1 Figure 11Multiplier effect E Y E 0 Ye Ye’ Y-line C* + I* EE 45 o E’ YY.

1Figure 11 Multiplier effect

0 Ye Ye’

Y-line

C* + I*

The Multiplier(Parkin)

Real GDP (trillions of 1992 dollars)

5 6 7 8 9

45o line

e' AE0

…increasesreal GDP by$2 trillion

A $0.5 trillionincrease ininvestment...

The Multiplier Process (Parkin)

Expenditure roundIncrease in current round

Cumulative increase from previous rounds

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

4Figure 14 The movement of expenditure multiplier

0 Ye Ye’

Y-line

Dr. Lam Pun Lee

Advanced LevelMicroeconomicsAdvanced Level

Macroeconomics

Previousslide

1. Calculate the equilibrium level of income.

AE = C + I

AE = 40 + 0.75Y

AE = Y in equilibrium

40 + 0.75Y = Y

Y = 160

2. If I is increased by 10, calculate the new equilibrium level of income.

AE = C + I = 50 + 0.75Y

50 + 0.75Y = Y

Y = 200

An autonomous change in investment by 10 induces a larger change (40)

in equilibrium level of income. Why is this so?

Autonomous change in I

Induced change in C

Change in YRounds of

effects

$10 - $101st

- $7.5 $7.52nd

- $5.625 $5.6253rd

- $4.21875 $4.218754th

- ... ...…

$10 $30 $40Total change:

The Multiplier Process (Miller)

Assumption: MPC = .8 or 4/5

Annual Increase Annual Increase Annual Increasein Real in Planned in Planned

National Income Consumption SavingRound ($ billions per year) ($ billions per year) ($ billions per year)

1 ($100 billion per year increase in I) 100.00 80.000 20.000

2 80.00 64.00 16.000

3 64.00 51.200 12.800

4 51.20 40.960 10.240

5 40.96 32.768 8.192

. . . .

All later rounds 163.84 131.072 32.768

Totals 500.00 400.00 100.000

How does the MultiplierMultiplier work (P.13-7.2.2.2.)?

Any initial change in spending by the government, households, or firms creates a chain reaction of further spending

Y = $10 + $7.5 + $5.625 + …

= I + C + C + …

= I + cY + c2Y + …

= I + cI + c2I + …

= I (1 + c + c2 + …)

= I [1/(1-c)]

Multiplier (k) = Y / I = 1/(1-c)

One divided by one tenth equals 10

MULTIPLIER

If investment increases by $100, If investment increases by $100, with an MPC of 9/10, what effect with an MPC of 9/10, what effect will this have on the economy?will this have on the economy?

The economy will grow by The economy will grow by $1,000 eventually$1,000 eventually

If investment declines by $100, If investment declines by $100, what’s the effect on the economy what’s the effect on the economy

with an MPC of 9/10?with an MPC of 9/10?

If investment declines by $100, If investment declines by $100, what’s the effect on the economy what’s the effect on the economy

with an MPC of 9/10?with an MPC of 9/10?The economy will shrink by

$1,000

Numerical example

I = 10

k = 1/(1-c) = 4

c = 0.75

Y = k I = 4*10 = 40

E = 50 + 0.75Y

45 line

E = 40 + 0.75Y

160 200

Given: C = 20 + 0.75Y

I = 20 + 0.1Y

1. Calculate the change in Y resulted from an autonomous increase in I by $10.

2. Calculate the value of the multiplier.

AE = C + I

AE = 40 + 0.85Y

40 + 0.85Y = Y

Y = 266.67

1. Calculate the change in Y resulted from an autonomous increase in I by $10.

When I = 20 + 0.1Y, AE = C + I

AE = 50 + 0.85Y

50 + 0.85Y = Y

Y = 333.33

When I = 30 + 0.1Y,

Change in Y = 66.67

2. Calculate the value of the multiplier.

k = Change in Y / Change in I = 6.67

If I is an induced function, the size of the simple Keynesian multiplier will be greater. Why is this so?

Multiplier with induced I

1/mps-mpi

Figure 23-10 (Lipsey)

The Size of the Simple Multiplier

Relationship between MPC, MPS, and the Spending Multiplier

Spending Multiplier

Figure 12 The multiplier effects of autonomousdecrease in saving (= C rise)

Figure 13 The multiplier effects of autonomousincrease in investment

3-Sector & 4-Sector Models

The simple Keynesian model discussed is a two-sector model, which includes only firms and households. In this section, we first add the government sector and then the foreign trade sector into our model. Lastly, we consider the concepts of aggregate demand and aggregate supply and how they are related with the Keynesian model.

