11 -- Part 2: Classical and Keynesian Macro Analyses
We will assume that the short-run aggregate supply curve within the current range of real GDP is horizontal.
We assume that it is the same as Figure 11-6 on page 236.
The equilibrium level of GDP is determined by demand.
Keynes wanted to look at the elements of desired aggregate expenditures.
Inflation is not a concern because of the Keynesian assumption of inflexible prices.
Real values are the same as nominal values.
Businesses don't pay indirect taxes.
Businesses give their profits to their shareholders.
Gross private domestic investment is equal to net investment.
There is no foreign trade in the economy.
If you have a dollar of disposable income, you can either consume it or save it.
You will be able to consume it if you save the entire dollar.
Food and movies are consumption goods.
Whatever is not consumed is saved.
If you don't consume anything, you can consume at some time in food and go to a concert.
It is important money.
This rate is moving.
Consumption is a flow concept.
You use up after-tax income from goods bought by households at a certain rate per week, per month or per year.
A dollar of take- home income can be spent or saved.
Saving is the amount of disposable income that is not spent to purchase consumption goods.
It is often used to describe putting money into the stock market or real estate.
A future stream of income is expected.
Changes in business inventories are included in our definition.
The answers can be found on page 275.
If we assume that we are operating in a stock market, that is a stock.
The equilibrium level of from saving is the short-run aggregate supply curve.
It's also a flow.
Expenditures on ___________ is a flow that occurs over time.
The rate of interest was used to determine the supply of saving in the classical model.
The higher the rate of interest, the more people want to save and the less they want to consume.
The main determinant of saving is income, not the interest rate.
Keynes argued that real saving and consumption decisions are dependent on a household's disposable income.
It shows how much each household will consume at each level.
The facing page function tells us how much people plan to show a consumption function for a hypothetical household.
The saving per year is shown by column 6.
Column 7 shows are negative.
Column 5 has a list of things to save.
The planned saving of this hypothetical household is negative if the income is $60,000.
Spending exceeds income in a negative saving situation.
Table 12-1 presents the consumption and saving relationships.
In the lower part of the figure, the horizontal axis is disposable income, but the vertical axis is savings per year.
The point is that we are measuring flows, not stocks.
What is not consumed is saved.
We start by drawing a line that is equidistant from the horizontal and vertical axes.
The line along which the income axis was planned is the same distance from the origin as the horizontal line.
The consumption function can be found in Table 12-1 on the previous d page.
The rate of real saving or dissaving at any income level is measured.
The consumption function is above it.
At a real disposable income level of $60,000, the planned annual rate of real saving is zero.
The vertical distance between the consumption function and the 45 degree line can be used to calculate the rate of real saving or dissaving in the upper part of the figure.
If our household's real disposable income falls to less than $60,000, it will not limit its consumption to this amount.
It will either go into debt or consume assets to make up for lost income.
The diagram shows a point where real disposable income is zero but planned consumption is $12,000.
Independent income is part of consumption.
The household will always attempt to consume at least $12,000 disposable income no matter how low the level of real income is.
The consumption function is shifted by changes in consumption.
Things other than the level of income determine the yearly consumption of $12,000.
In our example, it is $12,000 per year because we state that it exists.
In our model, consumption is not dependent on the household's disposable income.
There are many different types of expenditures.
We can assume that investment is independent of income.
Government expenditures can be assumed to be autonomously.
At times in our discussions, we will do that to simplify our analysis of income determination.
Government economists always account for the current disposable income when forecasting total U.S. consumption, as they will engage in more consumption spending today at any given level of spending over the coming weeks and months.
The University of Michigan's index of consumer consumption is used to do this.
For any level of real income, the real consumption proportion of total real disposable income that is consumed is divided.
For any given level of real income, the proportion of total real disposable income that is saved is divided by real disposable income.
As income increases, the fraction of the household's real disposable income going to consumption falls.
Column 5 shows that the average propensity to save is negative at first and then becomes positive after hitting an income level of $60,000.
The value of theAPS is 0.1 at $120,000.
The household saves 10 percent of their income.
