Chapter 10 - Basic Macroeconomic Relationships 

(An Introduction to Fiscal Policy)

 

Introduction

In unit 3 we will discuss macroeconomic POLICY. The term "policy" implies that the government is attempting to influence the macroeconomy. The issues discussed in macroeconomics are:

1. full employment
2. price stability
3. economic growth

In the week 1 online lecture "The 5 Es of Economics" we discussed the importance of these topics in reducing scarcity and receiving the maximum satisfaction possible from our limited resources.

Here we will look at what the government can do to reduce unemployment or reduce inflation. We will study fiscal policy in chapters 10 and 13 and monetary policy in chapters 14, 15, and 16.

In chapter 10 we will look at the following three basic macroeconomic relationships to better understand how fiscal policy works.

1. Income and consumption, and income and saving. (We will look at this first)

2. The interest rate and investment. (We will look at this last.)

3. Changes in spending and changes in output. (This is the most important relationship that we study in this chapter.)

 

Review: Macroeconomic Policies

The following is from the Aggregate Supply / Aggregate Demand (chapter 12) lecture.

Macroeconomic Policies

Now that we have this handy tool (the AS/AD graph), let's use it to discuss government policies (NOTE: when I use the term "policies", I always mean "government policies"). What is the role of the government in a market economy? In a market economy (capitalist economy) the government has a limited role, but some people believe that the government should try to help the economy maintain full employment and low inflation. We have discussed in the 5 Es lesson that unemployment results in greater scarcity since some resources are not being used so less will be produced. Government policies may be able to help the economy achieve full employment and therefore reduce scarcity.

In a previous chapter we discussed the five economic functions of governments in capitalist economies. Here we will begin our discussion of how to "promote stability".

Economic Functions of Government in a Market (Capitalist) Economy

  • Providing the legal structure
  • Maintaining competition
  • Redistributing income
  • Reallocating resources
    • negative externalities
    • positive externalities
    • public goods and services
  • Promoting stability

Stabilization Policies

Definition: government policies design to reduce unemployment (UE) and/or inflation (IN). All the policies discussed here can be classified as stabilization policies.

There are two major types of stabilization policies:

  1. demand-management policies
  2. supply-side policies

Demand-Management Policies

Definition: Policies design to shift the AD curve in order to reduce unemployment or to reduce inflation.

Tools -- Some of the determinants of AD can be manipulated by the government to achieve these goals.

There are two types of demand-management policies depending upon WHO conducts the policy:

  1. fiscal policy is undertaken by the president and the congress, and
  2. monetary policy is undertaken by the Federal Reserve Board (often called the "fed").

FISCAL POLICY

There are two types of fiscal policy:

  1. expansionary fiscal policy
  2. contractionary fiscal policy

The goal of expansionary fiscal policy is to reduce unemployment. Therefore the tools would be an increase in government spending and/or a decrease in taxes. This would shift the AD curve to the right increasing real GDP and decreasing unemployment, but it may also cause some inflation.

The goal of contractionary fiscal policy is to reduce inflation. Therefore the tools would be an decrease in government spending and/or an increase in taxes. This would shift the AD curve to the left decreasing inflation, but it may also cause some unemployment.

MONETARY POLICY

There are two types of monetary policy

  1. easy money policy or expansionary monetary policy
  2. tight money policy or contractionary monetary policy

The goal of an easy money policy is to reduce unemployment. Therefore the tool would be an increase in the money supply. This would shift the AD curve to the right decreasing unemployment, but it may also cause some inflation.

MS ¯ Interest Rates I AD (MEMORIZE THIS!)

 

The goal of a tight money policy is to reduce inflation. Therefore the tool would be a decrease in the money supply. This would shift the AD curve to the left decreasing inflation, but it may also cause some unemployment.

MS Interest Rates I ¯ ¯ AD (MEMORIZE THIS!)

 

"Supply-Side Economics"

Supply-Side economic policy occurs when the government tries to increase the AS curve. this will reduce both unemployment and inflation.

