Spending, Income, and Interest Rates Chapter 3 Instructor: MELTEM INCE

1. Spending, Income, and Interest Rates Chapter 3 Instructor: MELTEM INCE

2. The “Great Moderation” The goal of monetary and fiscal policy is to dampen business cycle fluctuations and to promote steady economic growth.

3. Aggregate Demand and Supply • Aggregate Demand (AD) is the total amount of desired spending expressed in current (or nominal) dollars. • A demand shock is a significant change in desired spending by consumers, business firms, the government, or foreigners. • Algebraically, any change in C, I, G or NX • Aggregate Supply (AS) is the amount that firms are will to produce at any given price level. • A supply shock is a significant change in costs of production for business firms, including wages and the prices of raw materials, like oil.

4. Aggregate Demand and Supply The price level (P) is fixed in the short run. • Implication: All changes in AD automatically cause changes in real GDP by the same amount and in the same direction. • Changes in Real GDP= Changes in AD Fixed Price Level

5. Aggregate Demand and Supply • The variables that an economic theory tries to explain are called endogenous variables. • Examples: Output and interest rates • Exogenous variable are those that are relevant but whose behavior the theory does not attempt to explain; their values are taken as given. • Examples: Money supply, government spending, tax rates

6. Consumption Function The consumption function is any relationship that describes the determinants of consumption spending. General linear form: C = Cα + c(Y – T) Cα = Autonomous consumption c = marginal propensity to consume c(Y – T) = induced consumption

7. Saving Function Savings (S) = Y – T – C Substituting in C from above yields: S = Y – T – [Cα + c(Y – T)] S = – Cα + (1 – c)(Y – T) (1 – c) = marginal propensity to save (s)

10. Issues of Macroeconomics Macroeconomic Problems 1) Economic Growth 2) Unemployment 3) Inflation 4) Deficits

11. Factors Affecting Cα • Interest Rates (r): When r↓  borrowing is cheaper for consumers  Cα↑ • Example: Low interest rates in 2001-04 stimulated consumption of automobiles and other consumer products. • Household Wealth (W) is the total net value of all household assets (minus any debt), including the market value of homes, possessions such as automobiles, and financial assets such as stocks, bonds, and bank accounts. • If W↑  household spending can rise even if income is fixed  Cα↑ • Example: The 1990s stock market boom raised consumption.

12. Planned vs. Unplanned Expenditure Y = C + I + G + NX GDP or Output = Unplanned Expenditure Unplanned Expenditure always equals GDP because the equation is an identity. Planned Expenditure (EP) = C + IP + G + NX Only Investment has an unplanned spending component Goods that are produced but not sold are counted as unplanned inventories. EP = GDP only at equilibrium (unplanned spending = 0) Algebraically, EP = AP + c(Y – T) AP= Autonomous Spending = Cα– cTα + IP + G + NZ

13. Planned vs. Unplanned Expenditure • At equilibrium, Y = EP Y = AP + cY (assuming T = 0) To find equilibrium Y, solve the above equation for Y:  (1 – c)Y = AP  sY = Ap  Y = (1/s) AP • If the level of AP changes over time by ∆AP, then thechange in output, ∆Y, is given by: ∆Y = (1/s) ∆AP • 1/s is called the multiplier because it shows how each additional dollar of autonomous spending results in a greater than $1 increase in equilibrium output.

14. Types Of Unemployment Frictional unemployment is unemployment that arises from normal labor market turnover. • The creation and destruction of jobs requires that unemployed workers search for new jobs. • Increases in the number of young people entering the labor force and increases in unemployment benefit payments raise frictional unemployment.

15. Shifts in Planned Spending EP = C + IP + G + NX = AP + cY where AP = Cα– cTα + IP + G + NZ • Any increase in AP will shift up EP on the Keynesian Cross Diagram. • Effect on Y: ∆Y = (1/s) ∆AP • If c changes, the EP line will rotate • If the effect on Y is negative, fiscal policy can be used to offset the effect.

16. Types Of Unemployment • Full employment occurs when there is no cyclical unemployment or, equivalently, when all unemployment is frictional or structural. • The unemployment rate at full employment is called the natural rate of unemployment.

17. Inflation • Inflation: Inflation is an increase in the overall price level. • Deflation: A decrease in the overall price level. • Stagflation: Occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).

18. Deficits A government budget deficit exists if a government spends more than it collects in taxes. An international deficit exists if our imports exceed our exports.

19. Macroeconomic Policy Challenges and Tools • There are three kinds of policy that the government has used the influence the macroeconomy: • Fiscal policy: Government affects the economy is through its tax and expenditure decisions. • Monetary policy : Central Bank determines and control the quantity of money in the economy. Most economists agree that the quantity of money supplied affects the price level, interest rate and exchange rates, unemployment rate and level of output. • Growth or supply-side policies: Government policies that focus on stimulating aggregate supply instead of aggregate demand.

20. The Components of The Macro Economy Macroeconomics focuses on four groups: • households • Firms which together compose the private sector • The government (the public sector) • International sector (the rest of the world).

21. Households Households work for firms and the government and they receive wages for their work. Households also receive interest on corporate and government bonds and dividends from firms. Many households receive other payments from the government such as Social security benefits. Economists call these payments from the govenment transfer payments. Households spend by buying goods services from firms and by paying taxes to the governments.

22. Consider an economy in which all taxes are autonomous and the following values of autonomous consumption, planned investment, government expenditure, autonomous taxes and the marginal propensity to consume are: Cα= 1400 Tα= 1750 IP= 1800 G= 1950 c=0.6 • The level of consumption when Y=10000 is: C = Cα + c(Y – T) 1,400 + 0.6(10,000 - 1,750) = 1,400 + 4,950 = 6,350 • The level of saving when Y=10000 is: S = – Cα + (1 – c)(Y – T) or S= Yd – C S= 8,250 - 6,350 = 1,900

23. c. The level of planned investment, the level of actual investment and the level of unintended inventory investment 1. IP= 1800 2.E=Ito compute actual investment E = C + I + G I = Y - C - G I = 10,000 - 6,350 - 1950 = 1,700 3. Iu = I - IP, Iu = 1,700 - 1,800 = -100 d. Leakages= S+T= 1,900 + 1,750 = 3,650 Injections= I+G= 1,700 + 1,950 = 3,650

24. Cα= 1400-15r Tα= 1600 IP= 2350-35r G= 1940 NX= -200 c=0.5 • s= 1 - c = 1 - 0.5 = 0.5 k= 1/s = 1/0.5= 2 • Ap= Ca - cT + Ip + G + NX Ap= 1,400 -15r - 0.5(1,600) + 2,350 - 35r + 1,940 - 200 Ap= 4,690 - 50r • Y = kAp Y= 2(4,690 - 50r) = 9,380 - 100r d. i=0 Y= 9380 i=3 Y= 9,380 – 100*3 = 9,080 i=6 Y= 9,380 – 100*6= 8,780 e. Slope= Δr/ΔY (3 - 0)/(9,080 - 9,380) = (6 - 3)/(9,080 - 8,780) = 3/(-300) = -0.01.

25. New Cα= 1440-15r Ap= Ca - cT + Ip + G + NX Ap= 1,440 - 15r - 0.5(1,600) + 2,350 - 35r + 1,940 - 200 Ap= 4,730 - 50r IS curve = 2(4,730 - 50r) = 9,460 - 100r g. i=0 Y= 9460 i=3 Y= 9,460 – 100*3 = 9,160 i=6 Y= 9,460 – 100*6= 8,860