Nextslide

Household

Financial markets

Figure 1 Three-sector national income model

National income

National expenditure

Incomegenerated

Payment for goods and service

Government GT

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

BANKS, etc GOV.

Investment (I)Investment (I)

GovernmentGovernmentexpenditure (expenditure (GG))

NetNetsaving (S)saving (S)

NetNettaxes (T)taxes (T)

The circular flow of incomeThe circular flow of income

26Figure 2(d) Consumption function in an 3-sector

income-expenditure diagram

Slope = c (1 – t)

Keynes and the Great Depression• Keynes argued that prices and wages are not

sufficiently flexible to ensure the full employment of resources

• Furthermore, Keynes argued that when resources (especially labor) are not fully employed (due to a lack of private investment expenditures), the government could provide offsetting expenditures as a means of stabilizing the economy

• Thus, Keynesian economics places emphasis on planned expenditures and all its components

What is the GDP Gap (P.16-7.2.5.4. & Wong 2000: 104)?

The difference between full employment real GDP and actual real GDP

What is the Recessionary AD Gap (P.16-7.2.5.4.)?

The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

30Figure 2(a) Deflationary AD gap

Y-line

Ye Yf0

The deflationary AD gap

Deflationary AD gap

The deflationary AD gap

Deflationary AD gap

What is the Keynesian Keynesian remedyremedy for a Recessionary AD Gap (P.16-7.2.5.5.)?

Increase autonomous spending by the amount of the recessionary AD gap

What can the Government doGovernment do to close a Recessionary AD Gap?• Increase government

spending• Lower taxes• Raise transfer payments

Exhibit 2: U.S. Federal Budget Deficits and Surplus Relative to GDP (P.17-7.2.6.1.2.)

Source: Developed based on budget figures in Economic Report of the President, February 1999.

11975 1980 1985 1990 1995 2000

Fiscal Year

3Federal Budgets and Public Policy

What is an Inflationary AD Inflationary AD GapGap (P.16-7.2.5.4.)?

The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

39Figure 2(b) Inflationary AD gap

Y-line

The inflationary AD gap

Inflationary AD gap

The inflationary AD gap

Inflationary AD gap

What is the Keynesian Keynesian remedyremedy for an Inflationary AD Gap (P.16-7.2.5.5.)?

Reduce autonomous spending by the amount of the inflationary AD gap

How can the GovernmentGovernment close an Inflationary AD Gap?

• Cut government spending• Increase taxes• Reduce transfer payments

9. Keynes’ criticism of the classical theory was that the Great Depression would not correct itself. The multiplier effect would restore an economy to full employment if

a. government would follow a “least government is the best government” policy.

b. government taxes were increased.c. government spending were increased.d. government spending were decreased.

c. Keynes’ prescription to cure the Great Depression was for government to play an active role rather than depend on the classical theory that the price system will eventually restore full employment.

10. The equilibrium level of real GDP is $1,000 billion, the full employment level of real GDP is $1,250 billion, and the marginal propensity to consume (MPC) is 0.60. The full-employment target can be reached if government spending is increased

a. by $60 billion.b. by $100 billion.c. by $250 billion.d. by $25 billion.

b. Change in real GDP required = spending multiplier x change in government spending (G). Rewritten,

G = 1/(1 - 0.60) x ($1,250 - $1,000) G x 2.5 = $250 G = $100 billion.

48Figure 2(c) Equilibrium income equals

potential income

Y-line

0 Yf = Ye

Does the equilibrium yield full Does the equilibrium yield full employment?employment?

Not necessarily, according to Keynes. We could move toward a less than full employment equilibrium.

What can we do if the What can we do if the economy is moving toward economy is moving toward less than full employment?less than full employment?

We use our fiscal policies to shift the equilibrium to a point of GDP that gives us full employment.

What is Fiscal Policy? (P.16-7.2.6. & Wong 2000: 137)

• Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP

What is a Discretionary Discretionary Fiscal PolicyFiscal Policy (P.16-7.2.6.1. & Wong 2000: 139)?

