-Western Aggregate Demand  Aggregate Price Level is …  The rising price level for ALL goods and services in the economy.

© 2007 Thomson South-Western Aggregate Demand Why does the AD curve slope downward? The Wealth Effect price level = consumer spending = Q demand Consumers ‘feel more wealthy’. Downward movement along the AD curve.

© 2007 Thomson South-Western Aggregate Demand Why does the AD curve slope downward? The Interest Rate Effect price level = interest rate = Q demand Greater spending on investments. Increasing real GDP along the AD curve.

© 2007 Thomson South-Western Aggregate Demand Shifts of the AD Curve Shifts in AD Curve Changes InAD RightAD Left ExpectationsOptimistic about futurePessimistic about future WealthIncreased wealth = increased consumer consumption Decreased wealth = decreased consumer consumption Size of Existing Stock of Physical Capital Need more stock to meet demand Have enough stock to meet demand Fiscal PolicyIncrease G in GDPDecrease G in GDP Monetary PolicyIncrease $$$ in circulation = higher I and C in GDP Decrease $$$ in circulation = lower I and C in GDP

© 2007 Thomson South-Western Aggregate Demand Fiscal Policy is the use of … Use of Government Spending –Purchase of final goods/services –Government transfers Tax Policy Congress and the President control

© 2007 Thomson South-Western Aggregate Demand Monetary Policy is the use of … Changes in the Money Q –Increase/decrease of $$$$ in circulation Interest Rate Federal Reserve controls

© 2007 Thomson South-Western Aggregate Supply  Aggregate Supply (AS) shows the…  Relationship between Economy-wide Production and  Aggregate Price Level

© 2007 Thomson South-Western Aggregate Supply  There are two AS curves.  SRAS  Positive slope  LRAS  Vertical at the level of potential GDP

© 2007 Thomson South-Western Aggregate Supply  The reason the SRAS is positive is …  P is rising faster than the Cost of the unit  The unit will be produced SRAS Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply Sticky Prices –Do not rise or fall very quickly in response in a change in demand.

© 2007 Thomson South-Western Aggregate Supply  Shifts in SRAS  Increase = producers willing to produce more output at any price level SRAS Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply  Shifts in SRAS  Decrease = Q of Aggregate Output supplies falls at any price level SRAS Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply Shifts of the SRAS Curve Shifts in SRAS Curve Changes InSRAS RightSRAS Left Commodity PricesDecrease in Commodity Prices Increase in Commodity Prices Nominal Wages (Current Price of Labor) Wages decreaseWages Increase ProductivityDecrease in ProductivityIncreased Productivity (tools/technology)

© 2007 Thomson South-Western Aggregate Supply  LRAS  Nominal wages adjust along with the price of output.NO STICKY WAGES LRAS Yp Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply  SRAS to LRAS Weak Economy. Recession. GDP Y1 < Yp LRASSRAS1 SRAS2 Y1 Yp Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply What is expected to happen? 1.Weak labor market = falling D for labor. 2.Many Us. 3.Workers accept lower wages. 4.Nominal wages fall. 5.SRAS shifts right until current output = Yp.

© 2007 Thomson South-Western Aggregate Supply  SRAS to LRAS Booming Economy. GDP Y2 > Yp SRAS2 LRASSRAS1 Yp Y2 Aggregate Price Level Real GDP

© 2007 Thomson South-Western Aggregate Supply What is expected to happen? 1.Strong labor market = rising D for labor. 2.Few Us. 3.Employers are scrambling to find scarce resources. 4.Nominal wages rise. 5.SRAS shifts left until current output = Yp.

© 2007 Thomson South-Western AD/ AS Equilibrium Micro equilibrium S D P Q

© 2007 Thomson South-Western AD/ AS Equilibrium Micro equilibriumMacro Equilibrium S D P Q Aggregate P Level Real GDP AD SRAS LRAS Yp

© 2007 Thomson South-Western AD/ AS Equilibrium Aggregate P Level Real GDP AD SRAS LRAS P level above AD/SRAS intersection 1.Surplus of aggregate output 2.Prices fall P level below AD/SRAS intersection 1.Shortage of aggregate output 2.Prices rise P2 P1 Yp

