The Income Consumption / Income Saving Relationship Economists care about income/spending:

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relationship with each other relationship to overall health of the economy relationship to/ effects on economic growth, inflation, recession, and business cycle

The Consumption Schedule: - Reflects the direct consumption (C) -disposable income (DI) relationship -Households increase their C as DI rises. -Households spend a larger proportion, if their DI is small. -Break-even income is when C=DI , which also means that households consume their entire income, but not to the point where they go in debt. At this point, the consumption schedule intersects the 45 degree line (the savings schedule intercepts the x-axis). -When developing macroeconomic models, economists change their focus from consumption and disposable income to the relationship between consumption and saving and real domestic output (real GDP). The 45 Degree Line: - A reference line that bisects the the 90 degree angle formed by the y-axis and x-axis of the graph. - At each point on the 45 degree line,C=DI. - The vertical distance between the 45 degree line and Consumption line measures either savings (when C line is below the 45 degree line) or dissavings (when C line is above the 45 degree line). -Dissaving occurs when household consume more than its DI, indicating that the household borrowed money or spent accumulated wealth. -Dissaving usually occur with households of lower income. The Saving Schedule: Savings = Disposable Income - Consumption Savings are essentially the portion of your income you don't consume. Dissavings= consuming more than the available income either by liquidating accumulated wealth or borrowing money. If households consume a smaller and smaller proportion of DI as DI increases, then they must be saving a larger and larger proportion. Average and marginal propensities

APC and APS: o Definitions:

Average Propensity to Consume (APC): total percentage of DI consumed Average Propensity to Save (APS): total percentage of DI saved o APC = Consumption/Income the fraction of total income that is consumed o APS = Saving/income the fraction of total income that is saved o APC+APS= 1 Every leftover dollar not spent is saved MPC and MPS:
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MPC (marginal propensity to consume) = change in consumption/change in income. the proportion of changes in income consumed. MPS (marginal propensity to save) = change in saving/change in income. the proportion of changes in income saved. MPC + MPS =1 The sum of the MPC and the MPS for any change in DI must always be 1 becuase every leftover dollar not spent is counted "saved". *Note that if a consumer's income changed by a certain percentage, their propensity to spend does NOT always change in accordance with it.

MPC and MPS as Slopes

The MPC and MPS are the numerical values of the slopes of the consumption and savings schedule, respectively.

Nonincome determinants of consumption and saving:

Wealth = value of real assets (i.e. houses, land) and financial assets (i.e. cash, savings, stocks, bonds) o When wealth increases, households increase spending and reduce savings Shifts Consumption schedule upward and Supply schedule downwards Opposite occurs when wealth decreases Expectations about future prices and income o Expectations of rising prices in the future will cause an increase in consumption and decrease in saving in the present. Shifts Consumption schedule upward and Saving schedule downward Opposite occurs, when there are expectations of a recession and lower income in the future Real Interest Rates o When real interest rates fall, households borrow more, consume more, and save less. o When real interest rates climb, households borrow less, consume less, and save more. o These effects on consumption and saving are very modest. They mainly shift products bought on credit.

Household Debt o When consumers as a group increase household debt, they can increase current consumption at each level of DI. Household debt is a constant proportion in DI. Greater household debt means greater borrowing. Increased borrowing shifts the consumption schedule upward. Reduced borrowing shifts consumption schedule downward.

The Interest Rate - Investment Relationship

The investment decision is a marginal benefit-marginal cost decision

The marginal benefit from investment is the expected rate of return (r) The marginal cost is the interest rate (i) that must be paid for borrowed funds; the two are the determinants ofinvestment spending. An investment is made if the expected rate of return exceeds the interest rate (r > i). Investments are not made when interest rate exceeds the expected rate of return (r < i)

Expected rate of return:

Businesses only make investments when they expect to recieve profits. r = (TR - cost of investment) / cost of investment. Firms are risk takers. therefore, can't guarantee profits. Firms have to think about expected rate of return must be greater than the real interest rate.

