Graph 9 - Investment Demand

i - Interest = cost of doing.

Reasons to borrow money:

_ Business

_ Mortgage

_ Education 

Unit 3 - Feb 26 (Interest Rate vs. Investment Rate)

Investment - money spent or expenditure on:

• New plans (factories)
• Capital equipment (machinery)
• Technology (hardware/software)
• New homes
• Inventories (goods sold by producers)

Expected Rate of Return

• How does business make investment decision?
• Cost/benefit analysis.
• How does business determine the benefits?
• Expected rate of return.
• How does business count the cost?
• Interest cost.
•  How does business determine the amount of investment they undertake?
• Compare expected rate of return to interest cost.
• Expected cost > interest cost, then invest.
• Expected cost < interest cost, then don't invest.

Real (r %) vs. Nominal (n %)

• Differences?
• Nominal - observable rate of interest.
• Real - subtracts out inflation(π %) and is only known ex post facto.
• Real interest rate (r %)
• r % = i % - π %
• What determine the cost of investment decision?
• The real interest rate (r %).

Investment Demand Curve (ID)

• Downward sloping.
• Why?
• When interest rate is high, fewer investments are profitable.
• When interest rate is low, more investments are profitable.
• Determinants
1. Cost of production
2. Business tax
3. Technological changes
4. Stock of capital
5. Expectation

Graph 8 - Consumption and Savings Link

C_{2 - consumption increase at every level of DI.}

_{The poor and rich are spending more.}

DI = Consumption + Saving

If C increase, then S decrease.

MPC + MPS = 1

Graph 7 - Savings Function

Graph 6 - Consumption Function

Unit 3 - Feb 25 (Classical vs. Keynesian)

Unit 3 - Feb 24 (Consumption & Saving)

Disposable Income - amount of money after taxes/net incomes.
 _ DI = gross income -taxes.
 _ 2 Choices : Spending/Consumption and Saving.

Consumption - household spending.

• The ability to consume is constrained by:
• the amount of DI.
• the propensity to save.
• Do household consume if DI = 0?
• autonomous consumption
• dis-saving
• APC = (C / DI) = DI that is spent.

Saving - household not spending.

• The ability to save is constrained by:
• the amount of DI.
• the propensity to consume.
• Do household consume if DI = 0?
• No
• APS = (S / DI) = DI that is not spent.

APS & APC 

_ APS + APC = 1
_ 1 - APS = APC 
_ 1 - APC = APS 
_ APC > 1 .: Dissaving

_ APS .: Dissaving

MPC & MPS

• Marginal propensity to consume.
• change in C / change in DI
• % of every extra dollars earned that is spent.
• Marginal propensity to save.
• change in in S / change in in DI
• % of every extra dollar earned that is saved.
• MPC + MPS = 1
• 1- MPC = MPS
• 1- MPS = MPC

Determinants of Consumption and Saving
 _ wealth
 _ expectations
 _ household debts
 _ taxes

Spending multiplier effect - an initial change in spending (C, Ig, G, Xn) causes a larger change in AD.

• Multiplier: change in AD/change in spending.
• Multiplier: change in AD/change in C, Xn, G, Ig.

 _ Why does this happen?
    . expenditures and income glow continuously which sets off a spending increase in the economy

Calculating the spending multiplier
 _ Multiplier: 1 / 1-MPC
 _ Multiplier: 1 / MPS
    . multipliers are (+) when there is an increase in spending & (-) when there is a decrease

Calculating the tax multiplier
 _ -MPC / 1 - MPC
 _ -MPC / MPS
 Tax cut - the multiplier is positive because there is now more money in the circular flow.
Works in reverse because now money is leaving the circular flow.

Ex: Assume US citizens spend 90 cents got every extra dollar they earn. Further assume that the real interest rate decreases causing a 50 billion dollar increase in gross private investment.
Step 1.) MPC : 0.9 /1= 0.9 ; MPS : 1- 0.9 = 0.1
Step 2.) Determine the multiplier: Spending multiplier (Spend .90)
Step 3.) Calculate multiplier: 1/0.1= 10
Step 4.) Change in AD: 50(10) = $500 billion.

Ex: Assume Germany raises taxes on it citizens by 200 billion. Furthermore, assume that Germans safe 25% of the change in DI.
Step 1.)MPC : 0.25 ; MPS : 0.75
Step 2.) Determine the multiplier: Tax multiplier
Step 3.) Calculate multiplier: -0.75/0.25=-3
Step 4.) Change in AD: 200(-3) = 600 billion