Unit 3: National Income and Price

Determination

Part 1: Building the Aggregate Expenditures

Model

A. Classical economists believed a market system would ensure full employment of the economy’s resources (except for temporary, short-term upheavals)

B. Deviations would be self-correcting Slumps in output and employment

reduced prices increased consumer spending

lower wages increase employment again lower interest rates expand investment spending

I. Background

C. Say’s Law1) Summarized this classical view:

“Supply creates its own demand.”

2) Think in terms of bartera. A woodworker produces

furniture to trade for other needed goods/services

b. All the products would be traded for something or there would be no need to make them

D. The Great Depression1) Refuted classical economics when markets did NOT self-correct2)GDP fell by 40% (in the U.S.) and unemployment rose to 25%

E. John Maynard Keynes1) 1936 – published his General Theory of Employment, Interest, and Money2) Alternative to classical theory3) Explained periods of recession

a. Not all income is always spent (contrary to Say’s law)

b. Producers may respond to unsold inventories by reducing output

instead of cutting prices.c. A recession or depression could follow

this decline in employment and incomes

F. The Modern Aggregate Expenditures model is based on Keynesian economics1) Saving and investment decisions may not be coordinated2)Prices and wages are not very flexible downward3) Therefore, internal market forces can cause depressions4) Government should play an active role in stabilizing the economy.

A.“Aggregate” means totalB. The theory assumes:

1) The level of output and employment depend directly on the level of aggregate expenditures2)Changes in output reflect changes in aggregate spending

II. Introduction to the Aggregate Expenditures Theory/Model

C. The Aggregate Expenditure model creates a simple model of the economy

D. Uses the national income identity: GDP = C + I + G + NX

• C = Consumption• I = Planned Investment (made by firms on

capital goods, but it does not always occur)• G = Government Spending• NX = Net Exports

E. So what is it used for?1) To describe the equilibrium between production and

planned expenditures.2) Investigates the way economic agents react when

planned expenditures do not equal production.3) If there are unexpectedly large changes in

inventories, firms change their output levelsa. If inventories fall below target levels, firms increase

production and hire more workers (unemployment falls)b. If inventories rise above target, firms decrease

production and lay off workers (unemployment rises)

F. Graphing AE1) 45-degree line

a) It represents all points where Real GDP = Planned Aggregate Expenditure (goods produced = total spending)

b) Equilibrium is the intersection of the 45° line and the C + I + G + NX line.

c) Equilibrium does not have to be at full-employment real GDP.

A. What if output is to the right of the Equilibrium point?

• Firms experience a build-up of inventories.• Firms must produce less and lay off workers.

B. What if output is to the left of the Equilibrium point?

• Firms do not have inventory.• Respond by increasing production and employment

III. Equilibrium and Disequilibrium

A. How do you calculate consumption?• Average Propensity to Consume = APC• APC = c/Y• Y stands for Income

• Marginal (change in) Propensity to Consume = MPC• MPC = change in C/change in Y

IV. Consumption

B. Why must the sum of the MPC and the MPS equal 1?

• MPS = change in saving/change in income• When your income changes, you have only 2 options:

spend it or save it.• MPC is the fraction of the change in income spent• MPS is whatever is left, which is saved.

V. KEYNESIAN MULTIPLIER EFFECTS Let’s say you find a dollar in the street. You

now have one dollar you did not have before. You now have an “income” of one dollar. What can you do with that dollar?? You can spend all of it, save all of it, or spend some of it and save some of it. You have options!

KEYNESIAN MULTIPLIER EFFECTS Let’s assume you decide to spend the

WHOLE dollar. Your spending of that dollar is an EXPENDITURE for you and INCOME for the person (entrepreneur) you traded with.

KEYNESIAN MULTIPLIER EFFECTS

How much did GDP increase with this transaction?

$1.00

(you bought “stuff”)

KEYNESIAN MULTIPLIER EFFECTS Now what happens to that dollar in the

possession of the entrepreneur? They have the same options you had:

Spend it or Save it.

KEYNESIAN MULTIPLIER EFFECTS

Let’s assume the entrepreneur spends the WHOLE dollar at another business.

This expenditure for the entrepreneur is now INCOME for another entrepreneur.

KEYNESIAN MULTIPLIER EFFECTS

How much did GDP increase with this transaction?

$1.00

Does this sound familiar??

KEYNESIAN MULTIPLIER EFFECTS

This “found” dollar has now purchased $2.00 worth of goods and/or services.

