Building the Aggregate Expenditures Model
Aggregate ExpendituresKeynesianismSays Law says that producing
goods generates an amount of income equal to the value of the goods
produced
Great Depression
Keynes theorizes that not all income is spent leaving
surplusesIn other words, the economy is not self-adjusting and that
external forces not always the cause of recession, there are also
internal forces caused by failure of certain fundamental economic
decisions (savings and investing)Keynes and the DepressionIncome
after taxes or net incomeDI=Gross Income Taxes
2 Choices with disposable incomeConsume or Save
Average Propensity to ConsumeAPC = consumption/income
Average Propensity to SaveAPS = saving/income
APC + APS = 1Disposable Income (DI)ConsumptionThe fraction of
any change in disposable income that is consumed.
MPC= Change in Consumption Change in Disposable IncomeMPC =
C/DI
Marginal Propensity to Consume (MPC)The fraction of any change
in disposable income that is saved.
MPS= Change in SavingsChange in Disposable Income
MPS = S/DI
Marginal Propensity to Save (MPS)MPC + MPS = 1.: MPC = 1 MPS.:
MPS = 1 MPCRemember, people do two things with their disposable
income, consume it or save it!Marginal PropensitiesAn initial
change in spending (C, IG, G, XN) causes a larger change in
aggregate spending, or Aggregate Demand (AD).
Multiplier = Change in AD Change in SpendingMultiplier = AD/ C,
I, G, or X
The Spending Multiplier EffectWhy does this happen?Expenditures
and income flow continuously which sets off a spending increase in
the economy.The Spending Multiplier EffectThe Spending Multiplier
can be calculated from the MPC or the MPS.Multiplier = 1/1-MPC or
1/MPS
Multipliers are (+) when there is an increase in spending and ()
when there is a decrease
Calculating the Spending MultiplierEx. Assume U.S. citizens
spend 90 for every extra $1 they earn. Further assume that the real
interest rate (r%) decreases, causing a $50 billion increase in
gross private investment. Calculate the effect of a $50 billion
increase in IG on U.S. Aggregate Demand (AD).Step 1: Calculate the
MPC and MPSMPC = C/DI = .9/1 = .9MPS = 1 MPC = .10Step 2: Determine
which multiplier to use, and whether its + or -The problem mentions
an increase in IG .: use a (+) spending multiplierStep 3: Calculate
the Spending and/or Tax Multiplier1/MPS = 1/.10 = 10Step 4:
Calculate the Change in AD( C, IG, G, or XN) * Spending
Multiplier($50 billion IG) * (10) = $500 billion AD
MPS, MPC, & MultipliersCalculating the Tax MultiplierWhen
the government taxes, the multiplier works in reverseWhy?Because
now money is leaving the circular flowTax Multiplier (note: its
negative) = -MPC/1-MPC or -MPC/MPSIf there is a tax-CUT, then the
multiplier is +, because there is now more money in the circular
flow
MPS, MPC, & MultipliersEx. Assume U.S. citizens spend 90 for
every extra $1 they earn. Further assume that the real interest
rate (r%) decreases, causing a $50 billion increase in gross
private investment. Calculate the effect of a $50 billion increase
in IG on U.S. Aggregate Demand (AD).Step 1: Calculate the MPC and
MPSMPC = C/DI = .9/1 = .9MPS = 1 MPC = .10Step 2: Determine which
multiplier to use, and whether its + or -The problem mentions an
increase in IG .: use a (+) spending multiplierStep 3: Calculate
the Spending and/or Tax Multiplier1/MPS = 1/.10 = 10Step 4:
Calculate the Change in AD( C, IG, G, or XN) * Spending
Multiplier($50 billion IG) * (10) = $500 billion AD
MPS, MPC, & MultipliersEx. Assume Germany raises taxes on
its citizens by 200 billion . Furthermore, assume that Germans save
25% of the change in their disposable income. Calculate the effect
the 200 billion change in taxes on the German economy.Step 1:
Calculate the MPC and MPSMPS = 25%(given in the problem) = .25 MPC
= 1 MPS = 1 - .25 = .75Step 2: Determine which multiplier to use,
and whether its + or -The problem mentions an increase in T .: use
(-) tax multiplierStep 3: Calculate the Spending and/or Tax
Multiplier-MPC/MPS = -.75/.25 = -3Step 4: Calculate the Change in
AD( Tax) * Tax Multiplier(200 billion T) * (-3) = -600 billion in
AD
MPS, MPC, & MultipliersEx. Assume the Japanese spend 4/5 of
their disposable income. Furthermore, assume that the Japanese
government increases its spending by 50 trillion and in order to
maintain a balanced budget simultaneously increases taxes by 50
trillion. Calculate the effect the 50 trillion change in government
spending and 50 trillion change in taxes on Japanese Aggregate
Demand.Step 1: Calculate the MPC and MPSMPC = 4/5 (given in the
problem) = .80MPS = 1 MPC = 1 - .80 = .20Step 2: Determine which
multiplier to use, and whether its + or -The problem mentions an
increase in G and an increase in T .: combine a (+) spending with a
() tax multiplierStep 3: Calculate the Spending and Tax
MultipliersSpending Multiplier = 1/MPS = 1/.20 = 5Tax Multiplier =
-MPC/MPS = -.80/.20 = -4Step 4: Calculate the Change in AD[ G *
