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Aggregate Expenditures Keynesianism

Aggregate Expenditures

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Aggregate Expenditures. Keynesianism. Keynes and the Depression. Say’s Law says that producing goods generates an amount of income equal to the value of the goods produced Great Depression Keynes theorizes that not all income is spent leaving surpluses - PowerPoint PPT Presentation

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Page 1: Aggregate Expenditures

Aggregate Expenditures

Keynesianism

Page 2: Aggregate Expenditures

Say’s Law says that producing goods generates an amount of income equal to the value of the goods produced

Great Depression

Keynes theorizes that not all income is spent leaving surpluses◦ In other words, the economy is not self-adjusting and

that external forces not always the cause of recession, there are also internal forces caused by failure of certain fundamental economic decisions (savings and investing)

Keynes and the Depression

Page 3: Aggregate Expenditures

Income after taxes or net income◦ DI=Gross Income – Taxes

2 Choices with disposable income◦ Consume or Save

Average Propensity to Consume◦ APC = consumption/income

Average Propensity to Save◦ APS = saving/income

APC + APS = 1

Disposable Income (DI)Consumption

Page 4: Aggregate Expenditures

The fraction of any change in disposable income that is consumed.

MPC= Change in Consumption Change in Disposable Income

MPC = ΔC/ΔDI

Marginal Propensity to Consume (MPC)

Page 5: Aggregate Expenditures

The fraction of any change in disposable income that is saved.

MPS= Change in SavingsChange in Disposable Income

MPS = ΔS/ΔDI

Marginal Propensity to Save (MPS)

Page 6: Aggregate Expenditures

MPC + MPS = 1◦.: MPC = 1 – MPS◦.: MPS = 1 – MPC

Remember, people do two things with their disposable income, consume it or save it!

Marginal Propensities

Page 7: Aggregate Expenditures

An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD).

Multiplier = Change in AD Change in Spending

Multiplier = Δ AD/Δ C, I, G, or X

The Spending Multiplier Effect

Page 8: Aggregate Expenditures

Why does this happen?◦Expenditures and income flow continuously which sets off a spending increase in the economy.

The Spending Multiplier Effect

Page 9: Aggregate Expenditures

The Spending Multiplier can be calculated from the MPC or the MPS.

Multiplier = 1/1-MPC or 1/MPS

Multipliers are (+) when there is an increase in spending and (–) when there is a decrease

Calculating the Spending Multiplier

Page 10: Aggregate Expenditures

Ex. Assume U.S. citizens spend 90¢ for every extra $1 they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in IG on U.S. Aggregate Demand (AD).◦ Step 1: Calculate the MPC and MPS

MPC = ΔC/ΔDI = .9/1 = .9

MPS = 1 – MPC = .10◦ Step 2: Determine which multiplier to use, and whether it’s + or

- The problem mentions an increase in Δ IG .: use a (+) spending

multiplier◦ Step 3: Calculate the Spending and/or Tax Multiplier

1/MPS = 1/.10 = 10◦ Step 4: Calculate the Change in AD

(Δ C, IG, G, or XN) * Spending Multiplier ($50 billion Δ IG) * (10) = $500 billion ΔAD

MPS, MPC, & Multipliers

Page 11: Aggregate Expenditures

Calculating the Tax Multiplier

When the government taxes, the multiplier works in reverse

Why?◦Because now money is leaving the circular flow

Tax Multiplier (note: it’s negative) = -MPC/1-MPC or -MPC/MPS

If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow

Page 12: Aggregate Expenditures

MPS, MPC, & Multipliers Ex. Assume U.S. citizens spend 90¢ for every extra $1

they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in IG on U.S. Aggregate Demand (AD).◦ Step 1: Calculate the MPC and MPS

MPC = ΔC/ΔDI = .9/1 = .9

MPS = 1 – MPC = .10◦ Step 2: Determine which multiplier to use, and whether it’s + or