The real interest rate: Business only invest when the rate of return is greater than the interest rate (r>i)

Ex: Taking out a loan for a 1000 dollar machine. If the interest rate is 7%, you pay $70 dollars in interest (1000 x 0.07). If the rate of return is 10%, then you gain $100 from buying the machine (1000 x 0.1). o Your net profit is $30 ($100-$70) o Notice that the rate of return > interest rate, therefore the investment is worth it. Real interest rate = Nominal Interest Rate - Inflation Interest cost= interest rate x cost

Investment demand curve:

This curve shows the amount of investment forthcoming at each real interest rate. o The level of investment depends on the expected rate of return and the real interest rate.

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Marginal-benefit, marginal-cost rule is applied to determine which investment projects should be undertaken there is an inverse relationship between the interest rate (price) and dollar quantity of investment demanded We apply the rule of undertaking all investment up to the point where the expected rate of return, r, equals the interest rate, i. Investment demand at one level includes prior investment having the level of expected rate of return and higher

Shifts of the investment demand curve Generally, any factor that leads businesses collectively to expect greater rates of return on their investments increases investment demand

Acquisition, maintenance and operating costs: o When these costs increase, expected rate of return from prospective investment decreases causes the investment demand curve to shift to the left o When costs fall, expected rate of return from prospective investment increase causes the investment demand curve to shift to the right Business taxes: o An increase in business taxes results in decreasing expected profitability of investments causes the investment demand curve to shift to the left o A decrease in business taxes results in an increase of expected profitability of investments causes the investment demand curve to shift to the right Technological change: o The development of new products, improvements in existing products, and the creation of new machinery can stimulate investment. cause the investment demand curve to shift to the right. Stock of capital goods on hand: o When firms are overstocked with capital, there is no incentive to invest so investments decline and the curve shifts to the left o When firms are running low with capital goods, firms tend to increase investment, therefore, shifting the ID curve to the right o Inventory that isn't moving costs the firm money for every second it sits on the shelf, so it would obviously be ill-advised to invest without moving inventory. Expectations: o If businesses expect the future sales, future operating costs, and future profitability to be poor, they won't increase their investment. cause the investment demand curve to shift to the left o If businesses expect profits in the future, then they will increase their investment. cause the investment demand curve to shift to the right. o The expected rate of return on capital investment depends on the firms expectations of future sales, future operating costs, and future profitability of the product that the capital helps produce

Instability of Investment

Durability o Since investments are durable, they can be reused. o During hard times, firms do not have to buy new capital o If firms anticipate a good future, they may buy a lot of new capital now o Depending on expectations for the future, a firm may choose to fix capital rather than purchase new units, thus spending less. Irregularity of innovation o When there is a new advancement in technology, this causes a surge in capital investment; however, innovation occurs at irregular times Variability of Profits o Future profitability is based on the firm's current profit but that in itself is variable o When a firm is expanding, it invests more whereas a firm with declining profits do the opposite Variability of Expectations o Businesses tend to react to future expectations but that is unpredictable and can change quickly o The stock market helps as one of the indicators of society's confidence in businesses so this influences the decisions made by firms. However, stocks themselves are unpredictable and fluctuates greatly.

The Multiplier Effect Explanation: -The multiplier effect shows that an initial change in spending can cause a larger change in DI and output. - The multiplier determines how much larger that change will be; it is the ratio of a change in GDP to the initial change in spending. - It measures the effect that any change in expenditure (I, G,C, or Xn) will have on GDP Multiplier = 1/(1-MPC) = 1/MPS - When person A spends their money, it becomes person B's income. Then person B will go spend their income which then becomes person C's money, etc. The cycle repeats, but because of the tendency to save which stays the same for every person percentage wise, the amount spent in each cycle is less and less.

Multiplier = change in real GDP/ initial change in spending (*Change in GDP = mutlplier*initial change in spending) The Investment Multiplier is always one more than Tax Multiplier Rationale:

Based on two facts: o The economy supports repetitive, continuous flows of expenditures and income o Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income Initial change in spending will set off a spending chain throughout the economy o Chain of spending, although of diminishing importance at each successive step, will cumulate to a multiple change in GDP o Eg. If the government chooses to spend an extra $10 million on hotels, the factors of production regarding the buliding industry will increase by $10 million; however, some (the MPC * 10 million) of this increase in income will be spent on local consumer goods needed for the hotel. Thus, more than just $10 million worth of goods and services are produced, hence why the multiplier effect is needed.

