National Income and Price Determination

National Income and Price Determination AP Economics Mr. Bordelon

Spending Multiplier • In 2009, the Federal government passed the American Recovery and Reinvestment Act, a stimulus package of $787 billion, with the intention of encouraging job growth and reversing the recession. How? • The general idea of spending is that spending in one area of the economy multiplies into more than $1 of spending throughout the economy. • Each dollar spent will cascade through the economy at each level. • I build a house. I spend money on construction materials, say lumber. • The lumber worker takes that money and spends it on groceries. • The grocery store uses that money to buy more groceries…and so on.

Spending Multiplier • When we talk about spending, we’re talking about an increase in aggregate output due to an increase in disposable income. This disposable income leads to a rise in consumer spending, which makes firms increase output again, and so on. • How large the effect is depends on the MPC and MPS.

MPC and MPS • Marginal propensity to consume (MPC). Increase in consumer spending when disposable income increases by $1. • When consumer spending changes because of a rise or fall in disposable income, MPC is the change in consumer spending divided by the change in disposable income.

MPC and MPS • Marginal propensity to save (MPS). Increase in household savings when disposable income increases by $1. • Consumers spend part, but not all of an additional dollar of disposable income. MPC is a number between 0 and 1. • We’ll get back to these concepts when we talk about the spending multiplier below.

Consumption Function • Another way to look at this is through the consumption function: • YD = C + S • When you get more disposable income, YD, this increases both C (consumption) and S (savings). • MPC is the amount by which consumer spending rises if current disposable income increases by $1. It is also the slope of the consumption function. • Because MPC is a number between 0 and 1, MPC + MPS = 1.

Consumption Function • Looking at this consumption function table, we notice the following • 1. Even when YD = 0, households consume as they draw down savings or borrow. That $5 is called autonomous consumption. It’s the amount a household would spend if no disposable income. • At every increase, we see a ration of 0.8:0.2. • MPC = ΔC/ΔDI = 8/10 = 0.8 • MPS = ΔS/ΔDI = 2/10 = 0.2 • This means that this household will consume 80 cents and save 20. • 3. With this information, we can create the consumption function: C = A + MPC x YD

Consumption Function C = A + MPC x YD A: autonomous consumption, $5 and is the Y-intercept MPC = 0.8 and is the slope C = 5 + 0.8YD

Consumption Function This is a general breakdown of the graph, showing slope and the function itself.

Spending Multiplier • Sticking to this MPC of 0.8 for a moment, assume that everyone spends 80% of every additional dollar of new disposable income. What would happen if there is a new amount of spending injected into the economy. • Valentina is a chicken farmer in Orange City. Suppose she decides to spend $1000 on chicken coups at Shane’s farm supply shop. This money now starts circulation through the economy. How?

Spending Multiplier • Shane now has $1000 from the sale and spends 80% ($800) (MPC!) on clothes at Dana’s boutique. • Dana now has $800 from the sale and spends 80% ($640) at Alex’s garage. • Alex now has $640 from the sale and spends 80% ($512) at Ashley’s grocery store. • Ashley now has $512 from the sale and spends 80% ($409.60) with Chantal’s vegetarian bakery! Where are our cookies, Chantal?

Spending Multiplier • After 5 rounds of spending, we’ve created $2,361.60, more than double the original injection of spending by Valentina. If we continued until someone spent 80% of nothing, Ted’s initial $1,000 purchase would multiply to a total of $5000 in income/spending. How, I hear you ask?

Spending Multiplier • M = 1/(1 – MPC) • M = 1/(1 - 0.8) = 1/0.2 = 5 • 5 x 1000 = $5,000 • Also, since MPC + MPS = 1  M = 1/MPS

Spending Multiplier • On the macro scale, the multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending (ΔAAS) to the size of the change (ΔY). Mathematically if we were to work it out: • ΔY = 1/(1 – MPC) x ΔAAS • M = ΔY/ΔAAS = 1/(1 – MPC) • M = 1/(1 – MPC) or 1/MPS

Consumer Spending Let’s come back to this table, and look at what happens when YD increases from $10 to $20. When that happens, C increases from $13 to $21. This is a movement along the consumption function. So the question is, what would cause C to increase, no matter the level of YD? In other words, what would cause a shift of the consumption function?

Shifts of the Consumption Function Changes in Expected Future Disposable Income. College senior graduates and has a job lined up. She knows her current disposable income will increase. This would shift the consumption function upwards. Changes in Aggregate Wealth. Wealth is accumulated assets. The stock market takes a dive and wealth declines. This would cause people to reduce consumption. Consumption function shifts downward.

Investment Spending • For a business to invest, they conduct a cost-benefit analysis on what they will spend on. • Expected Return on Investment (ROI) = (Total Revenue – Total Cost)/Investment Cost • The market interest rate is the cost of investment. Interest rate is ultimately the cost of borrowed funds, and is also the cost of investing your own funds since you’re forgoing that income (opportunity cost!)

Investment Spending • Investment will only occur if the firm expects a higher ROI than the cost of the funds they would need to borrow to finance the project. • If the interest rate rises, fewer projects will be done. • If the interest rate decreases, more projects will be done.

Expected Future Real GDP, Production Capacity, and Investment Spending • Expected Future Real GDP. Microsoft believes the economy will expand next year. They might increase investment spending in anticipation of increased sales. This is a “now” investment. Microsoft must build a new factory now to take advantage of customers next year. Firm increases investment. • Production Capacity. Microsoft can produce 100,000 units if the factory produces 24/7. The full capacity is 100,000 units. Currently, Microsoft only has enough customers to produce only 50% (50,000) of full capacity. Firm does not increase investment. • It can simply expand production. • Best case scenario for new investment spending. At production capacity with expectations of strong real GDP in the future.

Question #1 The accompanying table shows how consumers’ MPC in a particular economy are related to their level of income. Suppose the government engages in increased purchases of goods and services. For each of the income groups in the accompanying table, what is the value of the multiplier—that is, what is the multiplier from each dollar the government spends on government purchases of goods and services for each income group? Show your math. Citation from the text.

Question #2 From 2003 to 2008, Eastlandia experienced large fluctuations in both aggregate consumer spending and disposable income, but wealth, the interest rate, and expected future disposable income did not change. This table shows the level of aggregate consumer spending and disposable income in millions of dollars for each of these years. Show your math. Use citations from text. Plot the aggregate consumption function for Eastlandia. What is the MPC? What is the MPS? What is the aggregate consumption function?

National Income and Price Determination