The Economy in the Short run Consumption Business cycle ups and downs of economy Driven y aggregate demand Aggregate supply supply by all firms in economy Consumption Demand Determinants of consumption spending Marginal propensity to consume Marginal propensity to save Troughs period when economy is in recession The fundamental Macro Equation GDP Aggregate Expenditure AE Y c I G NX E IM Consumption Divided into goods durable nondurable services 70 of the economy Determinants of consumption 1 Current Disposable income total current income GDP after taxes are taken out and after payments are added y D GDP taxes transfer payments Y T TR Consumption depends on current disposable income y D not current income y Y d C and vice versa 2 Expected Future Disposable Income Y T TR e Y DE c R c v because 3 Real Interest Rate Nominal interest rate inflation rate It costs more to borrow than to finance consumption There is more incentive to save R v c because It costs less to borrow than to finance consumption Less incentive to save 4 Household Wealth Household wealth household assets household liabilities Household assets Value of home car financial investments checking saving accounts and bonds Household liabilites credit card debt balance due on mortgage balance due on auto icon Wealth consumption and vice versa 5 Price Level p price wealth v C and vice versa The consumption Function a the marginal propensity to consume mpc Consumption Function The relationship b w consumption spending and disposable income graph positive relationship sloping upwards Marginal Propensity to consume MPC The slope of the consumption function Amount by which consumption spending changes when disposable income changes MPC change in consumption change in disposable income Marginal Propensity to save MPS The change in saving divided by the change in disposable income MPS i MPC Example if MPC 0 9 MPS 1 0 9 0 1 Investment Determinants of investment The interest rate Components of Investment 1 Plant Equipment aka not residential Office buildings machines computer system About 78 of all investment 2 Residential Housing About 18 of all investment 3 Change in Inventories 1 Finished goods not yet sold Ex Ford 100 000 in inventory sell 75 000 of that inventory 100 000 75 000 25 000 change Strong demand in prod Demand in inventory 2 Raw materials not yet used 3 Unfinished goods still in the production process Why investment is important 1 It s role in economic growth promotes 2 Its volatility Varies w the economy Determinants of Investment Expectation of Future profitability Optimism or pessimism Taxes Corporate income tax US has the highest in world Investment tax incentives ex wind farms Cash Flow Real Interest Rate R I v As r goes up it is more expensive for firms to borrow to buy equipment build factories office buildings As r goes up it is more expensive for families to borrow to buy houses condos R v I Financing Alternatives What are a firm s financing alternatives Borrow the money Sell ownership shares in the company Use their own savings The Macroeconomics of saving and Investment Fundamental Identity An economy which interacts w other economies An economy which does not interact w other economies Savings Invesment s I Why Open vs Closed Economies Open Economy Trade in goods services Trade in Financial assets Closed Economy No trade in goods and services No trade in financial assets NX O Y C I G therefore I C Y G Private and Public saving Private saving Saving Income Expenditures For households and firms Income Y TR Expenditures C T taxes Saving private Y TR C T Public Saving Saving income Expenditures For government Income T tax revenue Expenditures G gov t purchases TR Saving public T G TR Saving can be negative dissaving T G TR saving public positive T G TR No public saving Gov t borrows bonds National Saving s Saving private saving public The Equality of Saving Investment S Y G C S I The Market for loanable funds T G TR Saving public Negative Public dissaving The interaction of borrowers lenders that determines the market interest rate the quantity of loanable funds exchanged Composed of diverse markets which make up the financial system Bond Market Stock Market Market for bank loan Market for fund shares Supply of Funds Private saving Public saving T G TR Demand for Funds Companies Government Consumers I Supply Demand Saving private T G TR I Gov t budget Balance Expenditure Income Equilibrium in the loanable funds market As r there is more incentive to save so qty of funds supplied As r go down it costs irms to borrow to finance investment so qty of funds demanded goes up At equilibrium E s 1 Qty of funds supplied qty of funds demanded Improvement in technology causes an increase in Demand An increase in business pessimism causes a decrease in demand for loanable funds An increase in private saving rate causes an increase in supply of loanable funds An increase in gov t spending causes a decrease in supply of loanable funds Exchange Rates Nominal Exchange Rate E Price of one currency in terms of another currency of units of foreign currency per unit of domestic currency 2012 volume of international currency transactions 794 B day Ex of euros per dollar What causes E to fluctuate What accounts for other 95 98 Speculation World trade in assets An important determinant of E is is r the real interest rate r us relative to r in the rest of the world Row Demand for denominated assets Demand for Price of a dollar Real Exchange Rate Price of goods in one country in terms of the price of goods in some other country i e E X X IM Ex Price of watch in us Real Exchange Rate e P Dom E P for Where E nominal exchange rate Determinants of Net Exports Net Exports NX NX exports Imports Trade Surpluses deficits NX measures the imbalance in a counry s trade in goods and services Trade Deficits an excess of imports over exports In 2013 exports 2 012 T imports 2 422 T leading to a trade deficits of 409B Trade surplus an excess of exports over imports Balanced trade when exports imports Determinants of Exports Exports depend on Real exchange rate e GDP of our trading partners Yfor Tastes preferences of people abroad for our good services real exchange rate goes up our goods are more expensive for foreigners to buy Trade policies Export Function X F9e Y for Tastes Trade policies e x v e v x Yfor x Yfor v x v goods cheaper to buy for foreigners Better the trading partners are doing the more they buy The worse the trading parners are