NATIONAL INCOME DETERMINATION WORK SCHEDULE (TEXT CHAPTER: 8)

Transcription

1 DAY 1: NATIONAL INCOME DETERMINATION WORK SCHEDULE (TEXT CHAPTER: 8) Objective: Create a circular flow of demand in the Macroeconomy and identify leakages and infections within the economy. DAY 2: Assign: Read o The Determinants of Consumption for a brief primer. o Read pages for more detailed explanations (Highly recommended) Define the following terms: Average Propensity to Consume and Save, Marginal Propensity to Consume and Save Create and identify elements of the Consumption Function as a graphical model Illustrate the APC, APS, MPC, MPS on the consumption function. DAY 3: Assign: Activity 20 Macro book Analyze the factors that not related to income that cause Consumption to change. Illustrate these changes on the consumption Differentiate between a change in the level of consumption and a shift in consumption. DAY 4: Assign: Read Investment, Government, and Net Exports Determinants (Focus on investment) Pages in text. Will help your understanding greatly. Illustrate the relationship between Investment and real interest rates. Analyze the factors not related to interest rates that change rates of investment. DAY 5: Assign: Activity 22 Macro Book Read Investment, Government, and Net Export Determinants (Focus on Government and Net Exports) Analyze the determinants of Government spending Analyze the determinants of Net Export spending Analyze the impact of a change in any Aggregate Expenditure category on overall economic activity. Assign: Read Demystifying the spending multiplier Pages for more details on the spending multiplier DAY 6: Given the MPC or MPS, calculate the simple spending multiplier. Analyze the impact of the simple spending multiplier on overall economic activity. Evaluate the impact of the S.S.M. on a change in any Aggregate Expenditures category. Assign: 1. Activity 21 Macro Book 2. Read: Aggregate Demand in packet DAY 7: DAY 8: Review for Aggregate Demand Exam Exam on aggregate demand

2 VOCABULARY: NATIONAL INCOME DETERMINATION 1. The Circular Flow Diagram 2. Injections 3. Leakages 4. Consumption 5. The Consumption Function 6. Marginal Propensity to Consume 7. Marginal Propensity to Save 8. Average Propensity of Consume 9. Average Propensity to Save 10. The simple spending multiplier 11. The Wealth Effect 12. Determinants of Consumption 13. Investment 14. The Investment Demand Curve 15. Interest Rates 16. Determinants of Investment 17. Government Spending 18. Determinants of Government Spending 19. Net Exports 20. Determinants of Net Exports 21. Strong Dollar/Weak Dollar

3 DETERMINANTS OF CONSUMPTION Consumption is the single largest component of Aggregate Spending (Aggregate Demand) in the economy (70%). Thus it would be wise for us to look a little more closely at consumption as a function of income, as well as the factors that influence consumption that are independent of income. All of these forces combine to change the levels of consumption, and thus of overall output and demand in the economy. Large swings in consumption can indeed cause economic problems, be they inflation or unemployment. CONSUMPTION AS A FUNCTION OF INCOME: The most important element in determining how much consumption there is in our economy is income. People gain income, and spend the money that they earn. As important as spending is, it is also important to note that people also save a portion of the income that they earn. Any money that is not spent may indeed end up as a leakage from the economic circle in the financial market, thus it is significant to know HOW MUCH people spend and save. Economists have come up with two unique terms to describe human behavior as it relates to spending and saving, they are: THE MARGINAL PROPENSITY TO CONSUME (MPC): This refers to the proportion of each extra dollar earned that is actually spent on consumption. To calculate the MPC, all you need to is to divide the CHANGE IN SPENDING by the CHANGE IN INCOME that caused it. For example: If you earned an extra $200, and spent $160 of it on consumption, your MPC would be: =.8 MPC = THE MARGINAL PROPENSITY TO SAVE (MPS): This refers to the proportion of each extra dollar earned that is actually saved for later use. To calculate the MPS all you need to do is divide the CHANGE IN SAVING by the CHANGE IN INCOME that caused it. If you earned $200, and saved $40 of it for later, your MPS would be: =.2 MPS = NOTES ON THE MPC/MPS: A. You will note that the MPC and the MPS, when added together will always add up to 1. This is due to the fact that both are derived from the same dollar of income, and thus must equal exactly 1. B. The MPC/MPS is very important statistic in the economy. The MPC allows us to see exactly how much of an extra dollar in income will be spent and saved. This, in turn, allows us to see just how big or small the savings leakage is from the circular flow.