- The problem mentions an increase in Δ IG .: use a (+) spending

multiplier◦ Step 3: Calculate the Spending and/or Tax Multiplier

1/MPS = 1/.10 = 10◦ Step 4: Calculate the Change in AD

(Δ C, IG, G, or XN) * Spending Multiplier ($50 billion Δ IG) * (10) = $500 billion ΔAD

Page 13: Aggregate Expenditures

MPS, MPC, & Multipliers Ex. Assume Germany raises taxes on its citizens by

€200 billion . Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the €200 billion change in taxes on the German economy.◦ Step 1: Calculate the MPC and MPS

MPS = 25%(given in the problem) = .25 MPC = 1 – MPS = 1 - .25 = .75

◦ Step 2: Determine which multiplier to use, and whether it’s + or - The problem mentions an increase in T .: use (-) tax multiplier

◦ Step 3: Calculate the Spending and/or Tax Multiplier -MPC/MPS = -.75/.25 = -3

◦ Step 4: Calculate the Change in AD (Δ Tax) * Tax Multiplier (€200 billion Δ T) * (-3) = -€600 billion Δ in AD

Page 14: Aggregate Expenditures

MPS, MPC, & Multipliers Ex. Assume the Japanese spend 4/5 of their disposable income.

Furthermore, assume that the Japanese government increases its spending by ¥50 trillion and in order to maintain a balanced budget simultaneously increases taxes by ¥50 trillion. Calculate the effect the ¥50 trillion change in government spending and ¥50 trillion change in taxes on Japanese Aggregate Demand.◦ Step 1: Calculate the MPC and MPS

MPC = 4/5 (given in the problem) = .80 MPS = 1 – MPC = 1 - .80 = .20

◦ Step 2: Determine which multiplier to use, and whether it’s + or - The problem mentions an increase in G and an increase in T .:

combine a (+) spending with a (–) tax multiplier◦ Step 3: Calculate the Spending and Tax Multipliers

Spending Multiplier = 1/MPS = 1/.20 = 5 Tax Multiplier = -MPC/MPS = -.80/.20 = -4

◦ Step 4: Calculate the Change in AD [ Δ G * Spending Multiplier] + [ Δ T * Tax Multiplier] [(¥50 trillion Δ G) * 5] + [(¥50 trillion Δ T) * -4] [ ¥250 trillion ] + [ - ¥200 trillion ] = ¥50 trillion Δ AD

Page 15: Aggregate Expenditures

Money spent or expenditures on:◦New plants (factories)◦Capital equipment (machinery)◦Technology (hardware & software)◦New Homes◦Inventories (goods sold by producers)

What is Investment?

Page 16: Aggregate Expenditures

How does business make investment decisions?◦ Cost / Benefit Analysis

How does business determine the benefits?◦ Expected rate of return

How does business count the cost?◦ Interest costs

How does business determine the amount of investment they undertake?◦ Compare expected rate of return to interest cost

If expected return > interest cost, then invest If expected return < interest cost, then do not invest

Expected Rates of Return

Page 17: Aggregate Expenditures

What’s the difference?◦Nominal is the observable rate of interest. Real subtracts out inflation (π%)and is only known ex post facto.

How do you compute the real interest rate (r%)?

r% = i% - π% What then, determines the cost of an investment decision?◦The real interest rate (r%)

Real (r%) v. Nominal (i%)

Page 18: Aggregate Expenditures

What is the shape of the Investment demand curve?

◦ Downward sloping Why?

