Management in the Built Environment Lesson 8 – Economic Activity and Multiplier Effect

1. Management in the Built EnvironmentLesson 8 – Economic Activity and Multiplier Effect

2. Learning Outcome of this lecture • Understand the effect of spending • Circular flow of Production and Spending • Household – leakage from spending stream • Business Sector and the circular flow • The Government Sector • The Multiplier effect

3. Effect of Spending Economists have identified an important macroeconomic relationship: Changes in total (aggregate) spending in the economy cause changes in total (aggregate) production and employment. Total, or aggregate spending is all the spending for all new goods and services that occurs in the economy, which means we lump the spending of each of our major groups – households, businesses, government units and foreign buyers – together.

4. Effect of Spending In a market economy, spending is the driver. As long as buyers spend their money, producers will continue to produce goods and services and hire people to do so and this in turn leads to an increase in employment. Thus a reduction in spending leads to a recession because of its dampening effect on output, employment and income. An increase in spending leads to a recovery because of its expansive effects. The spending behaviour of households, businesses, the government and foreign buyers is critical to the health of the macroeconomy.

5. Relationship between Total Spending and the Level of Economic Activity

6. The Circular Flow of Production and Spending Figure 8.2 • Fig 8.2 showing the circular flow of production and spending illustrates: • Saving, Investing and Borrowing by Households and Businesses • The Government sector and the circular flow of Taxes, Purchases and Expenditure

7. HOUSEHOLDS • “Earned income”:Most of the spending that we do, come from income that we earn. In Fig 8.2, the “Earned Income” line shows a flow of earned income from selling factors of production to businesses. • “Consumption expenditures” : line shows a flow of personal consumption expenditures for goods and services. Thus, earned income provides the spending power to purchase goods and services. • “Household borrowing”:While earned income is the major source of household spending, it is not the only source. Households can also spend from funds that they borrow through bank loans, credit card purchases and from government transfer payments, which are payments from the government for which no direct work is performed in return. Government subsidies and social security payments are examples of transfer payments.

8. Household Savings Figure 8.3 Households do not spend all of their income. Some is used to pay taxes and some is saved through the use of financial institutions such as banks. (See Fig 8.3 above)

9. Households - Leakages from the spending stream Both savings and taxes are leakages from the spending stream because they are income that households are not spending but are channeling to other uses. Leakages from the spending stream cause output, employment and income in the economy to shrink as businesses cut back production in response to a reduced demand. When people earn more or less or change their saving habits, total consumption expenditures and the economy as a whole can be affected. For eg, fear of a recession could cause people to increase saving, with a resulting decline in spending. Another eg: a decrease in interest rates could encourage people to borrow for SUVs, home renovations and other spending purposes. Can you think of a country that is plague with this leakage for over decades ?

10. The Business sector Businesses play an important role in the macroeconomy because of their spending habits. First, the size of business spending on new goods is huge. Each year, they put millions of dollars into new machinery and equipment, buildings, inventories and so on. Technically, we term this investment spending. Second, investment spending is not steady and tends to fluctuate from year to year. Changes in investment spending are a primary cause of changes in economic activity. When business spending declines, it can bring about a slowdown or recession; when it increases, it can help pull the economy into a recovery.

11. The Business sector and the Circular Flow Figure 8.3 Investment spending by businesses as an injection into the spending stream is shown in Fig 8.3. Business savings or retained earnings as shown in Fig 8.3 are leakages from the spending stream. Businesses use financial institutions to hold their savings through deposits, stocks, bonds or other security that earns money until the funds are needed. Financial institutions also provide the means for financing investment spending through loans or new shares of stock. Through financial institutions, dollars saved by households and businesses – dollars that are leakages from the spending stream – can be borrowed and spent by other households and businesses and thereby returned to the spending stream. Thus, financial institutions are vehicles for changing leakages from the spending stream into injections.

12. The Government Sector • The Government is another sector that has a major impact on the economy because of its own spending as well as its power to influence spending in the other sectors through the taxes that are imposed. • We classify government spending into two major categories: • Purchase of goods and services • Transfer payments

13. The Government Sector – Purchase & Transfer Purchase of goods and services Governments provide us with many needed services and make government purchases of goods and services – fire trucks, police radar detectors, park benches and the service of government employees. Transfer payments Government also uses a substantial portion of its funds for transfer payments, such as social security which go to individuals or households. These transfer payments can then be used to buy groceries, pay for prescriptions. As seen in Fig 8.2. government purchases are a direct injection into the spending stream, transfers provide an injection through households and taxes are a leakage.

14. Fiscal policy The amount of money that government spends and the amount that it taxes affect the economy’s levels of output, employment and income. Furthermore, a change in either spending or taxes could cause the economy to move into an expansion, or recovery, or move into a contraction, or recession. When the government changes its spending and/or taxing to control unemployment or demand-pull inflation, it is putting fiscal policy into play. Fiscal policy is the means by which a governmentadjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply.

15. Fiscal Vs Monetary Policy

16. Leakages, Injections and Changes in Economic Activity The economy’s levels of output, employment and income depend on the combined effect of all leakages and all injections into the spending stream. The level of economic activity will: Expand When all injections into the spending stream exceed all leakages from the spending stream. Remain unchanged When all injections into the spending stream equal all leakages from the spending stream. Contract When all injections into the spending stream are less than all leakages from the spending stream.