4 THE CONSUMPTION FUNCTION: This is a graphical model that shows the relationship between consumption and income, and also shows the MPC if you are keen enough to see it. Below is an example of a consumption function. Pay attention to what is measured on each axis, as well as the relationship between consumption and function. Consumption CF 2 C2 C1 A B Consumption Function Disposable Income Movement along an existing CF is caused by a change in disposable income. This is illustrated by movement from Point A to Point B or vice versa. A change in taxation would be an example of something that would cause this to happen, as would an increase in DI for any other reason. SHIFTS IN THE CONSUMPTION FUNCTION: There are things that can cause the entire CF to shift either UP or DOWN. You should note that when this happens, there will be more consumption at ANY LEVEL OF DISPOSABLE INCOME. Inherent in this shift is the idea that it must be caused by a force that does not in itself change DI, but influences some force outside of DI like WEALTH or EXPECTATIONS. The following are the DETERMINANTS OF CONSUMPTION: CHANGES IN WEALTH: Changes in wealth cause the entire CF to shift either up or down, thus causing increases or decreases in consumption. This works due to the fact that wealth is independent of income, and can thus cause consumption to be higher than income. CHANGES IN THE GENERAL PRICE LEVEL: Changes in the general price level cause the real purchasing power of money to decline. This is not a problem with income because it changes with the price level, but it causes problems with wealth. Wealth is stored over time, and does not necessarily change with the price level. EXAMPLE: If you have a valuable baseball card collection and there is a rising price level, the purchasing power of your collection will decline. When this happens, you will be less likely to spend your wealth, and thus, consumption will decline. Increases in the price level will cause a decline in consumption; decreases will cause consumption to rise. CHANGES IN THE INTEREST RATE: When interest rates change, the level of consumption can change. The reason for this is that it costs more to borrow money to make purchases. Borrowing money is independent of income, and thus shifts the CF either up or down. As interest rates rise, consumption declines, as interest rates decline, consumption increases. NOTE: This connection is generally considered to be a weak one, due to the fact that a lot of borrowing is for houses, which count toward INVESTMENT not consumption. CHANGES IN INFLATION: DO NOT confuse this with a change in the price level. This deals with how fast prices are rising, not an erosion of wealth. If prices are rising fast, the theory is that people will purchase more now to avoid rising prices in the future. This connection is also considered to be weak by economists, but in theory it does make sense. EXPECTATIONS: If people expect the economy to turn "sour", they will consume less to save for the future. If they expect it to do well, they may consume more now with the expectation of future increases in income. When either of these two things happens, it causes the CF to shift either up or down. There is no hard and fast rule for this one, so solve these on a case-by-case basis.

