File - Ms. Nancy Ware`s Economics Classes

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NATIONAL INCOME &
PRICE DETERMINATION
SECTION 4
MODULES 16-21
Nancy K. Ware
Gainesville High School
AP Macro
Module 16 Essential Questions
1.
What is the nature of the multiplier?
2.
What is the meaning of the aggregate consumption function?
3.
4.
5.
How does expected future income and aggregate wealth affect consumer
spending?
What are the determinants of investment spending?
Why is investment spending considered a leading indicator of the future state
of the economy?
Terms to Know



Disposable Income: amount of household
income available to spend or save after taxes
Marginal Propensity to Consume (MPC): the
increase in consumer spending when disposable
income rises by $1
Marginal Propensity to Save (MPS): the
increase in household savings when disposable
income increases by $1
More Terms to Know


Autonomous Change of Aggregate
Spending: initial rise of fall in aggregate
spending that is the CAUSE, not the result of a
series of income and spending changes
Multiplier: ratio of the total change in real
GDP (caused by an autonomous change of
aggregate spending) to the size of that
autonomous change (a number by how
much spending will increase with an
autonomous $ injection)
The Multiplier: An Informal Introduction
1. Where does the
increased income
come from?
The Multiplier: An Informal Introduction
Autonomous
Change of
Aggregate
Spending
Each $1.00 spent in
the economy
translates into a
dollar’s worth of
income for workers
& producers
1. Where does the
increased income
come from?
Investment
spending,
Government
spending
Increased
disposable income
leads to increased
consuming
(spending) and
saving
How Does the Multiplier Work?
 American Recovery and Reinvestment
Act of 2009 enacted by the federal gov’t
 “stimulus package” of $787 billion was
intended to spark job growth to reverse
the worst recession since the Great
Depression. How was this supposed to
work?
1. The short answer: $1 of
s____________in one area of the
e_____________multiplies into
m__________than $1 of spending
throughout the economy.
2. Remember, the Circular Flow diagram
shows money s__________by one
person is received as i_________ by
another person.
How Does the Multiplier Work?
The federal government recently enacted
the American Recovery and
Reinvestment Act of 2009. This “stimulus
package” of $787 billion was intended to
spark job growth to reverse the worst
recession since the Great Depression.
How was this supposed to work?
1. The short answer: $1 of spending in
one area of the economy multiplies
into more than $1 of spending
throughout the economy.
2. Remember, the Circular Flow diagram
shows money spent by one person is
received as income by another
person.
Assumptions for Analysis
1. Ignore: g__________(or public sector) & n____
e________(or foreign sector) in the economy.
2. C_____________is a huge fraction (more than
___/__) of total spending in the e__________.
3. After a person pays her taxes, she is left with
d__________i__________that can either be
consumed or saved.
Yd = C + S
4. When a person gets more Yd, he will increase both
___and ____
5. The MPC is the amount by which consumer
spending r______ if current disposable income rises
by $____ and is the slope of the consumption
function.
Assumptions for Analysis
1. Ignore: government (or public sector) & net
exports (or foreign sector) in the economy.
2. Consumption is a huge fraction (more than
2/3) of total spending in the economy.
3. After a person pays her taxes, she is left with
disposable income that can either be
consumed or saved.
Yd = C + S
4. When a person gets more Yd, he will increase
both C and S.
5. The MPC is the amount by which consumer
spending rises if current disposable income
rises by $1 and is the slope of the
consumption function.
Marginal Propensity Formulas


Marginal
Propensity to
Consume (MPC)
Marginal
Propensity to
Save (MPS)
MPC =
∆ Consumer Spending
∆ Disposable Income
MPS =
∆ Saving
∆ Disposable Income



MPC + MPS = 1
MPC = 1 - MPS
MPS = 1 - MPC
Formulas


Autonomous
Change in
Aggregate
Spending (AAS)
Multiplier
1
∆Y = _________
X ∆AAS
(1 - _____)
Change in
_____
Multiplier =
Change in
________or $
injection
Spending
Multiplier
Formula
_____
∆Y = _________
1
∆AAS (1 - MPC)
250 billion
100 billion =
2.5
=
1
1-.60
2.5
Formulas