It's easy to figure out your average propensity to consume or save.
If you divide the value of what you consumed by your total disposable income for the year, you will get your personal APC.
Divide your real saving by your real disposable income to calculate your ownAPS.
The Greek letter propensity to consume of 0.8 tells us that the marginal is a small decremental change.
An additional $100 in take- home pay will lead to an additional $80 being consumed.
The change in saving and disposable income are related.
Out of an additional $100 in take- home pay, $20 change in real saving will be saved if the marginal propensity to save is defined as propensity to save of 0.2.
Whatever is not saved is consumed.
The marginal propensity to save must always be equal to the marginal propensity to consume.
They tell you the percentage of the increase or decrease in real income that goes to consumption and saving.
If there is a change in your real disposable income, the marginal propensity to consume will change.
The average propensity to consume is the percentage of your total real disposable income that you consume.
Table 12-1 shows that the APC is not equal to 0.8.
It is not possible for the MPC to be less than zero or greater than one.
Households increase their planned real consumption by between 0 and 100 percent of any increase in real disposable income that they receive.
We can show the difference between the average propensity to consume and the marginal propensity to consume.
Assume that your consumption behavior is the same as our household's.
You have an annual disposable income of $108,000.
The planned consumption rate from column 2 of Table 12-1 is $98,400.
Your average propensity to consume is $98,400/$108,000.
At the end of the year, your boss will give you an after-tax bonus of $12,000.
According to the table, you would save over $2,500.
A new consumption rate of $108,000 was added to find out.
The average propensity to consume is $108,000, divided by the new higher salary of $120,000.
In our simplified example, your MPC remains at 0.8 all the time.
At every level of income, the MPC is 0.8.
It is assumed that the amount that you are willing to consume out of additional income will remain the same in percentage terms no matter what level of real disposable income is your starting point.
Saving must equal income.
The change in total real disposable income is either consumed or saved.
The proportions of the measures that are consumed and saved must be the same.
The average propensities as well as the marginal propensities to consume and save must total 100 percent.
The two statements should be checked by adding the figures in columns 4 and 5 for each level of disposable income.
Do the same for columns 6 and 7.
The consumption function will shift if there is a change in any other economic variable.
The position of the consumption function can be determined by a number of nonincome factors.
The stock of assets owned by a person will cause the average household's real net wealth to increase.
A decrease in net wealth will cause it to shift downward.
The consumption function of an individual or a consist of a house, cars, personal belongings, household is what we have been talking about so far.
Let's move on to the national economy.
People think that the government would rise if it acted like Robin.
Hood would be caused by a redistribution of wealth.
The distribution of wealth would not be accomplished by changing the consumption of high-income households.
The answers can be found on page 275.
The saving function is dependent on disposable income.
The propensity to complement the consumption function because real save is equal to the change in planned real saving divided by real disposable income must equal real disposable by the change in real disposable income.
The propensity to consume is the same as the rate of consumption to change.
The consumption is divided by disposable income.
The consumption function is what it is.
The real saving change in a nonincome determinant of consumption will be divided by real disposable income.
Changes in business inventories and expenditures on new buildings and equipment are part of investment.
Real gross domestic investment in the United States has been volatile over the years.
In the depths of the Great Depression and at the peak of the World War II effort, the net private domestic investment figure was negative.
We weren't even maintaining our capital stock by fully replacing equipment.
We find that the real investment expenditures are less variable over time than the real consumption expenditures.
The real investment decisions of businesses are based on highly variable, subjective estimates of how the economic future looks.
Businesses see an array of investment opportunities.
The investment opportunities have rates of return ranging from zero to very high, with the number of projects being related to the rate of return.
As the interest rate falls, planned investment spending increases, and vice versa, the project is profitable if its rate of return exceeds the opportunity cost of the investment.
In our analysis, it doesn't matter if the firm must seek financing from external sources or use retained earnings.
As the interest rate falls, more investment opportunities will be profitable, and planned investment will be higher.
The investment function is represented as an inverse relationship between the rate of interest and the value of planned real investment.
If the rate of interest is 5 percent, the dollar value of planned investment will be $2 trillion a year.