The multiplier and marginal propensities:

The higher the MPC (thus, lower MPS), the larger the multiplier because the multiplier is equal to the reciprocal of the marginal propensity to save The multiplier is equal to the reciprocal of the marginal propensity to save: the greater is the marginal propensity to save, the smaller is the multiplier. also, the greater is the marginal propensity to consume, the larger is the multiplier. The idea that every dollar of spending creates more than one dollar in economic activity. Multiplier formulas o Investment multiplier = 1/ (1-MPC) OR 1/ MPS o Government multiplier = 1/ (1-MPC) OR 1/MPS o Tax multiplier = - MPC/ (1-MPC) OR - MPC/ MPS

Aggregate Demand Aggregate Demand Curve : A schedule that shows amounts of real output (real GDP) that buyers collectively desire to purchase at each possible price level. (Thus, price level and real domestic output are inversely related.) Rationale of downward slope of AD curve:

Real-balances effect (i.e. Wealth Effect): A change in the price level o A higher price level reduces the real value (purchasing power) of the public's accumulated savings balances. In other words, the real value of assets with fixed money values (eg. savings accounts, bonds) diminishes. Keep in mind that wealth also includes physical assets such as houses and cars; as such, a fall in the value of housing will diminish the wealth of homeowners. o Simply put, a lower price level makes you seem wealthier while a higher price level makes you seem less wealthy. o The public is then more poor in real terms and will reduce spending. Higher prices mean less consumption. Interest-rate effect: A change in the interest-rate level

Assume that the supply of money in an economy is fixed. low price levels will cause interest rates to decrease and result in more consumer spending If the price level rises, consumers and businesses need more money to consume or invest. Therefore, a higher price level increases demand for money An increase in money demand will drive up the price paid for its use - this is interest. Higher interest rates then reduces investment or consumption which require loans.

Foreign purchases effect (i.e. Net Export Effect):

When domestic price levels rise relatively to foreign products, foreigners buy fewer U.S. goods, and Americans buy more foreign goods. Thus, U.S. exports fall and U.S. imports rise o The rise in the price level of U.S. goods reduces the quantity of U.S. goods demanded as net exports.

Difference between AD curve and microeconomics demand curve:

No substitute effect, because you cannot substitute all goods. No income effect, because a lower price level actually means less nominal income for the resource suppliers -- e.g. lower wages, rents, interests, profits.

*We study aggregate demand to see how fluctuations in C, I, G, and Xn affect the AD curve* Determinants of Aggregate Demand / AD shifters Note: change in determinant that directly changes amount of real GDP
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multiplier effect produces greater change in AD than initiating change in spending shift along the curve = changes in real GDP

Consumer spending: (C) o Consumer Wealth: Consumer wealth includes both financial assets and physical assets. A sharp increase in the real value of consumer wealth prompts people to save less and buy more products, shifting the AD curve to the right. Also vise versa. o Expectations: Expectation of future income rises, ppl tend to spend more of their current incomes. Thus current consumption spending increases, and the AD curve shifts to the right. Also, a widely helped expectation of surging inflation in the near future may increase aggregate demand today because consumers will want to buy products before their price escalate. o Household debt: Increased household debt enables consumers collectively to increase their consumption spending, which shifts the AD curve to the right.

Taxes: A reduction in personal income tax rates raises take-home income and increases consumer purchases. Tax cuts shift the AD curve to the right. Investment spending: (unstable) (I) o Real Interest Rates: An increase in real interest-rate will decrease investments aka shift aggregate demand curve to the left. It identifies a change in the real interest rate resulting from a change in the nation's money supply. An increase in the money supply lowers the interest rate, thereby increasing investment and aggregate demand and vice versa. o Expected Returns: Expected future business condition: If firms think that the future is looking good, they will probably invest more today to help boost up their profits. However, if they think the future is looking bleak, they will cut back on investment, thus shifting AD to the left. Technology: New and better technology helps to shift AD to the right because they usually have a high expected rate of return. For example, recent advances in microbiology have motivated pharmaceutical companies to establish new labs and production facilities because there is a greater demand for those capital goods. Degree of excess capacity: When there's more excess capacity (unused capital), there will be less investment, meaning an inward shift of the AD curve. But once they realize that they have used up their capital, the expected returns on new investment rise, they will start investing more, meaning an outward shift of the AD curve. Business taxes: An increase in business taxes will cut out more of the after-tax profits so investment and AD will decrease and shift left. Conversely, a decrease in taxes will shift the curve out.

