Chapters 10 & 11 Aggregate Expenditures. Short Run Macro Model -- John Maynard Keyenes’ model explaining how changes in spending affects real GDP (spending

Chapters 10 & 11

Aggregate ExpendituresAggregate Expenditures

Short Run Macro ModelShort Run Macro Model

-- John Maynard Keyenes’ model explaining -- John Maynard Keyenes’ model explaining how changes in spending affects real how changes in spending affects real GDP (spending affects business GDP (spending affects business fluctuations)fluctuations)

-- The short run is devoted to analyzing -- The short run is devoted to analyzing business fluctuationsbusiness fluctuations

-- Assumption is that spending is the only -- Assumption is that spending is the only variable influencing real GDP (all others variable influencing real GDP (all others held constant)held constant)

Planned Aggregate Expenditure Model

Planned Aggregate Expenditure (PAE)

-- total amount of planned spending in the economy

Planned Aggregate Expenditure Model

-- model defining the relationship between total planned spending and real GDP (price level held constant)

-- used to explain business fluctuations

-- shows that real GDP is determined by planned aggregate expenditures

4 categories of Planned Aggregate Expenditure

1) Consumption (C) 3) Gov’t Purchases

2) Planned Investment (IP) 4) Net Exports (Xn)

PAE = C + IP + G + Xn

Macroeconomic Equilibrium

-- When Planned Aggregate Expenditure = GDP

(total planned spending) (total output)

Other Scenarios

1) When planned aggregate expenditure > GDP

-- typically results in decrease in inventories and increase in GDP and employment (surge in sales causes an increase in production inc in employment)

2) When planned aggregate expenditure < GDP

-- typically results in increase in inventories and decrease in GDP and employment (drop in sales causes excess inventories leading to less production and unemployment)

Components of Planned Aggregate ExpenditureComponents of Planned Aggregate Expenditure

I] Consumption SpendingI] Consumption Spending

-- largest component-- largest component

Variables influencing consumption spendingVariables influencing consumption spending

1) Disposable Income (Y1) Disposable Income (YDD))

-- main determinant-- main determinant

YYDD = Income + Transfer Payments – Taxes = Income + Transfer Payments – Taxes

-- as Y-- as YDD ↑, consumption spending ↑↑, consumption spending ↑

-- as Y-- as YDD ↓, consumption spending ↓↓, consumption spending ↓

2) Price Level 2) Price Level

-- increase in price level causes consumption -- increase in price level causes consumption ↓↓

-- decrease in price level causes consumption ↑-- decrease in price level causes consumption ↑

Variables influencing consumption spending, cont.Variables influencing consumption spending, cont.

3) Interest Rate (r)3) Interest Rate (r)

-- as r -- as r ↑, consumption spending ↓ (people are more willing to ↑, consumption spending ↓ (people are more willing to save)save)

-- as r -- as r ↓, consumption spending ↑↓, consumption spending ↑

-- interest rate has a larger effect on durable goods-- interest rate has a larger effect on durable goods

4) Wealth4) Wealth

Wealth = Assets - LiabilitiesWealth = Assets - Liabilities

-- as wealth -- as wealth ↑, consumption spending ↑↑, consumption spending ↑

-- -- as wealth as wealth ↓, consumption spending ↓↓, consumption spending ↓

55) Expectations about Futures) Expectations about Futures

-- Optimistic about future earnings-- Optimistic about future earnings, consumption spending ↑ , consumption spending ↑

-- Concerned about future earnings, consumption spending -- Concerned about future earnings, consumption spending ↓↓

Consumption Spending and Disposable IncomeConsumption Spending and Disposable Income

-- close relationship between consumption and -- close relationship between consumption and disposable incomedisposable income

Consumption FunctionConsumption Function

-- a positive linear relationship between consumption -- a positive linear relationship between consumption spending and disposable incomespending and disposable income

PointPoint Real Disposable Real Disposable Income (YIncome (YDD) in ) in

billions $billions $

Real Consumption Real Consumption Spending (C) in Spending (C) in billions $billions $