On a per-year basis, the planned investment is shown as a flow, not a stock.
Because planned real investment is assumed to be a function of the rate of interest, go to economic data provided by the Federal to see any non-interest-rate variable that can have the potential of shifting the Reserve Bank of St. Louis via the link at investment function.
The expectations of businesses are one of those variables.
You can see how the U.S. is depicted on www.econtoday.com/ch12
The expectation of higher profits will lead to more investment.
Investment function can be shifted by any change in productive technology.
Changes in business taxes can change the investment schedule.
We predict a leftward shift in the planned investment function if they increase because higher taxes imply a lower rate of return.
The answers can be found on page 275.
Changes in the non-interest-rate determinants of between real investment and planned investment will cause a slope.
The non-interest-rate factors will be made.
We want to figure out the equilibrium level of GDP per year.
When we looked at the consumption function earlier in the chapter, it related planned real consumption expenditures to the level of real disposable income per year.
In order to get real disposable income, adjustments must be made to GDP.
Real disposable income is less than real GDP due to the fact that net taxes are usually 14 to 21 percent of GDP.
The average disposable income in the last few years has been around 80% of GDP.
There is a part of real consumption that is labeled.
The change in the horizontal axis from real disposable income to real GDP per year is the difference between this graph and the graphs presented earlier in this chapter.
Assume that 20 percent of changes in real disposable income is saved, and that an additional $100 earned will be eaten.
The reference line is the same as in the earlier graphs.
The quadrant is divided into two equal spaces by the 45 degree line.
The rate of planned expenditures is shown in the consumption function.
Real consumption and real GDP are the same.
All real GDP is consumed at that GDP level.
Changes in inventories of final products to the rate of interest are included in the planned investment function.
We can treat the level of real investment as constant, regardless of the level of GDP, because we have a determinant investment level of $2 trillion at a 5 percent rate of interest.
The vertical distance of investment spending is $2 trillion.
Businesses will invest a certain amount of money no matter what the level of GDP is.
When total planned real expenditures are equal to real GDP, equilibrium occurs.
Real investment is not dependent on real GDP.
For better exposition, we only look at a part of the saving and investment schedules--annual levels of real GDP between $9 trillion and $13 trillion.
Reality confirms all anticipations.
Only at the equilibrium level of real GDP of $11 trillion per year will investment, and hence planned saving equal planned saving equal actual saving, planned investment equal actual investment.
Firms will be left with unsold products and their inventories will rise above planned levels.
Unplanned business inventories will rise at a rate of $400 billion per year, or $2.4 trillion in actual investment, minus $2 trillion in planned investment by firms that had not anticipated an inventory build-up.
This situation can't continue for a long time.
Businesses will respond to the increase in inventories by cutting back production of goods and services and reducing employment, and we will move toward a lower level of real GDP.
If real GDP is less than the equilibrium level, the adjustment process works differently.
If real GDP is $9 trillion per year, an inventory decrease of $0.4 trillion will bring about an increase in real GDP towards the equilibrium level of $11 trillion.
There will be an expansion of the circular flow of income and output in the form of inventory changes when the saving rate by households is different from the investment rate by businesses.
The equilibrium level of real GDP is zero until inventory changes are again zero.
The reason for the increase was that households wanted to save more.
A cut in household spending resulted in an equal amount of unsold business inventories.
The answers can be found on page 275.
We assume that the consumption function has an Whenever planned saving exceeds planned investment part that is independent of the level of real and real GDP per year.
GDP will fall as producers cut production.
For simplicity, we assume that real investment is investment, there will be unplanned inventory, and real GDP will rise as producers increase unaffected by the level of real GDP per year.
The level of real GDP can be found if planned saving and investment are combined.
The role of government in our model has been ignored.
The foreign sector of the economy has been left out.
When we consider these as elements of the model, what happens?
Federal government expenditures account for 25% of real GDP in the United States.
Real taxes are used to pay for a lot of government spending.
A tax that doesn't depend on income.
In Table 12-2 we show the example of a $1,000 tax that every household numbers for a complete model.
