Output and Expenditure in the Short Run

Output and Expenditure in the Short Run

Aggregate expenditure (AE) The total amount of spending on the economy’s output:

Aggregate Expenditure

• Consumption (C)

• Planned Investment (I)

• Government Purchases of Goods + Services (G)

• Net Exports (NX)

Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

AE = C + I + G + NX

Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y)

AE = C + I + G + NX = Y

Components of Real Aggregate Expenditure, 2008

The Aggregate Expenditure ModelAdjustments to Macroeconomic Equilibrium

IF … THEN … AND …

Aggregate expenditure isequal to GDP

inventories areunchanged

the economy is inmacroeconomic equilibrium.

Aggregate expenditure isless than GDP inventories rise

GDP and employmentdecrease.

Aggregate Expenditure isgreater than GDP inventories fall

GDP and employmentincrease.

Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

Real Consumption Expenditure, 1979 - 2009

Consumption follows a smooth, upward trend, interrupted only infrequently by recessions.

• Current disposable income

• Household wealth: Assets minus liabilities

Including equity in owner occupied houses?

The most important variables that determine the level of C:

Do Changes in Housing WealthAffect Consumption Spending?

Makingthe

Connection

Many macroeconomic variables, such as GDP, housing prices, consumption spending, and investment spending, rise and fall at about the same time during the business cycle

• Current disposable income

• Household wealth: Assets minus liabilities

Including equity in owner occupied houses?

• Expected future income

People try to keep their consumption fairly steady from year-to-year

save for a rainy day

• The price level

Higher price level reduces real value of monetary wealth

• The interest rate

High interest rate discourages spending on credit/encourages saving

• New, gotta-have styles and products

The most important variables that determine the level of C:

The Relationship between Consumption and Income, 1960– 2008

The Consumption Function

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

YD

CMPC

income disposablein Change

nconsumptioin Change

The Consumption Function

When disposable income changes:

Change in consumption = ΔYD× MPC

For a textbook economy:

The Relationship between Consumption and National Income

when net taxes are constant ΔYD = ΔNI

National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving + Change in taxes

Y = C + S + T

Income, Consumption, and Saving

TSCY If taxes are always a constant amount, ΔT = 0

ΔY = ΔC + ΔS

1 = MPC + MPS

Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save

Y

CMPC

Y

SMPS

NATIONAL INCOME AND REAL GDP (Y)

CONSUMPTION(C)

SAVING(S)

MARGINAL PROPENSITY TO CONSUME (MPC)

MARGINAL PROPENSITY TO

SAVE (MPS)

$9,000 $8,000 1,000

— —

10,000 8,600 1,4000.6 0.4

11,000 9,200 1,8000.6 0.4

12,000 9,800 2,2000.6 0.4

13,000 10,400 2,6000.6 0.4

Real Investment, 1979 - 2009

Planned Investment = I

Investment is subject to larger changes than is consumption. Investment declined significantly during the recessions of 1980, 1981–1982, 1990–1991, 2001, and 2007–2009.

• Expectations of future profitability

Waves of optimism and pessimism

• Major technology changes: new products & processes

• The interest rate

• Taxes

• Cash flow Retained earnings for financing investment

• Current capacity utilization

The most important variables that determine the level of investment:

Real Government Purchases, 1979 – 2009

Government Purchases = G

Government purchases grew steadily for most of the 1979–2009 period, with the exception of the early 1990s, when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992.

Real Net Exports, 1979–2006

Net Exports (NX)

Real Net Exports, 1979 – 2009

Net Exports = NX

Net exports were negative in most years between 1979 and 2009. Net exports have usually increased when the U.S. economy is in recession and decreased when the U.S. economy is expanding, although they fell during most of the 2001 recession.