Autonomous
Change in
Aggregate
Spending (AAS)
Multiplier
1
∆Y = _________
X ∆AAS
(1 - MPC)
Change
in GDP
Multiplier =
Change in
AAS or $
injection
Spending
Multiplier
Formula
_____
∆Y = _________
1
∆AAS (1 - MPC)
250 billion
100 billion =
2.5
=
1
1-.60
2.5
Where Marginal Propensity to Consume
Comes From
Yd (disposable
Consumption
(c)
Savings
(s)
MPC = ( C/ DI)
MPS = ( S /
0
5 (5 + 8)
-5 (-5 + 2)
10
13
-3
.8 (8/10)
.2 (2/10)
20
21
-1
.8 (16/20)
.2 (4/20)
30
29
1
.8 (24/30)
.2 (6/30)
40
37
3
.8 (32/40)
,2 (8/40)
income) When
disposable income
increases by $10,
DI)
When disposable income increases by $10, C increases by $8 and S increases by $2.
Thus the MPC = (Δ C/Δ Yd) = .8 and
The MPS = (Δ S/Δ Yd) = .20.
So if this household receives $1 of additional Yd, they will consume 80 cents and save
20 cents of it.
How Does the Multiplier Work?
Assume that everyone in the economy spends 80% of every additional $1 of new disposable income.
What would happen if there was an injection of new spending into the economy?
Example: Alec is a chicken farmer in the local community. Suppose Alec decides to spend $1000 on
some chicken coops at Andy’s farm supply shop. This money now starts to be circulated around the
economy. Calculate the outcome.
1. Andy now has $1000 from the sale and spends 80% ($______) on clothes at Sarah‘s boutique.
2. Sarah now has $_______from the sale and spends 80% ($______) to fix her car at Ben’s garage.
3. Ben now has $_______ from the sale and spends 80% ($_____) at Jorge’s grocery store.
4. Jorge now has $______ from the sale and spends 80% ($______) with Anna’s catering company.
After 5 rounds of spending, we’ve created $___________, more than DOUBLE the original injection of
spending!!!!! If we had continued until someone was trying to spend 80% of nothing, Alec’s initial
$1000 purchase would have multiplied to a total of $5000 in income/spending.
The spending multiplier can be shown to be equal to:
M = 1/(1-MPC) = 1/(1-_____) =
Since MPC + MPS = 1, we can also say that M=1/MPS
In the macroeconomy:
The multiplier is the ratio of the total change in real GDP (caused by an autonomous change in
aggregate spending)to the size of that autonomous change.
DAAS is the autonomous change in aggregate spending
DY is the total change in real GDP.
Multiplier is equal to DY/DAAS, or 1 / (1 – MPC)
How Does the Multiplier Work?
Example: Alec is a chicken farmer in the local community.
Suppose Alec decides to spend $1000 on some chicken coops at Andy’s farm supply shop.
This money now starts to be circulated around the economy.
1. Andy now has $1000 from the sale and spends 80% ($800) on clothes at Sarah‘s boutique.
2. Sarah now has $800 from the sale and spends 80% ($640) to fix her car at Ben’s garage.
3. Ben now has $640 from the sale and spends 80% ($512) at Jorge’s grocery store.
4. Jorge now has $512 from the sale and spends 80% ($409.60) with Anna’s catering company.
After 5 rounds of spending, we’ve created $2361.60, more than DOUBLE the original injection of
spending!!!!! If we had continued until someone was trying to spend 80% of nothing, Ted’s initial
$1000 purchase would have multiplied to a total of $5000 in income/spending.
The spending multiplier can be shown to be equal to:
M = 1/(1-MPC) = 1/(1-.80) = 1/.2 = 5
Since MPC + MPS = 1, we can also say that M=1/MPS
In the macroeconomy:
The multiplier is the ratio of the total change in real GDP caused by an autonomous change in
aggregate spending to the size of that autonomous change.
DAAS is the autonomous change in aggregate spending
DY is the total change in real GDP.
Multiplier is equal to DY/DAAS, or 1 / (1 – MPC)
The Consumption Function
The consumption function is an
equation that shows how an
individual consumer
spending varies with the
Consumption
household’s current disposable
income.
Consumption
Function
The simplest version of a
consumption function is a linear
equation:
c = a + MPC * Yd
13
Little a = autonomous
consumption ($5)
 MPC = marginal propensity to
consume (the slope ~ .80)
C = 5 + .80 * 10 (Yd)
C = ________

