National Income & price determination Section 4 Modules 16-21

1. National Income & price determinationSection 4 Modules 16-21 Nancy K. Ware Gainesville High School AP Macro

2. Module 16 Essential Questions • What is the nature of the multiplier? • What is the meaning of the aggregate consumption function? • How does expected future income and aggregate wealth affect consumer spending? • What are the determinants of investment spending? • Why is investment spending considered a leading indicator of the future state of the economy?

3. Terms to Know • Disposable Income: amount of household income available to spend or save after taxes • Marginal Propensity to Consume (MPC): the increase in consumer spending when disposable income rises by $1 • Marginal Propensity to Save (MPS): the increase in household savings when disposable income increases by $1

4. More Terms to Know • Autonomous Change of Aggregate Spending: initial rise of fall in aggregate spending that is the CAUSE, not the result of a series of income and spending changes • Multiplier: ratio of the total change in real GDP (caused by an autonomous change of aggregate spending) to the size of that autonomous change (a number by how much spending will increase with an autonomous $ injection)

5. The Multiplier: An Informal Introduction Where does the increased income come from?

6. The Multiplier: An Informal Introduction Where does the increased income come from? Investment spending, Government spending

7. How Does the Multiplier Work? • American Recovery and Reinvestment Act of 2009 enacted by the federal gov’t • “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: $1 of s____________in one area of the e_____________multiplies into m__________than $1 of spending throughout the economy. • Remember, the Circular Flow diagram shows money s__________byone person is received as i_________ by another person.

8. How Does the Multiplier Work? 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: $1 of spending in one area of the economy multiplies into more than $1 of spending throughout the economy. • Remember, the Circular Flow diagram shows money spentby one person is received as income by another person.

9. Assumptions for Analysis • Ignore: g__________(or public sector) & n____ e________(or foreign sector) in the economy. • C_____________isa huge fraction (more than ___/__) of total spending in the e__________. • After a person pays her taxes, she is left with d__________i__________that can either be consumed or saved.Yd= C + S 4. When a person gets more Yd, he will increase both ___and ____ 5. The MPC is the amount by which consumer spending r______if current disposable income rises by $____ and is the slope of the consumption function.

10. Assumptions for Analysis • Ignore: government(or public sector) & net exports (or foreign sector) in the economy. • Consumption is a huge fraction (more than 2/3) of total spending in the economy. • After a person pays her taxes, she is left with disposable income that can either be consumed or saved.Yd= C + S • When a person gets more Yd, he will increase both C and S. • The MPC is the amount by which consumer spending rises if current disposable income rises by $1and is the slope of the consumption function.

11. ∆ Consumer Spending ∆ Saving MPS = MPC = ∆ Disposable Income ∆ Disposable Income Marginal Propensity Formulas • MPC + MPS = 1 • MPC = 1 - MPS • MPS = 1 - MPC • Marginal Propensity to Consume (MPC) • Marginal Propensity to Save (MPS)

12. _____ _________ _________ ∆Y 1 1 ∆Y = Multiplier = = X ∆AAS (1 - MPC) (1 - _____) ∆AAS Formulas • Autonomous Change in Aggregate Spending (AAS) • Multiplier Change in _____ Spending Multiplier Formula Change in ________or $ injection 250 billion1 100 billion = 1-.60 2.5 = 2.5

13. _____ _________ _________ ∆Y 1 1 ∆Y = Multiplier = = X ∆AAS (1 - MPC) (1 - MPC) ∆AAS Formulas • Autonomous Change in Aggregate Spending (AAS) • Multiplier Spending Multiplier Formula Change in GDP Change in AAS or $ injection 250 billion1 100 billion = 1-.60 2.5 = 2.5

14. Where Marginal Propensity to Consume Comes From • When disposable income increases by $10, C increases by $8 and S increases by $2. Thus the MPC = (Δ C/Δ Yd) = .8 and • The MPS = (Δ S/Δ Yd) = .20. • So if this household receives $1 of additional Yd, they will consume 80 cents and save 20 cents of it.

15. How Does the Multiplier Work? Assume that everyone in the economy spends 80% of every additional $1 of new disposable income. What would happen if there was an injection of new spending into the economy? Example: Alec is a chicken farmer in the local community. Suppose Alec decides to spend $1000 on some chicken coops at Andy’s farm supply shop. This money now starts to be circulated around the economy. Calculate the outcome. 1. Andy now has $1000 from the sale and spends 80% ($______) on clothes at Sarah‘s boutique. 2. Sarah now has $_______from the sale and spends 80% ($______) to fix her car at Ben’s garage. 3. Ben now has $_______ from the sale and spends 80% ($_____) at Jorge’s grocery store. 4. Jorge now has $______ from the sale and spends 80% ($______) with Anna’s catering company. After 5 rounds of spending, we’ve created $___________, more than DOUBLE the original injection of spending!!!!! If we had continued until someone was trying to spend 80% of nothing, Alec’s initial $1000 purchase would have multiplied to a total of $5000 in income/spending. The spending multiplier can be shown to be equal to: M = 1/(1-MPC) = 1/(1-_____) = Since MPC + MPS = 1, we can also say that M=1/MPS In the macroeconomy: The multiplier is the ratio of the total change in real GDP (caused by an autonomous change in aggregate spending)to the size of that autonomous change. DAAS is the autonomous change in aggregate spending DY is the total change in real GDP. Multiplier is equal to DY/DAAS, or 1 / (1 – MPC)

