Principles of Economics

Principles of Economics

Session 11

Topics To Be Covered

Identities of Saving and InvestmentConsumption FunctionMarginal Propensity to ConsumeMarginal Propensity to SaveInvestment FunctionEquilibrium of the Goods MarketCase Study: Output Accounting and Output

Determination

Topics To Be Covered

Business CycleFiscal PolicyMultiplier EffectCrowding-Out EffectParadox of Thrift

National Saving

National saving is the amount of income that households have left after paying their taxes and consumption and the revenue that the government has left after paying for its purchases.

National Saving = Private Saving + Public Saving

Private Saving

Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.

Private Saving = Y – T - C

Public Saving

Public saving is the amount of tax revenue that the government has left after paying for its spending.

Public Saving = T - G

Surplus and Deficit

Budget SurplusIf T>G, the government runs a budget surplus because it receives more money than it spends.

Budget DeficitIf G>T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

Identities ofSaving and Investment

Assume a economy consisting of households and firms only. The expenditures are consumption and investment and the incomes are either spent on consumption or saved.

C + I = C + S Therefore, saving is equal to investment.

I = S


In a closed economy with households, firms, and government, there exists the following equation, the left side being expenditures and the right side being income allocations:

C + I + G = C + S + T

Therefore, the national saving is equal to investment.

I = S + (T – G)


In an open economy, import and export should be considered. Since the aggregate income (Y) is equal to the aggregate expenditure, there exist the following equations:

Y= C + I + G + NX

I + NX = Y – C - G


For an economy as a whole, net export (NX) and net foreign investment (NFI) must balance each other so that:

NX = NFI Therefore, in an open economy national

saving is equal to the sum of domestic investment and net foreign investment.

I + NFI = (Y – C -T ) – (T – G)

Consumption and Saving

In a society without tax, a household can do two things with its income— consumption and saving.

Y = C + S

Determinants of Consumption

Household income Household wealth Interest rates Households’ expectations

Consumption Function

Keynes points out that the household consumption is closely related to the income. With the income increase, people will consume more. However, the increase of consumption is not as great as that of income.

Empirical studies also reveal the close relationship between consumption and income but the increase of consumption is on the whole proportional to income.


C = Y

45º Income

Consumption

C = f ( Y)

Keynes’ View


C = Y

45º Income

Consumption

Empirical Finding

C = a + bY

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the extra amount that people

consume when they receive an extra dollar of income.


Income

Consumption

MPC=Slope

C = f ( Y)

MPC = f ‘( Y)


Income

Consumption

C = a + bY

MPC=Slope=b


Keeping other variables (interest rate, expectation, etc.) constant, consumption can be thought of as a function of income.

C = f (Y)

If the function is linear, it can be expressed as:

C = a + bY

Aggregate Income (Y)(Billion Dollars)

Aggregate Consumption (C)(Billion Dollars)

0 100

80 160

100 175

200 250

400 400

600 550

800 700

1,000 850



Income

Consumption C = 100 +

0.75Y

100

Marginal Propensity to Save

The marginal propensity to save (MPS) is the fraction of an additional dollar of income that is saved.

MPC + MPS = 1

MPS = 1 - MPC

Aggregate Income Aggregate Consumption Aggregate Saving

(All in Billion Dollars)

0 100 -100

80 160 -80

100 175 -75

200 250 -50

400 400 0

600 550 50

800 700 100

1,000 850 150


C = 100 + 0.75Y

45°

C = Y


Income0

consumption

0 Income

Save

S = -100 + 0.25Y

MPS = 0.25

Investment

Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stocks.

Generally, investment is considered a function of interest rate (r). When the interest rate is high (low), the financial cost for the firm is high (low), the firm invests less (more).

Investment

Investment

Interest rate

I = f (r)

Planned Investment

Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms.

Actual investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

Planned Investment

For simplicity, it is assumed that planned investment is fixed, for the major determinant of investment is the interest rate and the investment is an exogenous variable in the Keynesian cross model.

It does not change when income changes, so investment is an autonomous variable.

Planned Investment

Income

Investment

I = 25

Planned Aggregate Expenditure

To determine planned aggregate expenditure (AE), we add

consumption spending (C) to planned investment spending (I) at

every level of income.