5
10
Disposable
Income, Yd
Current Disposable Income and
Consumer Spending
1.
What is disposable income?
2. What usually happens to consumer
spending when DI goes up?
3.
What is the relationship between these
2 things & how can it be illustrated?
Current Disposable Income and
Consumer Spending
1.
Disposable Income: net income (after
federal & state taxes are paid) &
gov’t transfers are received
New Consumption
Function
Consumption
Function
2. What usually happens to consumer
spending when DI goes up?
It goes up too!
3.
What is the relationship between these
2 things & how can it be illustrated? See
the graph
13
5
10
Current Disposable Income and
Consumer Spending
• What is the Relationship
between Disposable Income
and Consumer Spending?
• Consumption Function:
c = a + MPC * yd
• Using the hypothetical
information from the earlier
table: c = 5 + .80Yd
• If Yd increases from $10 to $20, C
increases from $13 to $21. This is
seen as a movement upward
along the fixed consumption
function.
New Consumption
Function
Consumption
Function
13
5
10
Consumption Function FRQ 1
1.
Use the consumption function to answer the following questions: c = 15,000 + .80 x yd
2.
What is the value of MPC?
3.
If Disposable income is $40,000, how much will individual household consumer spending be
equal to?
4.
Draw a correctly labeled graph showing this consumption function.
5.
What is the slope of the consumption function?
6.
On your graph, what would happen if expected future income decreased?
Consumption Function FRQ 2
1.
Use the consumption function to answer the following questions: c = 20,000 + .90 x yd
2.
What is the value of MPC? MPS?
3.
If Disposable income is $34,000, how much will individual household consumer spending be equal
to?
4.
Draw a correctly labeled graph showing this consumption function.
5.
What is the slope of the consumption function?
6.
On your graph, what would happen if expected future income increased?
Shifts of the Aggregate (Whole Economy)
Consumption Function: Terms & Formula
• Autonomous Consumer Spending (BIG A):
amount of money a household would spend if
it had no disposable income
• Aggregate Consumption Function:
relationship for the economy as a whole
between aggregate current disposable income
& aggregate consumer spending
• C = A + MPC x DI
• What would cause C to increase, no matter
the level of Yd? There are several factors
that will shift the consumption function
upward or downward, similar to demand &
supply shifters.
Shifts of the Aggregate Consumption
Function
1. Changes in Expected Future
Disposable Income

https://www.youtube.com/wat
ch?v=aNsS1hCqYA8
Shifts of the Aggregate Consumption
Function
1. Changes in Expected Future
Disposable Income
Suppose a college senior was about
to graduate and already had a job
lined up. In other words, she knows
that her current disposable income is
going to rise. This expectation of
more income in the future shifts the
consumption function upward.

http://www.youtube.com/watch?v=aNs
S1hCqYA8&safety_mode=true&persist
_safety_mode=1&safe=active
Shifts of the Aggregate Consumption
Function
2. Changes in Aggregate Wealth
3. Permanent Income Hypothesis:
Shifts of the Aggregate Consumption
Function
2. Changes in Aggregate Wealth
 Wealth = accumulated assets, and this is very
different from disposable income.
 If you own a house, a car, shares of stock or even a
savings account, you have wealth.
 Suppose that the stock market has a bad year and the
value of your wealth substantially declines? This lost
wealth, even if it is only on paper, usually causes
people to reduce their consumption. (think homes
losing value during the 2008 Recession)
 The consumption function shifts downward .
3. Permanent Income Hypothesis: Consumer spending
today depends on the income people expect to have over
the long term rather than their current income.
Shifts of the Aggregate Consumption
Function

Current Income
Savings today

Expected Income
Savings today

How does this premise fit into the current state of
the economy? (recent recession, hard recovery)
Investment Spending
1.
2.
3.
Although consumer spending is much
larger than investment spending, booms
and busts in i_____________s__________
tend to d________the b_________c_______.
In fact, most recessions originate as a
f_______in i______________s_______________!!
Planned Investment Spending:
investment spending that businesses
tend to undertake during a given period
Investment Spending
1.
2.
3.
Although consumer spending is much
larger than investment spending, booms
and busts in investment spending
tend to drive the business cycle.
In fact, most recessions originate as a
fall in investment spending!!
Planned Investment Spending:
investment spending that businesses
tend to undertake during a given period
Fluctuations in Investment
Spending & Consumer Spending
Changes in Investment Spending
What is your
conclusion
about this
graph?
Life Cycle Hypothesis:
Planned Spending

