National Income and Price Determination

Disposable Income – DI A. Personal income after taxes B. Consumption + Savings = Disposable Income

pro·pen·si·ty prəˈpensətē/ noun noun: propensity; plural noun: propensities an inclination or natural tendency to behave in a particular way

Average Propensity to Consume Percentage of total income that is consumed APC = III. Average Propensity to Save Percentage of total income that is saved APS = APC + APS = 1 Consumption income savings income

Let’s work a sample problem C + S = DI DI C S APC APS $1500 $1540 1600 1620 1700 1800 1780 1900 1840 2000 1940 2100 2020

Let’s work a sample problem C + S = DI DI C S APC APS $1500 $1540 -40 1600 1620 1700 1800 1780 1900 1860 2000 1940 2100 2020

Let’s work a sample problem C + S = DI DI C S APC APS $1500 $1540 -40 1600 1620 -20 1700 1800 1780 20 1900 1840 60 2000 1940 2100 2020 80

Let’s work a sample problem Consumption income APC = DI C S APC APS $1500 $1540 -40 1.027 1600 1620 -20 1700 1800 1780 20 1900 1840 60 2000 1940 2100 2020 80

Let’s work a sample problem Consumption income APC = DI C S APC APS $1500 $1540 -40 1.027 1600 1620 -20 1.013 1700 1 1800 1780 20 .989 1900 1840 60 .968 2000 1940 .97 2100 2020 80 .962

Let’s work a sample problem savings income APS = OR APC + APS = 1 DI C S APC APS $1500 $1540 -40 1.027 -.027 1600 1620 -20 1.013 1700 1 1800 1780 20 .989 1900 1840 60 .968 2000 1940 .97 2100 2020 80 .962

Let’s work a sample problem APS = OR APC + APS = 1 savings income DI C S APC APS $1500 $1540 -40 1.027 -.027 1600 1620 -20 1.013 -.013 1700 1 1800 1780 20 .989 .011 1900 1840 60 .968 .03 2000 1940 .97 2100 2020 80 .962 .038

Marginal Propensity to consume A. Marginal = extra B. proportion of any change in income that is consumed C. MPC = change in consumption change in income V. Marginal Propensity to Save A. proportion of any change in income that is saved B. MPS = change in saving C. MPC + MPS = 1

Savings = DI - C Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 390 410 405 430 420 450 435 Savings = DI - C

Savings = DI - C Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 390 410 405 430 420 450 435 Savings = DI - C

Savings = DI - C Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 390 410 405 5 430 420 10 450 435 15 Savings = DI - C

APC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 390 410 405 5 430 420 10 450 435 15 Consumption Disposable income APC =

APC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 390 410 405 5 430 420 10 450 435 15 Consumption Disposable income APC =

APC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 390 1.0 410 405 5 .99 430 420 10 .98 450 435 15 .97 Consumption Disposable income APC =

APS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 390 1.0 410 405 5 .99 430 420 10 .98 450 435 15 .97 savings Disposable income APS =

APS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 390 1.0 410 405 5 .99 430 420 10 .98 450 435 15 .97 savings Disposable income APS =

APS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 390 1.0 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 savings Disposable income APS =

MPC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ___consumption Disposable income MPC =

MPC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 .75 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ___consumption Disposable income MPC =

MPC = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 .75 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ___consumption Disposable income MPC =

MPS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 .75 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ______savings___ Disposable income MPS =

MPS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 .75 .25 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ______savings___ Disposable income MPS =

MPS = Disposable income Sample Problem – From page 161 in your textbook = change in (1) GDP = DI (2) Consumption C (3) Savings (S) – (2) DI - C (4) APC (2)/(1) C/DI (5) APS (3)/(1) S/DI (6) MPC (2)/ (1) C/ DI (7) MPS (3)/ (1) S/ DI $370 $375 -5 1.01 -.01 - 390 1.0 .75 .25 410 405 5 .99 .01 430 420 10 .98 .02 450 435 15 .97 .03 ______savings___ Disposable income MPS =

Investment spending (Ig) Government purchases (G) Net exports (Xn) VI. Multiplier A small change in: Consumption (C) Investment spending (Ig) Government purchases (G) Net exports (Xn) leads to an even bigger change in GDP http://www.youtube.com/watch?v=Xg-0z5RWbAU

leads to an even bigger change in GDP VI. Multiplier A small change in Investment spending Consumption Net exports Government purchases leads to an even bigger change in GDP Multiplier determines how large the change will be Multiplier = ___1___ 1 - MPC _1__ MPS

Let’s review and go through an example - Fill in your handout as we go Disposable Income APC (as a % or fraction) -- The average of what people will APS (as a % or fraction) -- The average of what people will APC + APS will always = consume. save. one

Marginal Analysis: What happens when a NEW unit is added? consume. MPC = What % of new DI people will MPS = What % of new DI people will MPC + MPS will always = save. one

