Unit 5—Aggregate Models

1. Unit 5—Aggregate Models Chapters 9, 10 and 11 Time Period: 3 weeks Graphs: 7

2. Chapter 9—Building the Aggregate Expenditures Model Aggregate means TOTAL (aggregate expenditure means total spending)

3. Consumption and Saving • What can a person do with DI? • What is not spent is called savings • DI – C = S LOOK AT THE GRAPH ON PAGE 160

4. C & DI Graph • The reference line is a 45° line • Each point is equidistant from the axes • C = DI • Green dots = C • When the green dot falls short of the reference line, savings has occurred • Again, DI – C = S • As DI increases both C and S increase • Direct relationship to the level of income • Household C most of their DI

5. C Schedule • Page 161 shows a hypothetical C schedule • Households spend a larger proportion of a small income than of a large income • See graph on Page 162 • C Schedule Graph • 45° reference line • Shows C and S • Shows DISSAVINGS = occurs at low levels of income where C exceeds DI & people must borrow

6. Average Propensities to C & S • Measures the average C (APC) or S (APS) at any level of disposable income • APC = C / DI • APS = S / DI • C%  and S%  as DI  • APC + APS = 1

7. Marginal Propensities to C & S • (marginal means extra) • Proportion of any change in income C is called MPC or income S is called MPS • MPC = change in C / change in DI • MPS = change in S / change in DI • MPC + MPS = 1 • The only choice people have is to C or to S. An additional dollar in income must result in a change in C and/or a change in S.

8. Practice Worksheet • Do together and correct in class

9. Investment (review) • Spending on new plants, capital equipment, machinery, construction, etc. • Investment decision weighs marginal benefits & marginal costs • The expected rate of return = marginal benefit The interest rate = marginal cost

10. Expected Rate of Return • Found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return • Example in text (page 166) • Woodworker wants to buy equipment for $1,000. He expects a $100 profit. The expected rate of return is 10%. In order to make a profit, the woodworker would not want to pay more than 10% interest on the investment.

11. The Real Interest Rate • The real interest rate, i, is the cost of the investment • Real interest rate = nominal rate - inflation • Interest rate is either the cost of borrowed funds or the cost of investing your own funds, which is income forgone. • If i exceeds the expected rate of return, r, the investment should not be made

12. Investment Demand Curve • Shows an inverse relationship between the interest rate and amount of investment • As long as r exceeds i, the investment is expected to be profitable • See graph on page 168 • Investment demand curve is always downward sloping • Less will be invested if interest rates are high

13. Self Assessment • Take the quick quiz on page 168 to assess your own understanding. 

14. Shifts in the Investment Demand Curve • Movement along the IDC or DIgC occur with a change in the interest rate • Shifts occur ( to the right,  to the left) • 1. acquisition, maintenance and operating costs • When cost falls, the r from prospective investment project rises, shifts the IDC to the right • Higher electricity costs = shift to the left • 2. business taxes • in taxes = shift to the left

15. Shifts Continued • 3. technological change • Development stimulates investment • Shift to the right • 4. stock of capital goods on hand • When firms are overstocked, the r declines (shifts to the left) • There is little incentive to invest in new capital when there is excess production • When firms are under stocked, the r increases (shifts to the right)

16. Shifts continued again . . . • 5. Expectations • Optimistic about future sales, the curve will shift to the right • Pessimistic outlook = shift to the left

17. Instability of Investment • 1. capital goods are durable so spending can be postponed • 2. innovation occurs irregularly • 3. profits vary considerably • 4. expectations can be easily changed

18. Classwork! Yeah! • Page 179 • Number 2 • Number 3 • A=c&s B=c&s C=c, s & i F=I G=c&s I=c&s • Number 4 • Number 5—complete the table and part B only (refer to table 9.1) • Number 6 •  Due today 

19. Equilibrium GDP • Equilibrium level of GDP is the level at which the total quantity of goods produced (GDP) = the total quantity of goods purchased • GDP = C + Ig • Savings and planned investment are equal • Savings represents a “leakage” from spending and causes C to be < GDP

20. Table 9.4 • See table on page 173 • See line 8, GDP is $510 billion • C + Ig = 500 billion (disequilibrium) • Businesses have $10 billion of unplanned inventory investment on top of what was already planned • Unplanned portion is a business expenditure

21. Table 9.4 • See line 5, GDP = $450 billion • Consumer spending is $435 billion • $20 billion is planned investment • Businesses have experienced a $5 billion unplanned decline in inventory because of unexpected sales

22. Self Assessment • See graph on page 175 • Quick quiz on page 175—work with a partner or on your own  for your own assessment of understanding

23. Say Vs Keynes • Read page 177 • Do question 16 on page 180—this will be turned in. You need to actually draw a PPF for and label efficiency for both men.