Unit 3 Income & Spending PDF

ECN201: Principles of Macroeconomics Unit 3: Income & Spending DR. VERONICA REID-JOHNSON  COURSE TOPICS o Unit 1 The Realm of Macroeconomics o Unit 2 The Goals of Macroeconomics Policy o Unit 3 Income and Spending o Unit 4 Demand-side Equilibrium and Changes on the Demand...

ECN201: Principles of Macroeconomics Unit 3: Income & Spending DR. VERONICA REID-JOHNSON  COURSE TOPICS o Unit 1 The Realm of Macroeconomics o Unit 2 The Goals of Macroeconomics Policy o Unit 3 Income and Spending o Unit 4 Demand-side Equilibrium and Changes on the Demand Side WEEK 8: MSA o Unit 5 Supply-side Equilibrium o Unit 6 Fiscal and Monetary Policy o Unit 7 Money and the Banking System o Unit 8 International Trade UNIT 1: COMPONENTS OF AGGREGATE DEMAND  WE WILL COVER: Aggregate demand and aggregate supply Components of aggregate demand i.e. C + I + G + ( X -IM ) National Income and Disposable Income AGGREGATE DEMAND  Aggregate Demand is the total amount that all consumers, business, firms, government agencies and foreigners wish to spend on final goods and services.  The actual numerical value of AD depends on the price level and a variety of other factors such as consumers income, government policies to some extent the events in foreign countries. COMPONENTS OF AGGREGATE DEMAND AD = C + I + G + ( X – IM) Consumer Expenditure (c) is the total amount spent by consumers on newly produced goods and services (excluding purchases of new homes). Largest component of aggregate expenditure. Investment Spending (I) This is the sum of the expenditures of business firms on new plant and equipment and households on new homes. Financial investment is not included.  Government Spending (G) This refer to the goods such as planes or paper clips) and services purchases by all levels of government.  Net Export (NX) NET EXPORTS ( X – IM) is the difference between exports (X) and imports (IM). It indicates the difference between what is exported and what is imported.  Aggregate Supply Aggregate Supply is the total quantity of goods and services that all the nation’s businesses are willing to produce for each possible price level during a specified period of time, holding all other determinants of aggregate quantity supplied constant.  National Income National Income (NI) is the sum of the incomes that all individuals in the economy earned in the forms of wages, interest, rents and profits. It excludes government transfer payments and is calculated before any deductions are taken for income tax.  Disposable Income (DI) Disposable income (DI) is the sum of the incomes of all individuals in the economy after all taxes have been deducted and all transfer payments have been deducted.  Disposable income = National Income – (taxes + transfers) UNIT 2: CIRCULAR FLOW OF INCOME/CALCULATING GDP  WE WILL COVER:  Circular flow Diagram  Measure GDP using the circular flow diagram (expenditure method)  Measure GDP using Value added method  Measure GDP using Factor payment method  Consumption function.  Circular Flow of Income  It is a simplified exposition of the way in which income flows around the economy in exchange for goods and services between the various sectors that contribute to overall economic activity.  Injections Additions to the circular flow of income representing any expenditures on domestic goods and services which originate from outside the household sector, comprising Investment expenditure, government expenditure and export revenues.  Withdrawals This refers to the part of the National Income that is not spent on households on the consumption of domestically produced goods and services, comprising savings, taxes and expenditure on imports, also referred to withdrawals. Three ways of measuring GDP 1. Expenditure method 2. Income method 3. Output/value added method  Expenditure Method This method follows from the circular flow diagram. By this method, the final demand for all the consumers, business firms, government and foreigners are added. Y = C + I + G + (X –IM) Y=C+I+G+NX  Components of the Expenditure Method  Where Y is GDP.  C represents the portion that consumers spend.  The I in the formula is called gross private domestic investment. Private indicates that government investment is considered a part of  G and domestic means that machinery sold to foreign companies is included in exports rather than investments (I).  Components of the Expenditure Method Cont.  In the national income accounts investments includes only newly produced capital goods such as factories, machinery and new homes.  The symbol G for government purchases represents the volume of current goods and services purchased by all levels of government. All government payments to employees and all its purchases of goods and services are counted in G.  Components of the Expenditure Method Cont.  It should be noted that transfer payments are excluded from G and are included in C. If transfer payments are included in G than it would get counted twice.  The final component of GDP is called the net exports which are simply exports of goods and services minus import of goods and services.  Income Method GDP is by adding up all the incomes in the economy. This method handles all the incomes to each sector of the economy.  Income Method Revenues from sales = Wages + interest + rentals + profits earned – purchases from other firms (intermediate goods) Output method/Value Added Approach  This approach account only the value addition from each sector. Since, GDP takes into account only the final goods and services, what happens to the intermediate goods.  If all intermediate goods were included in GDP, there would be double or triple counting of certain goods. To cope with this difficulty, the method of accounting of value added is accepted. Output method/Value Added Approach The value added by a firm is its revenue from selling a product minus the amount paid for goods and services purchased from other firms. If we sum up the value added by all the firms in the economy we must get the total value of all final products. Output method/Value Added Approach  Thus, it can be measured as Sales Revenue – Purchases from other firms = Wages + Interest +Rents +Profits The left hand side of the equation is precisely the value added by a firm.  