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CHAPTER The Short-Run Macro Model Chapter 11 1 Short-Run Macro Model • Macroeconomic model that explains how changes in spending can affect real GDP in the short run. • Short-run is month-to-month, quarter-to quarter, year-to-year. • Long-run model presented in chapter 8 covers multi-year time frame. 2 Start with Consumption Spending (C) • Recall that C (personal household consumption expenditure) is about 70% of total spending on final goods and services. • Consumption spending increases when: – – – – Disposable income (Y-T) rises Wealth (W) rises The interest rate (r) falls Households become more optimistic about the future - positive expectations about the future 3 Disposable Income • Disposable income = Income − Tax payments + Transfers received = Income − (Taxes − Transfers) = Income – Taxes + Transfers = Income − Net taxes = Y–T • Transfers increase disposable income 4 Relationship Between Consumption and Disposable Income • A direct relationship meaning as disposable income rises, consumption spending rises – is roughly linear • We call this relationship the consumption function. 5 Quarterly U.S. Consumption and Disposable Income, 2000–2011: roughly linear 6 Quarterly U.S. Consumption and Disposable Income, 2000–2014 11000.0 C = 453.95 +0.8713(Y-T) 10500.0 R² = 0.9783 10000.0 9500.0 9000.0 8500.0 8000.0 8500.0 9000.0 9500.0 10000.0 10500.0 11000.0 11500.0 12000.0 7 Relationship Between Consumption and Disposable Income Notation: ∆ = change ∆ C = change in consumption ∆ Y = change in income ∆ (Y-T) = change in disposable income 8 Autonomous Consumption Spending • The part of consumption spending that is independent of income – Measured by the vertical intercept of the consumption function 9 Example: Hypothetical Data on Disposable Income and Consumption (C) (Y – T) NOTE: ∆ (Y-T) = 1000 ∆ C = 600 10 Marginal propensity to consume (MPC) • MPC is the slope of the consumption function – the change in consumption divided by the change in disposable income ∆C MPC = ∆(Y−T) • The amount by which consumption spending rises when disposable income rises by one dollar ∆C 600 • On the previous table MPC = = ∆(Y−T) 1000 MPC = 0.60 11 The Marginal Propensity to Save S marginal propensity to save (MPS) Y MPC + MPS = 1 The marginal propensity to consume (MPC) is the fraction of an increase in disposable income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in disposable income that is saved (or the fraction of a decrease in income that comes out of saving). The Consumption Function Graph Real Consumption Spending ($ billions) MPC = ∆C = 0.6 ∆(Y−T) 8,000 7,000 Consumption Function The vertical intercept ($2,000 billion) is autonomous consumption spending . . . 6,000 5,000 Consumption Function 600 4,000 ∆C 1,000 3,000 ∆ (Y-T) 2,000 and the slope of the line (0.6) is the marginal propensity to consume (MPC). 1,000 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 Real Disposable Income ($ billions) 13 Consumption and Disposable Income • Formula for the straight line consumption function C = a + b ˣ (Y - T) – “a” is the vertical intercept of the consumption function • The theoretical level of consumption spending at disposable income (Y-T) = 0 • Referred to as autonomous consumption spending – “b” is the MPC, the slope of the consumption function – From the previous graph, what’s the equation? C = (?) + (?) ˣ (Y –T) 14 Consumption and Income • We can redefine the consumption function to show the value of consumption spending at each level of income (Y) rather than disposable income(Y-T) • Assumption – T is a fixed dollar amount independent of income – this is referred to as a lump-sum tax. 15 The Relationship between Consumption and Income (C) (Y-T) (T) (Y) ∆ (Y) = 1000 ∆ (Y-T) = 1000 ∆ C = 600 16 Consumption and Income • H&L call this the Consumption–income line. • It is the same as the Consumption Function, relating C to Y rather than C to (Y-T). • I will refer to it as the Consumption Function – A function showing aggregate consumption spending (C) at each level of income (Y) or real GDP • It has the same slope - MPC! 17 Consumption and Income • The only difference is the vertical intercept. It becomes: (a − MPC × T) • Here’s why: Start with: C = a + MPC ˣ (Y – T) C = a + MPC ˣ Y – MPC ˣ T C = (a – MPC ˣ T) + MPC ˣ Y C = (2000 – 0.6 ˣ 2000) + 0.6 ˣ Y C = 800 + 0.6 ˣ Y 18 Consumption and Income: Real Consumption Spending ($ billions) 5,600 B 5,000 4,000 A 2. The line has the same slope as the consumption function in Figure 2 . . . 