A Quick Review in the Movies!!!

NATIONAL INCOME AND PRICE DETERMINATION UNIT 3 NATIONAL INCOME AND PRICE DETERMINATION

Why do cities want the Superbowl? Because an initial change in spending will set off a spending chain that is magnified throughout the economy. Example: Bobby spends $100 on Jason’s product Jason now has more income so he buys $100 of Nancy’s product Nancy now has more income so she buys $100 of Tiffany’s product. The result is an $300 increase in consumer spending The Multiplier Effect shows how spending is magnified in the economy. 3

Marginal Propensity to Consume (MPC) How much people consume rather than save when there is an change in income. It is always expressed as a fraction (decimal). MPC= Change in Consumer Spending Change in Income Before we can fully comprehend the multiplier, we have to look at consumption and savings Example: Consumer spending goes up by 6 billion Disposable income goes up by 10 billion What is the MPC? Means? 4

Marginal Propensity to Save (MPS) How much people save rather than consume when there is an change in income. It is always expressed as a fraction (decimal) MPS= Change in Saving Change in Income Or…. MPS=1-MPC 5

MPC + MPS = 1 ----------------------- MPS = 1 - MPC Why is this true? Because people can either save or consume The new disposable income they receive 6

Practice Problems

The Multiplier It’s a simple concept…

The Multiplier in the real world… The federal government recently enacted the American Recovery and Reinvestment Act of 2009. This “stimulus package” of $787 billion was intended to spark job growth to reverse the worst recession since the Great Depression. How was this supposed to work? The short answer is that $1 of spending in one area of the economy multiplies into more than $1 of spending throughout the economy

Autonomous Change in Aggregate Spending This is the initial change in aggregate spending before real GDP rises. It is the cause, not the result, of the chain reaction. The multiplier is the ratio of the total change in real GDP caused by AAS. Multiplier = change in real GDP change in AAS

The size of the multiplier will depend on the MPC The size of the multiplier will depend on the MPC. The higher the MPC the higher the multiplier. {In other words, the more money spent the greater the impact the multiplier will have}

What do you need to know and understand how the multiplier works?

= x How is Spending “Multiplied”? Assume the MPC is .5 for everyone Assume that when the Super Bowl comes to town there is an increase of $100 in Ashley’s restaurant. Ashley now has $100 more income. She saves $50 and spends $50 at Carl’s Salon Carl now has $50 more income He saves $25 and spends $25 at Dan’s fruit stand Dan now has $25 more income. This continues until every penny is spent or saved Change in GDP = Multiplier x Initial Change in Spending 13

or Multiplier = Change in GDP Change in Spending *** I just made an algebraic change

= = x or If the MPC is .5 how much is the multiplier? 1 Simple MPS 1 - MPC If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? How much will a decrease of $3 in spending decrease GDP? MPC = .5 the multiplier is 2 Change in GDP = Multiplier x initial change in spending 15

= The Multiplier Effect or Practice calculating the spending multiplier Simple Multiplier = or 1 MPS 1 - MPC If MPC is .9, what is multiplier? If MPC is .8, what is multiplier? If MPC is .5, and consumption increased $2M. How much will GDP increase? If MPC is 0 and investment increases $2M. How much will GDP increase? Conclusion: As the Marginal Propensity to Consume falls, the Multiplier Effect is less 16

Did the stimulus help or hurt the economy.

APE 21

APE 21

APE 21 Smaller The increase in GDP would be smaller if they held more money. If we all spent ALL of our income or our change the spending multiplier would be infinite..

APE 21

APE 21 -.90/.10= -9.0 -.80/.20= -4.0 -.75/.25= -3.0

APE 21 -4 (-.80/.20) 3 (1/.33) -3 (-.75/.25) If people begin to worry about their jobs and/or their wealth (stocks, housing prices, etc) they will hold more money which decreases the multiplier.

APE 21 If the multiplier is 5 the MPC is .80. Tax multiplier= -.80/.20=-4

APE 21 MPC=Change in consumption/change in income MPC=75/100=.75

Tax Multipliers Tax Multipliers Tax Multipliers A change in taxes also has a multiplied effect, but the tax multiplier is smaller than the spending multiplier.

Tax Multipliers Tax Multipliers Tax Multipliers Tax Multiplier (note: it’s negative because tax increases reduce spending) -MPC/1-MPC or -MPC/MPS If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow

Marginal Propensity to Consume The consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income.

Two factors can change Aggregate Consumption Function 1. Changes in expected future disposable income 2. Changes in aggregate wealth

Duffka School of Economics

Investment Spending Consumer spending is much larger than investment spending, but booms and busts in investment spending tend to drive the business cycle. Most recessions originate as a fall in investment spending. When a firm considers investment spending, they are really doing a benefit- cost analysis on the dollars they are about to spend. Example: A firm is considering building a new factory. This will increase sales, but it will also require borrowing to fund the investment.

Investment Spending Planned Investment is what firms intend to undertake in a given period but it will depend on three (3) factors: 1- interest rates 2-expected future GDP 3- current level of production capacity Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in investment spending.

Investment demand handout

Inventories Increase in inventories =investment spending Higher than anticipated inventories due to a unplanned decrease in sales is known as unplanned inventory investment. Investment (I) = I unplanned + I planned