Unit 3: National Income and Price Determination

1. Unit 3: National Income and Price Determination

2. Part 1: Building the Aggregate Expenditures Model

4. I. Background A. Classical economists believed a market system would ensure full employment of the economy’s resources (except for temporary, short-term upheavals) B. Deviations would be self-correcting Slumps in output and employment  reduced prices  increased consumer spending  lower wages  increase employment again  lower interest rates  expand investment spending

5. C. Say’s Law 1) Summarized this classical view: “Supply creates its own demand.” 2) Think in terms of barter • A woodworker produces furniture to trade for other needed goods/services • All the products would be traded for something or there would be no need to make them

6. D. The Great Depression 1) Refuted classical economics when markets did NOT self-correct 2)GDP fell by 40% (in the U.S.) and unemployment rose to 25%

7. E. John Maynard Keynes 1) 1936 – published his General Theory of Employment, Interest, and Money 2) Alternative to classical theory 3) Explained periods of recession a. Not all income is always spent (contrary to Say’s law) b. Producers may respond to unsold inventories by reducing output instead of cutting prices. c. A recession or depression could follow this decline in employment and incomes

8. F. The Modern Aggregate Expenditures model is based on Keynesian economics 1) Saving and investment decisions may not be coordinated 2)Prices and wages are not very flexible downward 3) Therefore, internal market forces can cause depressions 4) Government should play an active role in stabilizing the economy.

9. II. Introduction to the Aggregate Expenditures Theory/Model A.“Aggregate” means total B. The theory assumes: 1) The level of output and employment depend directly on the level of aggregate expenditures 2)Changes in output reflect changes in aggregate spending

10. C. The Aggregate Expenditure model creates a simple model of the economy D. Uses the national income identity: GDP = C + I + G + NX • C = Consumption • I = Planned Investment (made by firms on capital goods, but it does not always occur) • G = Government Spending • NX = Net Exports

11. E. So what is it used for? • To describe the equilibrium between production and planned expenditures. • Investigates the way economic agents react when planned expenditures do not equal production. • If there are unexpectedly large changes in inventories, firms change their output levels • If inventories fall below target levels, firms increase production and hire more workers (unemployment falls) • If inventories rise above target, firms decrease production and lay off workers (unemployment rises)

12. F. Graphing AE • 45-degree line • It represents all points where Real GDP = Planned Aggregate Expenditure (goods produced = total spending) • Equilibrium is the intersection of the 45° line and the C + I + G + NX line. • Equilibrium does not have to be at full-employment real GDP.

13. III. Equilibrium and Disequilibrium • What if output is to the right of the Equilibrium point? • Firms experience a build-up of inventories. • Firms must produce less and lay off workers. B. What if output is to the left of the Equilibrium point? • Firms do not have inventory. • Respond by increasing production and employment

14. IV. Consumption • How do you calculate consumption? • Average Propensity to Consume = APC • APC = c/Y • Y stands for Income • Marginal (change in) Propensity to Consume = MPC • MPC = change in C/change in Y

15. B. Why must the sum of the MPC and the MPS equal 1? • MPS = change in saving/change in income • When your income changes, you have only 2 options: spend it or save it. • MPC is the fraction of the change in income spent • MPS is whatever is left, which is saved.

16. V. KEYNESIAN MULTIPLIER EFFECTS Let’s say you find a dollar in the street. You now have one dollar you did not have before. You now have an “income” of one dollar. What can you do with that dollar?? You can spend all of it, save all of it, or spend some of it and save some of it. You have options!

17. KEYNESIAN MULTIPLIER EFFECTS • Let’s assume you decide to spend the WHOLE dollar. Your spending of that dollar is an EXPENDITURE for you and INCOME for the person (entrepreneur) you traded with.

18. KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 (you bought “stuff”)

19. KEYNESIAN MULTIPLIER EFFECTS • Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had: Spend it or Save it.

20. KEYNESIAN MULTIPLIER EFFECTS Let’s assume the entrepreneur spends the WHOLE dollar at another business. This expenditure for the entrepreneur is now INCOME for another entrepreneur.

21. KEYNESIAN MULTIPLIER EFFECTS How much did GDP increase with this transaction? $1.00 Does this sound familiar??

22. KEYNESIAN MULTIPLIER EFFECTS This “found” dollar has now purchased $2.00 worth of goods and/or services. The original dollar appears to be cloning itself!!