3,000 Consumption 600 Function 1,000 2,000 ∆ (Y) 1,000 800 ∆C 3. but a different vertical intercept. 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real Income 1. To draw the consumption–income line, we measure real ($ billions) income (instead of real disposable income) on the horizontal axis. 19 What happens if Income Changes? • If income (Y) increases and net taxes (T) remain unchanged – Disposable income will rise – Consumption spending will rise – Movement rightward up along the consumption function MPC = ∆C = 0.6 ∆(Y) • If income decreases and net taxes remain unchanged – the opposite occurs 20 What happens if Taxes Change? • With a decrease in T (net taxes) – Disposable income (Y – T) will rise at each level of income – Consumption spending will rise at each income level – Shift upward of the consumption function 21 A Shift in the Consumption Function caused by a reduction in T Real Consumption Spending ($ Billions) 6,000 5,000 Consumption function when net taxes drop to $500 billion 4,000 3,000 2,000 1,700 Consumption Function Consumption Function when net taxes start at $2,000 billion 1,000 800 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) A decrease in T is caused by a reduction in taxes or and increase in transfer payments. 22 Other factors that Shift the Consumption Function – Wealth (W), which is accumulated household savings and investments – Interest rates (r), which is the cost to borrow. – Expectations about the future 23 Other factors that Shift the Consumption Function • Increase in autonomous consumption – Because of • an increase in household wealth (W) • a decrease in interest rates (r) • households become more optimistic about the future ( ) • Shift the consumption function upward 24 Upward Shift in the Consumption Function Real Consumption Spending ($ Billions) 6,000 W↑, r ↓, T ↓ , 5,000 4,000 3,000 Consumption Function 2,000 1,000 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) 25 Shift in the Consumption Function • Decrease in autonomous consumption – Because of • a decrease in household wealth (W) • an increase in interest rates (r) • household became more pessimistic about the future ( ) – Shift the consumption function downward 26 Downward Shift in the Consumption Function Real Consumption Spending ($ Billions) 6,000 5,000 4,000 3,000 Consumption Function W ↓, r ↑, T ↑, 2,000 1,000 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) 27 Movement Along Versus a Shift • Move along the consumption function – is caused by a change in income • Shift of the consumption function – is caused by a change in factors beside income that cause consumption spending to change (W, T, r, expectations) 28 Total Spending • Components of total spending in the economy – – – – Consumption spending by households (C) Planned investment spending (Ip) Government purchases (G) Net exports (NX) • We Assume: Ip, G, and NX – are determined outside of our analysis – have fixed values – called autonomous 29 Total Spending • Planned Investment Spending (Ip) – Plant and equipment purchases by business firms and new home construction – Remember Ip does not included unplanned changes in inventories • Government purchases – All of the goods and services that government agencies - federal, state, and local - buy during the year • Net exports (NX) – Exports minus imports 30 We Call Total Spending Aggregate Expenditure • Aggregate Expenditure (AE) – Sum of spending by households, business firms, the government, and foreigners on final goods and services produced in the United States AE = C + P I + G + NX 31 The Relationship Between Income, Aggregate Expenditure and Unplanned Change in Inventories 32 Inventories and Equilibrium GDP • Change in inventories during any period will always equal output minus aggregate expenditure Δ Inventories = GDP – AE 33 Equilibrium GDP in the Short-Run • When AE < GDP (total spending < what is produced) – Output will decline in the future • Thus, any level of output at which AE < GDP cannot be the equilibrium GDP • When AE > GDP – Output will rise in the future • Thus, any level of output at which AE > GDP cannot be the equilibrium GDP • Equilibrium GDP in the short run – The level of output at which AE = GDP 34 35 Equilibrium GDP in the Short-Run • The level of aggregate expenditure (AE) in the economy determines the equilibrium level of GDP in the short-run. • The equilibrium level of GDP in the short-run can be less than full employment. • This is an important difference from the long-run classical model, and its is because of sticky prices! (Chapter 10) 36 The Aggregate Expenditure (AE) Line and Equilibrium GDP • AE line – C, consumption at each level of income, consumption function – C+IP at each level of income – C+IP+G at each level of income – AE line: C+IP+G+NX at each level of income – Slope = MPC 37 Deriving the Aggregate Expenditure Line Real Aggregate Expenditure ($ billions) 12,000 C + IP + G + NX C + IP + G 5. to get the aggregate expenditure line. C + IP C 10,000 8,000 Consumption Function 4. and net exports (NX) . . . 