Value Added = Wages + Interest +Rents + Profits. In the value added approach, every purchase of a new good or service counts but the entire selling price is not counted, only the portion that represents value added is counted.  This method is useful in avoiding double counting. UNIT 3: CIRCULAR FLOW OF INCOME/CALCULATING GDP  WE WILL COVER: Marginal Propensity to Consume (MPC) Marginal Propensity to Save (MPS) Consumption function Factors determining consumer spending wealth, the price level, the inflation rate, the real interest rate, future income expectations. Exceptions to the rules in GDP: Treatment of government outputs, goods added to inventories, treatment of investment goods.  The Marginal Propensity to Consume (MPC) The slope of the consumption function drawn on a graph is quite constant and is called the marginal propensity to consume (MPC) The MPC tells how much more consumers will spend if disposable income rises by $ 1.  Marginal Propensity to Save (MPS)  The marginal propensity to save is defined as the fraction of an extra dollar of income that goes to extra saving.  The MPC and MPS are related to like mirror images because income equals consumption plus saving. MPC+MPS =1 .2+.8=1  This implies that every additional dollar of income will be divided into consumption and savings. If MPC is 0.85 then MPS will be 0.15.  So, everywhere and always MPS = 1 – MPC PRACTICE (1) Consumption in Jamaica is $10,000 in 2020. If the MPC is 0.6 and income is increases by $500 what is the new level of consumption is?  PRACTICE (2) Consumption in Jamaica is 5,000 in 2020. If the MPC is 0.7 and income is increases by 1000 what is the new level of consumption is?  PRACTICE (3) Calculate the change in consumption if the MPC is 0.6 and the additional disposable income is $1,500.  Consumption Function There is a close relationship between consumption and disposable income. The consumption function shows the relationship between total consumer expenditures and total disposable income in the economy, holding all other determinants of consumer spending constant.  Movement along the consumption Function  is caused only by a change in the disposable income.  Any other factor that changes will cause a shift of the consumption function.  A shift to the right indicates a decrease in consumer spending while a shift to the left indicates an increase in consumer spending.  Factors the Cause the Consumption Function to Shift. Consumers Wealth – as consumers wealth increase they are inclined to spend more, shifting the consumption function upwards to the left while the reverse will happen in consumers wealth decrease.  Factors the Cause the Consumption Function to Shift. The Price level – Lower price levels means more disposable income for consumers.  With more disposable income consumers will spend more thus, shifting the consumption function upward to the left or vice-versa.  Factors the Cause the Consumption Function to Shift. Inflation Rate – Higher inflation rates decreases consumers purchasing power and this will shift the consumption function outwards.  Factors the Cause the Consumption Function to Shift. The Real Interest Rate – The higher the real interest rate on borrowing the less will be consumers purchasing power, thereby shifting the consumption function outwards to the right and vice versa.  Factors the Cause the Consumption Function to Shift.  Future Income Expectation – Expectation of future income may induce consumers to spend more, this in turn will cause the consumption function to shift upwards to the left.  Expectations of income loss may induce consumers to spend less thereby shifting the consumption function outwards. Exceptions to the Rule of GDP The treatment of government outputs involves a minor departure from the norm of using market prices. Outputs of private industries are sold on markets so we can observe and record their prices, but outputs of government offices are not sold. Exceptions to the Rule of GDP  Lacking prices for outputs, national income accountants draw back on the only prices they have, that is, the price of the inputs from which the outputs are produced.  As a result, government outputs are valued at the cost of the inputs that produce them. For e.g., if a clerk at the Inland Revenue Office earns $ 1,000 per hour then the GDP would be increased by $ 1,000. Exceptions to the Rule of GDP  Some goods that are produced during the year but not yet sold are nonetheless counted in the GDP of that year.  Specifically goods that firms add to their inventories counts in the GDP even though they do not pass through the markets.  Inventories are treated as if they were bought by the firms that produce them (even though these purchases do not occur, simply a book- keeping entry). Exceptions to the Rule of GDP The treatment of investment goods runs a little contrary to the rule that GDP includes only final goods, factories, generators, machines, tools etc., might be considered as intermediate goods as their owners only use them to produce other goods. Exceptions to the Rule of GDP  Because factories and machines are never sold to consumers.  To avoid the problem of double counting in GDP, national income statisticians define investment goods as final products demanded by the firms that buy them. Items that are not included in GDP Calculations 1. Do it yourself activities 2. Black market activities/ illegal 3. Purely financial activities (shares) 4. Transfer payments (pension) 5. Destruction to the environment 6. Second hand products (used) 7. Intermediate goods  End of Unit 3 Review! Review! Review! then ask questions.