The deliberatedeliberate use of changes in government spending, transfer payments, taxes and borrowing to alter aggregate demand and stabilize the stabilize the economyeconomy

Discretionary Fiscal PolicyDiscretionary Fiscal Policy (P.16-7.2.6.1. & Wong 2000: 139)

= The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals

• High employment• Price stability• Economic growth• Level of GDP• Improvement of international payments balan

Why is Government spendingGovernment spending considered an AutonomousAutonomous Expenditure (Wong 2000: 94)?

Because Government spending is primarily the result of a political decision made decision made independent of the level independent of the level of national output.of national output.

What are examples of Expansionary Fiscal PolicyExpansionary Fiscal Policy

(P.16-7.2.6.1.1.)?

• Increase government spending

• Decrease taxes• increase government

spending and taxes equally

The Effect on GDP of an Increase in Government Spending

Real GDP

45o C+I+G’

G Simple government expenditures multiplier =

GDP/G = 1/(1-MPC)

Simple government expenditures multiplier =

GDP/G = 1/(1-MPC)

The Effect on GDP of a Decrease in Lump-sum Taxes

Real GDP

45o C’+I+G

Simple tax multiplier =

GDP/T = -MPC/(1-MPC)

Simple tax multiplier =

GDP/T = -MPC/(1-MPC)

Shifting the aggregate demand curve upward

Real GDP

C1 + I1 + G1

less than full employment

C2 + I2 + G2

full employment

How can we shift the aggregate How can we shift the aggregate demand curve upward?demand curve upward?

We can use fiscal policies to• lower taxes• increase government

spending

60Figure 3(a) Expansionary fiscal policy

Y-line

Ye Yf0

What is a Cyclical Deficit & a Structural DeficitStructural Deficit (P.16-7.2.6.1.4.)?

• The part of the deficit that varies with the business cycle is a Cyclical Deficit.

• The part of the deficit that is independent of the business cycle is a Structural Deficit.

C:\My Documents\Econppt\Macro\HLch27GovtSpending.ppt

What are examples of Contractionary Fiscal PolicyContractionary Fiscal Policy

(P.16-7.2.6.1.1.)?• Decrease government

spending• Increase taxes

63Figure 3(b) Contractionary fiscal policy

Y-line

Figure 4 A balance-budget increase in G and T will have an expansionary effect on the economy

Y-line

C + I + G

What is the Tax Multiplier Tax Multiplier (P.15-7.2.4.3.=Wong 2000: 101)(P.15-7.2.4.3.=Wong 2000: 101)?

The change in aggregate demand (total spending) resulting from an initial change in taxes

What is the Balanced Balanced Budget Multiplier (P.15-Budget Multiplier (P.15-

7.2.4.3.)7.2.4.3.)?An equal change in

government spending and taxes, which changes aggregate demand by the amount of the change in government spending

What is a Countercyclical Countercyclical Fiscal Policy (P.16-7.2.6.1.3.)?Changes in taxes or

government spending designed to counteract a boom or recession.

C:\My Documents\Econppt\Macro\HLch27GovtSpending.ppt

What are What are limitationslimitations to to Countercyclical Policies?Countercyclical Policies?TimingTiming Problems Problems – there are the lags of recognition, decision, and action IrreversibilityIrreversibility – government policies tend to become entrenched

Fiscal Policy: problems • Time lags (P.18-7.2.6.3.1.)

– Recognition Time Lag• The time required to gather information about the

current state of the economy

– Action Time Lag• The time required between recognizing an economic

problem and putting policy into effect– Particularly long for fiscal policy

– Effect Time Lag• The time it takes for a fiscal policy to affect the

economySlide 13-39

Discretionary Fiscal Policy

in Practice• Fiscal policy time lags are long. A policy designed to correct a recession may not produce results until the economy is experiencing inflation.

• Fiscal policy time lags are variable in length (1–3 years). The timing of the desired effect cannot be predicted.

What are Automatic Stabilizers? (P.17-7.2.6.2. & Wong 2000: 138)

Forces that reduce the size of the expenditure multiplier and diminish the impact of spending shocks

What is an Automatic Automatic StabilizerStabilizer (P.17-7.2.6.2. & Wong 2000: 138)?• Government expenditures and tax

revenues that automatically change levels in order to stabilize an economic expansion or contraction

• Structural features of government spending and taxation that smooth fluctuations in disposable income over the business cycle

Automatic Stabilizers• Changes in government spending and

taxation that occur automatically without deliberate action of government

• Examples:–Progressive income tax system with its

increasing marginal income tax rates

–Unemployment compensation

–Welfare spending

–Transfer paymentsSlide 13-43

What are some examples of Stabilizers?