© 2007 Thomson South-Western AD/ AS Equilibrium Aggregate P Level Real GDP AD1 SRAS Pessimism about future income/earning. 1.AD shift left 2.Aggregate Price Level falls. 3.Real GDP falls. 4.Recession. Increase in consumer wealth. 1.AD shift right 2.Aggregate Price Level rises. 3.Real GDP rises. Ye Pe Demand shock is an event which shifts the AD Curve. AD2 Y1 P1 AD3 Pe2 Y2

© 2007 Thomson South-Western Long Run Equilibrium What is expected to happen? Recessionary Gap is the amount that GDP fall below potential output. 1.Output gap is negative 2.Weak economy 3.U rises 4.Nominal wages fall 5.SRAS shifts right 6.GDP begins to rise 7.GDP reaches Yp = LR equilibrium 8.P level has fallen further

© 2007 Thomson South-Western AD/ AS Equilibrium Aggregate P Level Real GDP AD1 SRAS Commodity prices increase. 1.SRAS shift left 2.Aggregate Price Level rise. 3.Real GDP falls. 4.Stagflation. Technology increases labor productivity. 1.SRAS shift right 2.Aggregate Price Level fall. 3.Real GDP rises. Ye Pe Supply shock is an event which shifts the SRAS Curve. SRAS2 Y1 Pe2 SRAS1 Pe1 Y2

© 2007 Thomson South-Western Long Run Equilibrium What is expected to happen? Inflationary Gap is the amount that GDP rises above potential output. 1.Output gap is positive 2.Booming economy 3.U falls 4.Nominal wages rise 5.SRAS shifts left 6.GDP begins to falls 7.GDP reaches Yp = LR equilibrium 8.P level has increased further

© 2007 Thomson South-Western Economic Fluctuations Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium.

© 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Exercise Draw the AD-SRAS-LRAS diagram for the U.S. economy, starting in a long-run equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 49

© 2007 Thomson South-Western A C T I V E L E A R N I N G 2 : Answers 50 LRAS YNYN P Y AD 2 SRAS 2 AD 1 SRAS 1 P1P1 P3P3 C P2P2 Y2Y2 B A Event: boom in Canada 1. affects NX, AD curve 2. shifts AD right 3. SR equilibrium at point B. P and Y higher, U lower 4. Over time, P E rises, SRAS shifts left, until LR equilibrium at C. Y and U back at initial levels.

© 2007 Thomson South-Western Long Run Equilibrium Output Gap = 100(Ye – Yp)/Yp LR economy is self-correcting. Shocks to AD affect aggregate output in the SR NOT in the LR.

© 2007 Thomson South-Western Economic Policy and AD/AS Fiscal Policy is …  Conducted by the executive and legislative branches of the government.  Combination of spending and taxation to stabilize an economy.

© 2007 Thomson South-Western Economic Policy and AD/AS Government Budget and Total Spending  GDP = C + I + G = NX  Government MAJOR player in AD

© 2007 Thomson South-Western Economic Policy and AD/AS Government Budget and Total Spending  GDP = C + I + G = NX  Government indirectly affects consumer spending – HOW?  Taxes and Transfer Payments  What equation show us this?  Yd = Y – taxes + transfers = C + S or  C = Yd – S  What happens when Yd increases?  C increases  How can the government increase Yd?  Cut taxes  Increase Transfer Payments

© 2007 Thomson South-Western Economic Policy and AD/AS Expansionary Fiscal Policy  Example of a Recessionary Gap  Fiscal policy should try to shift AD right  Expansionary Fiscal Policy takes one of three form:  An increase in government purchases of g/s  A cut in taxes  An increase in government transfers

© 2007 Thomson South-Western Economic Policy and AD/AS Contractionary Fiscal Policy  Example of a Inflationary Gap  Fiscal policy should try to shift AD left  Expansionary Fiscal Policy takes one of three form:  A decrease in government purchases of g/s  An increase in taxes  A decrease in government transfers

© 2007 Thomson South-Western Economic Policy and AD/AS Fiscal Policy Time Lags  Recognition Lag  Decision Lag  Implementation Lag

© 2007 Thomson South-Western Economic Policy and AD/AS Scenario 1: The economy is currently experiencing a recessionary gap. List two fiscal policy options that would move the economy closer to potential real GDP. Describe how your policy would achieve the desired results. a.Increase G, increase Transfer Payments, or Decrease Taxes a.Increase G directly affects AD, right shift, increasing real GDP b.Increase in Transfer Payments or Decrease in Taxes a.Indirectly increase AD by increase