There are three determinants of AS:

a. change in input prices
price of resources AS

b. changes in the productivity of resource
productivity AS

c. legal-institutional environment
business taxes and gov't red tape AS

Supply-Side Policies

Supply-side policies try to increase productivity. Often this includes less government regulations. Also, in the 1980s President Reagan decreased marginal income tax rates as a supply-side policy (sometimes called "Reaganonmics"). The idea was that people will work more if they can keep more of their income

We have said that decreasing income taxes will INCREASE AD. But here we said that it may also INCREASE AS. Which is it? both may be true, but the effect on AD is probably quicker. In this class a tax cut will increase AD, UNLESS we mention that is is a "supply-side" tax cut. Then we will increase the AS curve.

SUMMARY - Know the following:

  • stabilization policy
  • demand management policy
  • fiscal policy
  • expansionary fiscal policy
  • contractionary fiscal policy
  • monetary policy
  • easy money policy or expansionary monetary policy
  • tight money policy or contractionary monetary policy
  • supply side policy

SO, WE ALREADY KNOW:

If there is UE?
  • increase G
  • decrease T
  • or do both

If there is IN?

  • decrease G
  • increase T
  • or do both
    •  

NOW, WE ARE GOING TO LEARN:

 

 

 



 

 

 

 

HOW MUCH Should the Government Change G or T?

So we already know that if there is unemployment the appropriate fiscal policy would be to increase government spending and/or decrease taxes. Here we will discuss HOW MUCH should government spending be increased or taxes cut?

From chapter 7 we know the expenditures approach to calculating GDP:

GDP

=

C

+

Ig

+

G

+

Xn

400

Look at the graph to the right and the formula above. You can see that this economy is at equilibrium producing an output of $400, but if there were full employment, a real GDP of $500 could be achieved. Therefore, this economy has an unemployment problem and is not producing as much as it could. What is the appropriate fiscal policy could the government use to move this economy to full employment?

We know that the government could increase government spending and/or reduce taxes to increase AD and achieve full employment. Here, let's just concentrate on government spending.

By HOW MUCH should government spending be increased to achieve and equilibrium of $500 and full employment?

GDP

=

C

+

I

+

G

+

Xn

to ­ $100

­ ?

One would think that if government spending was increased by $100 that GDP would go up by $100, BUT THIS IS NOT THE CASE! What we are going to learn in this chapter is that a small initial increase in spending results in a much larger change in GDP. This is called the MULTIPLIER EFFECT. A small initial change in spending will result in a larger change in GDP as the spending change works it way through the economy.

The Multiplier Effect: (How the multiplier process works)

This is because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some. The amount that they spend increases GDP even more AND it also becomes income to someone else. These other people will spend some of this additional income and save some. The amount THEY spend increases GDP again and becomes income to someone else. This is called "induced consumptions" or consumption caused by an increase in income. This process continues so that the TOTAL change in GDP is much larger than the initial change in spending. See graph below.

This multiplier process helps explain why cities want the Superbowl, political conventions, or the Olympics to be held in their town. It's not just because these activities bring in people who will spend money and create jobs, but more importantly, this initial change in spending begins the multiplier process so that the total economic effect, and the number of jobs created ,is much larger than the initial spending on these activities alone would cause.

Read this article from the Philadelphia Inquirer newspaper (http://home.phillynews.com/gop/news/impa110698.asp). the Republican National Convention was held in Philadelphia in 2000 and in San Diego in 1996. It is clear that civic leaders understand the multiplier effect when they discuss "spinoff benefits".

 

The Philadelphia Inquirer, November 6, 1998

Plentiful gains seen from GOP

 

The publicity for the city may be priceless. The visitors' spending could reach $300 million.