5 INVESTMENT, GOVERNMENT, NET EXPORTS: MAIN DETERMINANTS INVESTMENT: Business investment in capital makes up 10-15% of total GDP, and is also one of the most volatile components of GDP. The following is a list and brief description of the things that cause changes in investment. Any change in investment causes aggregate spending to increase, thus increase GDP. Business Expectations: This refers to the outlook for future economic growth. Business must be diligent in planning for the future, and buy capital goods today that will not be ready for use until later. Positive expectations mean more capital today; negative expectations mean less capital spending today. Current Growth in Demand: This refers to current levels of demand in the economy, and it's strength relative to potential supply. Strong current demand can increase INVESTMENT; weak demand levels can lower INVESTMENT. Technology Change: Technological advances allow workers to be more productive, and will lower production costs. When firms see these advances they will INVEST more in capital goods. As the level of tech. advancement slows, so too does INVESTMENT. The is a prime example of this. Interest Rates: Interest rates affect investment because they alter the cost of borrowing the money needed to buy more capital goods. Higher interest rates mean less INVESTMENT; lower interest rates mean more INVESTMENT. Tax Environment: Tax levels can be altered to create more investment in capital goods. Incentives such as lower taxes or depreciation allowances can alter investment. NET EXPORTS: Net exports are also somewhat variable in their levels in the economy. They are not fixed amounts and change, causing a change in aggregate spending. While the overall net of exports and imports are small compared to consumption, changes in these levels can affect the greater economy. Let us now focus on the things that have the power to alter levels of net exports. National Income: If National Income in one nation is rising, the people of that nation will have higher incomes with which to purchase IMPORTS from other nations. Thus, rising national income will cause Net Exports to fall due to higher imports. Just the opposite occurs when NI is falling. Less income means fewer imports, thus higher Net Exports. Exchange Rates: All nations use different types of money, and the value of this money changes from time to time. If the U.S. dollar is getting STRONGER relative to other nations currencies, we should see the level of net exports FALL. This is due to the fact that a stronger dollar buys more imports from other nations. If the dollar is getting WEAKER, it buys less imports, thus, net exports RISE. Relative Prices: Changes in the rate of inflation in one nation versus another also have the power to affect overall levels of imports and exports. Generally, high inflation in the U.S. means we can get goods cheaper from other nations. Thus, high inflation in our economy will cause Net Exports to fall, as imports rise. GOVERNMENT SPENDING: Government spending is a large component of aggregate spending in the economy, about 20% of all spending is done by the government. As G increases or decreases so too does aggregate demand. Government spending is determined by the following factors: Fiscal Policy: Sometimes the government takes action to counter problems associated with business cycle phases such as unemployment or inflation. It has the power to change rates of taxation, giving more money to the citizenry to spend as well as changing its own level of spending. Either of these can be used to slow down the economy of speed it up when necessary. State and Local: State and local governments can, and do, change tax rates and levels of spending. Doing so either puts money into the economy or takes if out. Either has the power to change overall demand in the economy. Politics: Government programs can have a big impact on the economy. Creating a new space program or starting a war carry a hefty price tag and the economy will feel it through increased spending. Local projects such as the indoor Rainforest in built in Iowa, so called pork barrel impact the local economy and ripple through the national economy as well.

6 DEMYSTIFYING THE SPENDING MULTIPLIER The spending multiplier is not really all that magical, it just may seem that way until you better understand how it works. The key to the entire multiplier can be found in the circular flow diagram, and by thinking about the notion that every dollar spent becomes income from someone else. The multiplier works because, and is limited in size by the MPC. Each dollar spent goes around the circular flow diagram to business, which then becomes income for those who were involved in the production process. It then comes back to the consumer as income, and is spend again. The actual size of the multiplier is determined at the point where savings is leaked from the flow, and thus does not become spending to support more income. The amount of spending that actually exits as CONSUMPTION will always be less than the original amount that came to the consumer as income, assuming that there is some level of savings in the economy. For example: Assume that the MPC is.8. This implies that the MPS is.2. When the first dollar is spent it goes to business as $1 of income for other members of the economy. When it returns to the consumer as $1 they will save 20 cents and spend the remaining 80 cents. Thus, in the second round only 80 cents of income will be generated from the original dollar. In the third round, people will save 16 cents, and spend 64 cents. This will generate 64 cents in income, and start a new round of spending that will be less than 64 cents. Over time, the amount generated in successive rounds will eventually become too small to count. After many rounds the original dollar will thus have exhausted it's ability to generate new spending due to increased savings. THE OVERSIMPLIFIED MULTIPLIER FORMULA: Given the MPC, you can calculate the multiplier with the following formula: MULTIPLIER = THUS MPC(.8) = = 5 1- MPC SOME SIMPLE TIPS FOR THE MULTIPLIER: The larger the MPC the larger the multiplier, the larger the MPS, the smaller the multiplier. The multiplier means that every dollar spent will sustain many more dollars spent until it exhausts itself. WHY THE MULTIPLIER IS OVERSIMPLIFIED: The real multiplier is actually smaller than it seems due to the following limitations: Taxes: Taxes take some of the income generated by spending out of the flow. World Economy: More GDP spending means more imports, which means money leaking from the flow, thus less "multiplication". Inflation: It erodes the real purchasing power of wealth, thus it reduces the new money coming into the economy to be multiplied. Interest Rates: More spending in the economy usually raises interests, for reasons we will see later. This means less INVESTMENT, and thus less money injected to be multiplied. THE MULTIPLIER AND THE AD/AS MODEL: It is easy to see the results of the multiplier on the AD/AS model. If you see a shift in either aggregate demand or aggregate supply, the amount of GDP that changes after the shift includes the full effect of the multiplier that was caused by a lesser change in INITIAL SPENDING. Example: If GDP increased by $500B and the MPC was.8 we could assume that a change of $100 caused $500B, meaning that the multiplier was equal to five.

