UNIT 3: Consumption and Savings

                                                             Consumption and savings

Disposable income (DI)

•     Income after taxes or net income
•        DI = Gross Income - Taxes

                                  2 choices

With disposable income, households can either

-          Consume (spend money on goods and services)

-          Save (not spend money on goods and services)

                                Consumption

-          House hold spending

-          The ability to consumme is constrained by

·         The amount of disposable income

·         The propensity to save

-          Do households consume if DI = 0

·         Autonomous consumption

·         Dissaving.

                                                           Saving

·         Household not spending

·         The ability to save is constrained by

-          The amount of disposable income

-          The propensity to consume

·         Do househols save if DI =0?

-          No

                                   APC and APS

·         APC + APS = 1

·         1 – APC = APS

·         1 – APS = APC

·         APC > 1 : Dissaving

·         - APS : Dissaving

                            Marginal Propensity to consume (MPC)

·         The fraction of any change in disposable income that is consumed.

·         MPC = change in consumption divided by change in disposable income

                             Marginal propensity to save (MPS)

·         The fraction of any change in disposable income that is saved.

·         MPS = change in savings divided by change in disposable income.

                                Marginal Propensities

MPC + MPS = 1

MPC = 1 – MPS

MPS = 1 – MPC

·         Remember, people do two things with their disposable income. They consume it or save it.

                                           The spending multiplier effects

·         An initial change in spending  (C, IG, G, Xn) Causes a larger change in Aggregate Spending (AS), or Aggregate Demand (AD).

·         Multiplier = change in AD divided by change in spending.

                                        Calculating the spending multiplier

·         The spending multiplier can be calculated the MPC or the MPS

·         Multiplier = 1 divided by 1-MPC or 1 divided by MPS

·         Multipliers are (+) when there is an increase in spending and (-) when there is a decrease.

                                   Calculating the Tax multiplier

·         When the government taxes, the multiplier works in reverse.

-          Why?

-          Because now money is leaving the circular flow

·         Tax multiplier (note: its negative)

·         -MPC divided by 1-MPC or –MPC divided by MPS

·         If there is a tax cut, then the multiplier is positive, because there is now more money in the circular flow.

UNIT 3: Interest rates and Interest Demand

                                                Interest Rates and Interest Demand

  What is investment?

·         Money spent or expenditures on:

-          New exports (factories)

-          Capital equipment (machinery)

-          Technology (hardware and software)

-          New homes

-          Inventories (goods sold by producers)

Expected rates of return

·         How does a business make investment decisions?

-          Cost/benefit analysis

·         How does business determine the benefits?

-          Expected rate of return.

·         How does business count the cost?

-          Interest costs.

·         How does business determine the amount of investment they undertake?

-          Compare expected rate of return to interest cost.

·         If expected return >interest cost, then invest

·         If expected return < interest cost, then do not invest.

                                              Real (r%) v. nominal (i%)

-          Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.

-          How do you compute the real interest rate (r%) ?

               r% = i% - π% (π means inflation)

-          What then, determines the cost of an investment decision?

·         The real interest rate (r%)

        Investment demand curve (ID)

ØWhat is the shape of the investment curve?

-          Downward sloping.

Ø  Why?

-          When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

                        Shifts in investment demand (ID)

·         Cost of production

-          Lower cost shifts ID to the right.

-          Higher costs shifts ID to the left.

·         Business Taxes

-          Lower business taxes shifts ID to the right

-          Higher business taxes shifts ID to the left

Technological change

-          New technology shifts ID to the right.

-          Lack of technological change shifts ID to the left.

Stock of capital

-          If economy is low on capital, then ID shifts to the right.

-          If an economy has much capital, then ID shifts to the left.

Expectations

-          Positive expectations shifts ID to the right

-          Negative expectations shifts ID to the left

                      Difference between classical and Keynesian

                                                   Classical

·         Competition is good.

·         The invisible hand (means market will fix itself no government needed).

·         In the long run the economy will balance at full employment

·         Trickledown effect (help the rich first and everybody else second).

·         The economy is always close to or at full employment.

                        

                                          Keynesian

·         Competition is fraud.

·         AD is the key not AS.

·         Lits and savings cause recessions.

·         Ratchets effects and sticky wages blocked says law.

·         In the long run we are all dead.

   

UNIT 3: Aggregate Supply (Long run and Short run)

                                                         Aggregate Supply

             The level of real GDP (GDPr) that firms will produce at each price level (PL)

                                                        Long run v. Short run

-Long run:

ü  Period of time where input prices are completely flexible and adjust to changes in the price level.

ü  In the long run, the level of real GDP supplied is independent of the price level.

-Short run:

ü  Period of time where input prices are sticky and do not adjust to changes in price level.

ü  In the short run, the level of real GDP supplied is directly related to the price level (PL).

                         Long run Aggregate Supply (LRAS)

·         The long run aggregate supply or LRAS marks the level of full employment in the economy (analogous to ppc).