By Howard Goodman
INQUIRER STAFF WRITER

When the elephants thunder into Philadelphia in 2000, the vibrations are expected to shake an incredibly bountiful money tree, showering dollars all over the region.
The economic impact of the Republican National Convention will almost certainly exceed $125 million in direct spending on hotel rooms, meals and the like, along with at least $175 million in spinoff benefits (emphasis added), David L. Cohen said yesterday. Cohen, Mayor Rendell's former chief of staff, is cochairman of Philadelphia 2000, the committee formed to woo a political convention.
The estimate is based on a Federal Reserve Board study of the economic blessings felt in Chicago from the 1996 Democratic convention, with a little extra figured in for four years' worth of inflation, Cohen said.
"There is no convention you can host that has a greater economic impact than a national political convention," he said. "Most people agree the only thing you can host that has a greater economic impact is the Olympics."
. . . . .

In San Diego, where the Republicans last met, business leaders still bask in the 1996 convention's glow. "We look at the convention as a week-long television commercial for your city as a destination," Salvatore Giametta, a spokesman for the San Diego Convention and Visitors Bureau, said in an interview this summer.

. . . . .

According to the Greater San Diego Area Chamber of Commerce, the four-day convention attracted 30,000 visitors who spent $26 million on hotel rooms. But there has been no follow-up study to show the convention's broader effect on the San Diego economy.
Despite the lack of data, San Diego "absolutely" would host a convention again, Giametta said. "We think it was good for the tourism industry without a doubt."
Brian Ford, an accountant for Philadelphia 2000, said that insisting on a study to prove that Philadelphia will benefit mightily from the GOP meeting "is like saying you need a study to show that a car works."

. . . . .

------------- ------------------ --------------------- ------------------ --------------------- ---------

Above we said that the multiplier works "because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some. The amount that they spend increases GDP even more AND it also becomes income to someone else." This process then goes on and on . . . but why does it eventually stop or does it go on forever? If you reread the explanation of the multiplier process above you will get a clue as to why the process eventually stops. Notice that we said "What will these people do with their new income? Well, they will spend some and save some." People do not spend 100% of any additional income that they receive. the spend some and SAVE SOME. So that the additional spending is less than their increase in income. And when this additional spending becomes income to someone else, they sill save some and spend even a smaller amount. This will continue until the total change in savings is equal to the initial increase in spending. When this occurs there is nothing left to spend and the process stops.

To understand the multiplier process we must gain a better understanding of how consumption and saving respond to changes in income. The table below is for a hypothetical economy. All values are in $ billions.

A schedule showing the amounts households plan to spend for consumer goods at different levels of disposable income.

GDP
or
disposable income
C
S
APC
APS
MPC
MPS

$ 0

$ 40

|

|

|

|

|

100

120

|

|

|

|

|

200

200

|

|

|

|

|

300

280

|

|

|

|

|

400

360

|

|

|

|

|

500

440

|

|

|

|

|

As expected, as the economy's GDP (income) increases, household consumption increases. GDP and consumption are directly related. If we graphed this consumption data we would get:

 

Notice that when income is equal to $ 0, there is still some consumption ($ 40 billion). this is called "autonomous consumption". It is consumption that is not related to income. Think about what a GDP of $ 0 represents. If GDP, or an economy's income, were equal to $0, this means that nothing was produced in this. If an economy does not produce a thing, would there still be some consumption? Yes, but how? they would consume goods that were saved from earlier periods. Of course, a GDP of $0 is a ridiculous concept, but there are two components to household consumption: (1) autonomous consumption that is not related to income, and (2) induced consumption or consumption that is directly related to income.

Now, to understand, and calculate, the multiplier, we need to complete the table.

First we need some simplifying assumptions to make our model easier to understand:

  1. For now let's ignore government (no government spending and no taxes)
  2. Let's also ignore the foreign sector (no exports or imports)

    This leaves us with an economy of only businesses and consumers, so:

    GDP

    =

    C

    +

    I


  3. And let's also assume that there is no inflation so equilibrium in this economy occurs in the horizontal, or Keynesian, range of the AS curve.

