Fluctuations of Investment Durability Irregularity of Innovation Variability of Profits Variability of Expectations

Transcription

1 Shifts in the Invest Demand Curve Acquisition, Maintenance and Operating Costs Business Taxes Technological Change Stock of Capital Goods on Hand Expectations Fluctuations of Investment Durability Irregularity of Innovation Variability of Profits Variability of Expectations Summary: Equilibrium GDP The equilibrium output is that out put which creates total spending just sufficient to produce that output Other features of equilibrium GDP Saving equals planned investment saving represents a leakage of spending investment can be thought of as an injection of spending No unplanned changes in inventories Through a multiplier effect, an initial change in investment spending can cause a magnified change in domestic output. Multiplier the ratio of a change in the equilibrium GDP to the change in investment Changes in GDP = multiplier x initial change in spending The initial change in spending associated with investment spending because of investment s volatility associated with investment spending results from either a change in the real interest rate or a shift of the ID curve 1

2 may create a multiple increase in GDP and a decrease in spending may be multiplied into a large decrease in GDP Rationale: spending generates income change in income will cause both consumption and saving to change The larger the MPC (and the smaller the MPS), the greater the size of the multiplier Summary: Basic Keynesian Model Assumption: price is fixed in the short run Aggregate expenditure is the planned total spending on final goods and services AE = C + I (no government, no trade) The equilibrium output is that out put which creates total spending just sufficient to produce that output (Y = AE) Saving equals planned investment (S = I) No unplanned changes in inventories Suppose that France has an MPC (Marginal Propensity To Consume) of 0.22 and a real GDP (Gross Domestic Product) of $431 billion. Also suppose that its investment spending decreases by $9 billion. Calculate (correct to 1 decimal place) France's new level of real GDP in the aggregate expenditures model. Recall ΔY e = Δ(C 0 + I g )/(1-c) ΔY e = = $9/(1-0.22) = $11.54 billion New GDP = Old GDP + change in GDP (-) = $431 - $11.54 = $ billion Adding the Government Sector Simplifying Assumptions government purchases do not cause any shift in consumption or investment schedules net tax revenues are derived totally from personal taxes taxes do not vary with GDP Government spending (G is autonomous expenditure Taxes affect disposable income Increases in public spending shift the AE schedule upward and result in higher equilibrium GDP Examples suppose government add 40 billion of purchases suppose government impose 40 billion of lump-sum tax The Transmission Mechanism 1. With prices constant, changes in money supply change nominal and real interest rates 2. Changes in real interest rates change consumption expenditure 3. Change in real interest rate also cause changes in planned investment expenditure 4. Changes in nominal interest rate also cause changes in exchange rates, which change the price competitiveness and profitability of trade. 2

3 Keynes s Solution to a Recessionary Expenditure Gap Two different policies that a government might pursue to close a recessionary expenditure gap and achieve full employment: 1. Increase government spending 2. Lower taxes Both work by increasing aggregate expenditures France is falling 2.0% above its targeted income of $18,000 and has a marginal propensity to consume of 0.6. By using the multiplier model, what change in government expenditures would be needed to achieve this target? Recall, Multiplier = ΔY e /ΔAE Multiplier = 1/(1-MPC) = 1/(1-0.6) = 2.5 ΔY e = 2%*$18,000 =$360 ΔAE = $360 / 2.5 = $144 Government must increase its expenditure by $144 to close the output gap. The aggregate demand aggregate supply model Shows how economic factors and policies can simultaneously affect the overall price level as well as real output Deals with changes in the overall price level of the economy Consumer Price Index not inflation The general level of prices directly determines the purchasing power of money Stagflation was difficult to explain with the Keynesian cross model Aggregate Demand (AD) - The amounts of real output that buyers collectively desire to purchase at each possible price level 3

