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M E = 4 460 500 460 500 AE(C+Ig 1 ) AE(C+Ig) AE(C+Ig 2 ) S Y R Y * Y R Y * 10 Ig 390 470 550 630 390 470 550 630 Real GDP 0 AE 3 (C+Ig+G+Xn) ( Complex Economy) [ Mixed-open ] AE 2 (C+Ig+Xn) (Private-open) [X(40)-M(20)] AE 1( C+Ig )[Basic Economy][Private(no G)-Closed(no X or M)] Consumption +80 +80 +80 C =390 ( AE 1 )470 ( AE 2 )550 ( AE 3 )630 +20 Xn +20 G +20 Ig S Real GDP Building Private-open Mixed - open …added foreign trade Added gov spending [ Simple [ Basic ] economy to Complex economy] [C+Ig+G+Xn] [C + Ig] [C + Ig + Xn] Private - closed

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AE [ C + Ig ] AE [ C + Ig ] (billions of dollars) o 45 o C onsumption C + I g I g = $20 Billion Equilibrium 390470 370 390 410 430 450 470 490 510 530 550 Building the Model AE[C+Ig] [ Basic or Simple economy] C =$450 Billion $530 510 490470 450 430 410 390 370 + 20 Ig +80 S GDP will increase by a multiple of 4 & that is why it is called the multiplier. Real GDP M ultiplier = 4 Private - Closed

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Change in QC ( or QS) [Income change, movement from point to point] Consumption Saving o o 45oConsumption S C1C1C1C1 S DI 2 Disposable Income S AVING DISSAVING [Negative saving] DISSAVING So, the key to a change in QC ( QS ) is a change in ? Breakeven DI1DI1DI1DI1 DI3DI3DI3DI3 C2C2C2C2 S (Disposable Income)

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NON-INCOME DETERMINANTS [Shifters] OF CONSUMPTION AND SAVING NON-INCOME DETERMINANTS [Shifters] OF CONSUMPTION AND SAVING Wealth Increase or decrease in wealth Increase or decrease in wealth Increase/decrease in PL Taxation increases/decreases Taxation increases/decreases Consumer Expectations Consumer Expectations [about future availability, income, & prices] Household Debt

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Consumption Saving o o 45 o C1C1C1C1 S1S1S1S1 Disposable Income C2C2C2C2 S2S2S2S2 Increase in Consumption (Decrease in Saving) [shift/whole curve/non-income] Increases in consumptionmeans… Decrease in saving May be caused by : Increase in wealth Decrease in PL Expect. PL incr. Expect. of positive Y Expect. of shortages Decrease in debt *Decrease in taxes increases both C & S Ill buy more and save even more.

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Consumption Saving o o 45 o C1C1C1C1 S0S0S0S0 Disposable Income C2C2C2C2 S2S2S2S2 Decrease in Consumption (Increase in Saving) [shift/whole curve/non-income [shift/whole curve/non-income] Decreases in consumptionmeans… Increase in saving May be caused by : Decrease in wealth Increase in PL Expect. PL decrease Expect. neg. future Y Increase in debt *Increase in taxes decreases both C & S

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.80.85.90.951.0.986.976.972.940.907.873.869.842 Canada United States Netherlands United Kingdom GermanyItalyJapanFrance GLOBAL PERSPECTIVE Average Propensities to Consume [C/Y], Selected Nations, 2000

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NominalInterestRate RealInterestRate InflationPremium - 8%8%8%8% 6%6%6%6% 2%2%2%2% [Nominal I.R. – inflation rate = Real I.R.] = - =

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Marginal Efficiency of Investment [MEI] [If expected returns equal or exceed the real interest rate of interest, the firm will normally make the investment.] 30%25% 20 % 15%10%5% [ QID ] Quantity of Investment Demanded (millions) 0 1 2 3 4 5 6 MEI = 27% Renovate plant $2 million MEI=20% Add new wing to factory $1 mil. MEI=15% Purchasemachines $1.5 mil. MEI=12% Acquireadditionalpowerfacilities MEI = 7% Install computer system $1 mil. [ One firms demand curve for investment] Real Interest Rate