The original dollar appears to be cloning itself!!

KEYNESIAN MULTIPLIER EFFECTS

If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? Unlikely…Why?

KEYNESIAN MULTIPLIER EFFECTS

People have a TENDENCY TO SAVE some portion of each dollar they receive.

Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.

KEYNESIAN MULTIPLIER EFFECTS

The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive.

Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.

KEYNESIAN MULTIPLIER EFFECTS Example: If I get an additional dollar I may

consume .90 and save .10. My Marginal Propensity to Consume (MPC)

that dollar is then: 90%. My Marginal Propensity to Save (MPS) that

dollar is then: 10%.

KEYNESIAN MULTIPLIER EFFECTS Example: If I get an additional dollar I may

consume .80 and save .20. My Marginal Propensity to Consume (MPC) is

then: 80%. My Marginal Propensity to Save (MPS) is

then: 20%.

KEYNESIAN MULTIPLIER EFFECTSDo you notice a pattern?

MPC + MPS = 1.00 (or 100%)

KEYNESIAN MULTIPLIER EFFECTS Let’s see how this works in practice. Assume the Government wants to increase

their spending by $10 billion dollars. Assume that the MPC in the economy is 90% and the MPS is 10% (remember these must equal 100%). What is going to be the effect on the GDP when we consider the Multiplier effect of EACH of those dollars?

KEYNESIAN MULTIPLIER EFFECTS The Government initially spends $10 billion

in the economy to purchase goods and services. Does the Government SAVE any of this money? NO. They spend the whole shebang! What is the immediate effect of this transaction on GDP? It INCREASES by $10 billion.

KEYNESIAN MULTIPLIER EFFECTS What is now going to happen to that $10

billion now in the hands of people in the economy? Keynes says that people in general will spend 90% of it and save 10%.

So when people spend 90% of $10 billion, how much is GDP going to increase by? $9 billion.

KEYNESIAN MULTIPLIER EFFECTS With these initial two transactions, how

much has GDP increase by?

$10B + 9B = 19B

Once again the original $10B has “magically” turned into $19B in GDP .

KEYNESIAN MULTIPLIER EFFECTS Now when people who receive the $9B, they are

going to spend 90%, or $8.1B and save 10%, or $900 Million.

GDP is now growing again!

$10B + $9B + $8.1B = $27.1 Billion

It does not stop here. Each time the money is spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

KEYNESIAN MULTIPLIER EFFECTS Do you want to do all that math to arrive at

how much GDP is going to increase in the end. I did not think so.

Keynes came up with a simple formula to do the math for you. Remember in the beginning it was GOVERNMENT that started this buying frenzy. This is very IMPORTANT to remember.

KEYNESIAN MULTIPLIER EFFECTS The Keynesian Government Spending

Multiplier is 1/MPS. Let’s use the information we have already been

given: The MPC is 90% and the MPS is 10%. We can plug the appropriate number into the

Government Spending Multiplier and come up with a useful number.

Govt. Spending Multiplier = 1/MPS = 1/10% = 1/.10 = 10

KEYNESIAN MULTIPLIER EFFECTS

Now this is AMAZING! According to KEYNES when government spends a dollar in the economy it is going to purchase a multiple of 10 times itself in GDP.

If Government increases spending by 10 Billion, then the eventual impact on GDP is going to be an increase of:

$10 Billion X 10 = $100 Billion

NOTE: This works in REVERSE as well. If Government DECREASES spending by $10 Billion, it will serve to DECREASE GDP by a multiple of 10!

KEYNESIAN MULTIPLIER EFFECTS

SUBTLETY ALERT!!

Notice in the VERY FIRST round of spending by the Government that NOTHING is SAVED. The economy has the benefit of the FULL impact of the $10Billion in new spending. In subsequent rounds of spending people are saving a portion of the money they receive, therefore REDUCING the impact on the economy. When we do the TAX CUT MULTIPLIER next, this distinction will be important. It forms the foundation of why Keynes suggested that in times of severe economic crisis it should be the role of Government to be “active” in the economy.

KEYNESIAN MULTIPLIER EFFECTS

TAX CUT MULTIPLIER

Instead of Government changing its spending, they could change TAXES instead.

KEYNESIAN MULTIPLIER EFFECTS Assume in the economy the MPC and the

MPS are still 90% and 10% respectively. Assume the Government decides to

REDUCE taxes by $10 Billion. This means that $10B is now in the hands of people and NOT in the hands of the Government. According to Keynes, what is the first thing that people in the economy are going to do with that new $10Billion?? They are going to Spend 90% and Save 10%!!

