Unit 3 (MPC, MPS, Multiplier)

Unit 3 (MPC, MPS, Multiplier)

APC & APS

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = Dissaving
• -APS = Dissaving

Marginal Propensity to Consume (MPC)

• The fraction of any change in disposable income that is consumed.
• MPC = Change in Consumption / Change in Disposable Income

Marginal Propensity to Save (MPS)

• The fraction of any change in disposable income that is consumed.
• MPS = Change in Savings / Change in Disposable Income

Marginal Propensities 

• MPC + MPS = 1
• MPS = 1 - MPC
• MPC = 1 - MPS
• People do two things with DI: Either consume it or save it !
• An initial change in spending (C, Ig, G, Xn) causes a larger change in AS or AD.
• Multiplier = Change in AD / Change in Spending
• Multiplier = ΔAD / ΔC, I, G, X

Calculating the Spending Multiplier 

• Multiplier = 1/1 - MPC ; 1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease.

Calculating Tax Multiplier 

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

• Tax multiplier (negative) = -MPC/(1-MPC) = -MPC/MPS

• If there is a tax-cut the multiplier is positive b/c there is now more $ in the circular flow.

Unit 3 Notes (part 2)

February 22, 2016

Nominal Wages - the amount of money received by a worker per-unit cost of time.

Real Wages - the amount of goods and services a worker can produce with their nominal wage. (The purchasing power of your nominal wage)

Sticky Wages - the nominal price/wage level that is set according to an initial price level, and it does not vary due to labor, contracts or other restrictions.

	Price	Wages	Employment Level
Recession	fixed	fixed	flexible
Intermediate	flexible	fixed	flexible
Inflation	flexible	flexible	Fixed

What is Investment?

• money spent or expenditures on - 

• new plants (factories)
• capital equipment (machinery)
• technology (hardware and software)
• inventories (goods sold by producers)

Expected Rate of Return 

• How does business make investment decisions?
• Cost/Benefits Analysis 

• How does business determine the benefits?
• Expected Rate of Return 

• How does business count the cost?
• interest cost

• 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 expenditure < interest cost, then do not invest 

Real (r%) vs. Nominal (i%) 

• Nominal is the observable rate of interest
• Real subtracts out inflation ( ∏%) and is only known ex post facto. 
• r% = i% - ∏% 

What determines cost of an investment decision? 

• The real interest rate (r%)

Investment Demand Curve 

• downward sloping
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in Investment Demand (ID)

1. Costs of Production
• Lower costs shift ID →
• Higher costs shift ID ←
2. Business Taxes 
• Lower business taxes shift ID →
• Higher business taxes shift ID ←
3. Technological change
• New technology shifts ID →
• Lack of technology shifts ID ←
4. Stock of capital 
• Economy low on capital shifts ID →
• Economy has much capital shifts ID ←
5. Expectations 
• Positive shifts ID →
• Negative shifts ID ←

CONSUMPTION & SAVING 

Disposable Income (DI)

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

Two choices: With disposable income, households can either
           - consume (spend $ on goods and services)
           - save (not spend $ on goods and services)

1. Consumption

• Household Spending
• The ability to consume is constrained by:
• The amount of disposable income
• The propensity to save

• Do households consume if DI = 0 ?
• Autonomous consumption
• Dissaving 

     2.  Saving

• Household NOT spending 
• The ability to save is constrained by the - 
• The amount of disposable income
• The propensity to save
• Do households consume if DI = 0 ? No.

Unit 3 Notes

February 12, 2016

Aggregate Demand Curve

• the demand by consumers, businesses, government, and foreign countries.
• changes in the price level cause a move along the curve

        

Why is AD downward sloping?