23. KEYNESIAN MULTIPLIER EFFECTS If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? Unlikely…Why?

24. KEYNESIAN MULTIPLIER EFFECTS People have a TENDENCY TO SAVE some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.

25. KEYNESIAN MULTIPLIER EFFECTS The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive. Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.

26. KEYNESIAN MULTIPLIER EFFECTS • Example: If I get an additional dollar I may consume .90 and save .10. • My Marginal Propensity to Consume (MPC) that dollar is then: 90%. • My Marginal Propensity to Save (MPS) that dollar is then: 10%.

27. KEYNESIAN MULTIPLIER EFFECTS • Example: If I get an additional dollar I may consume .80 and save .20. • My Marginal Propensity to Consume (MPC) is then: 80%. • My Marginal Propensity to Save (MPS) is then: 20%.

28. KEYNESIAN MULTIPLIER EFFECTS Do you notice a pattern? MPC + MPS = 1.00 (or 100%)

29. KEYNESIAN MULTIPLIER EFFECTS • Let’s see how this works in practice. • Assume the Government wants to increase their spending by $10 billion dollars. Assume that the MPC in the economy is 90% and the MPS is 10% (remember these must equal 100%). What is going to be the effect on the GDP when we consider the Multiplier effect of EACH of those dollars?

30. KEYNESIAN MULTIPLIER EFFECTS • The Government initially spends $10 billion in the economy to purchase goods and services. Does the Government SAVE any of this money? NO. They spend the whole shebang! What is the immediate effect of this transaction on GDP? It INCREASES by $10 billion.

31. KEYNESIAN MULTIPLIER EFFECTS • What is now going to happen to that $10 billion now in the hands of people in the economy? Keynes says that people in general will spend 90% of it and save 10%. • So when people spend 90% of $10 billion, how much is GDP going to increase by? $9 billion.

32. KEYNESIAN MULTIPLIER EFFECTS • With these initial two transactions, how much has GDP increase by? $10B + 9B = 19B • Once again the original $10B has “magically” turned into $19B in GDP .

33. KEYNESIAN MULTIPLIER EFFECTS • Now when people who receive the $9B, they are going to spend 90%, or $8.1B and save 10%, or $900 Million. • GDP is now growing again! $10B + $9B + $8.1B = $27.1 Billion It does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

34. KEYNESIAN MULTIPLIER EFFECTS • Do you want to do all that math to arrive at how much GDP is going to increase in the end. I did not think so. • Keynes came up with a simple formula to do the math for you. Remember in the beginning it was GOVERNMENT that started this buying frenzy. This is very IMPORTANT to remember.

35. KEYNESIAN MULTIPLIER EFFECTS • The Keynesian Government Spending Multiplier is 1/MPS. • Let’s use the information we have already been given: The MPC is 90% and the MPS is 10%. • We can plug the appropriate number into the Government Spending Multiplier and come up with a useful number. • Govt. Spending Multiplier = 1/MPS = 1/10% = 1/.10 = 10

36. KEYNESIAN MULTIPLIER EFFECTS • Now this is AMAZING! According to KEYNES when government spends a dollar in the economy it is going to purchase a multiple of 10 times itself in GDP. • If Government increases spending by 10 Billion, then the eventual impact on GDP is going to be an increase of: $10 Billion X 10 = $100 Billion NOTE: This works in REVERSE as well. If Government DECREASES spending by $10 Billion, it will serve to DECREASE GDP by a multiple of 10!

37. KEYNESIAN MULTIPLIER EFFECTS SUBTLETY ALERT!! Notice in the VERY FIRST round of spending by the Government that NOTHING is SAVED. The economy has the benefit of the FULL impact of the $10Billion in new spending. In subsequent rounds of spending people are saving a portion of the money they receive, therefore REDUCING the impact on the economy. When we do the TAX CUT MULTIPLIER next, this distinction will be important. It forms the foundation of why Keynes suggested that in times of severe economic crisis it should be the role of Government to be “active” in the economy.

38. KEYNESIAN MULTIPLIER EFFECTS TAX CUT MULTIPLIER • Instead of Government changing its spending, they could change TAXESinstead.