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[A 20% cost of funds attract $100 billion of investment25% 15%10% Change in QID [interest rate change, point to point movements] QID 1 QID 2 I.R. QID 100 200 A 5% cost of funds attracts $200 bil. Ig 050 150 250[MEI] D I (MEI) Firms invest with their profits & also borrow(5%) to invest.(10%) Real Interest Rates 20% 5%

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Positive profit expectationsreal interest rate Positive profit expectations and the real interest rate are the most important determinants of investment. Drill Press - $1,000 Drill Press - $1,000 Expected gross profits$1,10010% return A. Expected gross profits = $1,100 or a 10% return. [$100/$1,000 x 100 = 10%] 8 % invest12 % dont invest [At 8 %, invest ; at 12 %, dont invest ] Real interest rate B. Real interest rate [ nominal interest rate-inflation ] Single Firm

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Investment (billions) Expected rate of return, r, and interest rate, i (percents) 16 14 12 10 8 % 6 4 % 2 0 15 202530 110 15 20 25 30 35 40 QID Change in Quantity of Investment Demanded [QID] (Interest rate change, point to point movement) DIDIDIDI Firms will undertake all investments [additions to plant, equipment, inventory, and residential construction] and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest. Monetary Policy Monetary Policy – by lowering interest rates, the Fed can increase Ig & employment. [Inverse r elationship b etween real interest r ate and Q I D] QID

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CHANGE [Shift] IN INVESTMENT [ curve] 8% QID 1 I1I1I1I1 I2I2I2I2 QID 2 Increase in Investment 1.Positive profit expectations 2.Scarcity of inventory 3.Technology [innovation] 4.Decrease in production costs 5.Decrease in business taxes

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INVESTMENT DEMAND & SCHEDULE Expected rate of return, r, and real interest rate, i (percents) Investment (billions of dollars) Investment (billions of dollars) 20 8 20 Real Domestic Product, GDP (billions of dollars) DIDIDIDI IgIg Investment Demand Curve InvestmentSchedule Ig independent of Y 20 20 Y1 Y2 Y3 In constructing the AE graph, I g will be independent [not influenced] by income. Investment decisions are made months ahead. 20

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most important determinant of consumer spending 1. The most important determinant of consumer spending is (wealth/indebtedness/income). aggregate income increasesconsumption and saving 2. As aggregate income increases, consumption and saving both (increase/decrease). 3. The (consumption/saving) schedule shows how much plan to consume households plan to consume at various income levels. Dissaving 4. Dissaving occurs where consumption (exceeds/is less than) Y. consumption schedule shifts upward 5. If the consumption schedule shifts upward [not caused by saving schedule a tax change], the saving schedule will shift (upward/downward). 6. ( The expectation of a recession /A change in consumer incomes / not cause the An expected change in the price level) will not cause the consumption curve to shift consumption curve to shift. Closed and private [C+ I g] Simple Economy Open & private [C+ I g+Xn] Open & mixed [C+ I g+G+Xn] Complex E conomy Open & mixed [C+ I g+G+Xn] Complex E conomy C+ I g A ssumptions : N o internat. trade or G ; no business saving; depreciation & NFFIEUS are 0; PL is constant [Keynesian] [GDP = D I ] Closed

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APC=C/Y APC = C/Y(DI)=$48,000/$50,000 =.96 APC = C/Y(DI)=$48,000/$50,000 =.96 APS = S/Y(DI)= $2,000/$50,000 =.04 APS = S/Y(DI)= $2,000/$50,000 =.04 1 APC = C/Y=$52,000/$50,000 = 1.04 APC = C/Y=$52,000/$50,000 = 1.04 APS = S/Y= -$2,000/$50,000 = -.04 APS = S/Y= -$2,000/$50,000 = -.04 1 APC - percentage of income (Y) consumed. APC - percentage of income (Y) consumed. AE=GDP High maintenance Econ teacher APS – percentage of income (Y) saved. APS – percentage of income (Y) saved. Econ,Econ,APS=S/Y APC and AP S ?