The nation's foreign trade deficit has been the focus of the media for a long time.
We have been buying goods and services from foreign residents that are more expensive than what we are selling to them.
The level of real exports depends on international economic conditions.
Economic conditions at home affect real imports.
There are trillions of dollars.
We are in a position to determine the equilibrium level of real GDP per year under the continuing assumptions that the price level is unchanging, that investment, government, and the foreign sector are independent, and that planned consumption expenditures are determined by the level of real GDP.
In Table 12-2 on the preceding page, we can see that total planned real expenditures of 15 trillion per year equal real GDP of 15 trillion per year, and this is where we reach equilibrium.
When total planned real expenditures equal real GDP, equilibrium occurs.
There are inventory changes when total planned real expenditures differ from real GDP.
When total planned real expenditures are greater than GDP, there is a drop in inventory levels.
Firms try to increase their production of goods and services in order to get inventories back up.
Real GDP goes to its equilibrium level.
The opposite occurs when total planned real expenditures are less than GDP.
Firms have to cut back on their production of goods and services in order to push inventories back down to planned levels.
The result is a drop in GDP.
The answers can be found on page 275.
For a closed economy at that level.
Real GDP will be equal to total planned expenditures and net exports.
When total planned real expenditures exceed real planned real expenditures are less than real GDP, there will be an inventory problem.
The equilibrium real level of equilibrium real GDP will prevail because production of goods and services will increase.
There will be a decrease in total GDP.
Real consumption expenditures are the only real expenditures included in real GDP.
Next, we add the amount of planned real investment, $2 trillion, and then figure out what the new equilibrium level of real GDP will be.
It's $11 trillion per year.
The effect of changes in spending is what is operating here.
If there is a permanent increase in real GDP, it will cause a larger real expenditures.
The number of changes in real investment or GDP.
Even larger decreases in real GDP per year will be caused by permanent decreases in real spending.
Let's look at a simple real GDP to understand why this multiple is used.
The figures we used for the marginal propensity to consume and to save will be used again.
The difference between the two will be 0.8, or 4, or 0.2, or 1.
The first round of investment is increased by $100 billion.
This also means an increase in real GDP of $100 billion, because the spending by one group represents income for another, shown in column 2.
The increase in consumption by households that received additional income is given in column 3.
The increase in real GDP is used to find this.
During the first round, real consumption expenditures will increase by $80 billion.
There's more to the story.
$80 billion of additional income will be provided by this additional household consumption.
During the second round, we see an increase in GDP of $80 billion.
It will be more than twice as much as $80 billion.
The equilibrium level of real GDP will increase by $500 billion after an initial increase in investment expenditures of $100 billion.
A permanent $100 billion increase in real investment spending has led to an additional $400 billion increase in real consumption spending, for a total increase in real GDP of $500 billion.
The equilibrium real GDP will change by five times the change in real investment.
The marginal propensity to save is used to divide the spending multiplier.
The MPS was equal to 0.2 or 1.
That was our goal.
A $500 billion increase in the equilibrium level of real GDP was caused by a $100 billion increase in real planned investment.
You can always figure it out if you know the two.
Let's look at an example.
The following is due to the fact thatMPS is 1 and the following is due to the fact that it is 1 and the following is due to the fact that it is 1 and the following is due to the fact that it is 1 and the following is due to the fact that it is If we are given a marginal propensity to consume, we can always figure out the multiplier.
The larger theplier, the smaller the marginal propensity to save.
The bigger the marginal propensity to consume, the bigger the multiplier.
When the marginal propensity to save is 3, 1, and 1 you can demonstrate this.
The multiplier works for either a permanent increase or a permanent decrease in spending.
The reduction in equilibrium real GDP would have been $500 billion per year if the component of real consumption had fallen permanently.
It is possible that a relatively small change in planned investment can cause a larger change in equilibrium real GDP per year.
The fluctuations in equilibrium real GDP are caused by changes in spending.
The larger the marginal propensity to consume, the bigger the multiplier.
The multiplier is 2 if the marginal propensity to consume is 1.
The multiplier will be 10 if the marginal propensity to consume is 9.
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