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USC ECON 205 - Consumption, investment, and the business cycle

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ECON 205 2nd Edition Lecture 7Outline of Last Lecture I. Answer key given to previous testII. Consumption functionIII. Marginal propensityIV. Federal policy and taxationV.Outline of Current LectureI. Savings, the savings function, and investmentII. Consumption and the consumption functionIII. Marginal propensityIV. Economic cyclesCurrent LectureI. Savings, the savings function, and investmentSavings could be equal to investment. But in reality it could be different: it could be greater, or less than it as well. However, the relationship between savings and investment is significant.Not only domestic savings going into investment. Worldwide integration makes financial resources shift between nations. Many countries could have much more investment than domestic savings (like China).The savings function shows the relationship between the level of saving and disposable income.The break-even point is where the consumption function intersects the 45-degree line of level of disposable income—it is the point in which households break even.Investment happens for many reasons, including: revenues, cost, expectations, and the role of interest rate on investment (which shifts the investment function).Autonomous investments are the marginal efficiency of capital is the expectation of profit. It influences investors to invest. It is autonomous from current economic conditions. II. Consumption and the consumption functionConsumption is made up of durable goods (automobiles, furniture), nondurable goods (food, clothing, energy), and services (transportation, healthcare, and recreation). It makes up approximately 70% of a country (like the US)’s GDP.- Services are largest category in modern economies.- Consumption priorities from greatest to least are: food, housing, transportation, medical, and then savings.The consumption function shows the level of consumption expenditures and the level of disposable personal income. Ergo, the consumption function is the relation between consumption and income. It is relatively stable.Disposable income is equal to personal income minus personal taxes. Furthermore, disposable income minus consumption and interest equals personal savings. Disposable income is after-taxes income, and is spent on either consumption or savings. III. Marginal propensityMPC—the marginal propensity to consume. It is the extra amount that people consume when they receive an extra dollar of disposable income. The slope of the consumption function is the marginal propensity to consume.- Marginal propensity to consume and the marginal propensity to save equals 1.The determinants of consumption are: disposable income, permanent income, the life-cycle method of consumption, wealth, and expectation of future income.Laffer curve: the relationship between taxes and revenue. At zero tax, you get zero revenue, while at 100% tax you also get zero revenue. At optimal tax you get the maximum of revenue fortaxes. IV. Economic cyclesGDP growth in market economics is not smooth – it occurs in cycles. The cycles have four phases: expansion of the economy, peak economic conditions, contraction of the economy, and trough (or revival).The causes of cycles are complex, but some of the more common are: employment and unemployment rates, profits, real income, inflation, interest rates, and pessimism vs. irrational exuberance. The duration of a business cycle is between two to ten years.Different theories of why the business cycle occurs are: exogenous vs. internal factors, financial crises, panics of early capitalism (19th century investment in railroad, canals, land resources, etc.), hyperinflation, economic bubbles (2007-2008, Dot Com companies), over-investment coupled with under-consumption, political factors, and inventions, innovations, and

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