What do you plan to spend your money on in your lifetime? Give the details
on your 5 year, 10 year, 20 year, 30 year, 50 year spending plan!
What Affects YOUR Spending?
Christmas is coming. Name as many things as possible
that will influence your spending. (This is your money.
Not momma’s or daddy’s.)
3 Factors that Affect Planned Investment Spending
Interest rate
Expected Future Level of GDP
Level of Production Capacity
3 Factors that Affect Planned Investment Spending
Interest rate
before a company invests dollars
they complete a benefit-cost analysis
to see the rate of return
Expected return on the investment =
expected economic profit from the
factory = (total revenue minus total
cost)/investment cost.
Expected Future Level of GDP
Expected GDP : up
Investment Spending: up
Expected GDP: down
Investment Spending: down
Level of Production Capacity
Demand for Product exceeds
production capacity…
Planned Investment
New factory or new machinery
will be invested in
The Interest Rate and Investment
Spending
1. Investment spending: before a company invests dollars they complete a
benefit-cost analysis so see the rate of return
Ex: A firm is considering building a new factory. This will increase sales, but it
will also require b______________ to fund the investment.
Expected return on the investment = expected economic profit from the
factory = (total revenue - total cost)/investment cost.
The market i______________ r________ is the cost of investment.
1. Interest rate = cost to borrow money
2. Interest rate = the cost of investing your own funds (no borrowing), since
it is i__________f__________. (opportunity cost)

When should the factory build?

When should they NOT build?

Thus there is a negative relationship between the interest rate and dollars
of investment spending.
The Interest Rate and Investment
Spending
1. Investment spending: before a company invests dollars they complete a
benefit-cost analysis so see the rate of return
Ex: A firm is considering building a new factory. This will increase sales, but it
will also require borrowing to fund the investment.
Expected return on the investment = expected economic profit from the
factory = (total revenue minus total cost)/investment cost.
The market interest rate is the cost of investment.
1. Interest rate = cost to borrow money
2. Interest rate = the cost of investing your own funds (no borrowing), since
it is income forgone. (opportunity cost)


When should the factory build?
When the rate of return higher than the cost of the funds they would have
to borrow to finance that project.


When should they NOT build?
If the interest rate rises.

Thus there is a negative relationship between the interest rate and dollars
of investment spending.
The Interest Rate and Investment
Spending
A d_________
in the real
interest rate
will result
in m______
gross
private
investment.
i
I
The Interest Rate and Investment
Spending
A decrease
in the real
interest rate
will result
in more
gross
private
investment.
i
I
The Interest Rate and Investment
Spending
Factors that Affect Planned Investment Spending:
Expected Future GDP & Production Capacity
There are some factors that would increase investment
spending at any interest rate.
1. Expected Future Real GDP
Expected GDP
Investment Spending
Expected GDP
Investment Spending
2. Production Capacity
Demand for Product exceeds production capacity
Planned Investment
New factory or new machinery will be invested in
The best conditions for new investment spending consists of
firms that are near production capacity with expectations of
strong real GDP in the future.
Expected Future Real GDP, Production
Capacity, and Investment Spending
An i__________in
either
expected
future
r_______G______
or production
capacity will
result in
m________
investment at
the same
i___________
r______.
Expected Future Real GDP, Production
Capacity, and Investment Spending
An increase in
either
expected
future real
GDP or
production
capacity will
result in more
investment at
the same
interest rate.
Multiplier Homework

Gabrielle has just found $10 in the pocket of a coat from last winter.
Gabrielle and everyone in her town has a MPC of .90. Create a table that
shows how rounds of spending will multiply into more than the initial $10.
Once you are spending less than $2.00, add up the spending rounds.
Including the initial $10, how much spending was eventually created?

Question: Why does the federal government spend taxpayer money on
programs?
Module 16 Review p. 170
Read Module 17 p. 172

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