Copyright © 2008 Pearson Education Canada Chapter 6 Determination of National Income

Copyright © 2008 Pearson Education Canada Chapter Objectives 1. Explain equilibrium GDP using the circular-flow approach. 2. Explain the paradox of thrift. 3. Use the multiplier formulas to calculate changes in equilibrium GDP. 4. Explain the fiscal-policy changes necessary to reach equilibrium GDP. 5. Define the recessionary and inflationary gaps and briefly describe theories of business cycles.

Copyright © 2008 Pearson Education Canada Gross Domestic Product GDP is measured by the flow of money in the circular flow diagram. Money circulates from the business sector to the household sector in the form of wages, salaries, rents, and profits. This money then returns to the business sector when households purchase goods and services. What are the reasons for changes in GDP levels? (Cont.)

Copyright © 2008 Pearson Education Canada Gross Domestic Product (Continued) When households increase their savings they also reduce spending on goods and services. Businesses reduce production and forward less money to households in the form wages, interest, and rent. This reduces the flow of money and the level of GDP. Household Savings and Investment (Cont.)

Copyright © 2008 Pearson Education Canada An increase in investment increases the flow of money and the level of GDP. Household Savings and Investment (Continued)

Copyright © 2008 Pearson Education Canada Whether the overall GDP increases is dependent on relative changes in investment and savings. If the increase in investment is greater than the increase in savings than the overall level of GDP will increase. When the levels of savings and investment are equal than the level of GDP will be at equilibrium. If the increase in investment is less than the increase in savings than the overall level of GDP will decrease. Household Savings and Investment (Continued)

Copyright © 2008 Pearson Education Canada Household Savings and Investment (Continued)

Copyright © 2008 Pearson Education Canada Taxation removes money from the circular flow, and government spending puts it back in. When the total amount of money injected into the circular flow (investment, government spending, and exports) exceeds the leakages from circular flow (savings, taxation, and imports), the level of GDP will increase. The Government and Foreign-Trade Sectors Exports add money to the circular flow, and imports remove it. (Cont.)

Copyright © 2008 Pearson Education Canada Injections ($) The Government and Foreign-Trade Sectors (Continued) Condition for equilibrium GDP: Investment (I) + Government spending (G) + Exports (X) Savings (S) + Taxes (T) + Imports (IM) = Leakages ($)=

Copyright © 2008 Pearson Education Canada Paradox of Thrift By saving more we end up saving less. The paradox of thrift states that an increase in the level of savings in the economy can lead to lower levels of income and ultimately to lower levels of savings. The paradox applies only if a significant number of people decide to increase their savings.

Copyright © 2008 Pearson Education Canada Components of Aggregate Expenditure Consumption Some factors influencing the level of consumption expenditure: Disposable income or after-tax income Interest rates Wealth Expectations (Cont.)

Copyright © 2008 Pearson Education Canada Consumption (Continued) Other factors influencing the level of consumption expenditure: Psychological factors New products Distribution of income Prices Demographic factors

Copyright © 2008 Pearson Education Canada Consumption Schedule Dissaving occurs when spending is greater than disposable income. (Cont.)

Copyright © 2008 Pearson Education Canada Consumption Schedule (Continued) Average propensity to consumer (APC) = Consumption Disposable Income Average propensity to save (APS) = Savings Disposable Income APC + APS = 1.0

Copyright © 2008 Pearson Education Canada Consumption Schedule (Continued) Marginal propensity to consumer (MPC) = Change in Consumption Change in Disposable Income Marginal propensity to save (MPS) = Change in Savings Change in Disposable Income MPC + MPS = 1.0

Copyright © 2008 Pearson Education Canada Consumption Schedule (Continued) At each point on the 45 O line, consumption is equal to disposable income.

Copyright © 2008 Pearson Education Canada Investment Investment is most volatile and most difficult to predict because decisions are based on business expectations about the future. There are also a number of factors that change investment: The interest rate Innovation and changes in technology Government policy and taxes Expectations (Cont.)