17. LEAKAGES AND INJECTIONS

18. Video 1 : Circular flow of income https://youtu.be/WlgMgppUx_Y Video 2 : Injection and Leakages https://youtu.be/6dpVSKiw-3Y

20. The Multiplier Effect • Spending can be identified as income-determined or non income-determined. • Income-determined spending: • spending on goods and services that comes from people’s earned incomes • Non income-determined spending: • spending from borrowed funds, • transfer payments from government to households, • investment spending • government purchases • The above are termed as non income-determined spending as they do not come directly from household earned income. • When non income-determined spending is injected into the economy, it is subjected to the multiplier effect, ie an increase or decrease in non income-determined spending causes changes in output and employment that are far greater than the initial change.

21. Definition of the multiplier effect The multiplier effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon household's marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps).

22. What causes the multiplier effect • Non income-determined spending is not part of the “basic circle” of the circular flow model. • This spending does not come from income earned from production. • It comes from outside the core circle of the economy; it is injected into the economy. • Once the injection enters the economy, it becomes part of the basic circle and these dollars are spent over and over again.

23. Example on the Multiplier effect – Round 1 Round 1 Suppose a developer borrows $10 million to build some homes. As the homes are constructed , the developer uses the $10 million to hire people and buy materials. This spending puts $10 million into the economy that was not previously there.

24. Example on the Multiplier effect – Round 2 Round 2 People who receive the $10 million in income will now take part of it and spend it – they can buy cars, go on vacation and use part for saving and taxes. Assuming they spend $8 million, this amount is “new” to the economy and it will result in $8 million of new production and incomes. The income earners of that $8 million will now take part of that, say $6.4 million, and spend it.

25. Example on the Multiplier effect – Round 3 onwards Round 3 and onwards When this is carried through successive rounds to approach a zero increase in the last round, and the output and income created in each round are summed, the result is $50 million in total output and income. This means that the initial injection of $10 million has been multiplied to $50 million, or five times the initial change in spending

29. Marginal Propensity to Consume (MPC) or Marginal Propensity to Saving (MPS) 1. The marginal propensity to consume (MPC) is the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it (MPS) 2. The marginal propensity to consume is equal to ΔC / ΔY where ΔC is change in consumption, and ΔY is change in income. If consumption increases by 80 cents for each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8 3 .MPC + MPS = 1 MPS in this case is 0.2

30. Calculating the Multiplier Effect Using the illustrated example : The initial injection was $10 million. Households spend $8 million or 80% and did not spend 20%. What is the multiplier and the effect on economy ? STEP 1 : Calculate the MPS or PMC In this question, both MPC (0.8) and MPS (0.2) are given Take note that MPC + MPS = 1 STEP 2 : Calculate the Multiplier Hence multiplier = 1/(0.2) 0R 1/(1-0.8) Multiplier = 5 STEP 3 : Multiply the initial injection into the economy by the multiplier : $10 million X 5 = $50 million Hence , the effect on the economy is $50 million. The more that is spent, the greater the multiplier effect.

31. Video : The Multiplier Effect https://youtu.be/lShcx6hLy24

32. SUMMARY • Change in total , or aggregate spending on new goods and services cause changes in economic activity. An increase in total spending increases output, employment and income and the economy grows until it reaches full employment. Total spending is the spending by households, businesses, government and foreign sectors together. • Household spending on new goods and services, called personal consumption expenditures, is fairly stable. Most household spending originates from income earned from producing goods and services. Households can also make purchases from borrowed funds and transfer payments. Households can also use income for saving or paying taxes, which are leakages from the spending stream. • The purchase of new goods such as machinery and equipment by businesses is called investment spending. Of the major components of total spending, investment is the least stable and a major source of fluctuations in output, employment and income. Investment spending is influenced by profit expectations that are affected by the outlook for future economic activity and the interest rate for borrowing funds. Investment spending is an injection into the spending stream: increases in investment spending stimulate the level of economic activity, and reductions in investment spending lead to reductions in output, employment, and income. Business saving and taxes are leakages from the spending stream. • Government can influence spending in 3 areas: the purchase of goods and services, transfer payments and taxes on households and businesses. Government purchases of goods and services are direct injections into the spending stream. Transfer payments provide injections and taxes are a leakage.

33. SUMMARY • If all leakages from the spending stream equal all injections, the level of economic activity will continue unchanged. If leakages exceed injections, spending decreases and the level of economic activity falls. If injections are greater than leakages, the spending stream expands, and the level of economic activity grows. • An increase or decrease in non income-determined household expenditures (from borrowed funds and transfer payments), investment spending, government purchases or foreign spending (through exports or foreign investments) leads to a multiple increase or decrease in the levels of output, employment and income. The multiplier effect is calculated by dividing the initial change in non income-determined spending by the percentage of additional income by households that is not spent. • If the economy is operating at or near full employment, increases in spending may lead to demand-pull inflation rather than to increases in output and employment. For this reason, increasing total spending does not always cause the economy to expand. • The objectives of full production and economic growth, full employment and stable prices can be accomplished through increasing or decreasing total spending. Fiscal policy influences total spending through changes in government purchases of goods and services, transfers and taxes. Monetary policy influences spending through changes in interest rates and money supply, or changes in lending and borrowing.