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Day 5 Review: Macro

DI = Consumption + Saving

APC & APS�MPC & MPS

Expected Rates of Return & Decision to Invest

Investment Demand

Loanable Funds Market

Multipliers: Spending, Tax, &Balanced Budget

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Disposable Income (DI)

  • Income after taxes or net income:
    • DI = Gross Income – Taxes

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  • With disposable income, households can either:
    • Consume (spend money on goods & services).
    • Save (not spend money on goods & services).

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Consumption

  • Household Spending

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  • The ability to consume is constrained by
    • The amount of disposable income.
    • The propensity to save.
  • Do households consume if DI = 0?
    • Yes, autonomous consumption:
      • Definition: This is the level of consumption which does not depend on income. The argument is that even with zero income you still need to buy enough food to eat, through borrowing or running down savings.
    • Dissaving
  • APC = C/DI = % DI that is spent

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Saving

  • Household NOT spending.
  • The ability to save is constrained by:
    • The amount of disposable income.
    • The propensity to consume.
  • Do households save if DI = 0?
    • NO!
  • APS = S/DI = % DI that is not spent

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APC & APS

  • APC + APS = 1
    • 1 – APC = APS
    • 1 – APS = APC

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  • APC > 1 is Dissaving

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  • -APS is Dissaving

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MPC & MPS

  • Marginal Propensity to Consume:
    • ΔC/ΔDI
    • % of every extra dollar earned that is spent
  • Marginal Propensity to Save:
    • ΔS/ΔDI
    • % of every extra dollar earned that is saved
  • MPC + MPS = 1
    • 1 – MPC = MPS
    • 1 – MPS = MPC

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Determinants of Consumption & Savings

  • Wealth
    • Increased wealth .: Inc. C & Dec. S
    • Decreased wealth .: Dec. C & Inc. S
  • Expectations
    • Positive .: Inc C & Dec S
    • Negative .: Dec C & Inc S
  • Household Debt
    • High Debt .: Dec C & Inc S
    • Low Debt .: Inc C & Dec S
  • Taxes
    • Taxes Inc .: Dec C & Dec S
    • Taxes Dec .: Inc C & Inc S

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What is Investment (I) in GDP?

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

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Expected Rates of Return

  • 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.

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

  • What’s the difference?
    • Nominal is the observable rate of interest.

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    • Real subtracts out inflation (π%)and is only known ex post facto.
  • How do you compute the real interest rate (r%)?

r% = i% - π%

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  • What then, determines the cost of an investment decision?
    • The real interest rate (r%)

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(Draw) The Investment Demand Curve

real%

IG

ID

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

5%

3%

$2 trillion

$3 trillion

→

→

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Shifts in Investment Demand (ID)

    • 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 ←

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Loanable Funds Market

  • 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 supply of loanable funds, or savings comes from households, firms, government and the foreign sector.

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r%

QLF

SLF

DLF

r

q

(Draw) Loanable Funds Market in Equilibrium

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Changes in the Demand for Loanable Funds

  • Remember that demand for loanable funds = borrowing.
  • 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%↓

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r%

QLF

SLF

DLF

r

q

DLF 1

r1

q1

DLF → .: r% ↑ & QLF ↑

Increase in the Demand

for Loanable Funds (Draw)

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Changes in the Supply of Loanable Funds

  • Remember that supply of loanable funds = saving
  • 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%↑

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r%

QLF

SLF

DLF

r

q

SLF → .: r% ↓ & QLF ↑

SLF 1

r1

q1

Increase in the Supply

of Loanable Funds (Draw)

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Final Thoughts On Loanable Funds

  • 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 may affect the loanable funds market.
  • Changes in the real interest rate (r%) will affect Gross Private Investment.

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Calculating the Spending Multiplier

  • The Spending Multiplier can be calculated from the MPC or the MPS.
  • Multiplier = 1/1-MPC or 1/MPS

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  • Multipliers are (+) when there is an increase in spending and (–) when there is a decrease .
  • Full multiplier; government spends all!

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Using the Multipliers: �Keynesian, Intermediate, & Classical Range

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Calculating the Tax Multiplier

  • When the government taxes, the multiplier works in reverse
  • Why?
    • Because now money is leaving the circular flow.

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

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  • If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow
  • Smaller than government spending multiplier. Assumed that households will save according their MPS, thus a smaller multiplier.
  • Why smaller? Households will save some of their disposable income; economists call this leakage into savings.

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The Balanced Budget Multiplier

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  • Remember when Government Spending increases are matched with an equal size increase in taxes, that the change ends up being = to the change in Government spending
  • Why?
      • 1/MPS + -MPC/MPS = 1- MPC/MPS = MPS/MPS = 1

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  • The balanced budget multiplier always = 1

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Multiple Choice Answers

1.c

2.d

3.d

4.c

5.a

6.c

7.c

8.d

9.b

10.d

11.c

12.d

13.d

14.a

15.e

16.c

17.d

18.b

19.c

20.e

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21.b

22.c

23.a

24.d

25.d

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Practice and Videos

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End Review Day 5

  • Which of the above topics do you need to spend more time studying?

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  • What specific steps will you take to study?

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