POLYTECHNIC UNIVERSITY OF THE PHILIPPINES STA. MESA, MANILA

AGGREGATE SUPPLY

AND

ALL NATIONAL INCOME

Submitted by:

Erennie D.Fabiolas

Donna Luz R. Ople

Royce P.Pardo

Ma. Jessica Pamela D. Pilpa

April Rose C. Soronio

Geneva O. Torrefiel

Submitted to:

Prof.Estefanie Cortez

AGGREGATE SUPPLY

Aggregate Supply (AS) is a schedule or curve showing the level of real domestic output that firms will produce at each price level. It measures the volume of goods and services produced within the economy at a given overall price level. 1

The production responses of firms to changes in the price level differ in the long run and in the short run.

AGGREGATE SUPPLY IN THE LONG RUN

Long run is a period in which nominal wages (and other resource prices) match changes in the price level.

Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labor, land and capital). 

The long-run aggregate supply curve LRAS is vertical at the full-employment level of real national output because in the long run, wages and other input prices rise and fall to match changes in the price level. So the price-level changes do not affect firms’ profit and thus they create no incentive for firms to alter their output.

1( http://tutor2u.net/economics/content/topics/ad as/aggregate supply.htm)

AGGREGATE SUPPLY IN THE SHORT RUN

Short Run is a period in which nominal wages (and other resource prices) do not respond to price-level changes.

Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector.

The upsloping aggregate supply curve AS indicates direct relationship between the price level and the amount of real output that firms will offer for sale. The AS curve is relatively flat below the full-employment output because unemployed resources and unused capacity allow firms to respond to price level rises with large increases in real output. It is relatively steep beyond the full-employment output because resource shortages and capacity limitations make it difficult to expand real output as the price level rises.

Determinants of Aggregate Supply

The relationship between the price level and real output may be represented in an aggregate supply curve, considering the fact that other things are equal. If the curve is shifting to the left, it signifies the decrease in the aggregate supply. In other words, firms are willing to produce less than the previous quantity. If the curve is shifting to the right, it signifies that aggregate supply increases which indicates the willingness of the firm to produce more than the previous quantity.

Reasons behind the movement of the curve are called the “determinants of aggregate supply.” Some texts call it “aggregate supply shifters.” Determinants of aggregate supply collectively motivate the curve to its position and how it shift. Changes in these determinants raise or lower per-unit production costs at each price level (or each level of output). As per-unit production costs rises, profits of the firm decreases. Because of this consequence, the firm makes changes in the number of quantity. The decrease in per-unit production costs does just the opposite.

The determinants of aggregate supply are listed below.1. Changes in Input Prices

Input or resource prices – to be distinguished from the output prices that make up the price level – are a major determinant of aggregate supply. Considering else are constant, higher input price causes the per-unit production costs to increase and the aggregate supply to reduce.a. Domestic Resource Availability

In order to decrease the per-unit production cost, there must be increase in the supply of domestic resources.

LandAn increase in the supply of land resources lowers the price of land inputs,

lowering per-unit production costs. e.g. Formerly, a farmer uses water from Maynilad for his farm. After two years, the farmer decided to undergo cost-cutting and dug a deep well and installed a watering system to his farm. From now on, he will not use water from Maynilad, instead from the water from the deep well.

LaborWages and salaries are part of per-unit production cost. Reduction of

wages and salaries will lower the cost of each unit. Increase has opposite effect. e.g. There are 10 skilled workers, who receives Php 10,000 each weekly in a factory, which can provide 1000 units of product every week. An analysis shows that 8 skilled workers, who will receive the same amount mentioned, and 4 semi-skilled, who will receive Php 8,000 each weekly, can

provide 1,700 units of product every week. The second option is more productive than the first option, wherein labor attributable to cost in first option is Php 100 per unit, unlike the second option, Php 65.88.

