Section 4 Lecture November 2016 Mr. Gammie AP Macroeconomics Section 4 Lecture November 2016 Mr. Gammie

Module 16: Income and Expenditure

What exactly is a bubble? What is a housing bubble?

How can a housing bubble, or a real estate market like that seen in Vancouver, lead to economic growth throughout the entire province?

How does a bubble burst?

15% 12% for Canada Usa 6% India 8% Diversification = good

Marginal Propensity to Consume Consumption GDP = C+I+G+(X-M) Disposable Income (Yd) is …. Disposable Income (Yd) can be used in two ways… Yd = + Consumption accounts for 2/3s of total spending in an economy Disposable income is what is left over after gov’t taxes (+ t payments) Consumption or saving Yd = C + S

What happens when your income goes up? Consumption increases, but so does saving

Marginal Propensity to Consume MPC = Δ consumption/ Δ disposable income The marginal propensity to consume is the amount by which consumer spending increases if disposable income increases by $1. Rises or falls

Marginal Propensity to Save MPS = Δ saving/ Δ disposable income What is the MPS statement? The marginal propensity to save is the amount by which consumer saving increases if disposable income increases by $1. The marginal propensity to save is the amount by which consumer saving increases if disposable income increases by $1.

MPC + MPS = ? 1

Consumption Function Yd C S MPC MPS 5,000 -5,000 10,000 13,000 -3,000 5,000 -5,000 10,000 13,000 -3,000 0.8 0.2 20,000 21,000 -1,000 30,000 29,000 1,000 40,000 37,000 3,000 This is a hypothetical consumption function for a household. When income = 0, some consumption still occurs due to borrowing. The $5,000 at 0 income is referred to as autonomous consumption. When income increases by $10,000, consumption increases by 8 and savings by 2. Therefore MPC = 8/10 = 0.8, MPS = 0.2 If a household receives 1 additonal dollar of income, they will consume 80 cents and save 20. We can create a consumption function with this information.

Consumption Function C = a + MPC x Yd The consumption function is an equation that represents how a household’s spending varies with disposable income. a, represents autonomous spending, the y intercept MPC is the slope C = 5 + 0.8*yD C = a + MPC x Yd

What happens when disposable income increases to 20? Consumption Function Movement along the curve C = 5+0.8*20 = 21 What happens when disposable income increases to 20?

What would cause the consumption function to shift? Shift up and down Different from demand and supply What would cause the consumption function to shift?

Shifts in the Consumption Function 1. Changes in Expected Future Disposable Income 2. Changes in Aggregate Wealth Changes in expected future income – imagine you knew that when you turned 25, your parents were going to give you $1,000,000. How might that affect your spending today? Changes in aggregate wealth – stock market real estate, etc.

Accumulated wealth in vancouver, housing bubble, causes people to increase consumption, based on their “net worth”

Question Most recessions originate from which of the following events: A fall in consumer spending A fall in government spending A fall in investment spending A fall in the stock market c

Investment Spending Key driver of the business cycle What would lead a business to increase investment spending? Interest rate changes Expected future economic growth Production capacity

Investment Spending Spend money to make money Investment decisions are based on cost-benefit analysis. What role do interest rates play in the cost of investing? Market interest rate really = the cost of investment How much will we spend compared to how much do we expect to make.

Interest Rates Example: A firm decides to build a new factory. This will increase sales, but also require borrowing to finance the investment. Expected return on investment = (total revenue – total cost) total cost Investment = 450 10% interest Interest cost = $45 Expected revenue = 1000 1000-495/495 = 102% - might you invest? Yes Interest rate goes up to 13% Interest cost = 58.5 1000-508.5/508.5 = .966 *100 =97% Would you invest? No

Compound Interest Mortgages http://cgi.scotiabank.com/mortgage/payment/en/payment.html

Interest Rates Interest Rate = cost of investment Interest Rate is the cost of borrowed funds It is also the cost of investing your own funds (forgone income) Ownership vs. renting

Interest Rates and Investment Spending Investment decisions will only go ahead if firms expect to make more money than they would have to pay to borrow the funds to finance it. Interest rate increase? Fewer projects will pass that test. Higher interest rates make it more expensive to borrow money.

Interest Rates There is a negative relationship between interest rates and investment spending.

Expected Future Real GDP Your firm has expectations that the economy for widgets is going to take off next year due to an increase in income levels around the world. What would you do today?

Production Capacity Your firm has a factory that can produce 100,000 widgets. Currently, we have a customer base that required 50,000 widgets. If we expect real GDP to take off will we engage in investment purchases? The best conditions for investment to occur are when real GDP is expected to grow and production capacity is close to maximum.

Can investment be negative? Inventory

I = I unplanned + I planned Inventories Why do firms hold inventories? What would lead to an unplanned increase in inventory investment? What would lead to an unplanned decrease in inventory investment? I = I unplanned + I planned To satisfy future orders. Decrease in consumer spending. Increase in consumer spending. Actual investment spending = planned investment spending + unplanned inventory investment

Module 16 Summary An increase in spending multiplies throughout the economy as that spending becomes another person’s income, part of which is spent, which becomes part of another person’s income, part of which is spent…. Etc. The marginal propensity to consume: MPC = Δ consumption/ Δ disposable income The MPC is the amount by which consumer spending rises if current disposable income rises by $1. The MPC = the slope of the consumption function. The marginal propensity to save: MPS = Δ saving/ Δ disposable income MPC + MPS = 1 The spending multiplier = 1/(1-MPC) = 1/MPS If aggregate autonomous spending changes by (Δ AAS) dollars, the multiplier effect will change real GDP (Y) by a greater amount: ΔY = M x AAS Investment spending is negatively related to the interest rate. Autonomous changes in investment spending have the same multiplying impact on real GDP as changes in autonomous consumption.

Module 17: Aggregate Demand

Aggregate Demand 1933 7.9 5.0 $716 950 Aggregate price level (GDP deflator, 2005 = 100) A movement down the AD curve leads to a lower aggregate price level and higher aggregate output. 1933 7.9 5.0 Aggregate demand curve, AD $716 950 Real GDP (billions of 2005 dollars)

NOT THE LAW OF DEMAND The demand curve for any one good shows the quantity demanded at given prices holding ALL OTHER PRICES EQUAL

So why is it downward sloping?

Wealth Effect As the price level increases, the purchasing power of you money decreases. Therefore you will buy fewer goods than you would if the price level remained constant. If you had $5000, and the price level rose 25%, you would only be able to buy the equivalent of $4000 worth of goods. Changes C

Interest Rate Effect As the price level increases, people and firms need to hold more money, which reduces the amount of money available for lending. A lower supply of money available to lend will drive interest rates up, which reduces investment spending because it is now more expensive to make investment purchases.

SHIFTS

Expecting a recession

Real estate boom, housing prices double

physical capital stocks low

Gov’t policies

New schools

Cut taxes

Money supply increase = shift right Increase in money supply = more money to lend, interest rate down, higher investment spending at any level

Module 17 Summary The aggregate demand curve illustrates the relationship between the aggregate price level and quantity of aggregate output demanded in an economy. Aggregate demand slopes downward like other demand curves, but for different reasons. All else equal, an increase in the aggregate price level will cause real spending to decrease. This will be a movement along the AD curve. The wealth effect and the interest rate effect explain the aggregate demand curve’s negative slope. Because GDP = C+I+G+(X-IM) anything that increases once of these components will cause the AD curve to shift. Several factors shift the demand curve: expectations, wealth, capital stocks, fiscal policy, and monetary policy.