• Transfer payments that increase and decrease with changes in the economy

• Income (proportional/progressive) taxes that rise and fall with income

How do automatic stabilizers affect spending How do automatic stabilizers affect spending shocks?shocks?

• They smooth out the ups and downs of the economy.

Automatic Stabilizers

Real GDP per Year($ trillions)

Taxrevenues

Unemploymentcompensation and welfare

Budget surplus

Budgetdeficit

The automatic changes tend to drive the economy back toward its full-employment output level

Automatic Stabilizers

Real GDP per Year($ trillions)

Taxrevenues

Unemploymentcompensation and welfare

Budget surplusBudgetdeficit

Figure 13-6 Slide 13-45

Household

Financial markets

Figure 5 Four-sector national income model

National income

National expenditure

Incomegenerated

Payment for goods and service

GovernmentGT

Foreign markets

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

BANKS, etc GOV. ABROAD

Investment (I)Investment (I)

GovernmentGovernmentexpenditure (expenditure (GG))

ExportExportexpenditure (X)expenditure (X)

NetNetsaving (S)saving (S)

NetNettaxes (T)taxes (T)

ImportImportexpenditure (M)expenditure (M)

The circular flow of incomeThe circular flow of income

WITHDRAWALSWITHDRAWALS

INJECTIONSINJECTIONS

79Figure 6 Determining the equilibrium income of an open economy

E = C + I + G + (X - M)

Y-line

I + G + X

S + T + M

80Figure 7 Aggregate demand curve

81Figure 8(a) Keynesian (kinked) aggregate supply

82Figure 8(b) Upward-sloping aggregate supply curve

83Figure 8(c) Classical aggregate supply curve

Figure 9 Equilibrium of aggregate demand and supply

85Figure 10(a) Unemployment equilibrium

Figure 10(b) Over-employment equilibrium

87Figure 10(c) Full employment equilibrium

Figure 11

Multiplier effect with changing price level

AD’•

If P unchanged

••

(a)(b)

Advanced LevelMicroeconomicsAdvanced Level

Macroeconomics

Previousslide

The paradox of thrift:An attempt to save more may lead to lower income and no actual increase in saving if everybody do the same.Saving is a virtue for the individual, but may not be good for the society as a whole!

Case 1

When you want to save more by decreasing autonomous consumption and others follow what you did, the saving function shifts upwards. The national income is decreased. The level of saving remains the same.

S = -a + sY

I = I*

S’ = -a’ + sY

Case 2

If investment is an induced function, how will an upward shift in saving function affect the level of equilibrium income and saving? Show your answer in the following diagram?

S’ = -a’ + sY

S = -a + sYI = I* + iY

Resolution:

The amount of investment is independent of the rate of interest and the amount of saving. An increase in saving leads to an accumulation of unintended inventory and then output and income will fall.

Rate of interest (r)

Loanable funds for investment

D = investmentS = saving

YeYe’

Would the paradox still arise if investment is negatively

related to the rate of interest?

Annual Percentage Changes in U.S. Real GDP, Real Consumption, and Real Investment

–20.0

–15.0

–10.0

–5.0

Investm ent

Consum ption

Source: Based on annual estimated found in Survey of Current Business, U.S. Department of Commerce, 77 (August 1997) and 79 (January 1999).

Why does the Consumption Function Shift (P.20-7.3.1.1.)?

• Expectations• Wealth• Price level• Interest rate

How do Expectations affect the Consumption (P.22-7.3.1.1.10)?Consumers expectations of

things to happen in the future will affect their spending decisions today

How does Wealth affect the Consumption (P.20-7.3.1.1.5)?Holding all other factors

constant, the more wealth households accumulate, the more they spend at any current level of disposable income

How does the Price Level affect the Consumption

(P.21-7.3.1.1.6)?Any change in the general

price level shifts the consumption schedule by reducing or enlarging the consumers purchasing power

How does the Interest Rate affect the Consumption

Function (P.21-7.3.1.1.8)?A high interest rate will

discourage people from borrowing money and a low interest rate will encourage people to borrow money

According to Keynes, what determines the level of

Investment?Expectations of future

profits is the primary factor, the interest rate is the financing cost of any investment proposal

7.4.3. How do Expectations affect Investment?

Business people are quite susceptible to moods of optimism and pessimism

How do Business Taxes affect Investment?