16. How Does the Multiplier Work? Example: Alec is a chicken farmer in the local community. Suppose Alec decides to spend $1000 on some chicken coops at Andy’s farm supply shop. This money now starts to be circulated around the economy. 1. Andy now has $1000 from the sale and spends 80% ($800) on clothes at Sarah‘s boutique. 2. Sarah now has $800 from the sale and spends 80% ($640) to fix her car at Ben’s garage. 3. Ben now has $640 from the sale and spends 80% ($512) at Jorge’s grocery store. 4. Jorge now has $512 from the sale and spends 80% ($409.60) with Anna’s catering company. After 5 rounds of spending, we’ve created $2361.60, more than DOUBLE the original injection of spending!!!!! If we had continued until someone was trying to spend 80% of nothing, Ted’s initial $1000 purchase would have multiplied to a total of $5000 in income/spending. The spending multiplier can be shown to be equal to: M = 1/(1-MPC) = 1/(1-.80) = 1/.2 = 5 Since MPC + MPS = 1, we can also say that M=1/MPS In the macroeconomy: The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. DAAS is the autonomous change in aggregate spending DY is the total change in real GDP. Multiplier is equal to DY/DAAS, or 1 / (1 – MPC)

17. The Consumption Function The consumption function is an equation that shows how an individual consumer spending varies with the household’s current disposable income. The simplest version of a consumption function is a linear equation: c = a + MPC *Yd • Little a = autonomous consumption ($5) • MPC = marginal propensity to consume (the slope ~ .80) C = 5 + .80 * 10 (Yd) C = ________ Consumption Consumption Function 13 5 Disposable Income, Yd 10

18. Current Disposable Income and Consumer Spending • What is disposable income? • What usually happens to consumer spending when DI goes up? • What is the relationship between these 2 things & how can it be illustrated?

19. Current Disposable Income and Consumer Spending • Disposable Income: net income (after federal & state taxes are paid) & gov’t transfers are received • What usually happens to consumer spending when DI goes up? It goes up too! • What is the relationship between these 2 things & how can it be illustrated? See the graph New Consumption Function Consumption Function 13 5 10

20. Current Disposable Income and Consumer Spending • What is the Relationship between Disposable Income and Consumer Spending? • Consumption Function: c = a + MPC * yd • Using the hypothetical information from the earlier table: c = 5 + .80Yd • If Yd increases from $10 to $20, C increases from $13 to $21. This is seen as a movement upward along the fixed consumption function. New Consumption Function Consumption Function 13 5 10

21. Consumption Function FRQ 1 • Use the consumption function to answer the following questions: c = 15,000 + .80 x yd • What is the value of MPC? • If Disposable income is $40,000, how much will individual household consumer spending be equal to? • Draw a correctly labeled graph showing this consumption function. • What is the slope of the consumption function? • On your graph, what would happen if expected future income decreased?

22. Consumption Function FRQ 2 • Use the consumption function to answer the following questions: c = 20,000 + .90 x yd • What is the value of MPC? MPS? • If Disposable income is $34,000, how much will individual household consumer spending be equal to? • Draw a correctly labeled graph showing this consumption function. • What is the slope of the consumption function? • On your graph, what would happen if expected future income increased?

23. Shifts of the Aggregate (Whole Economy) Consumption Function: Terms & Formula • Autonomous Consumer Spending (BIG A): amount of money a household would spend if it had no disposable income • Aggregate Consumption Function: relationship for the economy as a whole between aggregate current disposable income & aggregate consumer spending • C = A + MPC x DI • What would cause C to increase, no matter the level of Yd? There are several factors that will shift the consumption function upward or downward, similar to demand & supply shifters.

24. Shifts of the Aggregate Consumption Function 1. Changes in Expected Future Disposable Income • https://www.youtube.com/watch?v=aNsS1hCqYA8

25. Shifts of the Aggregate Consumption Function 1. Changes in Expected Future Disposable Income Suppose a college senior was about to graduate and already had a job lined up. In other words, she knows that her current disposable income is going to rise. This expectation of more income in the future shifts the consumption function upward. • http://www.youtube.com/watch?v=aNsS1hCqYA8&safety_mode=true&persist_safety_mode=1&safe=active

26. Shifts of the Aggregate Consumption Function • Changes in Aggregate Wealth 3. Permanent Income Hypothesis:

27. Shifts of the Aggregate Consumption Function • Changes in Aggregate Wealth • Wealth = accumulated assets, and this is very different from disposable income. • If you own a house, a car, shares of stock or even a savings account, you have wealth. • Suppose that the stock market has a bad year and the value of your wealth substantially declines? This lost wealth, even if it is only on paper, usually causes people to reduce their consumption. (think homes losing value during the 2008 Recession) • The consumption function shifts downward . 3. Permanent Income Hypothesis: Consumer spending today depends on the income people expect to have over the long term rather than their current income.