• The price level in the United States relative to the price levels in other countries

• The growth rate of GDP in the United States relative to the growth rates of GDP in other countries

• The exchange rate between the dollar and other currencies

Net Exports (NX)

The most important variables that determine the level of net exports:

The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Graphing Macroeconomic Equilibrium



Showing a Recession on the 45°-Line Diagram

Real GDP (Y)

Consump tion(C)

Planned Invest ment

(I)

Govern ment

Purchases(G)

Net Export

(NX)

Planned Aggregate Expenditur

e(AE)

Unplan ned

Change in Invent

ories

Real GDP

Will …

$8,000 $6,200 $1,500 $1,500 – $500 $8,700 –$700 increase

9,000 6,850 1,500 1,500 –500 9,350 –350 increase

10000 7,500 1,500 1,500 –500 10,000 0

be in equili brium

11000 8,150 1,500 1,500 –500 10,650 +350 decrease

12000 8,800 1,500 1,500 –500 11,300 +700 decrease

Macroeconomic Equilibrium

The Multiplier Effect

Learning Objective 11.4


Autonomous expenditure An expenditure that does not depend on the level of GDP.

Multiplier The increase in equilibrium real GDP in response to increase in autonomous expenditure, e.g.

Expenditure multiplier = ΔY/ΔI

Multiplier effect The process by which an increase in autonomous

expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC

= Change in autonomous spending that sparks an expansion

+

Change in consumption spending induced by increasing output and income.

The Multiplier Effect in Action

ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT)

ADDITIONAL INDUCED

EXPENDITURE(CONSUMPTION)

TOTAL ADDITIONAL EXPENDITURE =

TOTAL ADDITIONAL GDP

ROUND 1 $100 billion $0 $100 billion

ROUND 2 0 75 billion 175 billion




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.ROUND 10 0 8 billion 377 billion

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.ROUND 15 0 2 billion 395 billion

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n 0 0 $400 billion

The Multiplier in Reverse: The Great Depression of the 1930s

Makingthe

Connection

The multiplier effect contributed to the very high levels of unemployment during the Great Depression.

Year Consumption Investment Net Exports Real GDP Unemployment Rate

1929 $661 billion $91.3 billion -$9.4illion $865 billion 3.2%

1933 $541 billion $17.0 billion -$10.2 billion $636 billion 24.9%


A Formula for the Multiplier MPC1

1

MPC

1

1

eexpenditur autonomousin Change

GDP real mequilibriuin Change Multiplier

Y = C + I + G + NX

C depends on YD:

C = c0 + MPC x YD = c0 + MPC x (Y – T)

c0, I, G, T, and NX are autonomous—they do not depend on Y

Y = c0 + MPC x Y – MPC x T + I + G + NX

(1 – MPC) x Y = c0 + I + G – MPC x T + NX

Y = [1/(1 – MPC)] x [c0 + I + G – MPC x T + NX]

Summarizing the Multiplier Effect

1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

3 The larger the MPC, the larger the value of the multiplier.

4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on taxes, imports, prices and interest rates.

The Aggregate Demand Curve

The Effect of a Change in the Price Level on Real GDP

Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure, holding constant all other factors that affect aggregate expenditure.

Aggregate demand curve

Aggregate expenditure (AE)

Aggregate expenditure model

Autonomous expenditure

Cash flow

Consumption function

Inventories

K e y T e r m s

Marginal propensity to consume (MPC)

Marginal propensity to save (MPS)

Multiplier

Multiplier effect

The Algebra of Macroeconomic Equilibrium

Appendix

)(YMPCCC

1I

GG

XNNX

NXGICY

1 Consumption function

2 Planned investment function

3 Government spending function

4 Net export function

5 Equilibrium condition


Appendix

( )

1

1

Y C MPC(Y) I G NX

Y - MPC(Y) C I G NX

Y MPC C I G NX

C I G NXY

MPC

Or,

Or,

Or,

The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

C


Appendix

Remember that is the multiplier. Therefore an alternative

expression for equilibrium GDP is:

1

1 MPC

Equilibrium GDP = Autonomous expenditure x Multiplier

Documents

Output and Expenditure in the Short Run