CapitalMore capital can expand the capability of creating more units. Quality of

capital also affects the per-unit production costs. e.g. State-of-the-art machinery is more efficient than sub-standard machine.

Entrepreneurial AbilityThe quantity of people who performs entrepreneurial ability influences the

aggregate supply. e.g. Mr. Dong is a business man who owns poultry farm. After three years, his business experience boom, encouraging Mr. Bong and Mr. Kong, his colleagues, to enter a business.

b. Prices of Imported Resources -If the price of imported resources decreases, there is more potential to widen the aggregate supply of the country. Increasing the price will just limit the ability to have more resources, hence lowering the aggregate supply.

c. Market Power -Market power is the ability to set a price above the price that would occur in a competitive situation. Changes in the degree of the market power or monopoly power held by sellers of resources can also affect the input prices and aggregate supply.

2. Changes in ProductivityProductivity, the second major determinant of aggregate supply, is a measure of the relationship between a nation’s level of real output and the amount of resources used to produce that output. Productivity is a measure of average real output or of real output at per unit of input:

THE BUSINESS CYCLE

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.2

1. PEAKBusiness activity has reached a temporary maximum. Here the economy is

near or at full employment and the level of real output is at or very close to the economy’s capacity. The price level is likely to rise during this phase.

2. RECESSIONIt is a period of decline in total output, income, employment, and trade.

This downturn, which lasts 6 months or more, is marked by the widespread contraction of business activity in many sectors of the economy. But because many prices are downwardly inflexible, the price level is likely to fall only if the recession is severe and prolonged—that is, only if a depression occurs.

3. TROUGH

2( http://en.wikipedia.org/wiki/Business_cycle)

In the trough of the recession or depression, output and employment “bottom out” at their lowest levels. The trough phase may be either short-lived or quite long.

4. RECOVERYIn the expansion or recovery phase, output and employment rise toward

full employment. As recovery intensifies, the price level may begin to rise before full employment and full-capacity production return.

Causation: A First Glance

Economists have suggested many theories to explain fluctuations in business activity.

Some say that momentous innovations, such as the railroad, the automobile, synthetic fibers, and microchips, have great impact on investment and consumption spending and therefore on output, employment, and the price level.

Some economists see major changes in productivity as causes of business cycles. When productivity expands, the economy booms; when productivity falls, the economy recedes. Most economists.

Most economists, however, believe that the immediate cause of cyclical changes in the levels of real output and employment is changes in the level of total spending.

Cyclical Impact: Durables and Nondurables

Firms and industries producing capital goods (housing, commercial buildings, heavy equipment, and farm implements) and consumer durables (automobiles, personal computers, refrigerators) are affected most by the business cycle. Within limits, firms can postpone the purchase of capital goods. As the economy recedes, producers frequently delay the purchase of new equipment and the construction of new plants.

When recession occurs and households must trim their budgets, purchases of these goods are often deferred. Families repair their old cars and appliances rather than buy new ones, and the firms producing these products suffer.

In contrast, service industries and industries that produce nondurable consumer goods are somewhat insulated from the most severe effects of recession. A recession actually helps some service firms, such as pawnbrokers and law firms that specialize in bankruptcies. Nor are the purchases of many nondurable goods such as food and clothing easy to postpone. The quantity

and quality of purchases of nondurables will decline, but not so much as will purchases of capital goods and consumer durables.

MEASURING ECONOMIC ACTIVITY AND ALL NATIONAL INCOME

The common basis of determining the economic performance of a country is by measuring its GNP. Most often, countries compare their GNP’s to know who is more progressive and prosperous. Also countries compare their present and past GNP to know if their economy progress. Some people mistook GNP and GDP as one but they are not.

What is the difference between GNP and GDP? GNP is the total income earned by the nation’s factors of production regardless of where it is located. It is the sum of GDP and Net Factor Income from Abroad. GDP can be defined in two ways: 1. it is the total expenditure on domestically-produced final goods and services and. 2. It is the total income earned by domestically-located factors of production. Why is expenditure equal to income? In every transaction, the buyer’s expense becomes the seller’s income. Thus, the sum of all expenditures is equal to the sum of all income.