Assume new marginal income is created – a $1000 tax cut Assume new marginal income is created – a $1000 tax cut SO – everyone has an extra $1000 of DI MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000

WOW! $1,000 How much will I spend? MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000

I’m going to buy that new $900 guitar I wanted and save the rest MPC = 90% MPS = 10% I’m going to buy that new $900 guitar I wanted and save the rest Person MPC MPS First person to get the $1000 $900 $100

I just sold a $900 guitar! What should I do with the money? MPC = 90% MPS = 10% I just sold a $900 guitar! What should I do with the money? Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900

I’m going to buy my wife the diamond earrings she wanted. MPC = 90% MPS = 10% I’m going to buy my wife the diamond earrings she wanted. Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90

How should I spend my extra cash? MPC = 90% MPS = 10% How should I spend my extra cash? Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90 Third person gets $810

First person to get the $1000 $900 $100 MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90 Third person gets $810 $729 $81

First person to get the $1000 $900 $100 MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90 Third person gets $810 $729 $81 Fourth person gets $729 $656.10 $72.90

First person to get the $1000 $900 $100 MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90 Third person gets $810 $729 $81 Fourth person gets $729 $656.10 $72.90 Fifth person to gets $656.10 $590.49 $65.61 Total so far of the original $1000

First person to get the $1000 $900 $100 MPC = 90% MPS = 10% Person MPC MPS First person to get the $1000 $900 $100 Second person gets $900 $810 $90 Third person gets $810 $729 $81 Fourth person gets $729 $656.10 $72.90 Fifth person to gets $656.10 $590.49 $65.61 Total so far of the original $1000 $3685.59 $409.51

NOTICE For each person getting $1,000, several consumption events will occur. How long will the consumption pattern continue? The spending multiplier Formula is used to estimate the number of times the pattern will repeat __1___ _1_ 1 – MPC MPS

THEREFORE . . . If the MPC is .9, what is the multiplier?

THEREFORE . . . If the MPC is .9, what is the multiplier? __1___ __1__ _1_ 1 – MPC 1 - .9 .1 Multiplier = = = = 10

THEREFORE . . . SO - How many new dollars of consumption will be created if society receives $1 million? __1__ _1__ _1_ 1 – MPC 1 - .9 .1 = Multiplier = = = 10 Multiplier x initial change in GDP = TOTAL change in GDP 10 x 1 = $10

What if the MPC is .5? If the MPC is only .5 what is the multiplier?

What if the MPC is .5? If the MPC is only .5 what is the multiplier? __1___ __1__ _1_ 1 – MPC 1 - .5 .5 Multiplier = = = = 2

What if the MPC is .5? SO – how many new dollars of consumption will be created if society receives $1million? Multiplier x initial change in GDP = TOTAL change in GDP 2 x $1 = $2 million

Finish the rest of the work on the handout and we will go over the answers. http://www.youtube.com/watch?v=JQVfkH-2G-I

VII. Aggregate demand adjective adjective: aggregate 1. formed or calculated by the combination of many separate units or items; total.

VII. Aggregate demand A. The amounts of real output that buyers collectively desire to purchase at every possible price.

VII. Aggregate demand A. The amounts of real output that buyers collectively desire to purchase at every possible price. B. Curve is downward sloping showing an inverse relationship between price and GDP 1. slope is NOT a consequence of the law of demand 2. demand curve represents ONE good 3. when the price of that ONE good goes up people switch to a substitute. 4. Switch to a substitute does not change AD since TOTAL spending remains the same

C. Downward slope is caused by 3 things 1. Real balances effect (wealth effect) a. a higher price level reduces purchasing power b. the public is poorer in real terms c. spending is reduced

Downward slope is caused by 3 things 1. Real balances effect (wealth effect) 2. Interest Rate Effect a. people need more money b. public increases cash holdings c. reduces funds available for others to borrow d. interest rates go up 1. Reduces investment spending 2. Increases savings which reduces spending

C. Downward slope is caused by 3 things 1. Real balances effect (wealth effect) 2. Interest Rate Effect 3. Foreign purchases effect a. U.S. prices rise compared to foreign prices b. foreigners buy fewer U.S. goods c. Americans buy more foreign goods

D. Movement along the AD curve 1. caused by a change in price level 2. movements along a fixed aggregate demand curve represent changes in real GDP

E. Shift in the curve or demand shock Rightward shift shows increase in AD Price level Real GDP

E. Shift in the curve or demand shock Rightward shift shows increase in AD Leftward shift shows decrease in AD Real GDP

The same formula works for AD AD = C + I + G + Xn Remember this formula? Instead of X – M we used Xn The same formula works for AD AD = C + I + G + Xn When part of the formula changes the curve will shift