28. Shifts of the Aggregate Consumption Function • Current Income Savings today • Expected Income Savings today • How does this premise fit into the current state of the economy? (recent recession, hard recovery)

29. Investment Spending • Although consumer spending is much larger than investment spending, booms and busts in i_____________s__________ tend to d________theb_________c_______. • In fact, most recessions originate as a f_______ini______________s_______________!! • Planned Investment Spending: investment spending that businesses tend to undertake during a given period

30. Investment Spending • 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!! • Planned Investment Spending: investment spending that businesses tend to undertake during a given period

31. Fluctuations in Investment Spending & Consumer Spending Changes in Investment Spending What is your conclusion about this graph?

32. Life Cycle Hypothesis: Planned Spending • What do you plan to spend your money on in your lifetime? Give the details on your 5 year, 10 year, 20 year, 30 year, 50 year spending plan!

33. What Affects YOUR Spending? Christmas is coming. Name as many things as possible that will influence your spending. (This is your money. Not momma’s or daddy’s.)

34. 3 Factors that Affect Planned Investment Spending Interest rate Expected Future Level of GDP Level of Production Capacity

35. 3 Factors that Affect Planned Investment Spending • Interest rate • before a company invests dollars they complete a benefit-cost analysis to see the rate of return • Expected return on the investment = expected economic profit from the factory = (total revenue minus total cost)/investment cost. • Expected Future Level of GDP • Expected GDP : up • Investment Spending: up • Expected GDP: down • Investment Spending: down • Level of Production Capacity • Demand for Product exceeds production capacity… • Planned Investment • New factory or new machinery will be invested in

36. The Interest Rate and Investment Spending 1. Investment spending: before a company invests dollars they complete a benefit-cost analysis so see the rate of return Ex: A firm is considering building a new factory. This will increase sales, but it will also require b______________to fund the investment. Expected return on the investment = expected economic profit from the factory = (total revenue - total cost)/investment cost. The market i______________ r________ is the cost of investment. 1. Interest rate = cost to borrow money 2. Interest rate = the cost of investing your own funds (no borrowing), since it is i__________f__________. (opportunity cost) • When should the factory build? • When should they NOT build? • Thus there is a negative relationship between the interest rate and dollars of investment spending.

37. The Interest Rate and Investment Spending 1. Investment spending: before a company invests dollars they complete a benefit-cost analysis so see the rate of return Ex: A firm is considering building a new factory. This will increase sales, but it will also require borrowingto fund the investment. Expected return on the investment = expected economic profit from the factory = (total revenue minus total cost)/investment cost. The market interest rate is the cost of investment. 1. Interest rate = cost to borrow money 2. Interest rate = the cost of investing your own funds (no borrowing), since it is income forgone. (opportunity cost) • When should the factory build? • When the rate of return higher than the cost of the funds they would have to borrow to finance that project. • When should they NOT build? • If the interest rate rises. • Thus there is a negative relationship between the interest rate and dollars of investment spending.

38. The Interest Rate and Investment Spending A d_________in the real interest rate will result in m______gross private investment. i I

39. The Interest Rate and Investment Spending A decrease in the real interest rate will result in more gross private investment. i I

40. The Interest Rate and Investment Spending

41. Factors that Affect Planned Investment Spending: Expected Future GDP & Production Capacity There are some factors that would increase investment spending at any interest rate. 1. Expected Future Real GDP Expected GDP Investment Spending Expected GDP Investment Spending 2. Production Capacity Demand for Product exceeds production capacity Planned Investment New factory or new machinery will be invested in The best conditions for new investment spending consists of firms that are near production capacity with expectations of strong real GDP in the future.

42. Expected Future Real GDP, Production Capacity, and Investment Spending An i__________in either expected future r_______G______orproduction capacity will result in m________ investment at the same i___________ r______.

43. Expected Future Real GDP, Production Capacity, and Investment Spending An increase in either expected future real GDP or production capacity will result in more investment at the same interest rate.

44. Multiplier Homework • Gabrielle has just found $10 in the pocket of a coat from last winter. Gabrielle and everyone in her town has a MPC of .90. Create a table that shows how rounds of spending will multiply into more than the initial $10. Once you are spending less than $2.00, add up the spending rounds. Including the initial $10, how much spending was eventually created? • Question: Why does the federal government spend taxpayer money on programs?

45. Module 16 Review p. 170 Read Module 17 p. 172