◦ When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable

◦ Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Investment Demand Curve (ID)

Page 19: Aggregate Expenditures

The Investment Demand Curve

r%

IG

ID

Changes in r% cause changes in IG. Factors other than r% may shift the entire ID curve5%

3%

$2 trillion

$3 trillion

Page 20: Aggregate Expenditures

◦ Cost of Production Lower costs shift ID Higher costs shift ID

◦ Business Taxes Lower business taxes shift ID Higher business taxes shift ID

◦ Technological Change New technology shifts ID Lack of technological change shifts ID

◦ Stock of Capital If an economy is low on capital, then ID If an economy has much capital, then ID

◦ Expectations Positive expectations shift ID Negative expectations shift ID

Shifts in Investment Demand (ID)

Page 21: Aggregate Expenditures

Shifts in Investment Demand

r%

IG

ID

4%

$2.5 trillion

$3.25 trillion

ID1

When investment demand shifts, different levels of gross private investment occur even while r% remains constant

Page 22: Aggregate Expenditures

Durability◦ Capital has a long life-span, therefore once it is built

there is no immediate need for further investment Irregularity of Innovation

◦ Innovation does not proceed in a smooth linear fashion, instead there are bursts of innovation followed by periods of relative stability

Variability of Profits◦ Profitability is subject to the forces of competition,

cyclical changes in the economy, and human management decisions

Variability of Expectations◦ Political, social and natural phenomenon shape our

positive and negative expectations of the future

Instability of Investment

Page 23: Aggregate Expenditures

Many economists believe that investment instability is the chief cause of the business cycle.

Instability of Investment

Page 24: Aggregate Expenditures

The market where savers and borrowers exchange funds (QLF) at the real rate of interest (r%).

The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.

The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

Loanable Funds Market

Page 25: Aggregate Expenditures

r%

QLF

SLF & DBonds

DLF & SBonds

r

q

Loanable Funds Market in Equilibrium

Page 26: Aggregate Expenditures

Remember that demand for loanable funds = borrowing (i.e. supplying bonds)

More borrowing = more demand for loanable funds ()

Less borrowing = less demand for loanable funds ()

Examples◦ Government deficit spending = more borrowing = more demand for loanable funds .: DLF .: r%↑ ◦ Less investment demand = less borrowing

= less demand for loanable funds .: DLF .: r%↓

Changes in the Demand for Loanable Funds

Page 27: Aggregate Expenditures

r%

QL

F

SL

F

DLF

r

q

DLF

1

r1

q1

DLF .: r% ↑ & QLF ↑

Increase in the Demand for Loanable Funds

Page 28: Aggregate Expenditures

r%

QLF

SL

F

DLF

1

r1

q1

DL

F

r

q

DLF .: r% ↓ & QLF ↓

Decrease in the Demand for Loanable Funds

Page 29: Aggregate Expenditures

Remember that supply of loanable funds = saving (i.e. demand for bonds)

More saving = more supply of loanable funds() Less saving = less supply of loanable funds () Examples

◦ Government budget surplus = more saving = more supply of loanable funds .: SLF .: r%↓◦ Decrease in consumers’ MPS = less saving

= less supply of loanable funds .: SLF .: r%↑

Changes in the Supply of Loanable Funds

Page 30: Aggregate Expenditures

r%

QL

F

SL

F

DLF

r

q

SLF .: r% ↓ & QLF ↑

SLF 1

r1

q1

Increase in the Supply of Loanable Funds

Page 31: Aggregate Expenditures

r%

QL

F

SL

F

DL

F

r

q

SLF .: r% ↑ & QLF ↓

SLF 1

r1

q1

Decrease in the Supply of Loanable Funds

Page 32: Aggregate Expenditures

Loanable funds market determines the real interest rate (r%).

Loanable funds market relates saving and borrowing.

Changes in saving and borrowing create changes in loanable funds and therefore the r% changes.

When government does fiscal policy it will affect the loanable funds market.

Changes in the real interest rate (r%) will affect Gross Private Investment

Final thoughts on Loanable Funds

Page 33: Aggregate Expenditures

r%

QL

F

SLF

DLF

r

q

DLF

1

r1

q1G↑ and/or T↓ .: Government deficit spends .: DLF .: r%↑ .: IG↓

(Crowding-Out Effect)

Effect of Expansionary Fiscal Policy on Loanable Funds & Investment

r%

IG

ID

II1