Given these assumptions we can calculate saving (S). With these assumptions there are only two things that consumers can do with their income, spend it (C) or save it (S). So:

income

=

C

+

S

Therefore, we can calculate saving: Saving is a schedule which shows the amounts households plan to save (plan not to spend for consumer goods), at different levels of disposable income.

GDP
(income)
C
S
APC
APS
MPC
MPS

$ 0

$ 40

$ - 40

|

|

|

|

100

120

- 20

|

|

|

|

200

200

0

|

|

|

|

300

280

20

|

|

|

|

400

360

40

|

|

|

|

500

440

60

|

|

|

|

Notice that both consumption and saving is directly related to income. When income increases both consumption and savings increase.

Average Propensity to Consume (APC) and Average Propensity to Save (APS)

With this data we can calculate the APC and APS for each level of income.

APC is the fraction of the economy's total income that is spent (consumed) and APS is the fraction of total income that is saved.

C

APC =

--------

income

S

APS =

--------

income

When we calculate APC and APS we get:

GDP
(income)
C
S
APC
APS
MPC
MPS

$ 0

$ 40

$ - 40

---
---
---
---

100

120

- 20

1.2

- 0.2

|

|

200

200

0

1.0

0

|

|

300

280

20

0.93

.07

|

|

400

360

40

0.90

.10

|

|

500

440

60

0.88

.12

|

|

Notice that for each level of income: APC + APS = 1. Given our assumptions there are only two things that consumers can do with their income: spend it or save it. If you add the fraction of the total income that is spent (APC) and the fraction of the total income that is saved (APS) we get all of our income, or 1.

Can you think of anything else that we can do with our income besides spend it or save it? Many students will answer "invest it". But what does investment mean in economics? Investment is the accumulation of capital. "Capital" is a manufactured resource. Therefore, "investment" occurs when a carpenter buys a hammer or if McDonald's builds a new restaurant. Putting money into the stock market is NOT investment, it is saving.

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

To understand the multiplier effect we need to know what happens to ADDITIONAL, or MARGINAL, income.

Earlier we explained that the multiplier works "because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some. " But HOW MUCH will they spend of this additional income and HOW MUCH will they save of this additional income? To know this we need to calculate the MPC and MPS.

With our consumption and savings data we can calculate the MPC and MPS for each level of income.

MPC is the fraction of the economy's additional income that is spent (consumed) and MPS is the fraction of additional income that is saved.

"Marginal" means "additional" or "extra"

change in C

MPC =

-----------------

change in income

change in S

MPS =

-----------------

change in income

To calculate MPC and MPS select two levels of GDP or income. For example if income increases from $0 to $100, then consumption increases from $40 to 120. Therefore if income increases from $0 to $100 then the change in income is $100 and the change in consumption is $80. MPC is then equal to 0.8.

change in C

80

MPC =

---------------

=
------
=
0.8

change in income

100

If we do this again for income level of $ 00 and $200 and consumption levels of $120 and $200 we will get MPC = 0.8 again.

If you do the same thing for MPS you will get MPS = 0.2.

GDP
(income)
C
S
APC
APS
MPC
MPS

$ 0

$ 40

$ - 40

---
---
---
---

100

120

- 20

1.2

- 0.2

0.8

0.2

200

200

0

1.0

0

0.8

0.2

300

280

20

0.93

.07

0.8

0.2

400

360

40

0.90

.10

0.8

0.2

500

440

60

0.88

.12

0.8

0.2

Notice that for each level of income, MPC + MPS = 1. There are two things that you can do with additional income: spend a fraction (MPC) and save a fraction (MPS). If you add these fractions together you will get 1.

If you remember your 8th grade math you would recognize that our formula for MPC is actually the slope of the consumption graph.

change in C

rise

MPC =

---------------
=
------
=
slope of C

change in income

run

change in C

rise

MPC =

--------------

=
------

change in income

run

80

MPC =

--------------

=
0.8

100

And the same is true for MPS:

change in S

rise

MPS =

---------------

=
------

change in income

run

20

MPS=

---------------

=
0.2

100

One last item needs to be discussed: are MPC and MPS really constant? Note that in our table MPS equals 0.8 for all income levels and MPS equals 0.2. This means that if you get a raise (or additional income) of $1000 you would spend $800 of the raise (0.8 x 1000 = $800) and you would save $200 of it (0.2 x $1000 = $200). But is the fraction of additional income that is spent and saved really constant for all levels of income?