The Three Approaches in getting GDP:

1. Expenditure Approach (Millions)

Personal Consumption Expenditure P5489Investment 1238Government Consumption Expenditure 1545Net Exports -97 GDP P8084

(The Four Expenditure Components will be discussed later… )

2. Income Approach (Millions)

Compensations of Employees P4703Rents 148Interests 450Proprietor’s Income 545Corporate Income Taxes 319Dividends 336

Undistributed Corporate Profits 149National Income P6650Indirect Business Taxes 545Consumption of Fixed Capital 868Net Foreign Factor Income earned in the Philippines 21GDP P8084

3. Industrial Origin Approach (Millions)

Agriculture, Fishery and Forestry P1208Industrial Sector

A. Mining and Quarrying P 48B. Manufacturing 1830C. Construction 489D. Electricity, Gas and Water 255 2622

Services SectorA. Transportation P 357B. Trade 1134C. Finance and Housing 2218D. Services 545 4254

GDP P8084

Income Approach Compensation of employees is the largest category of income which includes salaries and

wages paid by businesses and government and payment by employers into social insurances and private pension and health.

Rents are the income payment received by households. These are the monthly payment of renters to landlords and annual lease payment by corporate tenants for use of office.

Interests are income payments flowing from private businesses to suppliers of money capital.

Proprietor’s Income is the net income of sole proprietorship and partnership. Corporate Income cannot be described easily because it may be distributed in several

ways:1. It may be collected as Corporate Income Tax - a tax based on the income made by the

corporation.2. It may be distributed as Dividends - a portion of corporate profits paid out to

stockholders.3. It may be retained as Undistributed Corporate Profits – the retained profits will be

invested currently or in the future, in new property and equipment, increasing the real asset of the business doing the investing.

Three items added to National Income to balance the GDP of Income Approach and Expenditure Approach.1. Indirect Business taxes is treated as cost of production by firms and therefore added

to the price of product they sell. Examples of these are general sales taxes and property taxes.

2. Consumption of Fixed Capital involves depreciation – bookkeeping entry designed to yield a more accurate statement of profit and hence total income for a firm in each year. It is the allowance for capital goods consumed in producing the year’s adjustments.

3. Net Foreign Factor Income is the country’s citizen’s gain from supplying resources abroad and the income foreigner’s gain by supplying resources in the country.

Industrial Origin Approach is related to the income approach where sectors are classified according to the nature of production. This approach particularly used in the Philippines includes the income of the following sectors:

Primary Sector of an economy which includes agriculture, fishery, and forestry. Secondary Sector or the Industry Sector of an economy which includes mining and

quarrying, manufacturing, construction, electricity, water and gas. Tertiary Sector or the Service Sector of an economy which includes transportation,

communication and storage, trade, finance real estate and dwelling, private and government services.

There are related national accounts of equal importance which can be derived from GDP as the measure of an economy’s annual output.

1. Net Domestic Product (NDP) – it measures the total annual output which the entire economy (household, business, government and foreigners) can consume without impairing its capacity to produce in ensuing years. It is simply the GDP adjusted for depreciation. GDP has a defect: it fails to make allowance for replacing the capital goods used up in the year’s production and as a result it gives exaggerated value of the output available for consumption and for addition of new capital.

(Millions)GDP P8084Consumption of Fixed Capital 868NDP P7216

2. National Income is the total income of a country whether earned domestically or abroad. To derived National income from NDP we must:a. Subtract net foreign factor earned in the Philippines because we need to exclude the

factor income earned in the Philippines by foreigners and add the factor income earned by Filipinos abroad.

b. Subtract indirect business taxes because government contributes nothing directly to production in return for the tax revenues it receives. Government is not an economic resource. Indirect taxes are not part of payments to resource, and thus not part o national income.