4 Slopes downward because of the following effects of a change in price level: 1. Real-balances Effect 2. Interest-rate Effect 3. Foreign Trade Effect Determinants of Aggregate Demand Consumer Spending Consumer wealth Consumer expectations Taxes Household indebtedness Investment Spending Real Interest Rates Expected Returns Expectations about future business conditions Technology Degree of excess capacity Business taxes Government Spending Net Export Spending National Income Abroad Exchange Rates Aggregate Supply The level of real domestic output that will be produced at each price level Production responses to price level changes differ in the long run & the short run In the long run, the aggregate supply curve is vertical at the economy s full-employment output (potential GDP) In the long run, wages and other input prices rise or fall to match changes in the price level Changes in the price level do not change real profit & there is no change in real output In reality, nominal wages adjust only slowly to changes in the price level Short-run aggregate supply curve is upward-sloping As the economy expands in the short run, per-unit production costs generally rise The extent of the rise depends on where the economy is operating, relative to its capacity an economy operating below its full-employment output has idle capital & labour little upward pressure on production costs when the economy is operating beyond its full-employment output, most available resources are already employed per-unit production costs increase as economy expands Determinants of Aggregate Supply 1. Change in input prices Domestic resource price Price of imported resources Market power 2. Change in productivity 3. Change in legal-institutional environment Business taxes and subsidies 4

5 Government regulation Increases in AD For any initial increase in aggregate demand, the resulting increase in real output will be smaller the greater is the increase in the price level Demand-pull inflation Decreases in AD Deflation is a rarity in the Canadian economy Real output takes the full brunt of the decline in AD because product prices are sticky in the short run wage contracts morale, effort, & productivity minimum wage menu costs fear of price wars 5

6 Decreases in AS: Cost-Push Inflation Effects of a leftward shift in AS are doubly bad output decreases price level increases From the Short Run to the Long Run Nominal wages and other input prices may remain constant in the short run, even though the price level has changed Once contracts have expired & nominal wage adjustments have been made, the economy enters the long run Recessionary Gap - A recessionary gap occurs when AD is too low, and equilibrium GDP is below potential GDP 6

7 Inflationary Gap - An inflationary gap occurs when AD is too high, and equilibrium GDP is above potential GDP Until the late 1960s, it looked as if inflation went up only when unemployment went down Economists thought there was a stable, inverse relationship The Phillips Curve Long-run Phillips curve: a relationship between the inflation rate and the unemployment rate in the long run the vertical long-run Phillips curve is drawn at the natural rate of unemployment Short-run Phillips curve (SRPC) a relationship between actual unemployment and the inflation rate for given inflationary expectations Expectations of inflation adaptive expectations of inflation a method of forming expectations about the inflation rate that involves looking to past experience Types of inflation 7

8 Demand-Pull Inflation Increases in the price level caused by an excess of total spending beyond the economy s capacity to produce excess demand Cost-Push Inflation Increases in the price level resulting from an increase in resource costs and hence in per unit production costs per-unit production costs supply shocks Assume C = DI T = 10% DI = (1-t)Y So C = (1 0.10)Y C = Y Each extra dollar of national income increase DI by $0.9 (90 cents), out of which household spend 72 cents and save 18 cents. Fiscal policy is government use of its taxes and spending to affect Aggregate expenditure and equilibrium GDP Expansionary fiscal policy eliminate recessionary gaps Restrictive/Contractionary fiscal policy eliminate inflationary gaps 8

9 Expansionary Fiscal Policy in AD/AS Model To raise aggregate demand and expanding real output Used when Recession Occurs Options: Increased Government Spending Tax Reductions Combined Government Spending Increases & Tax Reductions May Create a Budget Deficit Restrictive/Contractionary Fiscal Policy in AD/AS Model To decrease aggregate demand thus controlling inflation Used to Combat Demand-pull Inflation Options: Decreased Government Spending Increased Taxes Combined Government Spending Decreases & Tax Increases The cyclically adjusted budget shows what the budget balance would be if the economy were operating at full employment Budget Deficit Annual amount by which government expenditures exceed taxes E.g deficit = $55.9 billion Public Debt Accumulation of all past deficits & surpluses E.g public debt =$519.6 billion Substantive Issues Income Distribution Incentives External Debt Crowding-Out & the Stock of Capital The Crowding Out Effect - Increasing the debt may put upward pressure on interest rates. The higher interest rates may reduce private Investment (I g ) The crowding out effect may be partially offset by increased private investment, due to improvements in infrastructure Qualifications Public investment Public-private complementarities Built in stabilizer a mechanism that increases government budget deficit or reduces the surplus during a recession and increases governments budget surplus or reduces its deficit during inflation without any action by policy makers Progressive tax a tax with an average tax rate that increases as the taxpayers income increases and decreases as the taxpayer s income decreases 9

