Macroeconomics chapter 10 highlights PDF

Preview

Summary

Download Macroeconomics chapter 10 highlights PDF

Description

Consumption = disposable income – saving The relationship between disposable income-consumption as well as disposable income-saving is positive. That is, when income increases (decreases), consumption increases (decreases), and savings increase (decrease). Therefore, an increase in disposable income would cause a movement upward along an economy’s consumption and savings schedule and a decrease in disposable income would cause a movement downward along an economy’s consumption and savings schedule. See Figure 10.1 and 10.2 Notice that whenever the consumption schedule intersects the 45 degree line, the amount of savings would be zero (break-even level of income point). To the left of that point, savings would be negative (dissaving) and to the right of that point, savings would be positive. APS = saving / income APC = consumption / income MPS = change in saving / change in income MPS is equal to the slope of the saving schedule MPC = change in consumption / change in income MPC is equal to the slope of the consumption schedule APS + APC = 1 MPS + MPC = 1 See Table 10.1 Determinants of consumption and savings are (i) wealth – a household’s wealth is the dollar amount of all the assets that it owns minus the dollar amount of its liabilities (debt that it owes). A sudden increase in wealth (wealth effect) would shift the consumption schedule upwards and saving schedule downwards, (ii) borrowing – when a household borrows, it can increase current consumption thus borrowing shifts the current consumption schedule upward and thus current saving schedule downward, (iii) expectations – the expectation of higher prices tomorrow may cause households to buy more today while prices are still low. Thus, consumption schedule shifts up and the current saving schedule shifts down. Expectations of a recession and therefore possibility of lower income in the future may cause households to reduce consumption (shift

consumption schedule downward) today and increase saving (shift saving schedule upward), (iv) real interest rates – when real interest rates fall, households tend to borrow more, consume more, and save less. Thus, the consumption schedule shifts upward and saving shift downward. Higher interest rates do the opposite. A change in disposable income would neither shift the consumption nor the saving schedule. It would change the amount of consumption or saving by moving either upward or downward on a consumption and saving schedule. Changes in wealth, expectations, interest rates, and household debt will shift the consumption schedule in one direction and the saving schedule in the opposite direction. See Figure 10.4 In contrast, a change in taxes shifts the consumption and saving schedules in the same direction. An increase (decrease) in taxes will reduce (increase) both consumption and saving, shifting the consumption and saving schedules downward (upward). Economic investment decisions are based on marginal benefit and marginal cost analysis. The marginal benefit of an investment is equal to the expected rate of return whereas the marginal cost of an investment is equal to the real interest rate that must be paid back for borrowed funds. If the expected rate of return exceeds the interest rate, the investment should be undertaken. But if the interest rate exceeds the rate of return, the investment should not be undertaken. Suppose the owner of a small cabinetmaking shop is considering whether to invest in a new sanding machine that costs $1,000 and has a life expectancy of only 1 year. Suppose that the net expected revenue from the machine is $1,100. Therefore, the expected rate of return is 10 percent [= ($1,100 - $1,000) / ($1,000) × 100]. The investment demand curve is negatively sloped. As the real interest rate rises (falls), the amount of investment spending declines (rises). See Figure 10.5 Determinants of investment demand curve are (i) acquisition, maintenance, and operating costs – when these costs rise (fall), the expected rate of return from prospective investment projects fall (rise) and the investment demand curve shifts to the left (right), (ii) business taxes – an increase (decrease) in business taxes lowers (raises) the expected profitability of investments and shifts the investment demand curve to the left (right), (iii) technological change – the development of a

more efficient machine, lowers production costs or improves product quality and increases the expected rate of return from investing in the machine, (iv) stock of capital goods on hand – when the economy is overstocked (understocked) with production facilities and when firms have excessive (less than excessive) inventories of finished goods, the expected rate of return on new investment declines (raises), (v) planned inventory changes – if firms are planning to increase (decrease) their inventories, the investment demand curve shifts to the right (left), and lastly (vi) expectations – if business executives become more optimistic (pessimistic) about future sales, costs, and profits, the investment demand curve will shift to the right (left). Investment spending in the United States tends to be unstable b/c expected profits are highly variable, capital goods are durable, innovation occurs at an irregular pace, and expectations vary quickly. Real interest rate = nominal interest rate + inflation premium The multiplier is useful in determining the change in GDP resulting from a change in spending. It indicates that a change in spending will change aggregate income by a larger amount. Multiplier = 1 / (1-MPC) Since MPC + MPS = 1 Multiplier = 1 / MPS As MPS increases (decreases), the size of the multiplier decreases (increases). As MPC increases (decreases), the size of the multiplier increases (decreases). For instance, if the MPC is 0.90 and investment increase by $4 billion, the equilibrium GDP will increase by $40 billion (= [(1 / .10)] × $4 billion). To understand the multiplier process, please review Figure 10.8...