(Millions)NDP P7216Net Foreign Factor income earned in the Philippines -21Indirect Business Taxes -545National Income P6650

3. Personal Income includes all income received whether earned or unearned. It is likely to differ from National Income because some income earned (social security contributions, corporate income taxes and undistributed corporate profits) is not actually received by households and some income received (transfer payments) are not currently earned.

(Millions)National Income P6650Social Security Contributions -732Corporate Income Taxes -319Undistributed Corporate Profits -149Transfer Payments 1424Personal Income P6874

4. Disposable Income is the income received after personal taxes or simply the personal income less personal taxes (personal income taxes, personal property taxes and inheritance taxes).

(Millions)Personal Income P6874Personal Taxes -987Disposable Income P5887

Disposable Income is the amount of income which households have to dispose as they see fit. Because economist define savings as that part of disposable income not spent on consumer goods it follows that households divide their Disposable Income between Consumption and Savings. Therefore:

Disposable Income = Consumption + Savings

CONSUMPTION AND INVESTMENT EXPENDITURES

 I. Consumption

  Consumption spending and saving both rise when disposable income increases; they fall when disposable income decreases.

A.     Income and Consumption

Disposable Income - Income actually available for spending is personal income less net taxes. The difference between disposable income and consumption is savings.

Consumer spending and disposable income move together over time. Consumer spending and disposable income increased nearly every year. The relationship between consumer spending and disposable income has remained

relatively stable

*In the 90s, we have spent about 92 percent of our disposable income, and saved about 8 percent. More recently consumers have in some months increased consumption faster than income resulting in a negative savings rate (higher debt accumulations).

The Consumption Function - The relationship between the level of income in an economy and the amount households plan to spend on consumption, other things constant.

Households look at their level of disposable income and decide how much to spend. So spending depends on disposable income.

The relationship between consumption spending and disposable income is captured by the slope of the consumption function.

The influences of other factors that are independent of income are captured by the intercept.

B.     Marginal Propensity to Consume and Save

  Economists use marginal analysis to the relationship between changes in disposable income and changes in consumption.

Marginal analysis seeks to answer questions like, "If U.S. households receive another billion dollars in disposable income, what will happen to consumption spending, what about savings?"

MPC = change in consumption divided by the change in disposable income MPS = change in consumption divided by the change in disposable income Since disposable income is either saved or consumer: MPC + MPS = 1 

C.     MPC, MPS, and the Slope of the Consumption and Saving Functions

The slope of the consumption function is the MPC. Because the slope of a line constant everywhere along the line, the MPC for any linear consumption function will be constant at all levels of income.

The slope of the saving function equals the MPS. It is also a positive fraction that represents a leakage rate from increases in household income in the circular flow of income. Because the slope of a line is the same everywhere on that line, the MPS for any linear savings function is constant for all levels of income.

D.    Non-income (Autonomous) Determinants of Consumption

Along the consumption function, consumption spending depends on the level of disposable income, other things constant. What factors are held constant, and how do they affect Consumption?

Net Wealth and Consumption

Net Wealth - The value of a household's assets minus its liabilities (debts owed).

(Assets - home, cars, furniture, savings accounts, checking accounts; Liabilities - student loans, car loans, mortgage, credit card balances) 

o An increase in net wealth makes a household more likely to spend and less likely to save at each level of disposable income.

o A decrease in net wealth makes a household less likely to spend and more likely to save at each level of disposable income.

**Example, a fall in stock prices. What happens to net wealth if the value of stock declines? It falls. Households that own stock have a decrease in net wealth and are likely to spend less and save more. The consumption function shifts down.

The Price Level

Some household wealth is held in dollar-denominated assets (bank accounts, cash).

