Module 16-17

Multiplier

When there is an increase in the CIGXn, it is going to have a multiplying effect on the economy.

One person's income becomes another individual's income and on and on.

Thus, money in an economy is spent multiple times. It acts as a chain reaction that will increase GDP greater than the initial change in spending.

Disposable Income

All money left over after all taxes are deducted.

MPC - Marginal Propensity to Consume

Increase in consumer spending when disposable income rises by one dollar.

MPC = Change in consumer spending / change in disposable income.

The larger the MPC, the larger the multiplier.

MPS - Marginal Propensity to Save

MPC + MPS = one dollar.

Multiplier

1/(1-MPC) or 1/MPS

Consumption Function <- Test Question

What does the consumption show?

It shows the relationship between disposable income and consumer spending. If your disposable income increases, your consumers spending will then increase as well.

What will shift the consumption function?

• Changes in wealth.
  • Wealth is a person's net worth.
    • Assets - Liabilities
• Change in expectations about future income.

Aggregate Demand

Shifters of the demand curve: EWC$

• Anything that increases GDP - CIGXn
• E - Changes in expectations.
• W - Changes in wealth.
• C - Size of capital stock.
• $ - Fiscal policy and monetary policy.
  • When the government uses expansionary either, it will shift towards the right.
  • When the government uses contractionary either, it will shift towards the left.

Fiscal Policy 

• When congress speeds up or slows the economy by either manipulated taxes or manipulating government transfers or purchases.
  • i.e. Increasing taxes or decreasing; increasing government spending or decreasing.
  • Two types:
    • Expansionary - Fights recessions by shifting the AD curve to the right.
    • Recessionary - Fights inflations by shifting the AD curve to the left.
  • Discretionary - government by choice is deciding how they want to tax and spend. Government passes laws to do so.
  • Non-discretionary - Put in place by law that cannot change. Enacts permanent laws. Also known as automatic stabilizers. Automatically adjust based on economic conditions.
  • Monetary Policy - Increasing or decreasing interest rates.

When the aggregate supply curve shifts towards the left, the price level rises in the economy, and output in the economy will decrease.

Determinants of consumption:

• Household income - Higher incomes, consumption rises and vise versa.
• Household wealth - Value of a household's assets minus liabilities.
• Real interest rates: Higher interest rates means households will prefer to save.
• Household debt -  At high debt level, households must allocate more income to paying off those debts.
• Household confidence - If households are confident about future income, they are likely to spend more.

Determinants of investment:

• Real interest rates - At lower interest rates, firms will borrow more money and buy new capital equipment.
• Expectations of firms (confidence) - Same.

Determinants of government spending:

• Fiscal policy - Policy by the government related to spending and taxation.
  • When taxes decreases, the curve shifts to the right. <- Question of Test
  • When the government increase spending, the curve will shift to the right.
• Government debt - Too much government debt will have a negative effect in the long run. In the short run it can be helpful.

Determinants of net exports:

• Income of foreign consumers
• Domestic income changes
• Exchange rates

Exchange rate appreciation: When our currency increases in value, it makes foreigners trying to purchase our exports more difficult. Thus, our net exports decreases and therefore demand decreaes.

Conversely, exchange rate depreciation does the opposite.

The curve is downwards sloping because of the wealth effect and the interest rate effect.

• The wealth effect is when the price level goes up, the purchasing power of consumers decreases. Therefore, consumer spending will decrease and therefore spend less in the economy. This in turn proves the negative sloping curve.
• The interest rate effect is a change in the demand for money. When the price level goes up, individuals are more incentives to hold money. This increases the interest rates (as the demand for money increases). An increase in interest rates results in a decrease in investment spending (and consumer spending). This in turn proves the negative sloping curve.

Recessionary and inflationary gaps caused by aggregated demand shocks are fixable using fiscal and monetary policies.

Negative demand shocks = high unemployment

Positive demand shocks = inflation

Negative supply shock = stagflation

Positive supply shock = lowers prices and lowers unemployment 

Change in rGDP

Multiplier * change in spending.

Usually government or investment spending.

Stagflation

When there is both greater inflation and higher unemployment.

Negative supply shocks that cause inflation and higher unemployment are not fixable using fiscal and monetary policies.

In the long run, the economy will ultimately self-correct.

Our government will intervene to fix the problem with the economy sooner than if the economy will self-correct.

John Maynard Keynes

Solution to recession: Deficit spending.

That if the economy is in a recession, use the government to actively assist the economy out of a recession.

i.e. let the government spend as much money as it wants.

When the government spends the money that it does not have to fix the economy. They borrow the money in order to do so.