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Real Disposable Income (in billions)

Real Consumption (In billions)

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Equation of Consumption FunctionEquation of Consumption Function

C = a + bYC = a + bYD D where a = C interceptwhere a = C intercept

b = slopeb = slope

2 Important Characteristics2 Important Characteristics1) Intercept1) Intercept

-- level of consumption where Y-- level of consumption where YDD (disposable (disposable income) = 0 or pt Aincome) = 0 or pt A

-- known as autonomous consumption spending -- known as autonomous consumption spending -- amount of consumption spending independent of -- amount of consumption spending independent of disposable incomedisposable income

-- includes items such as wealth and interest -- includes items such as wealth and interest rates rates (those other items affecting consumption)(those other items affecting consumption)

-- changes in autonomous consumption causes -- changes in autonomous consumption causes parallel shifts in the consumption function (i.e. parallel shifts in the consumption function (i.e.

slope slope remains the same)remains the same)

2) Slope2) Slope-- slope is rise/run or slope = -- slope is rise/run or slope = ∆C/∆Y∆C/∆YDD

-- since consumption function is linear, slope is constant-- since consumption function is linear, slope is constant

Finding slope:Finding slope:Pt C Pt C Y YD D = 200 C = 180 Pt D = 200 C = 180 Pt D Y YD D = 300 C = 250= 300 C = 250

-- slope of consumption function is known as Marginal -- slope of consumption function is known as Marginal Propensity to Consume (MPC)Propensity to Consume (MPC)

MPC = MPC =

InterpretationInterpretation-- amount by which consumption spending ↑ for every $1 -- amount by which consumption spending ↑ for every $1 increase in disposable income (consumption spending increase in disposable income (consumption spending increases by $ for every $ increase in disposable increases by $ for every $ increase in disposable income)income)

-- 0 < MPC < 1-- 0 < MPC < 1as disposable income as disposable income ↑, consumption ↑ but ↑, consumption ↑ but

consumers consumers will not spend entire increase in incomewill not spend entire increase in income

Restating Equation to find ∆C as Income ChangesRestating Equation to find ∆C as Income Changes

∆ ∆C = MPC * ∆YC = MPC * ∆YDD

Example: If MPC = .75 and ∆YExample: If MPC = .75 and ∆YDD is $5 billion, find ∆C is $5 billion, find ∆C

∆∆C = C = ∆∆C =C =

Interpretation: a $ billion increase in income will Interpretation: a $ billion increase in income will cause consumption to increase by $ billion.cause consumption to increase by $ billion.

Consumption and National Income (Y)Consumption and National Income (Y)

-- Rewriting relationship between consumption and -- Rewriting relationship between consumption and disposable income to show relationship between disposable income to show relationship between national income and consumptionnational income and consumption

YYDD = Y – Net Taxes = Y – Net Taxes

where Net taxes = Taxes – Transfer where Net taxes = Taxes – Transfer PaymentsPayments

Y = National Income = GDPY = National Income = GDP

then Y = GDP = Ythen Y = GDP = YD D + Net taxes + Net taxes

Assumption: Taxes are a fixed amountAssumption: Taxes are a fixed amount

Real National Real National Income or Real Income or Real GDP (billions $)GDP (billions $)

Net Taxes Net Taxes (billions $)(billions $)

Real Disposable Real Disposable Income (YIncome (YDD) in ) in

billions $billions $

Real Real Consumption Consumption Spending (C) in Spending (C) in billions $billions $

$$ $$ $$ $$

Consumption Income Line

-- A line showing consumption spending at each level of national income (Y) or GDP

Real National Income (in billions)


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Consumption-Income Line

Unique CharacteristicSlope of Consumption Line and Consumption Function are Slope of Consumption Line and Consumption Function are

the samethe same-- slope is unaffected by changes in taxes (parallel -- slope is unaffected by changes in taxes (parallel

curves)curves)-- occurs only when taxes are fixed-- occurs only when taxes are fixed

-- Since slope of consumption function = MPC = ∆C/∆Y-- Since slope of consumption function = MPC = ∆C/∆YD, D,

and slope of consumption lines = slope of and slope of consumption lines = slope of consumption function, MPC can also be written as consumption function, MPC can also be written as ∆C/∆Y. Essentially then the change in disposable ∆C/∆Y. Essentially then the change in disposable income is the same as the change in national income is the same as the change in national income.income.