10 Proportional tax a tax with an average tax rate that remains constant as the tax payer s income increases or decreases Regressive tax a tax with an average tax rate that decreases as the taxpayer s income increases and increases as the tax payer s income decreases Money Definition M1 Currency: Coins + Paper Money token money Bank of Canada notes Demand Deposits about ⅔ of M1 Institutions That Offer Demand Deposits chartered banks are the primary depository institutions Money Definition M2 M1 + near monies Near monies are highly liquid financial assets that do not directly function as a medium of exchange but can be readily converted into currency Currency (coins & paper money) plus Demand deposits equals M1 plus Personal savings deposits, plus Nonpersonal notice deposits equals M2 plus Deposits: Other intermediaries equals M2+ plus Canadian saving bonds Plus non-money market mutual funs Money Creation: Single Bank The maximum amount of new money which can be created by a single bank is equal to its excess reserves The bank creates money when it creates new loans Money is destroyed when loans are repaid Banks create money when they buy government bonds from the public Bond purchases from the public by the chartered banks increases the money supply Bond sales to the public decreases the money supply Bankers have two conflicting goals: Profit Liquidity Overnight loans rate paid on overnight loans to cover temporary shortages of reserves 10

11 A single bank can lend one dollar for each dollar of excess reserves The banking system can lend (create money) by a multiple of its excess reserves Bond Example: Government of Canada, 4.25, 2009-sep-01 Marketable 4.25 percent bond with a maturity date September 1, is called coupon value, it pay its holder $4.25 for each $100 face value. $100 is the principal. Present Value of the Bond (PV) The present value is the discounted value of future payments X dollars today = X(1 + i) t dollars in t years at a compound interest rate of i Rearranging the formula X dollars today = X (1 + i) t dollars in t years, we obtain the present value formula: X / (1 + i) t dollars today = X dollars in t years For example, if $ is desired in 17 years, then at 8% compound interest, $370.00/(1+.08) 17 = $100 is required today A higher current interest rate leads to a lower bond price, and vice versa. 11

12 If the MPC in an economy is.75, a $1 billion increase in taxes will ultimately reduce consumption by: A) $1 billion. B) $.75 billion. C) $3 billion. D) $4 billion. Tax affects disposable income, then reduces autonomous consumption by the amount of tax*mpc, so if tax is 1 billion, the change in autonomous consumption is 1*0.75 = 0.75 billion, multiplier = 1/(1-MPC) = 4, so overall change in equilibrium output is 0.75*4 = 3. Use the following to answer question 31: The following information is for a closed economy: GDP C S Ig $100 $100 $ 0 $ Refer to the above information. If in addition to spending $80 billion at each level of GDP, government imposes a lump-sum tax of $100: A) equilibrium GDP will now be $350. B) equilibrium GDP will now be $400. C) equilibrium GDP will now be $300. D) the equilibrium GDP cannot be determined. The initial euqilibrium is 300 (where AE = Y and AE = C+ I), adding government spending 80 billion will increase autonomous expenditure by 80 billion. Increase 100 billion dollar tax will reduce autonomous consumption by 100*MPC amount. In this question, MPC = change in consumption/change in income = 60/100 = 0.6 (you can use any two rows of the first two column to compute this), so the reduction in autonomous expenditure due to tax is 100*0.6 = 60, the overall change in autonomous expenditure = = 20, multplier = 1/(1-MPC) = 2.5, so the overall change in equlibrium output = 20*2.5 = 50, the initial equilibrium is 300, the new equilibrium output = =

