Principles of Economics

1. Principles of Economics Session 11

2. Topics To Be Covered • Identities of Saving and Investment • Consumption Function • Marginal Propensity to Consume • Marginal Propensity to Save • Investment Function • Equilibrium of the Goods Market • Case Study: Output Accounting and Output Determination

3. Topics To Be Covered • Business Cycle • Fiscal Policy • Multiplier Effect • Crowding-Out Effect • Paradox of Thrift

4. National Saving • Nationalsavingis the amount of income that households have left after paying their taxes and consumption and the revenue that the government has left after paying for its purchases. National Saving = Private Saving + Public Saving

5. Private Saving • Privatesavingis the amount of income that households have left after paying their taxes and paying for their consumption. Private Saving = Y – T - C

6. Public Saving • Publicsavingis the amount of tax revenue that the government has left after paying for its spending. Public Saving = T - G

7. Surplus and Deficit • Budget SurplusIf T>G, the government runs a budget surplus because it receives more money than it spends. • Budget DeficitIf G>T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

8. Identities ofSaving and Investment Assume a economy consisting of households and firms only. The expenditures are consumption and investment and the incomes are either spent on consumption or saved. C + I = C + S • Therefore, saving is equal to investment. I = S

9. Identities ofSaving and Investment In a closed economy with households, firms, and government, there exists the following equation, the left side being expenditures and the right side being income allocations: C + I + G = C + S + T • Therefore, the national saving is equal to investment. I = S + (T – G)

10. Identities ofSaving and Investment • In an open economy, import and export should be considered. Since the aggregate income (Y) is equal to the aggregate expenditure, there exist the following equations: Y= C + I + G + NX I + NX = Y – C - G

11. Identities ofSaving and Investment • For an economy as a whole, net export (NX) and net foreign investment (NFI) must balance each other so that: NX = NFI • Therefore, in an open economy national saving is equal to the sum of domestic investment and net foreign investment. I + NFI = (Y – C -T ) – (T – G)

12. Consumption and Saving • In a society without tax, a household can do two things with its income—consumption and saving. Y = C + S

13. Determinants of Consumption • Household income • Household wealth • Interest rates • Households’ expectations

14. Consumption Function Keynes points out that the household consumption is closely related to the income. With the income increase, people will consume more. However, the increase of consumption is not as great as that of income. Empirical studies also reveal the close relationship between consumption and income but the increase of consumption is on the whole proportional to income.

15. C = f ( Y) 45º Consumption Function Keynes’ View Consumption C = Y Income

16. 45º Consumption Function Empirical Finding Consumption C = Y C = a + bY Income

17. Marginal Propensity to Consume The marginal propensity to consume (MPC) is the extra amount that people consume when they receive an extra dollar of income.

18. C = f ( Y) Marginal Propensity to Consume MPC = f ‘( Y) Consumption MPC=Slope Income

19. Marginal Propensity to Consume Consumption C = a + bY MPC=Slope=b Income

20. Consumption Function C = f (Y) Keeping other variables (interest rate, expectation, etc.) constant, consumption can be thought of as a function of income. • If the function is linear, it can be expressed as: C = a + bY

21. Consumption Function

22. C = 100 + 0.75Y 100 Consumption Function Consumption Income

23. Marginal Propensity to Save • The marginal propensity to save (MPS) is the fraction of an additional dollar of income that is saved. MPC + MPS = 1 MPS = 1 - MPC

24. Marginal Propensity to Save

25. 45° Save Income 0 Marginal Propensity to Save consumption C = Y C = 100 + 0.75Y Income 0 MPS = 0.25 S = -100 + 0.25Y

26. Investment • Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stocks. • Generally, investment is considered a function of interest rate (r). When the interest rate is high (low), the financial cost for the firm is high (low), the firm invests less (more).

27. Investment Interest rate I = f (r) Investment

28. Planned Investment • Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms. • Actual investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

29. Planned Investment • For simplicity, it is assumed that planned investment is fixed, for the major determinant of investment is the interest rate and the investment is an exogenous variable in the Keynesian cross model. • It does not change when income changes, so investment is an autonomous variable.