1. Real Balance Effect
• higher levels reduce the purchasing power of money
• this decreases the quantity of expenditures
• lower price levels increase purchasing power and increase expenditures
2. Interest Rate Effect
• when the price level increases, leaders need to charge higher interest rates to get a REAL return on their loans
• higher interest rates discourage consumer spending and business investment
3. Foreign Trade Effect
• When US price level rises, foreign buyers purchase fewer US goods and Americans buy more foreign goods
• Exports fall and imports rise causing real GDP demanded to fall. (Xn decreases)

Shifters (Determinants) of Aggregate Demand

GDP = C + I + G +Xn

Shifts in AD

• Two Points to a Shift in AD
1. Change in C, Ig, G, or Xn
2. a multiplier effect that produces a greater change than the original change in the 4 components.
• Increases in AD = AD shift →
• Decreases in AD = AD shift ←

Consumption

Household spending is affected by - 

1. Consumer Wealth
• more wealth = more spending (AD shifts →)
• less wealth = less spending (AD shifts ←)
2.  Consumer Expectations
• positive expectations = more spending (AD shifts →)
• negative expectation = less spending (AD shifts ←)
3. Household Indebtedness
• less debt = more spending (AD shifts →)
• more debt = less spending (AD shifts ←)
4. Taxes
• less tax = more spending (AD shifts →)
• more tax = less spending (AD shifts ←)

Gross Private Investment

Investment spending is sensitive to -

1. The Real Interest Rate
• lower real interest rate = more investment (AD shifts →)
• higher real interest  rate = less investment (AD shifts ←)
2. Expected Returns
• higher expected returns = more investment (AD shifts →)
• lower expected returns = less investment (AD shifts ←)
• Expected returns are influenced by - 
• expectations are future probability
• technology
• degree of excess capacity (existing stock of capital)
• business taxes

Government Spending

• More government, spending increases (AD shifts →)
• Less government, spending decreases

Net Exports

Net exports are sensitive to - 

1. Exchange Rates (International Value of Money)
• strong $ = more imports and fewer exports (AD shifts ←)
• weak $ = fewer imports and more exports (AD shifts →)
2. Relative Income 
• strong foreign economies = more exports (AD shifts →)
• weak foreign economies = less exports (AD shifts ←)

February 18, 2016

Aggregate Supply Curve

• the level of real GDP (GDPR) that firms will produce at each Price Level (PL).

Long Run vs. Short Run

• Long Run - period of time where input prices are completely flexible and adjust to changes in price level.
• Short Run - input prices are sticky and don't adjust to changes in PL. Level of Real GDP supplied is directly related to PL.

Long Run Aggregate Supply (LRAS)

• marks the level of full employment in the economy (analogous to PPC)
• because input prices are completely flexible in the long run, changes in price level do not change firms real profits and therefore do not change firms level of output
• LRAS is vertical at the economies level of full employment

Changes in SRAS

• increase in SRAS = shift to the right (SRAS →)
• decrease in SRAS = shift to the left (SRAS ←)
• the key to understanding shifts in SRAS is per-unit cost of production
• Per-Unit Cost of Production = (Quantity of Input x Price of Input)/Output

Determinants of SRAS (affects unit production cost)

1. input prices
2. productivity
3. legal institution environment

     INPUT PRICES

• Domestic Resources Prices
• wages (75% of all business costs)
• raw materials (commodity prices)
• cost of capital
• Foreign Resources Prices
• strong $ = lower foreign resource prices
• Market Power
• monopolies and cartels that control resources, control the price
• Increase in Resource Prices = SRAS shifts ←
• Decrease in Resource Prices = SRAS shifts →

     PRODUCTIVITY = total output/total input

• More productivity = lower unit production cost = SRAS →
• Lower productivity = higher unit production cost = SRAS ←

     LEGAL INSTITUTION ENVIRONMENT

• Taxes and Subsidies
• Taxes ($ to gov't.) on business increase per unit production cost = SRAS shifts ←
• Subsidies ($ from gov't.) to business reduce per unit production cost = SRAS shifts →

• Government Regulation
• Gov't. regulation creates a cost of compliance = SRAS shifts ←
• Deregulation reduces compliance costs = SRAS shifts →

February 19, 2016

Full Employment

• full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap

• exists when equilibrium occurs below full employment output

Inflationary Gap

• exists when equilibrium occurs beyond full employment output

Schools of Economics