Unit Four National Income and Price Determination

1. AP Macroeconomics Mr. Graham Unit Four National Income and Price Determination

2. Do Now. • Why did economists originally devise the multiplier? • What happened to consumer and investment spending during the Great Depression? • Is it less likely for a depression to occur today? Why?

3. Module 16: Income and Expenditure 3

4. The Multiplier: An Informal Introduction 3 Simplifying Assumptions for this analysis (i.e. ceteris paribus conditions): We assume that changes in overall spending (C and I) translate into changes in RGDP. We assume there is no government spending and no taxes (i.e. “private”). We assume that net exports are zero (i.e. “closed”).

5. The Multiplier: An Informal Introduction $100 billion increase in investment spending leads to increase in aggregate output (GDP) leads to increase in disposable income leads to a rise in consumer spending Leads to an increase in aggregate output…

6. How large is the total effect on aggregate output if we sum the effect from all these rounds of spending increases? Marginal Propensity to Consume (MPC) The increase in consumer spending when disposable income rises by $1 The Multiplier: An Informal Introduction 12-6

7. Recall that there are two things you can do with disposable income… Marginal Propensity to Save (MPS) The increase in household savings when disposable income rises by $1 MPS = 1 - MPC The Multiplier: An Informal Introduction 12-7

8. Some relationships Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income (i.e. MPC + MPS = 1). The Multiplier: An Informal Introduction • Complete Activity 24: “What Is An MPC?” 12-8

9. Question So…How can a $100 billion increase in investment generate a $500 billion increase in equilibrium real GDP? Answer The multiplier process The Multiplier: An Informal Introduction

10. It is possible that a relatively small change in investment can trigger a much larger change in real GDP The Multiplier: An Informal Introduction

11. The total effect of a $100 billion increase in investment spending, I, taking into account all the subsequent increases in consumer spending (and assuming no taxes and no international trade), is given by: The Multiplier: An Informal Introduction • Let’s consider a numerical example where the marginal propensity to consume is 0.6:

12. The Multiplier: An Informal Introduction • We’ve described the effects of a change in investment spending, but the same analysis can be applied to any other autonomous change in aggregate spending. • So the multiplier is:

13. By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier The smaller the MPS, the larger the multiplier The larger the MPC, the larger the multiplier The Multiplier: An Informal Introduction

14. Consumer Spending Consumption Spending on new goods and services out of a household’s current income Saving The act of not consuming all of one’s current income Whatever is not consumed out of disposable income is, by definition, saved.

15. Consumer Spending You can do only two things with income (in absence of taxes): consume it or save it Consumption + Saving = Disposable Income and Saving = Disposable Income – Consumption Investment and Consumption explained

16. Consumer Spending Consumption choices have a powerful effect on the economy. What determines how much consumers spend?

17. Consumer Spending The most important factor affecting a family’s consumer spending is disposable income (DI).

18. Consumption Function The relationship between amount consumed and disposable income A consumption function tells us how much people plan to consume at various levels of disposable income. Let’s first recall our understanding of slope. Consumer Spending

19. Consumption Function • c = MPC x y + a • Where c is individual household consumer spending. • y is individual household current disposable income*. • a is a constant term—individual household autonomous consumer spending • MPC for an individual household as : • MPC = change in c / change in y

20. Consumption Function

21. Consumption Function • In reality, the actual data never fit the equation perfectly…

22. Aggregate Consumption Function • Although Figure 16.3 shows a microeconomic relationship, macroeconomists assume a similar relationship holds for the economy as a whole: • C = A + MPC x Y • Where C is (aggregate) consumer spending. • Y is (aggregate) disposable income*. • A is aggregate autonomous consumer spending.

23. Shifts of the Aggregate Consumption Function A change besides real disposable income will cause the consumption function to shift. Changes in Population Changes in Expected Future Disposable Income Changes in Expected Future Prices Changes in Aggregate Wealth 12-23

24. Aggregate Wealth The stock of assets owned by a person, household, firm or nation For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash. Those who have accumulated a lot of wealth will, other things equal, spend more on goods and services than those who still need to save… Shifts of the Aggregate Consumption Function 12-24

25. Shifts of the Aggregate Consumption Function 12-25

26. Do Now. • Which makes up a larger portion of the GDP? • Consumption spending or investment spending • Which drives the business cycle more? Why?

27. Investment Spending Although consumer spending is much greater than investment spending, booms and busts in investment spending tend to drive the business cycle.