KEYNESIAN MULTIPLIER EFFECTS When they spend 90% it is going to

INCREASE GDP by $9Billion in the FIRST ROUND of Spending (how does that compare when in the previous example Government spent FIRST).

This transaction INCREASED GDP by $9B.

KEYNESIAN MULTIPLIER EFFECTS The people who receive the $9B are going

to SPEND 90%, or $8.1Billion and SAVE $900 Million.

This transaction will INCREASE GDP by $8.1Billion.

GDP is now $9B + $8.1B = $17.1Billion.

KEYNESIAN MULTIPLIER EFFECTS The people who receive the $8.1Billion are going to SPEND

90%, or $7.290 Billion and SAVE 10%, or $810 Million

This transaction will INCREASE GDP by $7.290 Billion.

GDP is now $9B + $8.1B + 7.29B = 24.390Billion. Once again, it does not stop here. Each time the money is

spent it keeps reducing by the 90% and 10% ratio UNTIL it gets to ZERO and GDP is some much larger number.

KEYNESIAN MULTIPLIER EFFECTS Keynes came up with a simple formula to

do the math for you. Remember in the beginning it was PEOPLE in the Economy that start this buying frenzy. This is very IMPORTANT to remember.

The KEYNESIAN TAX CUT MULTIPLIER

= -MPC/MPS or

= -MPC/(1-MPC)

KEYNESIAN MULTIPLIER EFFECTS

Example: We know the MPC is 90% and the MPS is 10%. We can plug the appropriate number into the

Tax Cut Multiplier and come up with a useful number.

Tax Cut Multiplier

-MPC/MPS = 90%/10% = -.90/.10 = -9

KEYNESIAN MULTIPLIER EFFECTS According to Keynes if the Government

REDUCED TAXES (-) and you multiply by the TAX CUT MULTIPLIER, that is how much GDP will INCREASE.

In our example, the Government DECREASED

taxes by 10Billion (-) and you multiply this by the tax cut multiplier of -9, then GDP will eventually INCREASE (two negatives make a positive) by $90Billion.

NOTE: This works in REVERSE. If Government INCREASE TAXES by $10Billion then this will serve to DECREASE GDP by a multiple of –9.

(+10billion X -9 = -90Billion).

KEYNESIAN MULTIPLIER EFFECTS

NOT SO “SUBTLE” ALERT!!!

Do you notice the different effects of the Government Spending Multiplier and the Tax Cut Multiplier? The Government Spending Multiplier appears to ALWAYS come out ahead of the Tax Cut Multiplier in terms of how much GDP is eventually impacted.

THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!!

According to Keynes, INCREASED Government spending “outperforms” DECREASES in Taxes to stimulate (“prime the pump”) the economy.

KEYNESIAN MULTIPLIER EFFECTS Let’s put these Keynesian Multipliers

together and see how it all washes out Assume the Government wants to do the

right thing when they INCREASE Government spending they ALSO INCREASE Taxes to pay for it, so they won’t have to borrow to pay for the spending. Novel idea, I know, but it could happen…

KEYNESIAN MULTIPLIER EFFECTS Assume Government wants to INCREASE

spending by $20 Billion and the MPC is 80% and the MPS is 20%. If they don’t want to create a budget deficit they must INCREASE Taxes by $20 Billion to pay for the new spending.

What is going to be the NET EFFECT of this action on the Economy?

KEYNESIAN MULTIPLIER EFFECTS Calculate the Government Spending

Multiplier (1/MPS = 1/20% = 1/.20 = 5) If government spending INCREASES by

$20B and the multiplier is 5 then, GDP is going to INCREASE by $100B ($20B X 5 = $100B).

KEYNESIAN MULTIPLIER EFFECTS This is only half the story…Now we have to take

$20B OUT of the Economy in TAXES to pay for the new spending.

Calculate the TAX CUT MULTIPLIER (-MPC/MPS = -80%/20%=-.80/.20 = -4)

If TAXES are INCREASED by $20B and the tax cut multiplier is -4 then GDP is going to DECREASE by $80B ( +20B X -4 = -80B)

The multiplier effect is working in REVERSE to DECREASE GDP by a multiple of 4!