Government spending: (G) o When the government spends more, the AD curve shifts to the right, as long as the interest rates and tax collections do not change o A decrease of government spending, such as fewer projects in transportation, will shift the AD curve to the left. Net export spending: (Xn) o A rise in net exports (higher exports relative to imports) shift the aggregate demand curve to the right.
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National income abroad: Rising national income abroad encourages foreigners to buy more products. Net exports of the U.S. thus rise and aggregate demand curve shift to the right. Exchange rates: change in the dollar's exchange rate. The price of foreign currencies in terms of the U.S. dollar-- may affect U.S. exports and therefore aggregate demand. If the U.S. dollar depreciates in terms of the euro, the new higher value euros enables consumers to obtain more dollars with each euro--> exports rise, imports fall --> AD shifts out.

Aggregate Supply Aggregate Supply: The schedule or curve showing the level of real domestic output that firms will produce at each level. Aggregate Supply in the long-run:

Long Run: A period in which nominal wages (resource prices) match changes in the price level.This occurs because enough time has passed for firms to adjust to any changes in price level. Long Run Aggregate Supply is only possible with flexible labor markets Ceterus paribus (other things equal), Aggregate Supply in the long run is vertical at the economy's full-employment (including the natural rate of unemployment) output because resources and capital are at full capacity; thus, if one company attempts to attract workers through increasing wages, employees from other firms will come, not new workers. Therefore the curve is perfectly inelastic, vertical curve shown. Because real profit does not change, the firm will not alter its production. Real GDP will remain at full-employment level. Shifters: o change in labor o technology o productivity (education, more machines) o open up trade with other nations

Aggregate Supply in the short-run:

Short Run: A period in which nominal wages (resource prices) do not match changes in price level. This occurs because firms have not had enough time to adjust to changes in price level. During this period, the prices of the factors of production do not change, especially the price of labor (wage rate) is fixed. There's a positive/direct relationship between the price level and the total output and so, the SRAS curve slopes upward because to produce more output, firms are likely to face higher costs of production, which increases the price levels. At outputs below the Qf level, the slope of the aggregate supply curve is relatively flat: -- large amounts of unused resources, can be put back to work with a little upward pressure on per-unit production costs At outputs above the Qf level, the slope of the aggregate supply curve is relatively steep.

-majority of resources is already employed, so adding more reduces the efficiency of workers, capital, and total output rises less rapidly than total input cost. In other words, when the output level exceeds Qf, the price level rises more rapidly over the same amount of increased output.

Can having three distinct segments: o Horizontal -unemployment & high excess capacity. o Upsloping - increase in real output = increase in price level; full-employment near, producer costs rise. o Vertical - full-employment w/ Natural Rate of Unemployment (NRU), full capacity is assumed, and increase output = increase in resource and product prices. With full employment this production equals the economies potential output.

Changes in Aggregate Supply: Determinants of Aggregate Supply

Input prices: Input or resource prices (domestic or imported) o Domestic Resource Prices: Wages and Salaries Labor supply wage aggregate supply (curve shifts right) Labor supply wage aggregate supply (curve shifts left) Rents and Capital Investments: Price of machinery because prices of steel per unit production cost aggregate supply (curve shifts right) Land resources due to irrigation or technological innovations per unit production cost aggregate supply (curve shifts right)

Prices of Imported Resources:

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A decrease in the price of imported resources increases U.S. aggregate supply (curve shifts right). An increase in the price of imported resources reduces U.S. aggregate supply (curve shifts left). Exchange rates also play a role: If dollar appreciates, domestic produces face a lower dollar price of foreign resources. increase in imports shift AS to the right. o Market Power: A change in the ability to set prices above competitive levels. OPEC's fluctuation market power. increase in power = increase in oil prices which reduced U.S. Aggregate supply dramatically leftward anddrove up per-unit production costs. decrease in power = decrease in oil prices which increased U.S Aggregate supply Productivity: o Measure of the relationship between a nation's level of real output and the amount of resources used to produce that output.