E. Shift in the curve or demand shock Rightward shift shows increase in AD Leftward shift shows decrease in AD Shifts caused by a change in the determinants of AD a. Consumer spending - C 1. Consumer wealth - increase in wealth causes increase in spending 2. Consumer expectations – expectations of a raise will increase spending 3. Household indebtedness – if debt rises consumers will temporarily cut spending 4. Taxes – cut in taxes means more DI and more spending

b. Investment spending - Ig 1. Interest rates – increase in interest rates lowers spending 2. Expected returns – expected high returns on investment leads to increased spending c. Government spending - G d. Net export spending - Xn 1. National income abroad – foreigners making more money will buy American goods 2. Exchange rates – if the dollar depreciates – a lower value of dollars and higher value of Euro encourages foreigners to buy

You Decide In each situation decide if the action will cause an increase, decrease or no change in AD. Always start at curve B and determine which curve (if any) will be the new demand curve

Congress cuts taxes AD New curve - C

Investment spending decreased AD New curve - A

Government spending increases AD New curve - C

Stock market collapses; investors lose billions AD New curve - A

AD Practice

Your textbook draws AS as one curve FYI Your textbook draws AS as one curve INSTEAD We will draw two curves

THEN – put both curves on the same graph

VIII. Aggregate Supply Shows the level of real domestic output firms will produce at each price level SRAS curve is upward sloping showing a positive relationship between price and output SRAS SRAS

Short Run Curve 1. costs of production are fixed in the short run a. Wages are biggest production cost b. Wages are inflexible or “sticky” As price rises producers produce more a. BECAUSE Price – cost = profit b. Increased price means increased profit

3. Movement along the curve caused by change in price

4. Shift in the curve or Supply Shock Leftward shift – decrease in SRAS Rightward Shift – increase in SRAS Changes in factors other than price shift curve Change in input a. price of resources b. wages Changes in productivity https://www.youtube.com/watch?v=UwAQRnpVMzI&index=3&list=PLBC35DEA1D1A98034

You Decide! Based on the situation decide: Which component of AS is affected Input prices OR productivity Will AS increase or decrease Which curve will the economy be at after the shift

Unions are effective so wages increase What determinant is affected? Input prices AS will Resulting curve AS1

OPEC successfully increases oil prices What determinant is affected? Input prices AS will Resulting curve AS1

Computer technology brings new efficiency to industry What determinant is affected? productivity AS will Resulting curve AS2

Improved schools have increased the skills of American workers What determinant is affected? productivity AS will Resulting curve AS2

SRAS Practice What people think Economists dream about What Economists really dream about

A. Real GDP demanded equals real GDP supplied IX. Equilibrium A. Real GDP demanded equals real GDP supplied Price Level SRAS PL1 AD1 Y1 Real GDP

A. Real GDP demanded equals real GDP supplied IX. Equilibrium A. Real GDP demanded equals real GDP supplied B. Shift AD curve OR demand shock 1. negative demand shock shifts curve left a. Lower output b. Lower equilibrium price Price Level AS P1 P2 AD1 AD2 Y2 Y1 Real GDP

A. Real GDP demanded equals real GDP supplied IX. Equilibrium A. Real GDP demanded equals real GDP supplied B. Shift AD curve OR demand shock 1. negative demand shock shifts curve left a. Lower output b. Lower equilibrium price 2. positive demand shock shifts curve right a. Higher output b. Higher equilibrium price Price Level AS P2 P1 AD2 AD1 Real GDP Y1 Y2

C. Shift SRAS curve OR supply shock 1. price level and output move in opposite directions 2. negative supply shock shifts left - stagflation a. Lower output b. Higher price

C. Shift SRAS curve or supply shock 1. price level and output move in opposite directions 2. negative supply shock shifts left - stagflation a. Lower output b. Higher price 3. positive supply shock shifts right a. Higher output b. Lower price

Equilibrium Practice!

X. Long Run Aggregate Supply A. Vertical B. LRAS crosses horizontal axis at the economy’s potential – or at full employment GDP C. In the long run price level has no effect on AS 1. all inputs are flexible 2. inflation or deflation has the same effect on ALL prices by the same proportion https://www.youtube.com/watch?v=em5Wqg1IVp8&index=6&list=PLBC35DEA1D1A98034 Real GDP

Long Run Equilibrium Where short run equilibrium and LRAS curve intersect The economy self corrects

E. From short run to long run 1. If economy is on SRAS only a. not producing at the potential or full employment GDP a AD Full employment GDP

E. From short run to long run 1. If economy is on SRAS only a. not producing at the potential b. Inflationary or recessionary gaps are created e AD Inflationary Gap

E. From short run to long run 1. If economy is on SRAS only a. not producing at the potential b. Inflationary or recessionary gaps are created e AD recessionary Gap

E. From short run to long run 1. If economy is on SRAS only a. not producing at the potential b. Inflationary or recessionary gaps are created c. Inflation or recession causes wages to adjust d. SRAS shifts accordingly to close the gap SRAS 1 b a AD

F. LRAS shifts to right over VERY LONG run 1. Increase in quantity of resources 2. Increase in quality of resources 3. Technology progress Real GDP