Copyright © 2008 Pearson Education Canada Investment (Continued) Factors that change investment: Replacement Cost of capital goods Gross domestic product Other Components of Aggregate Expenditures Government spending and the difference between exports and imports are the final components of aggregate expenditures. (Cont.)

Copyright © 2008 Pearson Education Canada Other Components of Aggregate Expenditures (Continued)

Copyright © 2008 Pearson Education Canada The Multiplier An increase in aggregate expenditures will cause an increase in GDP. The increase in GDP will be more than the initial increase in aggregate expenditures due to the multiplier process. For example, if someone decides to spend $10,000 on a new car overall increase in GDP will be larger than $10,000.

Copyright © 2008 Pearson Education Canada If someone decides to spend an extra $1000 on audio equipment then: The Expenditure Multiplier (Cont.)

Copyright © 2008 Pearson Education Canada The expenditure multiplier is the amount by which a change in aggregate demand is multiplied in order to determine the change in GDP. The Expenditure Multiplier (Continued) Assume MPC = 0.8 and spending increase of $1000.

Copyright © 2008 Pearson Education Canada The tax multiplier is the amount by which any change in the level of taxation must be multiplied in order to determine the impact on GDP. The Tax Multiplier Assume MPC = 0.75 and tax decrease of $20.

Copyright © 2008 Pearson Education Canada The balanced-budget multiplier is the amount by which an equal increase in taxes and in government spending increases GDP. (MPC = 0.8, and G and T increase $10.) The Balanced-Budget Multiplier

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP The real gross domestic product (RGDP) is the amount of goods and services produced in the economy adjusted for price increases. The aggregate demand (AD) is the total demand for all goods and services produced in the economy over a certain period of time. The aggregate supply (AS) is the total production of goods and services available in the economy over a certain period of time. (Cont.)

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) The negative relationship between the price level in the economy and AD is explained by the wealth effect and substitution effect. When the price level increases (holding all else constant), an individual’s wealth decreases, to restore that wealth individuals will spend less. When the price level increases (holding all else constant) this will increase interest rates, individuals will substitute away from spending for more saving.

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) The AS curve is positively related to the price level, as the price level increases more goods and services are produced. There is a limit to the amount of goods and services produced, determined by an output where all available resources are fully employed, or RDGP fe. When all resources are fully utilized the economy is operating at its natural level of unemployment.

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) As the price level increases the RGDP falls along the AD curve and increases along the AS curve. The AD curve shifts to the right when one of the components of AD increases, such as business investment or government spending. The AS curve shifts to the right when the quantity and/or quality of resources (land, labour, and capital) increase.

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) The equilibrium is at the price level where AD = AS, RGDP e.

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) At a low price of P 1 there is a depletion of inventories, firms hire more workers and machinery to increase production.

Copyright © 2008 Pearson Education Canada An Alternate Approach to Equilibrium GDP (Continued) If overall spending increases the AD curve shifts to the right and the RGDP increase to RGDP 2.

Copyright © 2008 Pearson Education Canada Full-Employment GDP The level of aggregate demand in the economy required to ensure that everyone who wants employment has a job is the full-employment level of GDP. The amount that aggregate demand must increase in order to bring the equilibrium level of GDP up to full-employment level is the recessionary gap. (Cont.) The decrease in the level of aggregate demand required to bring the equilibrium level of GDP down to the full- employment level of GDP is referred to as the inflationary gap.

Copyright © 2008 Pearson Education Canada Full-Employment GDP (Continued) If RGDP fe is $450 and RGDP is $400, what increase in aggregate demand is necessary in order to achieve full- employment, assuming MPC=0.75?

Copyright © 2008 Pearson Education Canada Full-Employment GDP (Continued) If RGDP fe is $450 and RGDP is $400, what reduction in taxes is necessary in order to achieve full-employment, assuming MPC=0.75?

Copyright © 2008 Pearson Education Canada Say’s Law and John Maynard Keynes Say’s Law states that the supply of products creates its own demand, since all production creates income for households that can be spent on goods and services. Keynesian economic theory proposes that government take an active role in the economy, increasing government spending in order to support he demand for goods and services and, therefore, preserve employment.

Copyright © 2008 Pearson Education Canada