Productivity = total output/total input. An increase in productivity enables the economy to obtain more real output from its limited resources. It does this by reducing the per-unit cost of output. per-unit production cost= total input cost/ total output. o By reducing the per-unit production cost, an increase in productivity shifts the aggregate supply curve to the right. o higher productivity --> lower per-unit cost --> AS curve shifts out. o The main source of productivity advance is improved production technology, bettereducated workforce, improved forms of business enterprises, and the reallocation of labor resources from lower to higher productivity uses. Legal-institutional environment: o Business taxes and subsidies Business taxes , per-unit production costs , supply Subsidy , per-unit production costs , supply o Government regulations regulation , per-unit production costs , supply

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Equilibrium and Changes in Equilibrium The intersection of the aggregate demand curve AD and the aggregate supply curve AS establishes the economy's equilibrium price level and equilibrium real output. Increases in AD: demand-pull inflation:

Is as though, the higher demand is "pulling" prices up so much so that inflation exists. This inflation occurs when demand for goods and services exceeds existing supplies; thus the price level is being pulled up by the increase in aggregate demand. Assume that economy is operating at full-employment output, but businesses and the government want to increase their spending (AD curve to the right). Consumers are becoming more wealthy and they demand more products, but the supply sector cannot catch up with the rapidly growing demand, therefore the price levels are brought up There is a positive GDP gap, where actual GDP > potential GDP. o Ex: U.S. during Vietnam war in the 1960s, where large government spending on the war shifted the economy's AD curve to the right, producing great inflation. Rise of price level reduces size of multiplier effect: For any initial increase in aggregate demand, resulting increase in real output will be smaller the greater the increase in price level

Decreases in AD: recession and cyclical unemployment:

Deflation (i.e. price level decreases) is rare in the economy, but it is still possible. However, deflation is NOT a good thing despite its "inflation" counterpart. Price levels should be STABLE, not decreasing. Recessions caused by a negative GDP gap are usually unaccompanied by a price level decrease; thus the term "GDP gap but no deflation", also called disinflation, constituting a recession and creating cyclical unemployment. Reasons why the price level tends to be inflexible in a downward direction during declines in aggregate demand in the United States:

Fear of price wars: big firms fear that if they lower their prices, competitors will lower theirs and even make deeper price cuts so the initial price cut would set off a price warsuccessively deeper price cuts. Each firm would eventually end up with far less profit or higher losses than would be the case if each had simply maintained its original prices. To avoid this, firms would reduce production and lay off workers instead of making the initial price cut Menu costs: costs of 'printing new menus' when price is reduced by the firm; prices of estimating the magnitude anbd duration of the shift in demand to determine whether to lower prices, of repricing inventory items, printing/mailing new catalogs, communicating new prices to customers Wage contracts: difficult to profit from cuts of product prices without cutting wage rates; wages are usually inflexible downward b/c many laborers are under contracts prohibiting wage cuts Morale, effort, and productivity: Efficiency wages: wages that elicit max. work effort and minimize labor costs per unit of output if the higher labor costs resulting from reduced productivity exceed the cost savings from lower wage, then wage cuts will increase rather than reduce labor costs per unit of output Minimum wage: a legal floor under the wages of the least skilled workers; firms paying minimum wage cannot reduce the wage rate when AD declines

Decreases in AS: cost-push inflation:

Is as though diminishing supply of g/s are "pushing" inflation higher. Costs AS PL = inflation - "Double" negative effects inflation and recession (y ) When a resource causes the cost of production for a wide variety of goods, this causes a decrease in aggregate supply and there is cost-push inflation (rising price levels). Ex: Terrorist attack on oil facilities drives up oil prices by 300%. A decrease in AS is doubly bad because: o there is cost-push inflation o recession and negative GDP gap
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Stagflation- Period with decreasing output(AD and AS shifts left), rising price levels (inflation), and increasing unemployment. Out put has decrease but Price level increase. This is experienced during an economic recession, such as the current state of the U.S. economy as the graph illustrates.

Increases in AS: full-employment with price-level stability:

Normally, a shift of the aggregate demand curve to the right will result in expansion of output and inflation. However, if the aggregate supply curve also shifts to the right, the economy will experience strong economic growth, full employment, and only very mild inflation. The aggregate supply curve will shift to the right when larger than usual increases in productivity (ex: burst of new technology). Expanding output beyond the full-employment level will lead to higher inflation.