Planned Aggregate Expenditure

Y

C + I

C = 100 + 0.75Y

I = 2525

100

AE = C+ I = 125 + 0.75Y

125

Equilibrium in Goods Market

In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output.

Y = C + I


Inventory investment is greater than planned.Actual investment is greater than planned, so there is unplanned inventory

Y ＜ C + I

Y ＞ C + I

Inventory investment is smaller than planned. There is negative unplanned inventory.


Saving is a leakage out of the spending stream. If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium.

Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I).

Case Study: Output Accounting and Output Determination

Assume an economy consists of the firm and the family only

and the firm produces a single product—bread.

Case Study: Output Accounting and Output Determination

The firm thinks that the household will consume $800 of bread.

Considering that the firm needs the inventory $200 of bread to entertain

international guests, the firm produces $1000 worth of bread.

Case Study: Output Accounting

As expected, the firm sells exactly $800 of bread and keeps an inventory of $200 of bread.

What’s the GDP of this economy for this period?

Case Study: Output AccountingAggregate Output=$1000

Ou

tput:$1000

Income: $1000

Consumption: $800

Inventory: $200

Aggregate Income=$1000

Aggregate Expenditure=C+I=$1000

GDP=$1000

Case Study: Output Determination

As expected, the firm sells exactly $800 of bread and keeps an inventory of $200 of bread.

Is the goods market in equilibrium? Why?


Unplanned Inventory: $0 Income: $1000

Planned Saving:

$200

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption: $800

Planned Expenditure = AD: $1000

Ou

tput

= A

S: $

1000

Planned Investment200

Planned Saving

C+I

45°

AS=AD

Case Study:Output Determination

GDP= AS =Output = Income=C+S1000

1000

1000

AD

= P

lan

ned

Exp

end

itu

re=

C+

I

0

0

Sav

ing

and

In

vest

men

t

GDP=Income

Investment here doesn’t include unplanned inventory, so investment does not necessarily

equal saving.

Output=AD, so the goods market is in

equilibrium.


Unexpectedly, the firm sells only $600 of bread, so it has to keep an

inventory of $400 of bread.



Ou

tput:$1000

Income: $1000

Consumption: $600

Inventory: $400



GDP=$1000



Unexpectedly, the firm sells only $600 of bread, so it has to keep an inventory of $400 of bread, $200 of which is unplanned inventory.


Unplanned Inventory: $200 Income: $1000

Planned Saving:

$400

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption: $600


Ou

tput

= A

S: $

1000

I200

S

C+I

45°


GDP= AS =Output = Income=C+S

AD

= P

lan

ned

Exp

end

itu

re=

C+

I

0

0

Sav

ing

and

In

vest

men

t

GDP=Income1000

400

1000

800

Output is greater than AD by $200

Planned saving is greater than planned investment by $200.

Other things held constant, the firm should decrease its output next period.

Equilibrium output


Unexpectedly, the firm sells all the bread it has produced—$1000 of

bread, so it has run out of inventory.



Ou

tput:$1000

Income: $1000

Consumption: $1000

Inventory: $0



GDP=$1000



Unexpectedly, the firm sells all the bread it has produced—$1000 of

bread, so it has run out of inventory, which means a negative

unplanned inventory of $200.


Unplanned Inventory: - $200 Income: $1000

Planned Saving:

$0

Planned

Inve

ntory

=

Planned

Inve

stmen

t: $2

00Planned Consum

ption:$1000


Ou

tput

= A

S: $

1000

I200

S

C+I

45°


GDP= AS =Output = Income=C+S

AD

= P

lan

ned

Exp

end

itu

re=

C+

I

0

0

Sav

ing

and

In

vest

men

t

GDP=Income

1000

1200

Other things held constant, the firm should increase its output next period.

Equilibrium output

1000

Output is smaller than AD by $200

Planned saving is smaller than planned investment by $200.


GDPPlanned

ConsumptionPlanned Saving

Planned Investment GDP

Total PlannedC and I

Resulting Tendency of Output

1000 600 400 200 1000 800 Contraction

1000 800 200 200 1000 1000 Equilibrium

1000 1000 0 200 1000 1200 Expansion

＞＝＜

Business Cycle

Time

GDP

Trough

Trough

Peak

Trend Growth

Expansi

on Recessio

n

AE

45°

Business Cycle

GDP

AE

0

1000

800

Equilibrium output

Trough PeakRecession

Expansion

150

Business Cycle

A recession is a period of declining real GDP, falling incomes, and rising unemployment.

