November 18th, 2011 Period 1

Sidharth Thakur

Chapter 10 Outline
Consumption and Investment Schedules I. Private closed economy- An economy without international trade or government. Opening this private economy to exports and imports as well as government purchases and taxes will turn it into a mixed economy. II. In a private closed economy, the two components of aggregate expenditures are consumption and gross investment. III. Planned Investment- The amounts business firms collectively intend to invest IV. In order to display the investment decisions of businesses to the consumption plans of households, an investment schedule showing planned investment must be created. When creating an investment schedule, we must assume that the planned investment is independent of the level of current CI or Real output and isnt influenced by it. V. Using the Investment demand curve and the real interest rate, we must figure out the amount of investment. This amount of investment will occur at both low and high levels of GDP. Equilibrium GDP: C+ Ig= GDP I. In a private closed economy, the sum of the consumption and investment makes up the aggregate expenditures schedule. This schedule shows the amount which will be spent at each possible output or income level. II. Here we are working with planned invest- the amount firms plan or intend on investnot the actual amount they will invest. III. The equilibrium output is that output whose production created total spending which is just enough to purchase the output. This is when the GDP is equal to the C+Ig. At this level, there is no overproduction nor is there an excess of total spending. This level of GDP is known as the Equilibrium GDP. IV. No levels, besides the equilibrium GDP can be sustained. Levels of GDP which are below the equilibrium, the economy wants to spend more than the level of GDP. Buyers are buying items faster than the firms can bring out, causing the firms to increase production. At levels above the equilibrium GDP, firms will have to cut back on production due to the lack of consumption. V. The Reference angle depicts the graphical state of the equilibrium condition. To graph the aggregate expenditures, we add Ig to the consumption schedule. The aggregate expenditures is parallel to the consumption schedule, and therefore also has the same slope as it. The aggregate expenditures graphs slope is equal to the MPC for the economy. VI. The equilibrium level of GDP is determined by the intersection of the reference line and the aggregate expenditures graph. Equilibrium occurs only when planned investment and savings are equal, but when unplanned changes in inventories are considered, investment and saving are always equal regardless of level of GDP. Other features of Equilibrium GDP: I. Saving and planned investment are equal. II. There are no unplanned changed in inventories.

III. Saving is a leakage or a withdrawal of spending from the income-expenditures stream. Savings is what causes consumption to be less than the total output/GDP. IV. Firms dont intend to sell all of their products to consumers; rather it would be sold to other businesses. V. Investment is an injection of spending into the income-expenditures stream. VI. When the leakage of saving at a level og GDP is greater than the injection of investment the C+Ig will be less than GDP and that level of GDP cannot be sustained. Changes in Equilibrium GDP and the Multipliers I. In a private closed economy, the equilibrium GDP will change in response to changes in either the investment schedule or the consumption schedule. Changes in the investment schedule are the main source of instability. II. In the example shown, the multiplier is 4 (25/5). The MPS is which means for everything 1 billion is new income, billion dollars of new savings occurs. Adding International Trade I. Like consumption and investment, exports create domestic production, income and employment for a nation. II. When we open up a private economy to international trade, there is going to be both foreign spending on our goods as well as our spending on foreign imports. III. In order to avoid overstating the GDP, we subtract the amount of money spent on foreign goods from the total spending. IV. For an open economy; aggregate expenditures are C+Ig+(X-M). V. A net export schedule list the amount of net exports which will occurs at every level of GDP. This may either be a negative or positive amount. VI. When a positive net exports schedule is added to the aggregate expenditures schedule, will increase aggregate expenditures and GDP beyond what they would be in a closed economy. In a negative net exports schedule, we must take away this schedule from the aggregate expenditures schedule decreasing the aggregate expenditures as well as the GDP. VII. A rising level of real output and income among U.S foreign trading partners enables the United States to sell more goods abroad, raising net exports and increasing total real GDP. Good fortune of our trading partners allow them to buy more of our exports therefore increasing our income and allowing us to buy more foreign imports. VIII. When foreign nations impose high tariffs on US goods to reduce imports, they restrict US exports. This depressing our economy while stimulates their own economy. IX. Depreciation of the dollar relative to other currencies allows consumers abroad to purchase more of US goods with the same respective dollar, stimulating purchases of US Exports. This will however reduce American consumption of foreign imports. This increased exports and reduced imports will increase Net exports and expand GDP. X. Depreciation of the dollar actually might result in inflation if the economy is already fully employed when there is an increase in exports and decrease in imports. This would result in a demand-pull inflation. Adding the Public Sector I. When adding the public sector, we assume that the government purchases have no upward or downward shifts on the consumption and investment schedules. Government net tax revenues are derived entirely from personal taxes.

II. Adding government purchases to private spending yields to a higher level of aggregate expenditures. Increases in public spending, like increases in private spending, shift the aggregate expenditure schedule upward and produce a higher equilibrium GDP. Government spending is subject to the multiplier. III. The government both spends and collects taxes. IV. Lump-sum tax- A tax of a constant amount, or a tax yielding the same amount of tax revenue at each level GDP. V. Taxes reduce disposable income relative to GDP by the amount of taxes. Decline in DI reduced both consumption and saving at each level of GDP. The MPC and MPS determine the decline in consumption and saving. It also lowers the aggregate expenditures schedule relative to the reference line and reduces the equilibrium GDP. A decrease in taxes will increase the aggregate expenditures schedule. VI. Ca+IgXn+G= GDP VII. Sa+M+T= Ig+X+G Equilibrium versus Full Employment GDP I. Recessionary gap- the amount by which aggregate expenditures at the full employment GDP fall short of those required to achieve the full employment GDP. II. Graphically the recessionary gap is the vertical distance by which the actual aggregate expenditure schedule lies below the hypothetical full employment aggregate expenditures schedule. III. Inflationary Gap- the amount by which an economys aggregate expenditures at the full employment GDP exceed those just necessary to achieve the full employment GDP. IV. The effect of inflationary gap is that the excessive spending will pull up output prices. This will then result in demand pull inflation. Limitations of the Model I. It does not show price-level change. The model does account for demand pull inflation, but doesnt indicate how much the price level rises when aggregate expenditures are excessive relative to the economys capacity. There is no way of measuring the rate of inflation. II. Ignored premature demand-pull inflation- Mild demand pull inflation can occur before an economy reaches its full employment level of output. III. Limits real GDP to the full employment level of output-For a time the economy can expand beyond its full employment real GDP. IV. It does not deal with cost push inflation- It doesnt not address cost-push inflation. V. It does not allow for self correction- Given some times, the economy has internal features which may correct recessionary gap or inflationary gap. Question 2) Savings; $-4, $0, $4, $8, $12, $16, $20, $24, $28 The equilibrium level is at 340 billion. (324 +16= 340) MPC= .8 and MSP= .2 3) $380 billion; $24 billion of savings and planned investment of $16 billion.

$300 Billion: $8 billion of savings and planned investment of $16 billion. At the 380 billion mark, the economy is at an above-equilibrium GDP and firms produce more goods than they are able to sell. They hold onto these goods which prompts them to cut back on employment and production. This will cause the GDP to fall to its equilibrium level. At the 340 billion mark, the economy is at an below-equilibrium GDP and sales exceed production. The unplanned decline in inventories will cause firms to expand production causing the GDP to price to its equilibrium price. 6) 1/1-.8= .2 8/.2= 40 Billion 1/1-.67=.33 .8/.33 = 24.24 Billion 7)

8) The New level of GDP would be 360 billion. The multiplier is 10, and 4*10 =40 billion. 400-40= 360.