Chapter:8
• With government spending and taxes in the model:
- Spending injections into the economy equal government spending plus business investment. - Withdrawals from the system include saving and taxes.
ISSUE: SAVINGS RATES AND THE MULTIPLIER
A high savings rate can make a country vulnerable in times of recession. The adverse effects of a high savings rate occurred in Japan in the 1990s when government incentives were not effective in jumpstarting consumption and investment. - The multiplier was too low to pull the economy out of recession, resulting in a 10-year recession referred to as the Lost Decade.
CHAPTER SUMMARY
A recessionary gap is the increase in aggregate spending (that is then multiplied) to bring a depressed economy to full employment. • An Inflationary gap is the reduction in aggregate spending (again expanded by the multiplier) needed to reduce income to full employment levels.
Good to know
Aggregate expenditures play a prominent role in macroeconomic analyses and theories. They achieve this status because they are critical to the performance and stability of the macroeconomy. In particular, most business-cycle instability is directly attributable to changes in aggregate expenditures. Business-cycle contractions are invariably the result of decreases in the four expenditures. And business-cycle expansions can be largely traced to increases in the four expenditures.
Equal changes in government spending and taxation lead to an equal change in income. Equivalently, the balanced budget multiplier is equal to 1. • If spending and taxes are increased by the same amount, income grows by this amount.
BALANCED BUDGET MULTIPLIER: Foundations of the balanced budget multiplier:
Keynesian macroeconomic equilibrium
By______ equilibrium, economists mean that income level at which there are no net pressures pushing the economy to move to a higher or lower level of income and output
Checkpoint
CHECKPOINT: AGGREGATE EXPENDITURES • Aggregate expenditures are equal to C + I + G + (X = M), with consumption being roughly 70% of aggregate spending. • The marginal propensity to consume and the marginal propensity to save represent the change in consumption and saving associated with a change in income. - Other factors affecting consumption and saving include wealth, expectations about future income and prices, the level of household debt, and taxes. • Consumption is relatively stable. In contrast, investment is volatile.
Expectations Businesses must forecast their market growth - Technological change Innovations require additional investment to be brought to market - Capital goods on hand and operating costs Accumulating inventories might dampen the need to expand productive capacity
DETERMINANTS OF INVESTMENT Investment levels depend on:
Income minus taxes. DI=I-T
Disposable income is equal to
Paradox of thrift
Economic concept that if everyone tries to save an increasingly larger portion of his or her income, they would become poorer instead of richer. This is because the economy will slow down from reduction in demand and the very same people would lose their jobs. This theory, however, applies mainly to Keynesian economics where increased savings represent a diminishing circular flow of income.(not a fact) This suggests that, as households save more, they reduce the income stream for other households, thereby shrinking the overall level of economic activity.
Income (but not as quickly)
Economic theory asserts that consumption spending increases along with_____
CHECKPOINT: THE FULL AGGREGATE EXPENDITURES MODEL
Government spending is like other spending in the way it affects the economy. • Tax increases withdraw money from the spending stream, whereas tax decreases inject money into the economy. • Equal changes in government spending and taxes result in an equal change in income (a balanced budget multiplier of 1).
CHAPTER SUMMARY
Gross domestic product (GDP) can be computed by adding up all spending or all income in the economy. • The marginal propensity to consume is equal to ΔC / ΔYD. • The marginal propensity to save is equal to ΔS / ΔYD.
Inflationary pressures
If aggregate spending generates income above full employment levels, the economy will eventually heat up, creating what?
The multiplier works in both directions
If spending increases raise equilibrium income by the amount of the increase times the multiplier, a spending decrease will reduce income in corresponding fashion
Great Depression
In the ______ , economist John Maynard Keynes proposed the idea of using government spending to offset fluctuations of the business cycle.
I + G + X = S + T + M.
Including the foreign sector, all injections into the economy must equal all withdrawals, so at equilibrium:
CHAPTER SUMMARY
Income is the main determinant of consumption and saving, but other influential factors include wealth, expectations, household debt, and taxes. • Investment levels depend mainly on the rate of return and the interest rate.
CHAPTER SUMMARY
Injections increase spending in an economy, and include investment (I), government spending (G), and exports (X). • Withdrawals decrease spending in an economy, and include savings (S), taxes (T), and imports (M). • In equilibrium, all injections must equal all withdrawals: I + G + X = S + T + M
Debt
Interest rate levels also are important in determining how much investment occurs since much of business investment is financed through____
First
Investments earning a high rate of return will be undertaken___
1 MPC + MPS = 1
MPC and MPS will always sum to__, since the only thing that can be done with additional income is to either spend it or save it.
CHECKPOINT: THE SIMPLE AGGREGATE EXPENDITURES MODEL
Macroeconomic equilibrium occurs when aggregate expenditures are just equal to what is being produced. • At equilibrium, aggregate saving equals aggregate investment. • The multiplier is equal to 1/(1 − MPC). • The paradox of thrift results when households intend to save more, but at equilibrium they end up saving less.