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MPC, MPS, & the M ultiplier MPC, MPS, & the M ultiplier * The M E is the reciprocal of the MPS. M The M works like a concentric circle. MPC - % change in Y consumed. MPS - % change in Y saved. MPC = C/ Y = $750/$1,000 =.75 MPS = S/ Y = $250/$1,000 =.25 M ultiplier [1/MPS] =1/.25=$1/.25 = M of 4 [MPC is important for G in policy making decisions.] M E =1/MPS

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The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $ 200 billion on the highways. The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $ 200 billion on the highways. Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 bil. [$37.50 bil.] & spend 75% or $112.50 bil. on iPod Video s, etc.

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AE[C+Ig+G] AE[C+Ig+G] (billions ) o 45 oAE[C+Ig] AE [C+Ig+G] G = $15 Billion Equilibrium Incr G $15 800 860 YrY* Yr Y* M E = 1/MPS, 1/.25 = $1/.25 = M E of 4 M E is 4 & we are short of Y*[$860] by $60 billion Recess. Spending gap Recessionary GDP Gap Real GDP M = Y/ E = 60/15 = 4 Recess. Gap +60

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Now, lets look at the T ax M ultiplier [ M T] M T = MPC/MPS,.75/.25 = M E of 3 M T is 3 & we are short of Y*[$860] by $60 billion With this situation, [short of Y* by $60 bil.], we would need to decrease taxes by $20 billion, with a multiplier of 3. $ 60 billion GDP gap 3 x ? will close a $ 60 billion GDP gap?

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AE[C+Ig+G] AE[C+Ig+G] (billions ) o 45 oAE[C+Ig] AE [C+Ig+G] Equilibrium Decr T $20 800 860 YrY* Yr Y* M T = MPC/MPS,.75/.25 = M T of 3 M T is 3 & we are short of Y*[$860] by $60 billion Recess. Spending gap Recessionary GDP Gap Real GDP Recess. Gap +60

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G AE[C+Ig+G] (billions of dollars) o 45 o C+Ig AE[C+Ig] C+Ig+G AE [C+Ig+G] G = $30 Billion Equilibrium + 30 G 860 Y* Y* M E = 1/MPS, 1/.50 = $1/.50 = M E of 2 M E is 2 & we are short of Y*[$860] by $60 billion R ecess. Spending gap Real GDP Recess. Gap +60 MYE60/302M = Y/ E = 60/30 = 2 Recessionary GDP Gap 800 Y R

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G AE[C+Ig+G] (billions of dollars) o 45 oAE[C+Ig] C+Ig+G AE [C+Ig+G] Equilibrium Decr. T by $60 860 Y* Y* M T = MPC/MPS,.50/.50 = M T of 1 M T is 1 & we are short of Y*[$860] by $60 billion R ecess. Spending gap Real GDP Recess. Gap +60 Recessionary GDP Gap 800 Y R Now, let s look at correcting this $60 billion recessionary gap with a tax cut. MPS=.5

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G AE[C+Ig+G] (billions of dollars) o 45 o AEC+Ig- G AE[C+Ig- G ] Equilibrium 840 880 840 880 Y* Y I Y* Y I M E = 1/MPS, 1/.50 = $1/.50 = M E of 2 M E is 2 & we are beyond Y*[$840] by $40 billion Inflationary Spending gap=$20 B Inflationary GDP Gap Real GDP AE C+Ig+G AE [C+Ig+G] Inflat. Gap -40 2 x -? = -40 -20 G