Spending Multiplier] + [ T * Tax Multiplier][(50 trillion G) * 5] +
[(50 trillion T) * -4][ 250 trillion ] + [ - 200 trillion ] = 50
trillion AD
Money spent or expenditures on:New plants (factories)Capital
equipment (machinery)Technology (hardware & software)New
HomesInventories (goods sold by producers)
What is Investment?How does business make investment
decisions?Cost / Benefit AnalysisHow does business determine the
benefits?Expected rate of returnHow does business count the
cost?Interest costsHow does business determine the amount of
investment they undertake?Compare expected rate of return to
interest costIf expected return > interest cost, then investIf
expected return < interest cost, then do not investExpected
Rates of ReturnWhats the difference?Nominal is the observable rate
of interest. Real subtracts out inflation (%)and is only known ex
post facto.How do you compute the real interest rate (r%)?r% = i% -
%What then, determines the cost of an investment decision?The real
interest rate (r%)
Real (r%) v. Nominal (i%)What is the shape of the Investment
demand curve?Downward slopingWhy?When interest rates are high,
fewer investments are profitable; when interest rates are low, more
investments are profitableConversely, there are few investments
that yield high rates of return, and many that yield low rates of
return
Investment Demand Curve (ID)The Investment Demand
Curver%IGIDChanges in r% cause changes in IG. Factors other than r%
may shift the entire ID curve5%3%$2 trillion$3 trillionCost of
ProductionLower costs shift ID Higher costs shift ID Business
TaxesLower business taxes shift ID Higher business taxes shift ID
Technological ChangeNew technology shifts ID Lack of technological
change shifts ID Stock of CapitalIf an economy is low on capital,
then ID If an economy has much capital, then ID
ExpectationsPositive expectations shift ID Negative expectations
shift ID Shifts in Investment Demand (ID)Shifts in Investment
Demandr%IGID4%$2.5 trillion$3.25 trillionID1When investment demand
shifts, different levels of gross private investment occur even
while r% remains constantDurabilityCapital has a long life-span,
therefore once it is built there is no immediate need for further
investmentIrregularity of InnovationInnovation does not proceed in
a smooth linear fashion, instead there are bursts of innovation
followed by periods of relative stabilityVariability of
ProfitsProfitability is subject to the forces of competition,
cyclical changes in the economy, and human management
decisionsVariability of ExpectationsPolitical, social and natural
phenomenon shape our positive and negative expectations of the
futureInstability of Investment
Many economists believe that investment instability is the chief
cause of the business cycle.Instability of Investment
The market where savers and borrowers exchange funds (QLF) at
the real rate of interest (r%).The demand for loanable funds, or
borrowing comes from households, firms, government and the foreign
sector. The demand for loanable funds is in fact the supply of
bonds.The supply of loanable funds, or savings comes from
households, firms, government and the foreign sector. The supply of
loanable funds is also the demand for bonds.Loanable Funds
Marketr%QLFSLF & DBondsDLF & SBondsrqLoanable Funds Market
in Equilibrium
Remember that demand for loanable funds = borrowing (i.e.
supplying bonds)More borrowing = more demand for loanable funds
()Less borrowing = less demand for loanable funds
()ExamplesGovernment deficit spending = more borrowing = more
demand for loanable funds .: DLF .: r% Less investment demand =
less borrowing = less demand for loanable funds .: DLF .: r%
Changes in the Demand for Loanable Fundsr%QLFSLFDLFrqDLF 1r1
q1DLF .: r% & QLF Increase in the Demand for Loanable
Fundsr%QLFSLFDLF 1r1q1DLFr qDLF .: r% & QLF
Decrease in the Demand for Loanable Funds
Remember that supply of loanable funds = saving (i.e. demand for
bonds)More saving = more supply of loanable funds()Less saving =
less supply of loanable funds ()ExamplesGovernment budget surplus =
more saving = more supply of loanable funds .: SLF .: r%Decrease in
consumers MPS = less saving = less supply of loanable funds .: SLF
.: r%
Changes in the Supply of Loanable Fundsr%QLFSLFDLFrqSLF .: r%
& QLF SLF 1r1q1Increase in the Supply of Loanable
Fundsr%QLFSLFDLFrqSLF .: r% & QLF SLF 1r1q1Decrease in the
Supply of Loanable Funds
Loanable funds market determines the real interest rate
(r%).Loanable funds market relates saving and borrowing.Changes in
saving and borrowing create changes in loanable funds and therefore
the r% changes.When government does fiscal policy it will affect
the loanable funds market.Changes in the real interest rate (r%)
will affect Gross Private InvestmentFinal thoughts on Loanable
Fundsr%QLFSLFDLFrqDLF 1r1 q1G and/or T .: Government deficit spends
.: DLF .: r% .: IG (Crowding-Out Effect)
Effect of Expansionary Fiscal Policy on Loanable Funds &
Investmentr%IGIDII1