When the price level changes, so does the real value of dollar-denominated assets. A falling price level increases the real value of dollar-denominated assets, thereby encouraging greater consumption for goods and services. A higher price level discourages consumption demand as it lowers the real value of the dollar.

The Interest Rate

Consumers make inter temporal decisions to consumer (or save) over their lifetime. Interest is the reward to savers for current saving. When graphing the consumption function, we assume a given interest rate.

If the current interest rate increases, savers will save more, borrow less, and spend less because it increases the opportunity cost of consumption. This, in turn causes the consumption function to shift downward. Lower current interest rates increase consumption and lower savings.

Expectations

Expectations about future prices can also affect current consumption. Higher expected prices for real assets can increase current consumption. Higher expected prices of financial assets can lower consumption. (Remember that “investing” in financial assets is savings.)

Example: If people grow more concerned about job security and future expected income, they will reduce their consumption spending at all levels of disposable income. An expected tax cut that is viewed as permanent could increase current consumption. 

II.             Investment

Gross Private Domestic Investment is spending in three categories:

1.      New factories and new equipment, such as buildings or computers2.      New housing3.      Net increases in inventories

A.     The Demand for Investment

Firms buy capital goods now in the expectation of a future return.

Expected Rate of Return: the annual dollar earnings expected from the investment divided by the purchase price.

B. Investment Demand for the Economy

The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market rate of interest, other things equal.

Business expectations are held constant along this curve. If businesses become more optimistic, the demand for investment increases, and the entire curve shifts to the right.

The price of capital goods is also held constant. If capacity constraints increase the cost of equipment, then less investment will occur at every interest rate because the marginal efficiency of investment decreases.

Falling prices of capital goods (computers) increases the volume of investment.

C. Planned investment and the Economy’s Level of Income

Unlike consumption, investment depends more on interest rates and on business expectations than on level of income.

Investment Function – The relationship between the amount businesses plan to invest and the level of income in the economy, other things constant.

The simplest investment function assumes that planned investment is autonomous investment is independent of level of income.

E. The Autonomous Investment Function (Non-income Determinants of Investment)

The Market Interest Rate Business Expectations

(http://business.baylor.edu/Tom_Kelly/2307ch9.htm)

Government Spending or Purchases

Government purchases are any type of purchase activity that takes place between a municipal, state, or national government entity. While the main focus of these types of purchases are to supply the government with goods and services needed for efficient operation, this approach can also be utilized to stimulate activity within a given sector of the economy. By doing so, the government is able to minimize the general damage that a decline in that particular industry would have on the general economy, often by preventing job losses in both the targeted industry and industries that are dependent on that target. These are one of four expenditures on gross domestic product. The other three are consumption expenditures, investment expenditures, and net exports.

Government purchases are used to operate the government (administrative salaries, etc.) and to provide public goods (national defense, highways, etc.). Government purchases do not include other government spending for transfer payments (e.g, unemployment insurance payments) because they do not present spending on goods and services.

The primary purpose of government spending is to perform the functions that society has relegated to the government sector. Some of those functions involve the purchase of goods and services, others do not. This suggests a distinction between two related terms government expenditures and government purchases. A third related term is the official government measure of government purchases--government consumption expenditures and gross investment.

Government Expenditures: This is the term for ALL spending by the government sector. It includes spending for the purchase of goods and services which falls under the title of government purchases. It also includes expenditures that are NOT for goods and services, which are termed transfer payments.

Government Purchases: This is the specific term referring to actual expenditures on final goods and services, or gross domestic product, by the government sector. It specifically excludes transfer payments.

Government Consumption Expenditures and Gross Investment: This is the official measure of the government purchases component of aggregate expenditures used in the calculation of gross domestic product This term reflects the fact that the government sector purchases both consumption goods and capital goods.

Government purchases determinants

Government purchases determinants affect the government purchases line much like any determinants affect a corresponding curve--they cause the curve to shift.

