Macroeconomics Unit 3 PowerPoint PDF

Macroeconomics Income and Spending...

Macroeconomics Income and Spending UNIVERSITY COLLEGE OF THE CARIBBEAN ASSOCIATE OF SCIENCE DEGREE IN BUSINESS ADMINISTRATION PRINCIPLES OF MACROECONOMICS The government of Farmland has been facing a lot of difficulty in reducing the inflation rate in the country. He sort help from the Central Bank to help him in this difficult time. As the Governor of the Central Bank identify FOUR (4) main instruments of monetary policy that could be used to reduce inflation and explain why EACH of these may not work always be effective in the context of the Caribbean. (20 marks) The government is also concerned that a lot of nationals are saving their money in US dollars, thus putting pressure on the local currency. Discuss why residents in many Caribbean countries choose to have their money in US dollars instead of their own currency (10 marks)  Objectives  Aggregate demand and aggregate supply  Components of aggregate demand i.e. C + I + G + ( X -IM )  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 aggregate demand 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 : AGGREGATE DEMAND = AD=C + I + G + ( EX – IM) AD=C + I + G + ( X – M)  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)  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)  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.  NX = X-M  100b-60b =40b positive net export  100b- 120b = -20b negative net export  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)  Objectives  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. National Income Account The national account keep track of the spending of consumers, sales of producers, business investment spending, government purchases and a variety of other flows of money among different sectors in the economy. This is generally calculated by STATIN Circular Flow of Income This is a simplified representation of the macro economy. It shows the flow of money, goods and services, and factors of production through the economy and allows us to visualize the key concepts behind the national accounts. The underlying principle of the circular flow diagram is that the flow of money into each market or sector is equal to the flow of money coming out of that market or sector. The simple model of the macroeconomy represents the transactions that take place in the economy by two kinds of flows: Physical things such as goods, services, labor or raw material flow in one direction (light green section). Payments (money flow) for these factors this factors flow in the opposite direction (dark green section) Note that there are only 2 agents or groups in the economy i.e the household and the firm.  Two markets in the circular flow 1. Factor market Firms buy the factors of production (resources) needed to produce goods and services from households. Households ultimately own, and receive income from the factors of production (land, labor, capital and entrepreneurship). Household mainly receive income in the form of wages/salaries for they labor. However, they also receive income in the form of rent, interest and profits.  2. The Product Market Households buy the products (goods and services) they want from the firm. Consumer spending occurs when the household make payments for goods and services. Consumer spending produces a flow of goods and services to the household and a return flow of money to the firm An Expanded Circular Flow Diagram  Government Taxes - This is a withdrawal/leakage from the circular flow of income. It is a compulsory payment made by households and firms to the government. Tax revenues are funds the government receives from taxes. Firms must pay taxes on consumer and government spending they receive through the product market and the funds that remain are used to pay wages, rent interest and profits to the household through the factor markets. Households pay taxes to the government , they then allocate their remaining income (disposable income) to consumer spending.  Government Continued Government Spending - Money is injected into the circular flow by way of government spending. Government spending is the total purchases made by levels of government. It includes spending on military arms, public school spending and so on. These spending are financed by tax revenues. Government Transfers/Transfer payments - Payments the government makes to households and firms without expecting returns from production. Example pension payments and providing goods and services for people in need.  The Financial Market - Savings and Investment Savings - This is household income that is not spent. It is a withdrawal/leakage from the circular flow. Private savings are frequently held by financial institutions (banks) and are injected back into the flow in the form of loans. Financial markets channel private savings into government borrowing and investment spending. Government borrowing to finance spending tax revenues cannot cover and firms borrow to finance investment.  Investment - This is an injection to the circular flow. This includes firm spending on new productive capital such as a new factory, machinery, new house, inventories (goods and raw material for production). As inventories increases, future sales increases and as inventories decreases, future sales decreases.  The Foreign Market- Exports and Imports Exports - Goods and services sold to other countries. Payment for exports is regarded as an injection of funds into the the home country. Imports - Goods and service purchased from other countries. Imports lead to leakages/withdrawal of funds out of the home country.  Although the circular flow has expanded the underlying principle is that inflow of money coming into each market or sector must equal the outflow of money from coming from the market or sector. The monetary flows within the circular flow model can be used to measure the size of the economy. The calculation of the dollar value of all final goods and services produced in an economy give the economy’s gross final product.  Injections and Withdrawals/Leakages Injections - where money enters the circular flow of income or an addition of money into the economy. This is in the form of government spending (G), investment (I) and exports (X). Injections stimulate economic activity, increase aggregate demand for goods and services, and can lead to economic growth. Withdrawals/Leakages - where money leaves the circular flow of income or the removal of money from an economy. This can be from taxes (T), saving (S) and imports (M). Withdrawals can reduce overall economic activity, decrease aggregate demand, and potentially lead to  Gross Domestic Product (GDP) This is the value of all final goods and services produced by the domestic economy during a year. The calculated value of the GDP is known as the nominal GDP. There are three ways/approaches to calculating GDP. The expenditure approach The income approach The output or value added approach  The Expenditure Approach This involves adding up aggregate spending on domestically final produced goods and services. Note that some goods can be considered final or intermediate goods depending on the end user. This is to avoid double counting. For instance a consumer tomatoes are considered finals goods if they are purchased by a consumer a end user. However it is also considered an intermediate good if it is an input in the production of a final good, for example tomato ketchup. Intermediate goods are input in the production of final goods and services.  