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G AE[C+Ig+G] (billions of dollars) o 45 o AE C+Ig+G AE[ C+Ig+G ] Equilibrium 840 880 840 880 Y* Y I Y* Y I M T = MPC/MPS,.50/.50 = M T of 1 M T is 1 & we are beyond Y*[$840] by $40 billion Inflationary GDP Gap Real GDP AE C+Ig+G AE [C+Ig+G] Inflat. Gap -40 1 x -? = -40 Incr T $40 Now, with a M T of 1, we would need a tax increase of how much to close the $40 bil. inflationary gap? $40 billion tax increase

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MPC 1/MPS = M E.901/.10= 10.801/.20= 5.751/.25= 4.601/.40= 2.5.501/.50= 2 M E [Change in G, Ig, or Xn] = 1/MPS

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MPC MPC/MPS = M T.90MPC/.10= 9.80MPC/.20= 4.75 MPC/.25= 3.60 MPC/.40= 1.5.50 MPC/.50= 1 M T [Change in Taxes] = MPC/MPS When the G gives a tax cut, the M T is smaller than the M E because a fraction [ MPS ] is saved and only the MPC is initially spent. So, the M T = MPC/MPS.

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start at $500 equilibrium GDP 1.We will start at $500 equilibrium GDP on each. three items 2.Of the three items (equilibrium GDP, change given in expenditures, and MPC), you will be given two figure two and if you know two you can always figure out the 3 rd out the 3 rd. For instance if you knew that equilibrium GDP increased by $400 and the multiplier was 4, then the change in expenditures was obviously $100. 6, 9, 15, & 18increase 3.Except for 6, 9, 15, & 18, you will increase equilibrium GDPabove $500 equilibrium GDP above $500, because there increase in G, or a decrease in T, or is an increase in G, or a decrease in T, or an equal increase in G&T. an equal increase in G&T. Ex: With MPC of.75 & therefore a M E of 4, Ex: With MPC of.75 & therefore a M E of 4, an increase in G of $20 means $20 x 4 = $580 an increase in G of $20 means $20 x 4 = $580 6, 9, 15, & 18decrease equilibrium 4. On questions 6, 9, 15, & 18, you will decrease equilibrium GDP below $500decreasing G, GDP below $500 because you are either decreasing G, increasing T, or there is an equal decrease in G & T. increasing T, or there is an equal decrease in G & T. Ex: With MPC of.75 & therefore a M E of 4, a decrease Ex: With MPC of.75 & therefore a M E of 4, a decrease in G of $20 means -$20 x 4 = $420. in G of $20 means -$20 x 4 = $420. INSTRUCTIONS FOR THE NEXT FOUR AE SLIDES AE E1 E3 E2 AE2AE1AE3 500 R ecessionary spending gap Inflationary spending gap R ecessionary GDP gap I nflationary GDP gap

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$10 M E __ M T ___ M BB ___ $ 100 Y with M E ___Y with M T ___Y with M T ___Y with M BB ___Y with M BB 1 90 10.9 ? 10 1 9 $ 200 Y with M E _____Y with M T _____Y with M BB 150 50 ____ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB 12 48 60 $12 $50 $20 Change in Expenditures MPC [So MPS & M E, M T, & M BB ] Chg in Equilibrium GDP The Multiplier & Equilibrium GDP $500 M E M T M BB [Give the correct equilibrium GDP [start from $500] using the M E, M T, M BB]$500 AE1AE2AE3 E2E2E2E2 E1E1E1E1 E3E3E3E3 Recessionary Spending gap Inflationary AE M E =1/MPS [chg in G, Xg, or Xn] M BB = 1 [G&T ] M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___.75.80.50 1 3 4 1 5 4 2 1 1 M T = MPC/MPS [Chg in T ] [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ M E s M E s[G,Ig,Xn] MPC M.90 = 10.87.5= 8.80 = 5.75 = 4.60 =2.5.50 = 2 540 520 520 40 20 20 M T s MPC M.90 = 9.87.5= 7.80 = 4.75 = 3.60 =1.5.50 = 1 700 650 550 512 548 560 600 510 590 S 32

