Consumption, Savings, and Aggregate Expenditures

Do you agree or disagree with the following? If income remains constant, when consumption increases savings must decrease. If income increases, savings decreases and if income decreases, savings increases. If consumption increases, ceteris paribus, GDP will increase. If GDP rises, unemployment rises. Consumption can be greater than income.

Consumption and Saving Largest component of AE is C DI = C + S If DI ↑, C ↑ and S ↑ ; if DI ↓, C ↓ and S ↓ C can be > DI; S can be negative If AE ↑, GDP ↑ and unemployment ↓ If AE ↓, GDP ↓ and unemployment ↑

APC, APS, MPC, and MPS APC = C / Income = % of income people are likely to consume APS = S / Income = % of income people are likely to save APC + APS = 1 MPC = ∆C / ∆Income MPS = ∆Savings / ∆Income MPC + MPS = 1

Investment If business expects to be able to produce $1100 worth of goods from $1000 machine, r = 10% ($100/$1000) If MB>=MC, they’ll invest so… r>=i If r = 10%, nominal i = 12%, inflation = 5%, they’ll invest until nominal i = 15%

i I = $20 billion @ 8% Real interest rate 8% ID I ($) 20

I I GDP ($) 45o I = $20 billion I is constant b/c it depends on r and i, not GDP 20 I GDP ($)

AE I = $20 billion 45o C + I C 470 450 GDP ($) 470

AE I = $20 billion 45o C 470 450 GDP ($) 470

The Simple Spending Multiplier Multiplier = (change in real GDP)/(change in spending) OR Change in GDP = Multiplier x (change in spending) Multiplier = 1/MPS OR 1/(1-MPC)

The Multiplier and GDP MPS = .20; consumption increases by $10 billion; what is the increase to GDP? $50 billion ($10 B x (1/.20)) = $10 B x 5 MPS = .25; income increases by $20 billion; what is the increase to GDP? Consumption increases by .75 x $20 B = $15 B; GDP increases by $60 B ($15 B x 4) If MPS falls to .20, how does that change the increase to GDP? C ↑ by .80 x $20 B = $16 B; GDP ↑ by $80 B ($16 B x 5)

AE C + I GDP ($) If net exports > 0 45o If net exports < 0 C + I + Xn C + I 490 C + I + Xn GDP ($) 490

45o AE I = $20 billion C+I+Xn C+I+Xn+G C + I C GDP ($)

Net Exports Positive Xn increase AE and negative Xn decrease AE Appreciation – value of currency rises against another Depreciation – value of currency falls against another Ex: $1.50 = 1 Euro; Appreciation -- $1 = 1 Euro ($1.50 = 1.5 Euros) Depreciation -- $2 = 1 Euro

Net Exports If $ appreciates, U.S. goods more expensive (costs more foreign currency) – X falls $ appreciates – foreign goods are cheaper; M rises so net exports fall If $ depreciates, U.S. goods cheaper (costs less foreign currency) – X rises $ depreciates – foreign goods more expensive (costs more $) so M falls; net exports rises

Government Purchases More purchases increase AE; fewer reduce AE ∆ in G have a greater effect on GDP than ∆ in taxes do Ex: MPS = .20; G ↑ by $20 B; GDP ↑ by $100 B ($20 B x 5) MPS = .20; taxes fall by $20 B; C ↑ by $16 B ($20 B x .80); GDP ↑ by $80 B ($16 B x 5) Some of the tax cut is saved and doesn’t affect GDP

Balanced Budget Multiplier Taxes and G change in the same direction by the same amount; i.e. -- $20 B GDP will change by the same amount in the same direction; i.e. -- $20 B Balanced budget multiplier is 1 (1 x ∆ in G and T) If G and T fall by $20 B, GDP will fall by $20 B

Leakages – pull $ out of the economy: savings, taxes, imports Injections – inject $ into the economy: investment, government, exports Recessionary gap – the amount that AE must increase to pull GDP up to full-employment GDP Inflationary gap – the amount that AE must fall to bring GDP back down to full-employment GDP

The Simple Spending Multiplier Multiplier = (change in real GDP)/(change in spending) OR Change in GDP = Multiplier x (change in spending) Multiplier = 1/MPS OR 1/(1-MPC)

Practice – What happens to GDP? Income goes up by $5 M. MPC = 0.8 Investment falls by $40 B. MPS = 0.1 Government purchases falls by $100 B. MPC = 0.75 The dollar appreciates causing net exports to change by $25 B. MPS = 0.2 The dollar depreciates causing net exports to change by $10 B. MPS = 0.33 Taxes fall by $50 B. MPC = 0.8 Taxes and government purchases increase by $25 B. MPC = 0.25

Answers GDP increases by $20 B. GDP falls by $400 B.