∆ ∆Y = 100 ∆C = 70 same as ∆YY = 100 ∆C = 70 same as ∆YDD = 100 ∆C = 70 = 100 ∆C = 70

Slope = 70/100 or .7Slope = 70/100 or .7

Real Income (in billions)


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Consumption-Function

Movement Along the Consumption-Income Line-- If income ↑, and taxes remained unchanged,

consumption spending ↑

Influence of ∆ Taxes on Consumption-Income Line-- If taxes ↓ Disposable Income ↑ causing

consumption at every income level to ↑, causing consumption-income line to shift upward.

Note: Consumption changes by MPC x ∆T at any Note: Consumption changes by MPC x ∆T at any income income levellevel

Example: If taxes decrease by $10 billion, at income Example: If taxes decrease by $10 billion, at income level level of $250 billion, curve will shift upward to a point of $250 billion, curve will shift upward to a point where where consumption would change by .7 x 10 or $7 billion to consumption would change by .7 x 10 or $7 billion to $187 $187 billion.billion.

National Income (in billions)

Consumption (In billions)

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Consumption-Income Line’


II] Planned Investment Spending (III] Planned Investment Spending (IPP))

-- Business purchase of plant and equipment and -- Business purchase of plant and equipment and household purchases of new home constructionhousehold purchases of new home construction

-- Excludes inventories because they are typically -- Excludes inventories because they are typically unplanned unplanned therein lies the distinction between therein lies the distinction between actual vs. planned inventoriesactual vs. planned inventories

a) actual investment > planned investment when there a) actual investment > planned investment when there is an unplanned increase in inventoriesis an unplanned increase in inventories

b) actual investment < planned investment when there b) actual investment < planned investment when there is an unplanned decrease in inventoriesis an unplanned decrease in inventories

c) actual investment = planned investment when there c) actual investment = planned investment when there is no planned change in inventoriesis no planned change in inventories

Variables Determining Level of InvestmentVariables Determining Level of Investment

1)1) Expectations of Future ProfitsExpectations of Future Profits

-- machinery, buildings and other big purchase items -- machinery, buildings and other big purchase items involve much planning and make up a big part of involve much planning and make up a big part of capital expenditures thus future state of the economy capital expenditures thus future state of the economy has a big influence on firm’s decisionhas a big influence on firm’s decision

Pending Recession Pending Recession postpone buying postpone buying investment investment goodsgoods

Pending Expansion Pending Expansion buy or move forward with buy or move forward with purchase of investment goodspurchase of investment goods

Variables Determining Level of Investment, cont.Variables Determining Level of Investment, cont.

2) Interest rate2) Interest rate

-- Borrowing or financing remains a viable option as a -- Borrowing or financing remains a viable option as a means to gain the funds for purchasing investment means to gain the funds for purchasing investment goods; therefore, the interest rate remains a key goods; therefore, the interest rate remains a key variable in this decision.variable in this decision.