6,000 4,000 3. government purchases (G) . . . 2,000 2. then add planned investment (Ip) . . . 2,000 1. Start with the consumption–income line, 4,000 6,000 8,000 10,000 12,000 Real GDP ($ billions) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38 The 45o Guide Line • A 45° line = translator line • It allows us to measure any horizontal distance as a vertical distance instead 39 Using a 45° Line to Translate Distances A Dollars 1. Using a 45° line . . . Consumption Function 3. into an equal vertical distance (BA). 45° 0 B Dollars 2. we can translate any horizontal distance (such as 0B) . . . © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 40 Equilibrium GDP • Any output level where – AE line lies below the 45° line • AE < GDP • Inventories will increase (unplanned!) • Output (GDP/Y) will decrease in the future – AE line lies above the 45° line • AE > GDP • Inventories will decrease (unplanned!) • output will increase in the future 41 At point E, where the aggregate expenditure line crosses the 45° line, the economy is in short-run Real AE ($ billions) Increase in inventories equilibrium. With real GDP equal to $8,000 billion, A aggregate expenditure C+IP+G+NX 12,000 equals real GDP. Decrease in inventories At higher levels of real GDP—such as $12,000 10,000 H billion—total production E exceeds aggregate 8,000 expenditures, and firms will Consumption be unable to sell all they K Function Total produce. Unplanned 6,000 Aggregate Output inventory increases equal to Expenditure HA will lead them to reduce 4,000 production. J Aggregate At lower levels of real Total Expenditure GDP—such as $4,000 2,000 Output billion—aggregate expenditure exceeds total 45° production. Firms find their Real GDP 2,000 4,000 6,000 8,00010,000 12,000 inventories falling, and they ($ billions) will respond by increasing production. Determining Equilibrium Real GDP 42 Equilibrium GDP • Equilibrium GDP is the output level at which the AE line intersects the 45° line – if firms produce this output level • Their inventories will not change and they continue producing the same level of output in the future • Equilibrium GDP Can Be Less than Full Employment GDP. Prices are assumed fixed in the short-run. 43 Equilibrium GDP and Employment • It is possible to have a short-run equilibrium and yet have abnormally high unemployment: – Aggregate expenditure is too low to create an intersection at full-employment output – Cyclical unemployment is caused by insufficient spending – As long as spending remains low • Production will remain low • Unemployment will remain high 44 Equilibrium GDP Can Be Less than Full-Employment GDP Aggregate Expenditure ($ billions) When the aggregate expenditure line is low . . . F 0 $10,000 Consumption Function A $8,000 Real GDP ($ billions) Potential GDP B and equilibrium employment is less than full employment Equilibrium output ($8,000) is less than potential output, $8,000 $10,000 Aggregate Production Function cyclical unemployment = 50 million AELOW $10,000 Consumption Function E 45° Real GDP ($ billions) 0 100 Million 150 Million Number of workers Full employment 45 Equilibrium GDP and Employment • Short-run equilibrium – Economy can overheat because spending is too high – As long as spending remains high • Production will exceed potential output • Unemployment will be unusually low – Abnormally high employment 46 Equilibrium GDP can be greater than full-employment GDP Aggregate Expenditure ($ billions) When the aggregate expenditure line is high . . . E’ Real GDP ($ billions) and equilibrium employment is greater than full employment AEHIGH F $10,000 Consumption Function Aggregate Production Function $12,000 H $10,000 Consumption Function B Equilibrium output ($12,000) is greater than potential output, 45° 0 $10,000 $12,000 Potential GDP Real GDP ($ billions) 0 150 Million Full employment 200 Million Number of workers 47