Let's assume that I am going to give two families $10,000 in additional income. So I go to the housing projects in Chicago and find a poor family and give them $10,000 and I fly to the state of Washington and find Bill Gates (probably the richest person in the world) and give him $10,000. Would they both spend and save the same fraction of this additional income?

No, the poor family would most likely spend the whole $10,000 and Bill Gates would probably spend nothing of the addition income. So the MPC of the poor family would be very high, or equal to 1, and the MPC of Bill Gates would be very low, or equal to 0. So as GDP or income increases, MPC should get smaller, or decrease, and MPS increases. This means the slope of the consumption graph should get smaller (flattens out) as GDP increases.

We will assume that the MPC is constant in this course. That way we can use straight line consumption graphs and we can find the MPC by finding its slope.

If you cut taxes on lower income people and raise taxes on higher income people, what effect, if any, will it have on aggregate demand?

"Eliminate payroll taxes to improve economy"

Marketplace commentator Robert Reich thinks that reducing payroll taxes will get consumers to start spending again, which will help get the economy moving again.

Text / Link to audio:
http://marketplace.publicradio.org/display/web/2010/08/25/pm-reich-eliminate-payroll-taxes-to-improve-economy/

Audio:
http://marketplace.publicradio.org/www_publicradio/tools/media_player/popup.php?name=marketplace/pm/2010/08/25/marketplace_cast2_20100825_64&starttime=00:10:16.500&endtime=00:12:50.0

How Does the Multiplier Work: A Numerical Example

To keep things simple let's assume that we have an economy with only consumers and businesses. Therefore:

GDP

=

C

+

Ig

Now let's assume that in this economy (let's say that it represents the Chicago area) a new stadium worth $20 million is built. What is the total impact of this investment on the economy?

Well, if GDP is the total market value of all final goods and services produced in an economy in one year , then building this $20 million stadium will increase GDP initially by $20.

GDP = Income

=

C

+

I

+ 20

+ 20

But when $20 is spent (and therefore $20 is produced) $20 is also earned as income to those who did the producing. so income also increases by $20. What do these people do with this additional income? Well, they spend a part and save a part. How much do they spend and save? What concept tells us the change in consumption that results from additional income? . . MPC !

change in C

MPC =

---------------

change in income

Let's use the MPC that we calculated above, so MPC = 0.8

So if incomes go up by $20, consumption will increase by $16
Change in C = (MPC) x (change in income)
Change in C = (0.8) x ($20) = $16 (we call this a induced consumption)

and the change in S = $4
Change in S = (MPS) x (change in income)
Change in S = (0.2) x ($20) = $4

So we get the following

GDP = Income

=

C

+

I

--------
S

+ 20

+ 20

+ 16

+16

+ 4

GDP has gone up by an additional $16, therefore so has income. What will they do with this additional income? They will spend 80% (MPC=0.8) of it and save 20% (MPS=0.2).

So we get the following:

GDP = Income

=

C

+

I

--------
S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

And again, GDP has increased. This time by $12.8 and so has income, part of which will be spent and part saved. So consumption and GDP increase by $10.24 (0.8 x 12.8) and saving increases by 2.56 (0.2 x 12.8).

GDP = Income

=

C

+

I

--------
S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

+ 10.24

+ 10.24

+ 2.56

This process will go on and on. When will it stop? If we add up all that has been saved and it equals 20, ( 4 + 3.2 + 2.56 + ...+...+...+...= 20) then there is nothing left to spend and the process stops. If you do this you will get the following total changes:

GDP = Income

=

C

+

I

--------
S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

+ 10.24

+ 10.24

+ 2.56

total change

total change

total change

total change

+ 100

+ 80

+ 20

+ 20

So with an initial increase in spending of $20, GDP increases by $100.