-- spans not only businesses but households (new -- spans not only businesses but households (new home construction)home construction)

-- the higher the interest rate, the less motivated firms -- the higher the interest rate, the less motivated firms are to borrow or finance for purchase of investment are to borrow or finance for purchase of investment goodsgoods


3) Taxes3) Taxes

-- Federal Gov’t imposes taxes on profits of firms. -- Federal Gov’t imposes taxes on profits of firms.

a) Corporate Income Taxa) Corporate Income Tax

-- A decrease in the corporate income tax increases -- A decrease in the corporate income tax increases the after tax profitability of investment spending the after tax profitability of investment spending making investment spending attractivemaking investment spending attractive

-- An increase in the corporate income tax reduces the -- An increase in the corporate income tax reduces the after tax profitability making of investment after tax profitability making of investment

spending spending making investment spending less making investment spending less attractiveattractive

b) Investment Tax Incentivesb) Investment Tax Incentives

-- Provides firms with a tax reduction for monies -- Provides firms with a tax reduction for monies spent on investmentsspent on investments

---- Provides addt’l incentive to engage in Provides addt’l incentive to engage in investment investment spendingspending


4) Cash Flow (Cash Revenue Received – Cash Spending)4) Cash Flow (Cash Revenue Received – Cash Spending)

-- Firms may decide to use their own cash to fund -- Firms may decide to use their own cash to fund investment spendinginvestment spending

-- Cash flow is the amount of money on hand to make -- Cash flow is the amount of money on hand to make these particular purchasesthese particular purchases

-- In expansionary periods, firms experience more -- In expansionary periods, firms experience more profitability hence greater cash flow than in profitability hence greater cash flow than in recessionary periods. The increased cash flow makes recessionary periods. The increased cash flow makes investment spending an attractive option in the investment spending an attractive option in the booming periods.booming periods.


III] Government PurchasesIII] Government Purchases

-- Spending by Federal, State and Local Gov’t-- Spending by Federal, State and Local Gov’t

IV] Net ExportsIV] Net Exports

-- Net Exports = TTL Exports – TTL Imports-- Net Exports = TTL Exports – TTL Imports

Net Exports are influenced by the following:Net Exports are influenced by the following:

1) Price level in U.S. vs Price Level in Other Countries1) Price level in U.S. vs Price Level in Other Countries

-- when inflation rate is lower in U.S. vs other nations -- when inflation rate is lower in U.S. vs other nations prices of U.S. goods are increasing slower than prices of U.S. goods are increasing slower than that of other countries making U.S. goods more that of other countries making U.S. goods more attractive. Boosts exports while reducing imports attractive. Boosts exports while reducing imports (causing net exports to (causing net exports to ↑)↑)

2) Growth rate of GDP in U.S. vs other countries2) Growth rate of GDP in U.S. vs other countries

-- when incomes in U.S. increase faster than other -- when incomes in U.S. increase faster than other countries countries U.S. consumers’ purchase of foreign U.S. consumers’ purchase of foreign goods will be greater than that of foreign consumers’ goods will be greater than that of foreign consumers’ purchase of U.S. goods. Leads to purchase of U.S. goods. Leads to ↓ in net exports ↓ in net exports since exports since exports ↓↓ and imports and imports ↑↑

3) Exchange Rate: As the value of the dollar 3) Exchange Rate: As the value of the dollar increases, foreign currency price of U.S. goods in increases, foreign currency price of U.S. goods in other countries increase & dollar price of foreign other countries increase & dollar price of foreign products sold in U.S. drops causing ↑ in imports and ↓ products sold in U.S. drops causing ↑ in imports and ↓ in exports causing net exports to fallin exports causing net exports to fall

Example:Example:Euro (Euro (€)€) and U.S. dollar exchange rate is .64 and U.S. dollar exchange rate is .64 Euros = $1.00Euros = $1.00Product that is $1.00 in U.S. is ___ Euros in Product that is $1.00 in U.S. is ___ Euros in Europe and 1 Euro product in Europe is $ Europe and 1 Euro product in Europe is $ in U.S.in U.S.

If exchange rate If exchange rate ↑ to ____ Euros = $1.00, ↑ to ____ Euros = $1.00, product that is $1.00 in U.S. is now ____ Euros product that is $1.00 in U.S. is now ____ Euros in Europe causing quantity demanded in in Europe causing quantity demanded in Europe to drop. However, the 1 Euro product Europe to drop. However, the 1 Euro product in Europe now sells for $____ in U.S. in Europe now sells for $____ in U.S. increasing quantity demanded in U.S.increasing quantity demanded in U.S.