Business decisions depend on the expected after-tax rate of profit

8. Can the government maintain a permanent budget deficit? What would you need to know about the future path of interest rates and GDP growth rates to be able to answer this question?

• It depends. The government can (cannot) maintain a permanent budget deficit if the interest rate is lower (higher) than the GDP growth rate.

Countercyclical fiscal policy• Argues that increasing government

spending or reducing taxes during a recession would mitigate the recession

–Suggested by Keynes in 1930s (Keynesian policy)

• Rationale now for “fiscal stimulus” package in Japan

• Discretionary versus automatic

Effect of the economy on the budget deficit

• Budget deficit is cyclical

–Deficit rises in recessions

–Deficit falls during recoveries and expansions

• To see the reason look at tax revenues and expenditures

Government tax revenues depend on the state of the economy

• when real GDP grows more rapidly, proportional tax revenues rise

–more people working, higher incomes

–people move into higher tax brackets

Expenditures also depend on the economy

• When real GDP grows more rapidly, as in a recovery, expenditures such as transfer payments grow less rapidly

• When real GDP grows less rapidly or falls, as in a recession, expenditures grow more rapidly – unemployment compensation rises– welfare payments go up– more people retire, increasing social

security payments

Net effect of real GDP on deficit

• deficit = government spending - tax revenue

•thus in a recession the deficit will rise, and in a recovery the deficit will fall

• Fill in P.17 table

The structural deficit• The structural deficit is the deficit that

would exist if real GDP = potential GDP

• Also called full employment deficit

• Purpose is to take out (control for) the effects of economic fluctuations in real GDP on the deficit

• Changing structural deficit requires – change in tax laws, size of government,...

4. The government budget deficit is

a) A stock variable.

b) A flow variable.

c) Neither a flow nor a stock variable.

d) Always increasing over time.

Answer: b

Countercyclical fiscal policy• Argues that increasing government

spending or reducing taxes during a recession would mitigate the recession

–Suggested by Keynes in 1930s (Keynesian policy)

• Rationale now for “fiscal stimulus” package in Japan

• Discretionary versus automatic

• There was no such thing as fiscal policy until John Maynard Keynes invented it in the 1930s– He maintained that

• The only way out of the Depression was to boost aggregate demand by increasing government spending

• If we ran a big enough budget deficit, we could jump-start the economy and, in effect, spend our way out of the depression

Fiscal Policy (P.16-7.2.6.)

The Public Debt (P.18-7.2.6.3.3.)• Differentiating between the Deficit and

the Debt– The deficit occurs when government spending is

greater than tax revenue– The debt is the cumulative total of all the budget

deficits less any surpluses• Suppose that our deficit declined one year from $200

billion to $150 billion

• The national debt would still go up by $150 billion

• So every year that we have a deficit – even a declining one – the national debt will go up

The Public Debt• Is the national debt a burden that will have

to be borne by future generations?– As long as we owe it to ourselves, the answer is

no– If we did owe it mainly to foreigners (in 4-sector

model), and if they wanted it paid off, it could be a great burden

– In the future, even if we never pay back one penny of the debt, our children and our grandchildren will have to pay hundreds of billions of dollars in interest. At least to that degree, the public debt will be a burden to future generations

The Public Debt

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

National Debt, 1975-2000

Economic Report of the President, 2000

The Automatic Stabilizers• The automatic stabilizers protect us

from the extremes (peak & trough) of the business cycle– Personal Income and Payroll Taxes

• During recessions, tax receipts decline• During inflations, tax receipts rise

– Personal Savings• During recessions, saving declines• During prosperity, saving rises

The Automatic Stabilizers

–Credit Availability–Credit availability helps get us through recessions

–Unemployment Compensation

–During recessions more people collect unemployment benefits

The Automatic Stabilizers–The Corporate Profits Tax

• During recessions, corporations pay much less corporate income taxes

–Other Transfer Payments• Welfare (or public assistance) payments, Medical aid payments, and food stamps rise during recessions

Consumption and investment are two important aggregates in macroeconomic models. An autonomous change in one of them will cause the level of national income to change, via the multiplier effect. In this lesson, we take a closer look at consumption and investment. Firstly, we consider possible determinants of consumption demand other than the one (i.e. income) in the simple Keynesian model. Secondly, we examine two hypotheses of consumption demand which are used to explain the empirical data: the permanent income hypothesis and the life-cycle hypothesis. Lastly, we turn our attention to determinants of investment.