7 FISCAL POLICY SOLVING INFLATIONARY AND RECESSIONARY GAPS **The following is a step by step process for how to solve any fiscal policy question. STEP 1: Look at the data or the graph and decide if the economy has high inflation or high unemployment. STEP 2: Based on the problem, decide if Expansionary or Contractionary policy is needed. STEP 3: Find the actual GAP in GDP by comparing current equilibrium with either potential or long run GDP, whichever is given. STEP 4: Look for the MPC and calculate the MULTIPLIER. If the MPC is not given, look at the model and compare the vertical distance with the new equilibrium that is reached from the vertical shift. Divide the total change in spending by the vertical distance. STEP 5: Now that you know the MPC and the MULTIPLIER, you can calculate the needed change in INITIAL spending that must come from the fiscal policy action. Divide the TOTAL GAP by the MULTIPLIER to get this. STEP 6: If you are using a change in GOVERNMENT SPENDING to solve the problem, it is the same as the INITIAL spending change. Recommend changing G by this amount. STEP 7: If you are using a TAX change or a change in TRANSFER PAYMENTS, you will need to know the formula that follows: INITIAL SPENDING CHANGE NEEDED MPC You will notice that the number that you get from this formula is ALWAYS larger than the initial spending change. This is because the consumer will save some of the money, and spend the rest. By calculating this larger number, you are actually giving the consumer more than is needed to account for the savings. You reply to an answer that requires TAX or TRANSFER PAYMENT changes should be the number that you calculate! EXAMPLE: Assume potential GDP is currently $6,000 Billion and current equilibrium is $5,000 Billion. Also assume that each $100 Initial change will increase GDP by $500. A. What is the problem in the economy? B. What is the MPC? C. By how much would Government spending have to change to correct the problem? D. By how much would TAXES or TRANSFERS have to change to correct the problem?

8 FISCAL POLICY: PRACTICE AND APPLICATION The following problems are designed for you to practice applying the principles of fiscal policy to real world applications using the models that we have constructed in class. Assume that the MPC for this economy is Current equilibrium GDP is $4,000 Billion, and potential GDP is $5,000 Billion. What problem would exist in this economy? 2. Using discretionary fiscal policy, what should the government do to solve the problem for each of the following possible policy options: A. If the government wanted to change spending, what should it do to spending, and by how much should it change spending? B. If the government wanted to change taxes, what action should be taken, and by how much should taxes be changed? Why is this number different than the answer to part A above? 3. What is the trade off that a policy maker must accept if they are to use fiscal policy to continually solve this type of economic problem? 4. On a dollar for dollar basis which is a stronger fiscal policy option, raising taxes or increasing government spending? 5. Why is the MPC so important when it comes to evaluating fiscal policy options?