Result: Imports ↑ Exports ↓ (Net Exports ↓)Result: Imports ↑ Exports ↓ (Net Exports ↓)

Income and Planned Aggregate Expenditure (data in billions $)Income and Planned Aggregate Expenditure (data in billions $)

PtPt Real Real Income / Income / Real GDP Real GDP (Y)(Y)

CC GG IIPP XXnn PAEPAE ∆ ∆ Unplanned Unplanned InventoriesInventories

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Notes: Notes:

1) Assume I1) Assume IPP, G and NX are fixed, G and NX are fixed

2) 2) ∆ inventories = Real GDP – PAE∆ inventories = Real GDP – PAE

3) As Y ↑, PAE ↑, but ∆PAE < ∆Y3) As Y ↑, PAE ↑, but ∆PAE < ∆Y

Example: Pt C to Pt D Example: Pt C to Pt D

∆ ∆PAE = ∆Y = PAE = ∆Y =

Why? Consumption is only variable that is not Why? Consumption is only variable that is not fixed fixed and consumption and income are related by the and consumption and income are related by the

MPCMPC

Finding Equilibrium Real GDP Using PAE and InventoriesFinding Equilibrium Real GDP Using PAE and Inventories

PtPt Real Income Real Income or Real GDP or Real GDP (in billions)(in billions)

Planned Planned Aggregate Aggregate Expenditure Expenditure (in billions)(in billions)

∆ ∆ inventories inventories (in billions)(in billions)

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Finding Equilibrium Real GDP Using PAE and InventoriesFinding Equilibrium Real GDP Using PAE and Inventoriesa) When PAE > Real GDPa) When PAE > Real GDP

∆ ∆ Inventories < 0Inventories < 0

Real GDP or output ↑ in futureReal GDP or output ↑ in future

Example: Pt B Example: Pt B

PAE = $ billion and Real GDP = $ billionPAE = $ billion and Real GDP = $ billion

Result: Inventories are depleting so output ↑ in futureResult: Inventories are depleting so output ↑ in future

b) When PAE < Real GDPb) When PAE < Real GDP

∆ ∆ Inventories > 0Inventories > 0

Real GDP or output ↓ in futureReal GDP or output ↓ in future

Example: Pt D Example: Pt D

PAE = $ billion and Real GDP = $ billionPAE = $ billion and Real GDP = $ billion

Result: Inventories are increasing so output ↓ in futureResult: Inventories are increasing so output ↓ in future

c) c) Equilibrium occurs where PAE = Real GDP or ∆ Inventories = 0Equilibrium occurs where PAE = Real GDP or ∆ Inventories = 0

-- occurs at Pt C-- occurs at Pt C

-- Firms are selling what they produce-- Firms are selling what they produce

Graphing EquilibriumGraphing Equilibrium

-- Use of 45° Line-- Use of 45° Line

PropertiesProperties

-- At Pt B, distance along horizontal axis (DA) = distance along -- At Pt B, distance along horizontal axis (DA) = distance along vertical axis (DC) or distance DA = distance DCvertical axis (DC) or distance DA = distance DC

-- Distance DA = distance AB-- Distance DA = distance AB

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$

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45° Line

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45°

Using PAE curve and 45Using PAE curve and 45° line to find equilibrium° line to find equilibrium

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a) 45a) 45° Line is above PAE Curve° Line is above PAE Curve

At Real GDP = $450 billion:At Real GDP = $450 billion:

-- From 45° line, real GDP is distance FG-- From 45° line, real GDP is distance FG

-- PAE is $390 billion or distance FE-- PAE is $390 billion or distance FE

Since real GDP > PAE, inventories are accumulatingSince real GDP > PAE, inventories are accumulating

∆ ∆ inventories = GDP – PAE or distance EG Thus real inventories = GDP – PAE or distance EG Thus real GDP ↓GDP ↓


