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04/10/2007 Econ 201: Principles of Economics Hakan TASCI

1. What we have done so far? The consumption function shows an indirect relationship between consumer spending

and disposable income. If consumers receive an increase in income of $1,000, their spending will increase by

a smaller amount. A change in the value of consumers stock market holdings will cause a shift in the

consumption function When the price level falls, consumers may feel wealthier and the consumption

function will shift upward. Financial investments, such as mutual fund purchases, are included in the national

income component. The purchase of a new house is included in consumer expenditures. The value of both exports and imports are added to the value of national product. To economists, investment means buying stocks and bonds. The slope of the consumption function is measured by the marginal propensity to

save.

Government transfer payments are income earned by individuals who work for the federal government.

An example of investment is the purchase of machinery by a manufacturing company.

2. Todays Outline Demand Side Equilibrium The Mechanics of Income Determination How to get Aggregate Demand Inflationary and Recessionary Gap Math of Income Determination Multiplier

3. Demand Side Equilibrium Equilibrium refers to a situation in which neither consumers nor firms have any incentive to change their behavior. If total spending of consumers exceed output than firms will notice that they are depleting their inventories and start to produce more to meet the higher demand, and If output exceeds spending, inventories rise and firms reduce production. Demand Side Equilibrium: The equilibrium level of GDP on the demand side is the level at which total spending equals production. In such a situation neither firms nor consumers change their behaviors. Expenditure Schedule: shows the relationship between national income and total spending. Induced investment: is the part of investment spending that rises when GDP rises and falls when GDP falls.

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4. The Mechanics of Income Determination

On the schedule, one can see how consumption, investment, government spending and net exports add up to total expenditure. The slope of the consumption function is the marginal propensity to consume.

Both the expenditure table and the corresponding income-expenditure diagram or 45 degree line diagram show the equilibrium level of GDP. All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the equilibrium.

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Exercise 1: GDP Consumption Investment Government Net Exports Total Expenditure 3000 2000 500 800 -100 3300 2200 500 800 -100 3600 2400 500 800 -100 3800 2600 500 800 -100

Schedule:

5. The Aggregate Demand Curve: Exercise 2: What is the effect of the price level changes on Equilibrium level of quantity demanded? price level consumption Price level purchasing power of wealth (not real income)

A change in real income would be illustrated as a movement along the consumption function, not a shift.

Price level consumption Therefore, price level total expenditures and equilibrium GDP Therefore, price level equilibrium level of real aggregate quantity

demanded

Exercise 3: How total expenditure schedule shift outwards? What can be the reason?

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The Aggregate Demand Curve: The negatively-sloped aggregate demand curve shows all the equilibria of price levels and GDP. Remember that any income-expenditure diagram is drawn for a specific price level. When there is a change in price, total expenditure shifts and a new equilibrium is formed. If you connect all these equilibrium points, you get the aggregate demand.

6. Recessionary and Inflationary Gap The recessionary gap: is the amount by which the equilibrium level of real GDP falls short of real GDP.

The Inflationary gap: is the amount by which equilibrium real GDP exceeds the full employment level of GDP.

The Coordination of Saving and Investment: Investment exceeds saving will result an inflationary gap. Saving exceeds investment will result a recessionary gap. If these happen then there exists a coordination failure in economy.

7. The Math of Income Determination All relationships that we dealt with can be represented as mathematical formulas: C= a + b.(Y-T) consumption= autonomous consumption + induced consumption TE= C+I+G+NX Total Expenditure TE=Y Equilibrium condition Therefore in equilibrium:

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8. Multiplier The Multiplier: The multiplier is the ratio of change in GDP to the change in any of the components of total expenditure. Multiplier is greater than 1 because one persons spending is another persons income. Examples: Investment Multiplier: Tax Multiplier: Government Exp. Multiplier:

How the Multiplier Works? Spending => Income => Spending => Income ..

The multiplier is greater than 1 because one persons spending is another persons income. A portion of the increase in income is spent on consumption, creating more income, which in turn creates more consumption spending, and so on.

Factors that reduce multiplier: International trade, inflation, income taxation, financial systems reduce the multiplier.

Algebraic Statement of the Multiplier Government Spending Multiplier = 1 / (1 - MPC) Tax multiplier = - MPC / (1 - MPC) The MPC has been estimated to be about 0.9, implying that the multiplier is

10. In fact, the multiplier is < 2.

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9. Multiple Choice Questions: 1. If total spending is less than total output, then price levels will a. rise and output will increase. b. rise and output will decrease. c. fall and output will increase. d. fall and output will decrease. 2. Using the standard 45-degree line diagram, how does an increase in investment spending

effect the expenditure schedule? a. It shifts the expenditure schedule downward. b. It shifts the expenditure schedule upward. c. It increases the slope of the expenditure schedule. d. It decreases the slope of the expenditure schedule. 3. Using the standard 45-degree line diagram, how does a decrease in net exports effect the

expenditure schedule? a. It increases the slope of the expenditure schedule. b. It decreases the slope of the expenditure schedule. c. It shifts the expenditure schedule upward. d. It shifts the expenditure schedule downward. 4. The amount by which equilibrium real GDP exceeds full-employment GDP is known as a. stagflation. b. employment. c. a recessionary gap. d. an inflationary gap. 5. If saving exceeds investment, then the level of GDP must a. increase. b. remain constant. c. decrease. d. rise above potential GDP. 6. The basic idea behind the multiplier is that an increase in a. GDP brings about an additional, larger increase in GDP. b. consumer spending causes a larger increase in investment spending. c. government spending causes a larger increase in tax revenues. d. spending will cause an even larger increase in equilibrium GDP. 7. The reason for the multiplier effect is that a. businesses make decisions about investment projects based on anticipated profits. b. one persons additional expenditure creates a new source of income for another person,

and this additional income leads to still more spending. c. changes in government spending typically deepen recessions and exacerbate

inflationary conditions in the economy. d. additional spending lowers the rate of interest and leads to further borrowing and

spending. 8. If businesses spend an additional $150 billion for investment projects in 2001, what will be

the impact on national income (Y) if the multiplier is 2? a. Y will increase by $50 billion. b. Y will increase by $150 billion. c. Y will increase by $300 billion. d. Y will increase by $350 billion.

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9. Assume that the MPC is .9 and investment falls by $30 billion. What is the change in real GDP?

a. $300 billion b. $270 billion c. $93 billion d. $39 billion 10. If an increase in investment of $100 billion generates an increase of $500 billion in real

GDP, the multiplier is a. 20. b. 50. c. 1.50. d. 5.00. 11. If the multiplier is 4 and real GDP increases by $520 billion, the increase in investment

spending must have been a. $110 billion. b. $120 billion c. $130 billion d. $140 billion 12. An increase in the U.S. price level will a. increase the slope of the expenditure schedule. b. decrease the slope of the expenditure schedule. c. shift the expenditure schedule upward. d. shift the expenditure schedule downward. 13. The slope of the aggregate demand curve illustrates that as the price level rises, a. real GDP demanded decreases. b. real GDP demanded increases. c. the aggregate demand curve shifts rightward. d. the aggregate demand curve shifts leftward. 14. Recessionary gaps are most likely to be accompanied by a. inflation. b. inventory reductions. c. unemployment. d. expanding output.