•Consumption and Investment

124Figure 3 Permanent-income hypothesis

Consumption

Income (years)

Slope = MPC = APC

7.3.1.3.

125Figure 4 Life-cycle income, consumption

and saving

Income stream

7.3.1.2.

126Figure 5 Life-cycle hypothesis

Consumption

Permanent income

Slope = MPC = APC =1

7.3.1.2.

127Figure 6 Change in income distribution

Slope = MPC

7.3.1.1.11.

128Figure 9 The paradox of thrift

YeYe’ Yf0

YeYe’ Yf

(a) (b)

Figure 10 The effect of increased saving on investment

Interest rate

Loanable fund forinvestment

(a) (b)

Discretionary Policy and Discretionary Policy and Permanent IncomePermanent Income

• Permanent income is income that individuals expect to receive on average over the long run

• To the extent that consumers base spending decisions on their permanent income, attempts to fine-tune the economy through discretionary fiscal policy will be less effective

Permanent Income Hypothesis(Milton Friedman) 7.3.1.3.

• People gear their consumption to their expected lifetime average earnings more than to their current income– Apparently there are quite a few deviations

from the behavior predicted by the permanent income hypothesis

Figure 8.6a Life-cycle consumption, income, and saving

7.3.1.2.

7.4 Investment (P. 23)

• “Investment” is the thing that really makes our economy go and grow!

• Investment is any NEW– Plant and equipment

• Investment is any NEW– Additional inventory

• Investment is any NEW– Residential housing

1960 1965 1970 1975 1980 1985 1990 1995 2000

Investment in Plant and Equipment, 1960-2000 (in 1987 dollars)

There has been a strong upward trend in this investment sector over the last four decades. Note the periodic downturns, especially during recession years

Ð251960 1965 1970 1975 1980 1985 1990 1995 2000

Inventory Investment, 1960-2000 (in billions of 1987 dollars)

This is the most volatile sector of investment. Note that investment was actually negative during three recessions

Residential Construction

• Involves replacing old housing as well as adding to it

• Fluctuates considerably from year to year

• Has mortgage interest rates play a dominant role

Investment• Investment is the most volatile sector in

our economy– GDP = C + II + G + Xn

• Fluctuations in GDP are largely fluctuations in investment

• Recessions are touched off by declines in investment

• Recoveries are brought about by rising investment

Determinants of the Level of Investment

• Interest rate• Sales outlook• Expected rate of profit• Technological change• Business taxes• Autonomous reasons

7.4.2. The Interest Rate

• You won’t invest if interest rates (cost) are higher than MEC (benefit)

Interest rate = The interest paid / The amount borrowed

Assume you borrow $1000 for one year @ 12 %, how much interest do you pay?

.12 = X

X = $120

You Won’t Invest If Interest Rates Are Too High

• In general, the lower the interest rate, the more business firms will borrow

• To know how much they will borrow and whether they will borrow, you need to compare the interest rate with the expected rate of profit

• Even if they are investing their own money they need to make this comparison

7.4.3. The Sales Outlook• You won’t invest if the sales outlook

is bad• If sales are expected to be strong the

next few months the business is probably willing to add inventory

• If sales outlook is good for the next few years, firms will probably purchase new plant and equipment

Expected Rate of Profit(ERP)

ERP = -------------------------------------------Expected Profits

Money Invested

How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?

ERP = -------------------------------------------Expected Profits

Money Invested

ERP = -------------------------------------------$1,650

$10,000

ERP = .165 = 16.5 %

Why Do Firms Invest?

• Firm’s will only invest if the expected profit rate is “high enough”

• Firms invest when– Their sales outlook is good– Their expected profit rate is high

• Even if firm’s invest their own money, the interest rate is still a consideration

10,000

8,000 10,000

4,0002,000

C +I +G

Disposable income ($)

10,000

8,000 10,000

4,0002,000

C +I +G

Disposable income ($)

C +I +G +Xn

C + I + G + Xn

Why is the C + I + G + Xn line lower than the C + I + G line?

Answer: It is lower because net exports (Xn) are negative

1 Figure 11Multiplier effect E Y E 0 Ye Ye’ Y-line C* + I* EE 45 o E’ YY.

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