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? inventories

b) 45b) 45° Line is below PAE Curve° Line is below PAE Curve


-- From 45° line, real GDP is distance HI-- From 45° line, real GDP is distance HI

-- AE is $110 billion or distance AI-- AE is $110 billion or distance AI

Since real GDP < PAE, inventories are shrinkingSince real GDP < PAE, inventories are shrinking

∆ ∆ inventories = GDP – PAE or distance AH Thus real inventories = GDP – PAE or distance AH Thus real GDP ↑GDP ↑


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c) 45c) 45° Line intersects PAE Curve (Equilibrium)° Line intersects PAE Curve (Equilibrium)


-- PAE curve intersects -- PAE curve intersects 4545° Line or PAE = Real GDP° Line or PAE = Real GDP

-- ∆ inventories = 0-- ∆ inventories = 0

-- Occurs at Pt C-- Occurs at Pt C


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Impact When Fixed Variables ChangeImpact When Fixed Variables Change

1) Impact of 1) Impact of ∆ in investment spending∆ in investment spending

-- Find the impact of an increase in I-- Find the impact of an increase in IP P of $10 billion on of $10 billion on real GDP and PAEreal GDP and PAE

(Assume equilibrium or real GDP = PAE and (Assume equilibrium or real GDP = PAE and Assume MPC = .3)Assume MPC = .3)

-- When firms ↑ I-- When firms ↑ IP P of $10 billion of $10 billion $10 billion of goods $10 billion of goods becomes factor payments for those firms supplying becomes factor payments for those firms supplying goods.goods.

-- MPC determines how much income is spent by -- MPC determines how much income is spent by households. The income that is spent becomes the households. The income that is spent becomes the next set of factor paymentsnext set of factor payments

-- This cycle continues as shown on next slide-- This cycle continues as shown on next slide

RoundRound Addt’l Spending Addt’l Spending CumulativeCumulative

Per RoundPer Round SpendingSpending

InitialInitial $10 billion (I$10 billion (IPP)) $10 billion $10 billionRound 2Round 2 $3 billion (C)$3 billion (C) $13 billion$13 billion

(MPC x previous(MPC x previous

spending)spending)

Round 3Round 3 $.9 billion (C)$.9 billion (C) $13.9 billion$13.9 billion(MPC x previous(MPC x previous

spending)spending)

.. . . ..

.. . . ..

.. . . ..≈ ≈ $14.3 billion$14.3 billion

Expenditure MultiplierExpenditure Multiplier

-- In total, -- In total, IIPP ↑ by $10 billion and overall spending (PAE) ↑ by $10 billion and overall spending (PAE) and real output ↑ by an amount greater than and real output ↑ by an amount greater than IIP.P.

-- Specifically, -- Specifically, ∆ real GDP or ∆PAE = 1.43 x ∆ ∆ real GDP or ∆PAE = 1.43 x ∆ IIPP

where 1.43 is expenditure multiplierwhere 1.43 is expenditure multiplier

Derivation of Expenditure MultiplierDerivation of Expenditure Multiplier• # by which ∆ # by which ∆ IIPP must be multiplied to find must be multiplied to find ∆ ∆

equilibrium GDPequilibrium GDP• Multiplier = 1/(1-MPC)Multiplier = 1/(1-MPC)

Example: If Example: If IIPP ↑ by $12 billion and MPC = .6↑ by $12 billion and MPC = .6

∆ ∆ real GDP = ____________real GDP = ____________

Expenditure Multiplier Effect for other fixed variables:Expenditure Multiplier Effect for other fixed variables:

a) ∆ real GDP =(1/1-MPC) x ∆Ga) ∆ real GDP =(1/1-MPC) x ∆G

b) ∆ real GDP =(1/1-MPC) x ∆NXb) ∆ real GDP =(1/1-MPC) x ∆NX

Documents

Chapters 10 & 11 Aggregate Expenditures. Short Run Macro Model -- John Maynard Keyenes’ model explaining how changes in spending affects real GDP (spending