04. Consumption, Investment, and Saving

Consumption Function

The relationship between consumption and income

Marginal Propensity to Consume (MPC)

The fraction of a change in income that is spent on consumption; the change in consumption divided by the change in income that caused it

Saving Function

The relationship between saving and income

Marginal Propensity to Save (MPS)

The fraction of a change in income that is saved; the change in income that caused it

Net Wealth

The value of assets minus the value of liabilities

Life Cycle Model of Consumption and Saving

Young people borrow, middle-agers pay off debts and save, and older people spend their savings; on average, net savings over a lifetime are small

Investment Function

The relationship between the amount of businesses plan to invest and the economy’s income

Autonomous

“independent“; autonomous investment is independent of income

Government Purchase Function

The relationship between government purchases and the economy’s income

Net Exports

The relationship between net exports and the economy’s income

Aggregate Supply

The relationship between the economy’s price level and the amount og output firms are willing and able to supply; Labor is the most important resource, accounting for about 70% of production costs

Nominal Wages

The wage measured in dollars of the year in question: the dollar amount on a paycheck

Real Wage

The wage is measured in dollars of constant purchasing power; the wage is measured in terms of the quantity of goods and services it buys

Potential Output

The economy’s maximum sustainable output, given the supply of resources, technology, and know-how, and rules of the game; the output level when there are no surprises about the price level

Natural rate of Unemployment

The unemployment rate when the economy produces its potential output

Short Run

In macroeconomics, a period during which some resource prices, especially those for labor, remain fixed by explicit or implicit agreements

Short-Run Aggregate Supply (SRAS) Curve

A curve that shows a direct relationship between the actual price level and real GDP supplied in the short run (o.t.c), including the expected price level

Short-Run Equilibrium

The price level and real GDP that result when the aggregate demand curve intersects the short-run aggregate supply curve

Expansionary Gap

The amount by which actual output in the short run exceeds the economy’s potential output

Long Run

In macroeconomics, a period during which wage contracts and resource price agreements can be renegotiated; there are no surprises about the economy’s actual price level

Long-Run Equilibrium

The price level and real GDP that occur when:

• The actual pierce level equals the expected price level

• Real GDP supplied equals potential output

• Real GDO supplied equals real GDP demanded

Recessionary (Contractionary) Gap

A vertical line at the economy’s potential output; aggregate supply when there are no surprises about the price level and all resource contracts can be negotiated

Supply Shocks

Unexpected events that affect aggregate supply, sometimes only temporarily

Beneficial Supply Shocks

Unexpected events that increase aggregate supply, sometimes only temporarily

Adverse Supply Shocks

Unexpected events that reduce aggregate supply, sometimes only temporarily

Hysteresis

The theory that the natural rate of unemployment depends in part on the recent history of unemployment; a long period of high unemployment can increase the natural rate of unemployment

Discretionary Fiscal Policy

Deliberate manipulation of government purchases, taxation, and transfer payments to promote macroeconomic goals, such as full employment, price stability, and economic growth

Simple Tax Multiplier

The ratio of a change in real GDP demanded to the initial change in autonomous next taxes that brought it about; the numerical value of the simple tax multiplier is: MPC / (1 - MPC)

Expansionary Fiscal Policy

An increase in government purchases, a decrease in net taxes, or some combination of the two aimed at increasing aggregate demand enough to return the economy to its potential output, thereby reducing unemployment, policy used to close a contractionary gap

Contractionary Fiscal Policy

A decrease in government purchases, an increase in net taxes, or some combination of the two aimed at reducing aggregate demand enough to return the economy to potential output without worsening inflation; policy used to close an expansionary gap

Classical Economists

A group of 18th and 19th-century economists who believed that economic downturns were short-run phenomena that corrected themselves through natural market forces; thus, they believed the economy was self-correcting and needed no government intervention

Overall Impact of Fiscal Policy

Don’t worry about a balanced budget, promote full employment and price stability

Automatic Stabilizers

Smooth out fluctuations in disposable income over the business cycle, thereby stimulating aggregate demand during recessions and dampening aggregate demand during expansions; Structural features of government spending and taxation that reduce fluctuations in disposable income and thus consumption over the business cycle

Progressive Income Tax

A system where the tax rate increases as a persons income risesperson’s

Unemployment Insurance

During economic expansion, the system automatically increases the flow of unemployment insurance taxes from the income stream into the unemployment insurance fund, moderating aggregate demand

Discretionary Fiscal Policy

A demand management policy; the objective is to increase or decrease aggregate demand to smooth economic fluctuation

1970s: Stagflation

• High unemployment

• High inflation resulting from a decrease in aggregate supply (crop failures, oil shocks, and war costs)

• Demand management policies weren't working

1980s: The Supply Side Experiment

• 23% tax cut

• Government spending (7.1% to 6.3%)

• The stimulus from the tax cut helped sustain a continued expansion during the 1980s, the longest peacetime expansion to that point in the nation's history

• The national debt strongly increased

1990s: Discretionary Fiscal Policy and Presidential Election

• President Clinton - 1993: substantially increased taxes on high-income households

• Republican Congress - 1994: more discipline on federal spending

• Economy recovered: growing consumer spending, rising business optimism (tech, globalization, and the bull market)

• By early 2001, the economy was in a recession

  • Compounded by 9/11

Post 9/11

Within several months, President Bush proposed a tax cut to help stimulate the economy (A gamble, which helped get the economy back during 2002)

2000s

• Tremendous deficit began to grow

• War on Terror - Afghanistan and Iraq

• Loss of jobs in the American economy: Jobless recovery 2004-07

• Early 2008: $600 stimulus checks were issued in an attempt to stimulate the economy; checks worked, and money was channeled back into the economy

2008

• Lehman Brothers and Bear Stearns failed (investment banks); JP Morgan acquired Bear Stearns for cheap.

• In late summer, subprime loans-tied to Freddie Mack and Fanny May, AIG, and numerous banks began to fail along with those institutions.

  • Ramifications wereworldwide

• JP Morgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley were all famously “too big to fail”

  • Took the bailout money, repaid the government, and emerged bigger after the recession

• The President and the U.S. Congress put together a $700b ballout plan for some of these institutions 

  • Essentially, making the government more of an “owner” of numerous financial institutions in America

American Rescue Plan (2021)

$1.9 Trillion stimulus package passed to bolster economic recovery

Infrastructure Investment and Jobs Act (2021)

$1.2 Trillion investment in roads, bridges, and broadband

Inflation Reduction Act (2022)

Focused on clean energy investment, healthcare costs (including capping insulin prices), and corporate tax changes; $3.6 Billion

CHIPS and Science Act (2022)

Boosted domestic semiconductor manufacturing; $280 billion

Record Job Growth & Low Unemployment

Over 16 million jobs added, with unemployment dipping below 4% for the longest period since the 1950s

High Inflation

Consumer prices rose rapidly, peaking at 9.1% in June 2022 before cooling in 2023-24

Record Stock Market

The stock market reached numerous record highs during the term