A depression is a severe recession.

Business Cycle

Economic fluctuations are irregular and

unpredictable.

Most macroeconomic variables fluctuate

together.

As output increases, unemployment falls,

but the price level increases.

Fiscal Policy

The government can play a very important role in smoothing the economic fluctuation.

When the economy is in recession, the government may adopt expansionary policy—decrease taxes or increase spending.

When the economy develops too fast, the government may adopt contractionary policy—increase taxes or decrease spending.

AD2

Expansionary Fiscal Policy

Quantity ofOutput

PriceLevel

0

AS

P1

P2

AD1

Q1 PotentialOutput

AD1

Contractionary Fiscal Policy

Quantity ofOutput

PriceLevel

0

AS

P2

P1

AD2

PotentialOutput

Q1

Potential Output

The potential output is determined by the stock of labor, capital, land, and technology. The price level has little effect on the supply of these factors in the long run. So in the AS-AD model, the potential output is vertical.

This level of production is also referred to as natural rate of output or full-employment output.

Fiscal Policy andAggregate Expenditure

In a closed economy with three sectors—firms, households, and government. Government spending (G) is a very important component in aggregate expenditure.

AE = C + I + GIn the Keynesian model, government

spending does not change with output, so G is an autonomous variable.

125

Fiscal Policy andAggregate Expenditure

Y

AE

C = 100 + 0.75Y

I = 2525

100

C+ I = 125 + 0.75Y

G = 2550

150

C+I+G = 150 + 0.75Y

The Multiplier

The 1 dollar increase of autonomous variable (investment, government purchase, etc.) is likely to result in more than 1 dollar increase in total output.

For example, if the government spending increases by $1, the individual who earns that dollar saves $0.25 and pays $0.75 for a book.

△GDP = $1 + $0.75 = $1.75

The MultiplierIf the book seller saves 25% of $0.75 received

and spends 75%, the increase of GDP is:

△GDP = $1 + $0.75 + $0.5625= $2.3125

If the MPC of every person is 0.75, then the GDP increase is:

4$75.01

1$0.75$0.750.75 $1 $1 GDP

GDP increases four times as large as the increase of government spending, so the multiplier is 4.

The Multiplier

The multiplier is the ratio of the change in the equilibrium level of output to a

change in some autonomous variable.

The Multiplier

Because S△ must be equal to I△ for equilibrium to be restored, I△ can be substituted for S△ .

MPS may be expressed as:

Y

SMPS

Y

IMPS

MPC1

1

MPS

1Multiplier

MPS

1IY

125

The Multiplier

Y

AE

AE1 = C+ I + G1

=125 + 0.75Y

45º

475.01

11

1

MPCMultiplier

150

AE2 = C+ I + G2

=150 + 0.75Y

500 600

The Tax Multiplier

A tax cut increases disposable income, which is likely to lead to added consumption spending. Income will increase by a multiple of the decrease in taxes.

However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

The Tax Multiplier

However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

MPS

MPCMultiplierTax

Multipliere ExpenditurMPCMultiplierTax

MPS

MPCT

MPS

1MPC)T(Y

The Crowding-Out Effect

There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect


Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

An increase in government purchases causes the interest rate to rise.

A higher interest rate reduces investment spending.


This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.


Quantity ofOutput

PriceLevel

0

AS

P1

AD1

Q1

AD2

AD3

Crowding-out effect=Q2 – Q3

Q2

P2

P3

Q3

The Paradox of Thrift

When households are concerned about the future and plan to save more, the corresponding decrease in consumption leads to a drop in spending and income.

In their attempt to save more, households have caused a contraction in output, and thus in income. They end up consuming less, but they have not saved any more.

The Paradox of Thrift

25

Y

S, I

S 1

－ 75

－ 25

75

175

125

I

S 2

300 600

Assignment

Review Chapter 22, 23, and 24Answer questions on P430, 444 and 463.Search for information on China’s fiscal

policies in the recent years.Preview Chapter 25 and 26

Thanks

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