The wealth of a family • Expectations about future prices and income • Household debt • Taxation
OTHER DETERMINANTS OF SAVING INCOME is the principal determinant of consumption and saving, but other factors can shift saving and consumption schedules. These factors include:
Average propensity to save (APS)
Saving divided by income is known as the____
Aggregate expenditures, income, and output are all equal. - All injections of spending into the economy must equal all withdrawals - Investment is an injection. - Saving is a withdrawal
THE SIMPLE KEYNESIAN MODEL At equilibrium 4 concepts
higher
THE SIMPLE KEYNESIAN MODEL • The general formula for the spending multiplier (k) is k = 1/(1 − MPC). - For an MPC of 0.8, the spending multiplier will be 1/(1 − 0.8) = 5. - For an MPC of 0.75, the spending multiplier will be 1/(1 − 0.75) = 4. A larger MPC means a ____ value for the multiplier
For this reason, economists typically describe the "tax" multiplier as being smaller than the "spending" multiplier.
THE TAX MULTIPLIER • A change in taxes will have less of a direct impact on income, employment, and output than will an equivalent change in government spending. What does this mean?
ISSUE: WAS KEYNES RIGHT ABOUT THE GREAT DEPRESSION?
The aggregate expenditures model provides some insight into the Depression. • Saving and investment were greater than $16 billion in 1929, a healthy 15% of GDP. • By 1933, investment had collapsed to just more than $1 billion (a 91% decline), and the economy was in equilibrium at an income of roughly half of the 1929 level. Keynes had it right: Unless something happened that would increase investment or exports, the economy would remain mired in the Depression. He suggested that government spending was needed to restore the economy to a full employment equilibrium. Government spending rose 10-fold during World War II, and the Depression was history.
Inflationary gap
The excess aggregate spending beyond what is necessary for full employment is called the?
Exports minus imports (X − M).
The impact of the foreign sector in the Keynesian model is through net exports which is:
Paradox of thrift
The implication of Keynesian analysis for actual aggregate household saving and household intentions regarding saving is called the
Keynesian macroeconomic equilibrium
The important question to ask is where an economy will come to rest. In other words, what income level characterizes the ______
CHAPTER SUMMARY
The multiplier effect occurs when a dollar of spending generates many more dollars of spending in the economy. • The multiplier is equal to 1/(1 − MPC) = 1/MPS. • A general way to analyze policies that increase or decrease aggregate output is to categorize activities as either an injection or a withdrawal.
Average propensity to consume (APC)
The percentage of income that is consumed is known as the _____
Savings
The portion of income not spent on consumption is counted as ____
spending
The total effect on income will be greater than the initial increase in_____ .
Fall
Thus, if we import more and all other spending remains the same, equilibrium income will____
When taxes are increased, money is withdrawn from the economy's spending stream. • When taxes are reduced, money is injected into the economy's spending stream because consumers and business have more to spend.
What is another concept of the THE FULL KEYNESIAN MODEL
We use the equation GDP = AE = C + I + G + X −( M) to show that aggregate expenditures in an economy will be the sum of: - Consumption spending(C) + Business investment(I) + Government purchases(G) + Net exports(X) - Import(M)
What is the AGGREGATE EXPENDITURE ANALYSIS equation
The American Recovery and Reinvestment Act of 2009
_______ was a stimulus policy passed by Congress to boost economic activity and to create jobs.
The marginal propensity to consume (MPC)
_______is equal to the change in consumption associated with a given change in income.
Personal consumption expenditures
_______represent nearly 70% of GDP and for this reason consumption is a major ingredient in a model of aggregate expenditures.
The marginal propensity to save (MPS)
______is equal to the change in saving associated with a given change in income.
The foundation of Keynesian macroeconomic theory
______is that prices, wages, and interest rates are fixed. Prices and wages are directly related because firms could not lower product prices if wages were not lowered. Classical economic theory suggested that high unemployment rates would lead to lower wage rates, which would lead to lower prices, which would lead to higher demand because of the increased purchasing power of existing wealth. But Keynes observed that wages were not falling (actually there was a decline in the average price level during the early 1930s but evidently not enough to matter). Keynes could not apply an economic theory to explain why those out of work were unwilling to accept a lower wage in order to get a job. He simply accepted it as an unexplained socioeconomic fact of life and built a theory around the assumption that prices and wages were rigid.
The recessionary gap
______is the additional aggregate spending needed to bring a depressed economy back to full employment.
Investment
_____levels depend mainly on the rate of return on capital.
The multiplier
_____tells us how much initial added spending is needed to boost total income to a specified level.
1)Exports 2)Imports
____are injections of spending into the domestic economy while ____ are withdrawals.