13 If the MPS is only half as large as the MPC, the multiplier: A) is 2. B) is 3. C) is 4. D) cannot be determined from the information given. MPC + MPS = 1 and MPS = 1/2*MPC, subsitute the later equation to the first one, so MPC + 1/2*MPC = 1, so 3/2*MPC = 1 and MPC = 2/3 then multiplier = 3. The following information is consumption and investment data for a private closed economy. Figures are in billions of dollars. C = Y I = I0 = Refer to the above data. The equilibrium level of income (Y ) is: A) 60. B) 225. C) 200. D) , AE = C + I = Y + 50 = Y. Two ways you can calculate it, first: AE = Y, so Y = Y, Y = 200; second: equilibrium output = autonomous expenditure * multiplier = 100 * 1/(1-0.5) = 200. The answer is C. Holly's break-even level of income is $10,000 and her MPC is If her actual disposable income is $16,000, her level of: A) consumption spending will be $14,500. C) consumption spending will be $13,000. B) consumption spending will be $15,500. D) saving will be $2,500. Break-even income is the where your consumption is equal to your income, so you are break even. So from this information, we know that C = Y = 10,000, and MPC = change in C/Change in Y = 0.75, if income increases to 16,000, or increased by 6000, the consumption should increase by 4500, since 6000*0.75 = 4500, so consumption has increases from 10, 000 to 14,500. If the MPC is.8 and the disposable income is $200, then A) consumption and saving cannot be determined from the information given. B) saving will be $20. C) personal consumption expenditures will be $80. D) saving will be $40. E) personal consumption expenditures will be $160. Consumption function can only be determined if you know the autonomous consumption as well as MPC. In this question, there is no way you can find out the autonomous consumption, so it cannot be determined. 13

14 Use the following to answer question 15: Assume that for the entire business sector of the economy there is $0 worth of investment projects which will yield an expected rate of return of 25 percent or more. But there are $15 worth of investments which will yield an expected rate of return of percent; another $15 with an expected rate of return of percent; and similarly an additional $15 of investment projects in each successive rate of return range down to and including the 0-5 percent range. 15. Refer to the above information. If the real interest rate is 15 percent, what amount of investment will be undertaken? A) $15 B) $30 C) $45 D) $60 t is about investment demand, which is a function of investment and rate of return (interest rate), the relationship is as follows rate of return(interest rate) investment and... so the answer is B. In a private closed economy the marginal propensity to save is 0.25, autonomous consumption equals $30 billion, and the level of investment is $40 billion. What is the equilibrium level of income? A) $280 billion B) $320 billion C) $262 billion D) $198 billion (I+C)/MPS If government increases its tax revenues by $15 billion and the MPC is 2/3, then we can expect the equilibrium GDP to: A) decrease by $30 billion. C) decrease by $35 billion. B) decrease by $45 billion. D) decrease by $55 billion. 1/1-MPC = 3 2/3rds of 15 is 10 consumption is 10 multiply consumption by multiplier 10 x 3 1. Refer to the above table. Suppose the transactions demand for money is equal to 20 percent of the nominal GDP, the supply of money is $800 billion, and the asset demand for money is that shown in the table. If the nominal GDP is $2000 billion, the equilibrium interest rate is: A) 4 percent. B) 5 percent. C) 6 percent. D) 7 percent *.2 Add it up with the chart, if it equals supply of money than picks it percentage 14

15 The price of a bond having no expiration date is originally $8000 and has a fixed annual interest payment of $800. A fall in the price of the bond by $3,000 will provide a new buyer of the bond an interest rate of: A) 10 percent. B) 12 percent. C) 14 percent. D) 16 percent. do you know this one? i did it like this = / 5000 = answer which i think is 16 Refer to the above information. If there is a deposit of $10 billion of new currency into chequeing accounts in the banking system, excess reserves will increase by: A) $1 billion. B) $2 billion. C) $8 billion. D) $10 billion =excess reserves. 10 *.8 = 8 15