KEYNESIAN MULTIPLIER EFFECTS What is the NET EFFECT after the TWO

MULTIPLIERS do their work? The INCREASED Government Spending has

INCREASED the GDP by $100B The Tax INCREASE has DECREASED the GDP by

-80B. BOTTON LINE: GDP (AGGREGATE DEMAND)

has INCREASED by $20B!! The Miracle of the Keynesian Multiplier…

NOTE: This works in REVERSE as well. If Government Spending DECREASED by $20B and DECREASED Taxes by $20B, then the NET EFFECT on the Economy will be a Net DECREASE in GDP of -$20B. THE HORRORS!!

KEYNESIAN MULTIPLIER EFFECTSThink about this: Government INCRESED

spending by $20B and INCREASED Taxes by $20B to pay for the spending and the economy came out AHEAD by $20B in INCREASED GDP. Notice a pattern??

KEYNESIAN MULTIPLIER EFFECTS

NOT SO SUBTLE ALERT:

Pick any dollar amount that Government could increase its spending by and increase taxes by the SAME amount to maintain a BALANCED BUDGET. The result will be an INCREASE in GDP by the SAME amount that you increased spending and increased taxes. Cool, huh!!

KEYNESIAN MULTIPLIER EFFECTS Keynes called this the BALANCED

BUDGET MULTIPLIER

The BALANCED BUDGET MULTIPLIER is 1 Take whatever you INCREASE

Government Spending and INCREASE Taxes by and Multiply by 1 you will get what the NET INCREASE is in GDP.

Note: THIS WORKS IN REVERSE AS WELL

KEYNESIAN MULTIPLIER EFFECTS Let’s Do Some Examples… Assume we can determine there is a

recessionary gap in the Economy of $100 Billion.

Assume the MPC is 75% and the MPS is 25%

If the Govt. decides to change spending, would they INCREASE or DECREASE spending? By How Much?

KEYNESIAN MULTIPLIER EFFECTS Determine the Govt. Multiplier.

1/MPS = 1/25% = 1/.25 = 4

This means that ANY dollar the Govt spends in the economy is going to multiply on itself 4 TIMES

The Recessionary Gap is $100B

$100/4 = $25 Billion

This is the amount Govt. would INCREASE spending to close this $100B gap (move closer to Full-Employment)

KEYNESIAN MULTIPLIER EFFECTS Assume we can determine there is a

recessionary gap in the Economy of $100 Billion.

Assume the MPC is 75% and the MPS is 25% If the Govt. decides to change TAXES would

they INCREASE or DECREASE Taxes? By How Much?

KEYNESIAN MULTIPLIER EFFECTS Determine the TAX CUT MULTIPLIER.

-MPC/MPS = -75%/25% = -.75/.25 = -3

This means that ANY dollar received in Tax Cuts in the economy is going to multiply on itself 3 TIMES

The Recessionary Gap is $100B

$100/-3 = -$33.33 Billion (-$33B X -3 = $100B)

This is the amount Govt. would DECREASE TAXES by to close this$100B gap (move closer to Full-Employment)

A. Definition1. Machinery and buildings that a firm uses to

produce output.2. NOT stocks/bonds

VI. Investment

B. Determinants of Investment1. Expected returns (profits)2. Interest rate

C. When do businesses invest?1. They must have the money (profits or borrowed)2. Determine profitability3. Compare the interest rate to the expected profit

rate of the investmenta. As Interest rates go down, the level of

investment goes up.b. If the interest rate goes down, the aggregate

expenditure curve will shift up

Part 2: Aggregate Supply and Demand

A. Introduction1. Definition - Sum of planned consumption (C),

investment (I), government expenditures (G), and net exports (NX)

2. Aggregate Demand is an inverse function between price level and output – price level rises, level of output demanded decreases

I. Aggregate Demand

B. Factors that affect aggregate demand1. Interest-Rate Effect

a. Decrease in households’ and businesses’ plans to buy capital and consumer durables because a price level increase will increase the interest rate.

b. A price level increase decreases the purchasing power of money.

c. With a smaller amount of real money available, financial institutions raise the interest rate.

B. Factors that affect aggregate demand, Cont.

2. Wealth Effect (Real Balance Effect)a. Decrease in the real value of cash balances as the

price level increases. b. Faced with this decrease in real wealth, people

decrease consumption and increase savings to restore their real wealth to the desired level.

B. Factors that affect aggregate demand, Cont.

3. Net Export Effecta. Decrease in domestic output demanded with an

increase in the domestic price level.b. Domestic products are mo re expensive to foreign

buyers and foreign goods are less expensive to domestic consumers.