30. Planned Investment Investment I = 25 Income

31. Planned Aggregate Expenditure To determine planned aggregate expenditure (AE), we add consumption spending (C) to planned investment spending (I) at every level of income.

32. AE = C+ I = 125 + 0.75Y 125 I = 25 25 Planned Aggregate Expenditure C + I C = 100 + 0.75Y 100 Y

33. Equilibrium in Goods Market • In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output. Y = C + I

34. Equilibrium in Goods Market Y＞ C + I • Inventory investment is greater than planned.Actual investment is greater than planned, so there is unplanned inventory Y＜ C + I • Inventory investment is smaller than planned. There is negative unplanned inventory.

35. Equilibrium in Goods Market • Saving is a leakage out of the spending stream. If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium. • Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I).

36. Case Study: Output Accounting and Output Determination Assume an economy consists of the firm and the family only and the firm produces a single product—bread.

37. Case Study: Output Accounting and Output Determination The firm thinks that the household will consume $800 of bread. Considering that the firm needs the inventory $200 of bread to entertain international guests, the firm produces $1000 worth of bread.

38. Case Study: Output Accounting As expected, the firm sells exactly $800 of bread and keeps an inventory of $200 of bread. What’s the GDP of this economy for this period?

39. Output:$1000 Consumption: $800 Income: $1000 Inventory: $200 Case Study: Output Accounting Aggregate Output=$1000 Aggregate Income=$1000 Aggregate Expenditure=C+I=$1000 GDP=$1000

40. Case Study: Output Determination As expected, the firm sells exactly $800 of bread and keeps an inventory of $200 of bread. Is the goods market in equilibrium? Why?

41. Planned Expenditure = AD: $1000 Output = AS: $1000 Planned Inventory=Planned Investment: $200 Planned Consumption: $800 Planned Saving: $200 Unplanned Inventory: $0 Income: $1000 Case Study: Output Determination

42. AS=AD C+I 1000 AD= Planned Expenditure=C+I GDP= AS =Output = Income=C+S 45° 0 1000 Planned Saving Saving and Investment Planned Investment 200 0 GDP=Income 1000 Case Study:Output Determination Output=AD, so the goods market is in equilibrium. Investment here doesn’t include unplanned inventory, so investment does not necessarily equal saving.

43. Case Study: Output Accounting Unexpectedly, the firm sells only $600 of bread, so it has to keep an inventory of $400 of bread. What’s the GDP of this economy for this period?

44. Output:$1000 Consumption: $600 Income: $1000 Inventory: $400 Case Study: Output Accounting Aggregate Output=$1000 Aggregate Income=$1000 Aggregate Expenditure=C+I=$1000 GDP=$1000

45. Case Study: Output Determination Unexpectedly, the firm sells only $600 of bread, so it has to keep an inventory of $400 of bread, $200 of which is unplanned inventory. Is the goods market in equilibrium? Why?

46. Planned Expenditure = AD: $800 Output = AS: $1000 Planned Inventory=Planned Investment: $200 Planned Consumption: $600 Planned Saving: $400 Unplanned Inventory: $200 Income: $1000 Case Study: Output Determination

47. Output is greater than AD by $200 C+I 800 AD= Planned Expenditure=C+I GDP= AS =Output = Income=C+S 45° 0 1000 Equilibrium output Planned saving is greater than planned investment by $200. S 400 Saving and Investment I 200 0 GDP=Income 1000 Case Study:Output Determination Other things held constant, the firm should decrease its output next period.

48. Case Study: Output Accounting Unexpectedly, the firm sells all the bread it has produced—$1000 of bread, so it has run out of inventory. What’s the GDP of this economy for this period?

49. Output:$1000 Consumption: $1000 Income: $1000 Inventory: $0 Case Study: Output Accounting Aggregate Output=$1000 Aggregate Income=$1000 Aggregate Expenditure=C+I=$1000 GDP=$1000

50. Case Study: Output Determination Unexpectedly, the firm sells all the bread it has produced—$1000 of bread, so it has run out of inventory, which means a negative unplanned inventory of $200. Is the goods market in equilibrium? Why?