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ [-G] 1. M E =___ [+T] 2. M T =___ [-G&T]3.M BB =___ 2.5 1.5 1 50 30 20 2 1 1 50 50 8 7 1 5 4 1 75 60 15 4 3 1 300 100 10 9 1 -200 300 -180 320 -20 480 $100 $50 [-G] 1. M E = ___ [+T] 2. M T =___ [-G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 550 530 520 600 550 550 460 495 465 575 560 515 900 800 600 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB -40 -35 -5 100 $15 -$20 -$5 $20 400 ___ Y with M E ____Y with M T ____Y with M BB 4 5 6 7 8 9.60.50 87.5.80.75.9 Here are a few helpers… try the rest on your own

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ [-G] 1. M E =___ [+T] 2. M T =___ [-G&T]3.M BB =___ 2.5 1.5 1 50 30 20 2 1 1 50 50 8 7 1 5 4 1 75 60 15 4 3 1 300 100 10 9 1 -200 300 -180 320 -20 480 $100 $50 [-G] 1. M E = ___ [+T] 2. M T =___ [-G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 550 530 520 600 550 550 460 495 465 575 560 515 900 800 600 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB -40 -35 -5 100 $15 -$20 -$5 $20 400 ___ Y with M E ____Y with M T ____Y with M BB 4 5 6 7 8 9.60.50 87.5.80.75.9

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ [-G] 1. M E =___ [+T] 2. M T =___ [-G&T]3.M BB =___ 2.5 1.5 1 125 75 50 20 19 1 38 2 5 4 1 4 3 1 60 45 15 2 1 1 100 100 8 7 1 -80 420 -70 430 -10 490 $100 $2 [+G] 1. M E = ___ [-T] 2. M T =___ [+G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 512.5 507.5 505 540 538 502 550 510 540 560 545 515 700 600 600 ___ Y with M E ____Y with M T ____Y with M BB 50 40 10 40 $15 -$10 $10 $5 200 10 11 12 13 14 15 __._ Y with M E _.___Y with M T __ with M BB.60.95 ? ? ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB.75.50 87.5 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB Here are a few helpers… try the rest on your own

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ [-G] 1. M E =___ [+T] 2. M T =___ [-G&T]3.M BB =___ 2.5 1.5 1 125 75 50 20 19 1 38 2 5 4 1 4 3 1 60 45 15 2 1 1 100 100 8 7 1 -80 420 -70 430 -10 490 $100 $2 [+G] 1. M E = ___ [-T] 2. M T =___ [+G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 512.5 507.5 505 540 538 502 550 510 540 560 545 515 700 600 600 ___ Y with M E ____Y with M T ____Y with M BB 50 40 10 40 $15 -$10 $10 $5 200 10 11 12 13 14 15 __._ Y with M E _.___Y with M T __ with M BB.60.95 ? ? ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB.75.50 87.5 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ 5 4 1 4 3 1 10 9 1 $8 [-G] 1. M E = ___ [+T] 2. M T =___ [-G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 625 600 525 532 524 508 400 490 410 ___ Y with M E ____Y with M T ____Y with M BB -$10 $25 16 17 18.80.75.9 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB 25 100 125 32 24 8 -100 -90 -10

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M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ M E __ M T ___ M BB ___ 5 4 1 4 3 1 10 9 1 $8 [-G] 1. M E = ___ [+T] 2. M T =___ [-G&T]3.M BB =___ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ [+G] 1. M E = ____ [-T] 2. M T = ____ [+G&T] 3. M BB =____ 625 600 525 532 524 508 400 490 410 ___ Y with M E ____Y with M T ____Y with M BB -$10 $25 16 17 18.80.75.9 ___ Y with M E ____Y with M T ____Y with M BB ___ Y with M E ____Y with M T ____Y with M BB 25 100 125 32 24 8 -100 -90 -10

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