Increase in Government Purchases: An increase in government purchases is illustrated by an upward shift of the government purchases line. At each income and production level, the government sector undertakes greater government purchases.

Decrease in Government Purchases: A decrease in government purchases is illustrated by a downward shift of the government purchases line. At each income and production level, the government sector undertakes fewer government purchases.

While government entities like Shady Valley city commission are bound to encounter a wide range of specific non-income factors affecting their own government spending (including floods and earthquakes), determinants affecting overall government purchases by the government sector tend to fall into a limited number of categories. Some of the more important determinants are:

Fiscal Policy: At the federal level, the desire to counter instability caused by other expenditures though fiscal policy is always a possibility. If aggregate expenditures decrease because of less spending from the household or business sectors, then the government sector is often inclined to spend more. Doing so increases government purchases and thus causes the government purchases line to shift upward. Alternatively, if aggregate expenditures have increased from extra consumption and investment to the point of triggering inflation, then the government is likely to decrease government purchases which thus cause the government purchases line to shift downward.

Politics: Political considerations are always bubbling near the surface of government activity. Perhaps the political winds start to blow in the direction of reducing the federal deficit or limiting government funded social programs. Such a force could decrease government purchases and result in a downward shift of the government purchases line. Or perhaps a number of rather vocal and financially powerful interest groups convince political leaders to spend more on worthy activities, like the space program, national defense, or environmental quality. This shift in the political winds is bound to increase government purchases and lead to an upward shift of the aggregate expenditures line.

Net Exports

The difference between exports, goods and services produced by the domestic economy and purchased by the foreign sector, and imports, goods and services produced by the foreign sector and purchased by the domestic economy. While exports and imports important unto themselves, when combined into a single measure net exports captures the overall interaction between the foreign sector and the domestic economy. Arithmetically speaking, if exports exceed imports, then net exports are positive, and if imports exceed exports, the net exports are negative.

In other words, net exports is the amount by which foreign spending on a home country's goods and services exceeds the home country's spending on foreign goods and services. For example, if foreigners buy 200 billion worth of Philippine exports and Filipinos buy 150 billion worth of foreign imports in a given year, net exports would be positive 50 billion. Factors affecting net exports include prosperity abroad, tariffs and exchange rates.

Prosperity Abroad: a rising level of real output and thus income among a nation’s foreign trading partners permits it to sell more goods abroad, thus rising its net exports and increasing its real GDP.Tariffs: Taxes that are usually on imports, but occasionally (very rarely) on exports. This is one form of trade barrier that's intended to restrict imports into a country, which means to increase production in their own countries.

Exchange Rates:  One of several specific aggregate expenditures determinants assumed constant when the aggregate expenditures line is constructed, and that shifts the aggregate expenditures line when it changes. An increase in the exchanges rates causes an increase (upward shift) of the aggregate expenditures line. A decrease in the exchanges rates causes a decrease (downward shift) of the aggregate expenditures line. 

Definition of terms from

(http://www.amosweb.com)

Multiplier Model

History

The tableau économique (Economic Table) of François Quesnay (1759), which lay the foundation of the Physiocrats economic theory, is credited as the "first precise formulation" of interdependent systems in economics and the origin of multiplier theory. In the tableau économique, one sees variables in one period (time t) feeding into variables in the next period (time t+1), and a constant rate of flow yields geometric series, which computes a multiplier. The modern theory of the multiplier was developed in the 1930s, by Kahn, Keynes, Giblin, and others, following earlier work in the 1890s by the Australian economist Alfred De Lissa, the Danish economist Julius Wulff, and the German-American economist N. A. J. L. Johannsen.

Multiplier

It is a factor of proportionality that measures how much a variable changes in response to a change in some other variable. Suppose a one-unit change in some variable x causes another variable y to change by M units. Then the multiplier is M.

Example: Variable x increases in to 6 which causes variable y to change to 2 and results to a multiplier of 3 by dividing the variable x by y.