·         Because input prices are completely flexible in the long run, changes in price level do not change firm’s real profits and therefore do not change firm’s level of output. This means that LRAS at the economy’s level of full employment.

                                         Changes in short run aggregate supply (SRAS)

·         An increase in SRAS is seen as a shift to the right. SRAS >

·         A decrease in SRAS is seen as a shift to the left SRAS <

·         The key to understanding shifts in SRAS is per unit cost of production.

Per unit production cost = total input cost divided by total output.

                             Determinants of SRAS

                      All affects unit production cost.

Ø  Input prices.

Ø  Productivity.

Ø  Legal-institutional environment.

            Input prices

·         Domestic resource prices.

-wages (75% of all business costs)

-cost of capital.

-raw materials (commodity prices)

·         Foreign resource prices

·         Market power

·         Increases in resource prices = SRAS shift to the <

·         Decrease in resource prices = SRAS shift to the >

                                                 Productivity

§  Productivity = total output divided by total inputs.

§  More productivity = lower unit production cost = SRAS shifting >

§  Lower productivity = higher unit production cost = SRAS shifting <

                                               Legal institutional environment

o   Taxes and subsidies.

-          Taxes ($ to gov’t) on business increase per unit production cost = SRAS shifting <

-Subsidies ($ from gov’t) to business reduce per unit production cost = SRAS shifting >

o   Government Regulation.

-          Government regulation creates a cost of compliance = SRAS shifting <

-          Deregulation reduces compliances costs = SRAS shifting >

                                                            Full Employment

 Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

                                                             Recessionary gap

A recessionary gap exists when equilibrium occurs below full employment output

                                                             Inflationary gap

An inflationary gap exist when equilibrium occurs beyond full employment output

                                                                  Nominal wages

                          The amount of money received by a worker per unit of time.

                                                                       Real wages

            It is the amount of goods and services a worker can purchase with their nominal wage. It is the purchasing power of your nominal wage.

                                                                      Sticky wages

It is the nominal wage level that is set according to an initial price level and does not vary due to labor contracts and other restrictions.

                                                                        

UNIT 3: Aggregate Demand Curve.

                                                        Aggregate Demand Curve

Aggregate Demand is the demand by consumers, businesses, government and foreign countries.
             what definitely doesn't shift the curve?
       changes in price level causes a move along the curve.

         Three reasons why Aggregate demand is down ward slopping:
•Real balance effect--- shift to the left
      -higher price levels reduce the purchasing power of money.
       -this decreases the quantity of expenditures.
        -lower price levels increase purchasing power and increase expenditures.
   Example: if the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.

•Interest rate effect
       -when the price level increases, lenders need to charge higher interest rates to get a real return on their loans.
      -higher interest rates discourage consumer spending and business investment . Why?
•foreign trade effect
     -when US price level rises, foreign buyers purchase fewer US goods and Americans buy more foreign goods.
      -exports fall and import rises causing real GDP demanded to fall.(Xn decreases).
             Shifters of aggregate demand
GDP= C+I+G+Xn

Shifts in aggregate demand (AD)
•there are two parts to a shift in AD:
    -a change in C,IG,G and/or Xn
     -a multiplier effect that produces a greater change than the original change in the 4 components.
•increases in AD = AD >shifting to the right.
•decrease in AD = AD < shifting left.

increase in AD

decrease in AD

                                                         Consumption
  -consumer wealth
       •more wealth= more spending (AD shift right >)
        •less wealth= less spending (AD shifts left <)
  -consumer expectations
          •positive expectations = more spending (AD shifts right>)
          •negative expectations = less spending (AD shifts left <)
  -household indebtness
          •less debt = more spending (AD shifts right >)
           •more debt = less spending (AD shifts<)
  -Taxes
            •less Taxes = more spending (AD shifts right >)
            •more taxes= less spending (AD shifts left <)

                                         Gross Private investment
        •       Investment spending is sensitive to:           

                    -the real interest rate.
        •       Lower real interest rate= more investment (AD shifts right)
        •       Higher real interest rate = less investment (AD shifts left).   

                     - Expected returns.
        •       Higher expected returns =  more investment (AD shifts right)
        •       Lower expected returns (AD shifts left)
        •       Expected returns are influenced by:     

               -expectations of future profitability.   

               -technology.                                             

               -degree of excess capacity (existing stock of capital).                                 

                -business taxes.                                 

                                           Government spending
        •       More Government spending (AD shifts right)
        •       Less government spending (AD shifts left).                                                         

                                               
                                                    Net exports

Net exports are sensitive to:
  -Exchange rates ( international value of $)
      Strong $ = more imports and fewer exports (AD shifts left)
      Weak $ = fewer imports and more exports = (AD shifts right)
-Relative income
        Strong foreign economies = more exports = (AD shifts right).
Weak foreign Economies = less expensive = (AD shifts left)