The Expenditure Approach Continued There are four groups that purchase goods and services in an economy: households (consumers) (C), firms (I), government (G) and the people in foreign countries(X-M). The largest spenders are the consumers. The expenditure approach adds up all these four sources of aggregate spending. GDP = C+I+G+(X-M) X-M : the difference between the value of exports and the value of imports is called net exports.  The Income Approach This involves adding up all the income earned from the factors of production in the economy: Wages/salaries by labor Interest earned by those who lend their savings to firms and the government Rent earned by those who lease their land or structures to firms Profits earned by the owners of the firm’s physical capital. GDP = W or S+I+R+P  The Value Added/Output Approach The value added by each producer at each stage of production. For example the total sale of the value of all goods, intermediate and final is say $34,700. $ 21, 500 from the sale of the car + $9,000 from the sale of the steel + $4200 from the sale of the iron ore. Using the value added approach to see the value added at each stage of production gives us the final value of the good. 0 + $4,200+ $4800+ $12,500 = $21,500 Nothing before + Iron ore +steel manufacturer + Car manufacturer  Example The table below shows data for the country of Boland from the most recent full calendar year: Wages 700 Tax Revenue 75 Consumption 600 Exports 100 Investment 250 Imports 50 Rent 100 Profits 100 Government Spending 100 Interest 100 Calculate GDP using the expenditure approach and the income approach. Example  Expenditure Approach GDP = C+I+G+X-M GDP = 600 + 250 +100+ 100 - 50 = $1000 Income Approach GDP = W or S + I +R +P GDP = 700 + 100+100 +100 = $1000  Exercise The table below shows data for the country of Jamrock from the most recent full calendar year: Wages 7,000 Tax Revenue 800 Consumption 10,000 Exports 2,000 Investment 8,000 Imports 1,000 Rent 3,000 Profits 10,000 Government Spending 5,000 Interest 4,000 Calculate GDP using the expenditure approach and the income approach.  It does not include: Financial transactions like the stocks and bonds - don’t represent production the production and sale of any final good. A bond represents a promise to pay interest and a stock represents ownership in a firm. Intermediate goods - cause double counting Used goods - cause double counting already included when they were produced Transfer payments - Is not in exchange for a good or service Imports - not produced domestically Non-market transactions - barter, do it yourself activities, sles in the underground economy/ black market, illegal goods 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  Used as a measure of economic performance of a country from one year to the next. Used to compare the performance of countries.  Exceptions to the Rule of GDP The treatment of government outputs. Outputs of private industries are sold on markets so we can observe and record their prices, but outputs of government offices are not sold. Therefore, the price of the inputs from which the outputs are produced is included in the calculations  Exceptions to the Rule of GDP 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  The value of goods is included in the year they were produced and not in the year they were sold.  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  Investment goods are considered intermediate goods and not final goods as they are only used to produced goods. These goods are not generally sold to consumers. For instance, factories, generators, machines, tools etc. Items Yes/No Why/why not Coca-Cola builds a new bottling plant in the USA Delta Air Lines sells one of its existing airplanes to Korean Air Ms. Moneybags buys an existing share of Walt Disney Company Stock A California farm produces Almonds and sells them to a customer in Montreal, Canada An American buys a bottle of French perfume in their hometown A book publisher produces too many copies of a new book; the books don’t sell this year; so the publisher adds the surplus books to its inventories.  Income (Y) Savings (S) Consumption (C) Y=S+C $100,000 = $20,000 +$80,000 S= Y-C 100,000 – 80,000 = $20,000 C= Y-S C= 100,000- 20,000 = $80,000  Average Propensity to Consume Average propensity to consume (APC) measures the percentage of income that is spent rather than saved. Formula – C/Y Average Propensity to Save The average propensity to save (APS) is a macroeconomic term that refers to the proportion of income that is saved rather than spent on current goods and services. Formula – S/Y APC + APS = Y APC + APS = 1  Average Propensity to Consume or save APC = C/Y = 80,000/100,000 = 0.8 APS = S/Y = 20,000/100,000 = 0.2 APC + APS = Y APC + APS = 1 0.8 + 0.2 = 1 APC = 1-0.2 = 0.8 APS = 1-0.8 =0.2 0.6 + 0.4 = 1 APC = 1-APS, APC = 1-0.4 = 0.6 APS=1-APC, APS =1-0.6 = 0.4  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  Marginal Propensity to Consume or Save (Additional Income) - $5,000 Additional Consume $4,000 MPC = Change in Consumption/Change in Income Income: Consumption: Savings: 100,000 80,000 20,000 105,000 84,000 21,000 MPC = 4,000/5,000 = 0.8 MPS = 1000/5000 = 0.2 Additional Saving $1000 MPS = Change in Saving/Change in Income = 1000/5000 = 0.2 = 20% MPS + MPC =1 1000+4000 = 5000 MPC = 1 – MPS MPC = 1- 0.2 = 0.8 MPS = 1-MPC MPS = 1-0.8 = 0.2  MPS and MPC $100,000 (Old income) $120,000 (New income) Additional Income $20,000 MPC = 75% and MPS = 25% calculate the MPC and the MPS. MPC = $20,000 x.75 = $15,000 MPS = $20,000 x.25 = $5,000 Consumption in Jamaica is $10,000 in 2024. If the MPC is 0.6 and income increases by $500 what is the new level of consumption? MPC = 0.6 X 500 = $300 MPS = 1-MPC 1- 0.6 = 0.4 0.4 x 500 = $200  Consumption in Jamaica is 5,000 in 2020. If the MPC is 0.7 and income increases by 1000 what is the new level of consumption? MPC = 1000 x 0.7 = $700 MPS = 1-MPC = 1-0.7 = 0.3 = 1000 x0.3 = $300  Calculate the change in consumption if the MPC is 0.6 and the additional disposable income is $1,500. Change in consumption = 0.6 x 1500 = $900 If the change in consumption is $5000 and the change in income is $70000, what is the MPC? MPC = change in consumption/change in income 5,000/70,000 =0.07 or 7% 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. The End