Product Markets and National Output Chapters 11 and 12 Discussion Topics Circular flow of payments Composition and measurement of gross domestic product Consumption, saving, and investment Equilibrium aggregate demand and supply John Maynard Keynes 1883-1946 Intellectual elitist from childhood When asked how to say his name replied Keynes as in brains Father an economics professor at Cambridge Outlived his son by 3 years dying at age of 97 Mother Cambridge s first woman mayor Close to his mother but not his father Like Marshall disliked the presence of female students Palm reader Spectacularly rich 1
Circular Flow Diagram for General Economy We can measure macro economic activity in either resource markets or product markets. Result is the same 2
Four major sectors In this economy Businesses are net borrowers in financial markets while households are net savers Government receives net inflows of taxes from businesses and households and is a net borrower in financial markets 3
Businesses make investment expenditures, Governments makes expenditures, and Households make consumption expenditures Businesses receive funds from total expenditures in product markets while households, who own businesses, receive wages, rents, interest and business in resource markets profits where they provide labor and capital services Measurement of Gross Domestic Product 4
GDP Defined Gross domestic product (GDP) Monetary value of all finished goods and services produced within a country for a specific time period 1990 1991 recession 1929-1932 Great Depression Years 1974 1975 recession 1981 1982 recession 2007-2009 recession Recessions of 1937 and 1949 1949 end of WWII transition period Notice 2008 recession is largest since Great Depression and WWII in terms of duration and depth GDP = C + I + G + (X M) 5
Consumption as a Percent of GDP 2009 Estimates World 60% U.S. 71% GDP = C + I + G + (X M) Investment as a Percent of GDP 2008 estimates U.S. 15% World 22% 6
GDP = C + I + G + (X M) Government as a Percent of GDP GDP = C + I + G + (X M) 7
Net Exports as a Percent of GDP 2008 estimates U.S. -4.3% World 4.3% What s in GDP? Types of consumer expenditures 8
Types of investment expenditures Types of government Expenditures Calculation of net exports 9
Items not included in GDP All Government Spending as a Percent of GDP Why higher than 20-24% earlier? 2011 Estimates World 14.6% U.S. 39% Environmental Accounting Idea arose in the 1970 s Idea To link economic activities, natural resources, and the environment Why needed Present estimates of the scope of economic activity do not factor in the depletion or discovery of new natural resources Give a more accurate picture of all economic activities Not widely calculated by governments U.S. started in 1992 and suspended 2 years later 10
Consumptions Expenditures Consumptions Expenditures Understanding the Domestic Determinants of GDP C, I and G Planned Consumption Function Autonomous or fixed consumption = A c Consumption Function C = A C + MPC x DPI A C The slope of the consumption function is the marginal propensity to consume (MPC), or C DPI where DPI represents disposable income. Disposable Personal Income Graphing - C Consumption Function C = 200 + 0.6 x DPI If disposal income is $400 billion dollars what is planned consumption expenditures? 800 500 440 A C C = 200 +0.6 x 400 = 440 What if disposal income is $500? C = 200 +0.6 x 500 = 500 What if disposal income is $1000? 400 500 1000 Disposable Personal Income C = 200 + 0.6 *1000 = 800 11
Consumptions Expenditures Consumptions Expenditures Marginal Propensity to Consume Change in consumption expenditures associated with a change in disposable income Slope of consumption function MPC = ΔC ΔDPI Calculation ΔDPI = (1000-500) ΔC = (800 500) MPC = 300 / 500 = 0.6 Interpretation consumers plan on spending 60 cents of every after tax dollar on consumer goods and services On your own calculate MPC for DPI of $400 and $500 Movements Along C Consumption Function C = 100 + 0.8 x DPI Test yourself graph? Changes in disposal income movements along the curve 1700 1300 900 A C 1000 1500 2000 Disposable Personal Income A cut in the tax rate increases consumption. Why? An increase in the tax rate decreases consumption. Why? Shifts in C - Examples Anything that impacts consumption other than DPI Changes in wealth, prices, or expectations = parallel shift = Change in A c Increase in wealth A C Decrease in wealth 1000 1500 2000 Disposable Personal Income 12
