1. Mr. Redelsheimer AP Economics Chapter 9

2. What are the 2 things you can do with your income?

3. The amount of spending affects total output in an economy

4. CONSUMPTION AND SAVING APC Consumption / Income APS Saving / Income MPS Change in Saving Change in Income MPC Change in Consumption Change in Income

5. Consumption o C Consumption schedule C Disposable Income SAVING DISSAVING MPC = Slope of C MPC + MPS = 1 CONSUMPTION AND SAVING 45 o

6. .80 .85 .90 .95 1.0 United States Canada United Kingdom Netherlands Germany Italy Japan France GLOBAL PERSPECTIVE Average Propensities to Consume, Selected Nations, 2000 Statistical Abstract of the United States, 2002

7. THE MULTIPLIER EFFECT For Example… Change in GDP = Multiplier x initial change in spending Multiplier = Change in Real GDP Initial Change in Spending

8. THE MULTIPLIER EFFECT Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All Other Rounds Total (1) Change in Income (2) Change in Consumption (MPC = .75) (3) Change in Saving (MPS = .25) $ 5.00 3.75 2.81 2.11 1.58 4.75 $ 3.75 2.81 2.11 1.58 1.19 3.56 $ 1.25 .94 .70 .53 .39 1.19 $20.00 $15.00 $ 5.00

10. THE MULTIPLIER EFFECT Inverse relationship between: Multiplier & MPS Multiplier Effect and the Marginal Propensities Change in GDP = Multiplier x initial change in spending Multiplier = or 1 MPS 1 1 - MPC

11. Step by Step Working of “Multiplier” [MPC is .5] $1,000.00 500.00 250.00 125.00 62.50 31.25 15.625 7.8125 3.90625 1.953125 .9765625 .48828125 .244140625 .1220703125 .06103515625 .030517578125 .015258789062 $2,000,000,000 [ Increased by a multiple of 2] “ What A Girl Wants.” Government increases spending by $1 billion with a multiplier of 2 On new highways Highway workers buy new boats Boat builders buy plasma TVs TV factory workers buy new cars Auto workers buy clothes Apparel workers spend $ on movies Movie moguls spend money on Christina Agulera songs.

12. The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $ 200 billion on the highways . Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 bil. [$37.50 bil.] & spend 75% or $112.50 bil. on iPod Minis, etc.

13. MPC 1/MPS = M .90 1/.10 = 10 .80 1/.20 = 5 .75 1/.25 = 4 .60 1/.40 = 2.5 .50 1/.50 = 2 M E [Change in G, Ig, or Xn] = 1/MPS

14. M T 4 3 1.5 1 9 The 2000 Olympics resulted in $3 1/2 billion to Australia’s economy over a year’s time. Super Bowl brought $166 million to Houston. Fiesta Bowl for national title brought in $85 million . OU M T = MPC/MPS M E = 1/MPS MPC M E .9 10 .8 5 .75 4 .60 2.5 .5 2 The larger the MPC , the smaller the MPS , and the greater the multiplier . This is the “simple multiplier” because it is based on a “simple model of the economy” . N otice the 2 nd round with .9 versus .5

15. THE MULTIPLIER EFFECT MPC Multiplier MPC and the Multiplier .9 .8 .75 .67 .5 10 5 4 3 2

16. Investment (billions of dollars) interest rate, i (percent) 16 14 12 10 8 6 4 2 0 INVESTMENT DEMAND CURVE 5 10 15 20 25 30 35 40 I D Interest Rate – Investment Relationship

17. Should A New Drill Press Be Purchased? Positive profit expectations and the real interest rate are the most important determinants of investment. Drill Press - $1,000 A. Expected gross profits = $1,100 or a 10% return . [$100/$1,000 x 100 = 10%] [At 8 % , invest ; at 12 % , don’t invest ] B. Real interest rate [ nominal interest rate-inflation ] Single Firm

19. GLOBAL PERSPECTIVE Gross Investment Expenditures as a Percentage of GDP, Selected Nations 30% 20% 10% 0% Source: World Bank Germany France United States Canada Mexico United Kingdom Sweden Japan South Korea

20. Nominal Interest Rate Real Interest Rate Anticipated Inflation - Real Interest Rate [ Nominal I.R. – inflation rate = Real I.R. ] = 12 % 5 % 7 %

21. GDP will increase by a “multiple” of 4 & that is why it is called the “multiplier”. The Magical Multiplier

22. INVESTMENT DEMAND & SCHEDULE Expected rate of return, r, and real interest rate, i (percents) Investment (billions of dollars) 20 8 D I Investment Demand Curve 20

23. Balanced Budget Multiplier [$20 billion] [ “T” affects AD indirectly thru “C ”; “G” affects AD directly ] GDP = $80 Net Change in GDP = The increase in “T” means we would have consumed $15 and kept $5 in our pockets. The increase in “G” flows directly into the economy. M E = 1/MPS M E = 1/.25 = 4 So, 4 x $20 = $80 G $20 MT = MPC/MPS=.75/.25= 3 So, 3 x -$20 = -$60 GDP = -$60 Ca= -$15 Sa= -$5 T $20 $470 billion AS AD1 $490 billion PL AD 2 +$20 Balanced Budget Multiplier Is ALWAYS 1.

24. MPC and MPS

25. Vol a tility of Investment R R R R R R R