Multiplier Effect

Multiplier effect happens when there is a change in a component of initial expenditures which causes the equilibrium GDP to also change. Equilibrium exists whenever the

level of output (income) is equal to total spending, (Y=A). There are two factors that could influence total spending and change this equilibrium which are the spending(investment) of firms and consumption of households. As the firms invests it will use up some factors such as labor and other resources from households. Since these factors are owned by the households their income will also increase. An increase in household income also increases the spending consumption. But take note that not the entire amount of the income earned are spent for consumption. A shift in the saving and consumption schedules causes the equilibrium output and income level to change by more than the amount of the initial change . By getting the percentage of the amount of consumption from the total income we can use the formula where ΔC is the change in consumption, and ΔY is the change in income that produced the consumption. The remaining amount of income will now go to savings which we can compute the percentage by where is the change in savings, and is the change in income. The figure below (Circular Flow Model) shows how the multiplier effect works:

MPC (Marginal Propensity To Consume) is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers). MPS (Marginal Propensity To Save), on the other hand, refers to the increase in saving (non-purchase of current goods and services) that results from an increase in income. The amount of an increase in income saved determines the cumulative respending effects of any initial change in investing and therefore determines the multiplier. The MPS and the multiplier are inversely related. We can summarize it by saying the multiplier is equal to the reciprocal of the MPS. The reciprocal of any number is the qoutient obtained by dividing 1 by that number:

Multiplier = 1/MPS or Multiplier = 1/1-MPC

The multiplier is equal to the reciprocal of the marginal propensity to save: The higher the MPS, the lower the multiplier. Also the lower the MPS, the higher the multiplier.

By using this multiplier we can now get the Total Change in GDP by multiplying the multiplier to the Total Change of Investment:

 ΔGDP = Multiplier x  ΔInvestment

From the information given on the circular flow model, as the firm invests 100M, the households receive the same amount of 100M because the resources that the firm uses for investing comes from the households such as labor, rents, etc. The amount of income that the household received will increase their spending for goods and services from the firm. But take

Circular Flow Model

note that this amount is only a part of the income received because households also tend to save the remainder for future use. From the diagrahm above, the household spent 80M for goods and services which indicates an MPC of 0.8 by dividing the the 80M by 100M. We can also get the MPC of 0.2 by dividing the the remaining amount of the income which is 20M by 100M. As the households increase their spending by 80M the firm also increases their production by the same amount to keep up with the demand. The increase in production will also increase the the households income by 80M and from this amount the household spend 80%(MPC) which is 64M and save 16M (0.2 x 80M). The firm will then increase the production by 64M to keep up with the demand and the process continues. And this is what the multiplier effect means, the cycle of round after round further consumption spending which is the indirect result of just one investment done by the firm. But the question is, does this multiplier effect happens indefinitely? The answer is no because the spending of households gets smaller and smaller with each cycle because they spend only a portion of the increase in income they earned and the rest goes to their savings. This saving represents as leakage from the circular flow model at the rate of 20% (MPC) and it accumulates until it reaches the same amount as the initial investment. And from the formula of multiplier we can now get the multiplier of 5.

Solution:

Multiplier = 1/MPS = 1/0.2 = 5

Therefore, for every peso increase in investment/spending the equilibrium income/GDP

increases by 5. The change in equilibrium level of income is therefore the multiplier times change in investment ( ΔGDP = Multiplier x  ΔInvestment).

Solution:

ΔGDP = Multiplier x  Δinvestment=5 x 100M=500M

The increase of total equilibrium GDP of 500M is equal to 100M, total investment plus 400M, total consumption spending. And the savings accumulate to 100M which is 20% of the total change in equilibrium level of income/GDP:

ΔGDP =C + I Savings = ΔGDP x MPS=400M + 100M = 500M x 0.2=500M = 100M

Therefore, Savings = Initial Investment