39. KEYNESIAN MULTIPLIER EFFECTS • Assume in the economy the MPC and the MPS are still 90% and 10% respectively. • Assume the Government decides to REDUCE taxes by $10 Billion. This means that $10B is now in the hands of people and NOT in the hands of the Government. According to Keynes, what is the first thing that people in the economy are going to do with that new $10Billion?? They are going to Spend 90% and Save 10%!!

40. KEYNESIAN MULTIPLIER EFFECTS • When they spend 90% it is going to INCREASE GDP by $9Billion in the FIRST ROUND of Spending (how does that compare when in the previous example Government spent FIRST). • This transaction INCREASED GDP by $9B.

41. KEYNESIAN MULTIPLIER EFFECTS • The people who receive the $9B are going to SPEND 90%, or $8.1Billion and SAVE $900 Million. • This transaction will INCREASE GDP by $8.1Billion. GDP is now $9B + $8.1B = $17.1Billion.

42. KEYNESIAN MULTIPLIER EFFECTS • The people who receive the $8.1Billion are going to SPEND 90%, or $7.290 Billion and SAVE 10%, or $810 Million • This transaction will INCREASE GDP by $7.290 Billion. GDP is now $9B + $8.1B + 7.29B = 24.390Billion. • Once again, it does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

43. KEYNESIAN MULTIPLIER EFFECTS • Keynes came up with a simple formula to do the math for you. Remember in the beginning it was PEOPLE in the Economy that start this buying frenzy. This is very IMPORTANT to remember. The KEYNESIAN TAX CUT MULTIPLIER = -MPC/MPSor = -MPC/(1-MPC)

44. KEYNESIAN MULTIPLIER EFFECTS • Example: • We know the MPC is 90% and the MPS is 10%. • We can plug the appropriate number into the Tax Cut Multiplier and come up with a useful number. • Tax Cut Multiplier -MPC/MPS = 90%/10% = -.90/.10 = -9

45. KEYNESIAN MULTIPLIER EFFECTS • According to Keynes if the Government REDUCED TAXES (-) and you multiply by the TAX CUT MULTIPLIER, that is how much GDP will INCREASE. • In our example, the Government DECREASED taxes by 10Billion (-) and you multiply this by the tax cut multiplier of -9, then GDP will eventually INCREASE (two negatives make a positive) by $90Billion. • NOTE: This works in REVERSE. If Government INCREASE TAXES by $10Billion then this will serve to DECREASE GDP by a multiple of –9. (+10billion X -9 = -90Billion).

46. KEYNESIAN MULTIPLIER EFFECTS NOT SO “SUBTLE” ALERT!!! Do you notice the different effects of the Government Spending Multiplier and the Tax Cut Multiplier? The Government Spending Multiplier appears to ALWAYS come out ahead of the Tax Cut Multiplier in terms of how much GDP is eventually impacted. THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!! According to Keynes, INCREASED Government spending “outperforms” DECREASES in Taxes to stimulate (“prime the pump”) the economy.

47. KEYNESIAN MULTIPLIER EFFECTS • Let’s put these Keynesian Multipliers together and see how it all washes out • Assume the Government wants to do the right thing when they INCREASE Government spending they ALSO INCREASE Taxes to pay for it, so they won’t have to borrow to pay for the spending. Novel idea, I know, but it could happen…

48. KEYNESIAN MULTIPLIER EFFECTS • Assume Government wants to INCREASE spending by $20 Billion and the MPC is 80% and the MPS is 20%. If they don’t want to create a budget deficit they must INCREASE Taxes by $20 Billion to pay for the new spending. • What is going to be the NET EFFECT of this action on the Economy?

49. KEYNESIAN MULTIPLIER EFFECTS • Calculate the Government Spending Multiplier (1/MPS = 1/20% = 1/.20 = 5) • If government spending INCREASES by $20B and the multiplier is 5 then, GDP is going to INCREASE by $100B ($20B X 5 = $100B).

50. KEYNESIAN MULTIPLIER EFFECTS • This is only half the story…Now we have to take $20B OUT of the Economy in TAXES to pay for the new spending. • Calculate the TAX CUT MULTIPLIER (-MPC/MPS = -80%/20%=-.80/.20 = -4) • If TAXES are INCREASED by $20B and the tax cut multiplier is -4 then GDP is going to DECREASE by $80B ( +20B X -4 = -80B) • The multiplier effect is working in REVERSE to DECREASE GDP by a multiple of 4!