28. Investment Spending Planned Investment Spending Amount firms intend to invest during a given period. Depends on three principal factors: the interest rate the expected future level of real GDP the current level of production capacity

29. The Interest Rate and Investment Spending PlannedInvestment Spending is negatively related to the interest rate—investment projects are typically funded through borrowing. • Higher interest rates will discourage borrowing. • Lower interest rates will encourage borrowing.

30. Expected Future Real GDP and Investment Spending Planned Investment Spending is positively related to expected future real GDP. Higher expected real GDP and, in turn, expected sales for firms, will encourage an increase in planned investment spending. Lower expected real GDP and, in turn, expected sales for firms, will encourage an decrease in planned investment spending.

31. Current Production Capacity and Investment Spending PlannedInvestment Spending is negatively related to production capacity. Higher than necessary production capacity will discourage planned investment spending. Lower than necessary production capacity will encourage planned investment spending.

32. Inventories and Investment Spending Inventories Stocks of goods held to satisfy future sales. Inventory Investment—Value of change in total inventories held in the economy during a period. Firms, anticipating higher future sales, can increase their inventories as a form of investment spending.

33. Inventories and Unplanned Investment Spending Firms cannot always accurately predict sales Unplanned Inventory Investment Actual sales are more or less than expected, leading to unplanned decreases or increases in inventories.

34. Combining Consumption and Investment • The equilibrium level of GDP is determined by the intersection of the aggregate expenditures schedule and 45-degree line • At this output ($11T), C is $9T and I is 2T

35. No levels of GDP above the equilibrium level are sustainable because C+I fall short. At the $12T GDP level, for example, C+I is only $11.5T; this underspending causes inventories to rise, prompting firms to readjust production downward, in the direction of the $11T output Inventories and Unplanned Investment Spending

36. Module 17: Aggregate Demand: Introduction and Determinants 36

37. The Aggregate Demand Curve When a demandcurve is derived, we are looking at a single product in one market only (Microeconomics). When the aggregate demandcurve is derived, we are looking at the entire circular flow of income and product (Macroeconomics).

38. Aggregate Demand Curve Aggregate Demand Curve Shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world Depicts the relationship between real GDP demanded and the price level in the economy Slopes downward from left to right

39. Aggregate Demand Curve

40. Aggregate Demand Curve Why is the AD curve downward sloping? What happens when the price level rises or falls? The real-balance effect (or wealth effect) The interest rate effect The open economy effect

41. The Real-Balance (a.k.a. Wealth) Effect There is an inverse relationship between the price level and real wealth As the price level increases, the purchasing power of money decreases and you spend less because of the negative wealth effect As the price level decreases, the purchasing power of money increases and you spend more because of the positive wealth effect Aggregate Demand Curve

42. The Interest Rate Effect There is a direct relationship between the price level and interest rates Increasing price levels indirectly increase the interest rate, which causes a reduction in borrowing/spending Decreasing price levels indirectly decrease the interest rate, which stimulates the economy Aggregate Demand Curve

43. The Open Economy Effect (a.k.a. Foreign Sector Substitution) There is an inverse relationship between the price level and net exports Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e. net exports fall). Lower price levels result in a greater desire for American-made goods (i.e. net exports rise) Aggregate Demand Curve

44. Shifts in the Aggregate Demand Curve The AD curve will shift when the components of spending change (AD=C + I + G + X) Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to the right. Any non-price-level change that decreases aggregate spending (on domestic goods) shifts AD to the left.

45. Shifts in the Aggregate Demand Curve The AD curve will shift when the components of spending change (AD=C + I + G + X) Changes in Expectations Changes in Wealth Size of the Existing Stock of Physical Capital Fiscal Policy Monetary Policy

46. Determinants of Aggregate Demand

47. Shifts in the Aggregate Demand Curve

48. Do Now. • Watch this video: • http://www.criticalcommons.org/Members/fsustavros/clips/stossel-2007-oil-supplies • What will happen to the world economy if the supply oil decreases significatly?

49. Module 18: Aggregate Supply: Introduction and Determinants 49

50. Aggregate Supply Curve Economists like to look at aggregate supply in two different ways: The short run refers to the period of time in which firms haven’t yet made price changes in response to an economic shock The long run refers to the period of time after which firms have made all necessary price changes in response to an economic shock The shape of the AS curve depends on whether one is looking at a long-run AS (LRAS) curve or a short-run (SRAS) curve