The most important formula for you to learn is:

change in GDP

=

initial change in spending

x

multiplier

So using our data we get:

change in GDP

=

initial change in spending

x

multiplier

+ 100
=
+ 20
x
?
+ 100
=
+20
x
5

The size of the multiplier depends on how much of additional income is NOT spent. In our example the MPS is .2, so 20% of additional income is not spent, but rather it is saved. The multiplier then is:

1

1

Multiplier =

--------

=

--------

=

5

MPS

0.2

Graphically -- how does the multiplier work?

THIS IS IMPORTANT!
(Be sure you understand table 10-3 and Figure 10.8 in the textbook.)

Assume: MPC = .8, and I increases by $20 billion

So initially, since I increased by $20, the AD curve shifts to the left by $20 (see graph below).

But since GDP has increase by $20 (see graph above) income has also increased by $20. What will people do with this additional income?

Spend some (MPC) and save some (MPS). The extra spending is consumption (C) and this shifts the AD curve further to the right. But, again, additional spending becomes additional income for someone else, part of which would be spend and part saved. The part spent shifts the AD curve some more. This process will continue until all of the initial investment ($20) is saved

 

 

 The multiplier and marginal propensities (slopes)

1

a. multiplier =

-------

MPS

1

b. multiplier =

------------

1 - MPC

A larger MPC (or smaller MPS) has a larger multiplier

IF the MPS is:

Then the multiplier is:

.1
10

.2
5

.75
4

.67
3

.5
2

In other words, the more that is NOT SPENT, the smaller is the additional spending that results, and the multiplier is smaller.

 

The Complex Multiplier (or the ACTUAL multiplier)

We can see from the circular flow diagram of chapter 1 that income becomes expenditure (or AD).

But not all income becomes spending. What ELSE can you do with your Disposable Income (DI) besides spend it?

  • You can save it
    • saving is a "leakage" from the income = expenditure stream
    • this creates the simple multiplier we learned above
  • But you can also use disposable income to pay taxes. This is another "leakage" from the income=expenditure stream.
  • Also, you can also spend it on imports. This is another "leakage" from the income = expenditure stream, because this spending on imports becomes income for people in the foreign country.

 

  • So not all increases in income become additional spending.
  • How does this affect the size of the multiplier?

 

DI

C

AD

Leakages

Injections

S

I

T

G

M

X

If there are more leakages, the multiplier is smaller

1

actual multiplier =

-------------

leakages
  • 1

    complex multiplier =

    -------------

    MPS + MPT + MPM
  • Where MPS is the marginal propensity to save or the fraction of additional income that is saved and so it doesn't become income for someone else.

    MPT would be the "marginal propensity to tax" or the fraction of additional income that is paid in taxes and so it doesn't become income for someone else.

    MPM would be the "marginal propensity to import" or the faction of additional income that is spent on imports and so it doesn't become income for someone else in the country where it was spent.

    The Complex (or ACTUAL) Multiplier is SMALLER than the Simple Multiplier because there are more leakages and less induced consumption.

We learned in the AS/AD chapter that the nonincome determinants of consumption and saving can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant. The following are the determinants of consumption (and AD) that we studied in chapter 12. See Figure 10.4

1 Wealth: An increase in wealth shifts the consumption schedule up, saving schedule down and AD to the right In recent years major fluctuations in stock market values have increased the importance of this wealth effect. A "reverse wealth effect" occurred in 2000 and 2001, when stock prices fell dramatically. Consider This … What Wealth Effect?

2. Expectations: Changes in expected future prices or wealth can affect consumption spending and AD today.

3. Real interest rates: Declining interest rates increase the incentive to borrow and consume, reduce the incentive to save, and increase AD. Because many household expenditures are not interest sensitive - the light bill, groceries, etc. - the effect of interest rate changes on consumption spending are modest (but interest rates do have a significant effect on investment).