Consumptions Expenditures Shifts in C cont. Anything that impacts consumption other than DPI Changes MPC = rotational shift = change in slope Increase MPC A C Decrease MPC 1000 1500 2000 Disposable Personal Income Savings vs. Consumption Savings = after tax personal income (DPI) minus spending on consumer goods and services S = DPI C Marginal propensity to save MPS = S DPI Relationship MPS and MPC MPS = 1.0 MPC Example MPC = 0.6 MPS = 1-0.6 = 0.4 Interpretation change in savings associated with a change in income carefully because of A c Savings vs. Dis-savings Consumption Function C = 200 + 0.6 x DPI DPI C Savings = DPI - C Effect Wealth position start of next year 400 440-40 Dis-savings Decreases 500 500 0 Break-even DPI Stays the same 1000 800 + 200 Savings Increases 13
Personal Savings Monthly Rate Jan. 1959 Sept. 2017 When the savings rate rises significantly, a recession is often near. Personal Savings Total Annual 1947-2016 Personal Savings Rate 14
Interest Rate % (R) Interest Rate % (R) Interest Rate (R) Planned Investment Function I = A I - MIS x R Note flip in axis The slope of the investment function is the marginal interest sensitivity of investment or MIS = I R A I Investment Expenditures (I) Autonomous or fixed investment = A I I = A I - MIS x R Let A I = 340 and MIS = 20 What is I if interest rate = 7? 7 5 I = 340-20 x 7 I = 200 What is I if interest rate = 5? I = 340-20 x 5 200 240 340 I = 240 Investment Expenditures (I) 7 I = A I - MIS x R What if profits expectations increase? Planned Investment shifts outward Same interest rate gives a higher investment On your own -- What if profit expectations decrease? 200 Changes in MIS? Investment Expenditures (I) 15
Interest Rate % (R) 7 MIS Calculation MIS = Δ I ΔR MIS = (240-200) / (5-7) = 40/(-2) = -20 = 20 Slope with note of previous graphical change 5 Definition Marginal interest rate sensitivity Change in investment expenditures with a change in the rate of interest 200 240 Investment Expenditures (I) Understanding Product Market Equilibrium Planned Aggregate Expenditures Aggregate Expenditures planned vs. actual AE = C + I + G + (X - M) Assume R = 13 Tax rate = 10% I = 340 20 x R = 340-20 x 13 = 80 G = $50 X M = 0 C = 200 + 0.6 x DPI What is AE? AE = (200 + 0.6 x DPI) + 80 + 50 + 0 AE = 330 + 0.6 x DPI 16
Aggregate expenditures AE Aggregate expenditures AE Calculating AE Based on Capacity Capacity Y G I = 340 20xR R= 13 Taxes = Y x.1 DPI Y - Tax C = 200 +.6xDPI AE = G + I + C 0 50 80 0 0 200 330 500 50 80 50 450 470 600 716 50 80 72 644 586 716 900 50 80 90 810 686 816 1600 50 80 160 1440 1064 1194 Graphing AE and Y Total Autonomous spending 1800 1600 1400 1200 1000 800 600 400 200 0, 330 Graph AE as a function of Y - capacity 500, 600 716, 716 1600, 1194 0 0 500 1000 1500 Aggregate output Y Keynesian Cross 1800 1600 1400 1200 Above equilibrium Y > AE Increase inventories 1000 Equilibrium Point 800 716 Spending equals output 600 400 Below equilibrium 200 Y < AE Decrease inventories 0 0 500 716 1000 1500 Aggregate output Y 45 0 Line Y = AE 17
Aggregate expenditures AE Aggregate expenditures AE Aggregate expenditures AE 1800 1600 1400 1369 1200 1000 800 Deriving Aggregate Demand Decrease in the price level what happens to AE? 600 Effect 400 Increase in equilibrium 200 Y and AE 0 0 500 1000 1369 1500 Aggregate output Y Increase in AE 1800 1600 1400 1200 1000 800 600 400 217 200 Deriving Aggregate Demand Increase in the price level what happens to AE? 0 0 217 500 1000 1500 Aggregate output Y Decrease in AE Effect Decrease in equilibrium Y and AE Results Price Changes 1800 1600 P 2 low 1400 1369 1200 P 1 middle 1000 P 3 high 800 716 600 400 217 200 0 0 500 1000 1500 Aggregate output Y 18
Price Level Price Level Price Level Aggregate Demand P 3 P 1 Graph Points Price Output P 1 middle price 716 P 2 low price 1369 P 3 high price 217 P 2 217 716 1369 Aggregate Output Aggregate Supply Curve Maximum potential output in the short run Classical range Depression range End of depression or Keynesian range Y D Normal range Y POT Aggregate Output Three distinct ranges of aggregate supply curve Aggregate Equilibrium AD AS P E Equilibrium Point AD = AS Point Y E Y D Y E Y POT 19
Price Level Price Level Inflationary Gap AD Y E > Y FE AS Inflationary Gap Planned spending exceeds full employment output, causing higher inflationary pressures in economy. Y FE Y E Y POT Y FE represents full employment output Y E represents current or actual output Y POT represents potential or maximum output Recessionary Gap AD Y E < Y FE AS Recessionary Gap Planned spending less than full employment output, causing underutilization of economy s resources. Y E Y FE Y POT Summary GDP consists of C, I, G and (X-M) Focus is on new goods produced and services performed in the current year Consumption influenced by disposable income and wealth Investment influenced by interest rates and profit expectations Product market equilibrium occurs where aggregate demand equals aggregate supply Inflationary and recessionary gaps occur when economy is not at full employment output 20
Chapter 13 focuses on the application of monetary and fiscal policy. 21