© 2007 Thomson South-Western Economic Policy and AD/AS Scenario 2: The economy is currently at a level of output that exceeds potential GDP (Yd). List two fiscal policy options that would move the economy closer to potential real GDP. Describe how your policy would achieve the desired results. a.Decrease G, Decrease Transfer Payments, or Increase Taxes a.Decrease G directly affects AD, left shift, increasing real GDP, Reducing P level b.Decrease in Transfer Payments or Increase in Taxes a.Indirectly decrease AD by decreasing Yd. b.Real GDP falls c.Price Level falls

© 2007 Thomson South-Western Fiscal Policy and the Multiplier Spending Multiplier –  When C or I increase by $1, eventually it would multiply into more dollars of spending and income and rea DGP  Multiplier size depends on the MPC  Spending Multiplier = 1/(1-MPC)

© 2007 Thomson South-Western Fiscal Policy and the Multiplier An Injection of Government (G) Spending Example: Suppose the government is experiencing a recessionary gap. Current output is $500 billion below potential GDP (Yp) and unemployment is beginning to rise. Does the government need to inject $500 of new G into the economy to return to full employment? NO! If MPC =.90, the Spending Multiplier: M = 1/.10 = 10 So, an increase of G = $50B will eventually multiply to a 10 * $50B = $500B positive shift of AD to the right.

© 2007 Thomson South-Western Fiscal Policy and the Multiplier A Reduction of Government (G) Spending Example: Suppose the government is experiencing an inflationary gap. Current output is $800B above potential GDP(Yp) and inflation is starting to hurt the economy. If MPC =.75, the Spending Multiplier: M = 1/.25= 4 So, a decrease of G = $200B will eventually multiply to a 4 * $200B = $500B negative shift of AD to the left.

© 2007 Thomson South-Western Fiscal Policy and the Multiplier Government Transfers and Taxes–  Indirectly affects real GDP because it 1 st impacts Consumer Disposable Income (Yd)  WHY?  Consumers save some of every new dollar of Yd  New saved Yd $ cannot multiply into additional spending and income.  Tm = MPC * M or MPC/(1 – MPC)

© 2007 Thomson South-Western Fiscal Policy and the Multiplier A Tax Decision Example: Suppose the government decides to lower income taxes by a lump-sum of $1000. MPC =.90 Americans get $1000 back into their pockets –Spend 90% = $900 –Save 10% = $100 $900 of new spending will multiply by 10 –M=1/.90 = 10 So, a $1000 tax cut will eventually multiply into $9000 of additional real GDP.

© 2007 Thomson South-Western Fiscal Policy and the Multiplier A Transfer Payment Decision Example: Suppose the government decides to increase transfer payments by a lump-sum of $500. MPC =.80 Americans receive $500 more Yd. –Spend 80% = $400 –Save 20% = $100 $400 of new spending will multiply by 5 –M=1/.80 = 5 So, an increase of transfers will eventually multiply into $2000 of additional real GDP.

© 2007 Thomson South-Western Economic Policy and the Multiplier Scenario 1: Real GDP is currently $600B above potential GDP and price inflation is beginning to dominate the headlines. How could the government adjust taxes or transfers to return the economy to full employment? How large would this lump-sum adjustment need to be? Assume the MPC =.75. a.Economy is suffering inflation a.Taxes need to be raised or transfers need to be cut b.Tm =.75(1 -.75) = 3. c.$600B / 3 = $200B

© 2007 Thomson South-Western Economic Policy and the Multiplier Scenario 2: Current Real GDP is $6 trillion and potential GDP is $7.5trillion. The government is prepared to pass a spending package to return the economy to full employment. What kind of spending package should be passed? How big does it need to be? Assume that the MPC =.90. a.Economy is in a recession a.Spending increased with expansionary fiscal policy b.M = 1/(1-.90) = 10 c.GDP needs to be increased by $1.5 Trillion d.$1.5T/10 = $.15T or $150B

© 2007 Thomson South-Western Fiscal Policy and the Multiplier Discretionary Fiscal Policy and the Progressive Tax System  Progressive Tax System is a form of Automatic Stabilizer.  Automatic Stabilizers (non-discretionary fiscal policy) are …  Government spending and taxation rules  Affect Fiscal Policy  Automatically expansionary when the economy contracts  Automatically contractionary when the economy expands  Do not require any deliberate action by policy makers