4. Household debt: Lower debt levels shift consumption schedule up, saving schedule down, and increases AD.

Other important considerations: See Figure 10.4.

1. Macroeconomic models focus on real domestic output (real GDP) more than on disposable income. Figure 10.4 reflects this change in the labeling of the horizontal axis.

2. Changes along schedules: Movement from one point to another on a given schedule is called a change in the amount consumed; a shift in the schedule is called a change in consumption schedule, and is caused by nonincome determinants of consumption

3. Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change.

4. Taxation: Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher taxes.

5. Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action.

 

The Multiplier with Changes in the Price Level

We have been assuming that the price level does not change as AD increases (see graph).

But in the real world as GDP increases and approaches the full employment level of output the price level will begin to rise and resource costs increase.

How does this inflation, which results from an increase in AD, affect the size of the multiplier? Or, what happens to the change in government spending needed to achieve full employment if we allow for inflation? Without inflation, and with an MPC of 0.8, if we increase government spending by $20 then GDP will increase by $100 because the multiplier is 5. This will shift AD from AD1 to AD2 in both graphs above. In graph (a) without inflation the equilibrium GDP increases from $400 to $500. But in graph (b) with inflation the same horizontal shift in AD increases GDP from $400 to only $460. From the same change in government spending ($20) GDP increases a small amount. With inflation the multiplier is smaller.

To calculate the multiplier with changes in the price level you need to know the initial change in spending ($20 in our example) and the resulting total change in GDP ($60 from graph b above).

change in GDP
=
initial change in spending
x
multiplier
+ $60
=
+ $20
x
?
+ $60
=
+ $20
x
3

The Interest Rate - Investment Relationship

Remember, the term "investment" consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. It does NOT mean "investing" in the stock market or buying bonds. Buying stocks and bonds is SAVING (not spending).

How much businesses spend on capital depends on (1) what they expect to make from it and (2) the cost of borrowing to pay for it. What they expect to make is called the "expected rate of return" and what they have to spend to borrow to pay for the capital is the interest rate they pay for the loan.

Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return. The text's example gives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus, the business would not want to pay more than 10% interest rate on investment. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk.

The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment.

1. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income you won't get.

2. If real interest rate exceeds the expected rate of return, the investment should not be made.

Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment.

1. As long as expected return exceeds interest rate, the investment is expected to be profitable (see the Table 10.2 example).

2. Key Graph 1.5 shows the relationship when the investment rule is followed. Fewer projects are expected to provide high return, so less will be invested if interest rates are high.

In chapter 10 we discussed the determinants of Investment, which are determinants of Aggregate Demand. Shifts in investment demand (Figure 10.6) occur when any determinant apart from the interest rate changes. This also shifts AD.

1. Greater expected returns create more investment demand; shift curve to right. The reverse causes a leftward shift.

2. Changes in expected returns result because:

a. Acquisition, maintenance, and operating costs of capital goods may change. Higher costs lower the expected return.

b. Business taxes may change. Increased taxes lower the expected return.

c. Technology may change. Technological change often involves lower costs, which would increase expected returns.

d. Stock of capital goods on hand will affect new investment. If there is abundant idle capital on hand because of weak demand or recent investment, new investments would be less profitable.

e. Expectations about future economic and political conditions, both in the aggregate and in certain specific markets, can change the view of expected profits

Unlike consumption and saving, investment is a very unstable type of spending; I is more volatile than GDP (See Figure 8.7). Investment is unstable because:

  • Capital goods are durable, so spending can be postponed or not. This is unpredictable.
  • Innovation occurs irregularly.
  • Profits vary considerably.
  • Expectations can be easily changed.  

Be sure to read "LAST WORD: Squaring the Economic Circle" in the textbook. It contains a humorous example of how the multiplier works. Furthermore it does a good job explaining how a small DECREASE in spending will result in a big decrease in overall spending and in GDP. Here is a summary: