Download Demand Side: Equilibrium and the Spending Multiplier

Aggregate
Demand Aggregate
Supply
Equilibrium
The Fixed-Price
Keynesian Model:
An Economy Below
Full – Employment
Focus on the
Demand Side
Factors that Affect AD
AD = C + I + G + NX
Consumption ≈ 68% of gdp
– INCOME
– Wealth  Price
– Interest Rates  Price
– Expectations
• Future Income
• Future Prices
– Demographics
– Taxes
Investment ≈ 17% of gdp
– Interest Rates  Price
– Technology
– Cost of Capital Goods
– Capacity Utilization
– Expectations!!!
Government Spending
≈ 18% of gdp
Net Exports ≈ - 3% of gdp
– Foreign Income
– Domestic INCOME
– Foreign Prices
– Domestic Prices
– Exchange Rates
–
–
–
Foreign Interest Rates
Domestic Interest Rates
Government Policy
– Tariffs, Quotas, etc.
– Gov’t Procurement
Consumption and Disposable Income
1947-2002
Simple Consumption Function
Ignore depreciation, taxes, etc. for the time being
Then DI = Y = Aggregate Income = Real GDP
C
= a + bY is a straight line
with slope b.
C
 a is autonomous consumption.
 The slope, b, is the marginal
propensity to consume (MPC).
0 < MPC < 1.
 MPC is C/Y, the amount by
a
which consumption changes
for each dollar change in Y
C
Y
Aggregate Income Y
MPC = C/Y = b
Saving Function
and
Autonomous
Shifts in
Consumption and
in Saving
Investment Spending (I)
•
•
•
•
Capital goods have a long life.
Capital goods take time to build.
Capital goods involve large expenditure.
The present value of a capital good
depends on the income it generates over a
long time horizon.
– Businesses must form expectations
about future conditions and profitability.
– Investment is inherently risky.
• Investment expenditure tends to be erratic.
Investment as a Function of Current Income
Investment depends more on expectations of the
future than on what’s happening now.
The Aggregate Expenditures Function
AE = C + I + G + NX
Movement to Equilibrium
o
45 line: AE = Y
700
Aggregate planned expenditure
Total Expenditure
600
Increase Output,
increase Employment
500
Reduce Output,
Reduce Employment
400
0
300
400
500
Real GDP (Output)
600
700
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
200
250
25
0
0
275
-75
Up
300
325
25
0
0
350
-50
Up
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
200
250
25
0
0
275
-75
Up
300
325
25
0
0
350
-50
Up
400
400
25
0
0
425
-25
Up
500
475
25
0
0
500
0
No
chg
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
200
250
25
0
0
275
-75
Up
300
325
25
0
0
350
-50
Up
400
400
25
0
0
425
-25
Up
500
475
25
0
0
500
0
No
chg
700
625
25
0
0
650
50
Down
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
200
250
25
0
0
275
-75
Up
300
325
25
0
0
350
-50
Up
400
400
25
0
0
425
-25
Up
500
475
25
0
0
500
0
No
chg
600
550
25
0
0
575
25
Down
700
625
25
0
0
650
50
Down
Equilibrium Real GDP: mpc = .75
(1)
Real
GDP
(Y)
(2)
Consumption
(C)
(3)
Planned
Investment
(I)
(4)
Gov’t
Spending
(G)
(5)
Net
Exports
(NX)
(6)
Aggregate
Expenditures
(AE)
(7)
Unplanned
Change in
Inventories
(8)
Change
in Real
GDP
0
100
25
0
0
125
-125
Up
100
175
25
0
0
200
-100
Up
200
250
25
0
0
275
-75
Up
300
325
25
0
0
350
-50
Up
400
400
25
0
0
425
-25
Up
500
475
25
0
0
500
0
No
chg
600
550
25
0
0
575
25
Down
700
625
25
0
0
650
50
Down
Equilibrium Output (Y) & Spending (AE)
and
Autonomous Spending Multiplier
Polish your algebra
Y = C + I = {100 + .75 Y} + 25
Y = 125 + . 75 Y
Y - .75 Y = (1 - .75)Y = (1 – mpc) Y = 125
.25 Y = 125
= Autonomous Spending
Y = (1/.25) 125 = 4 x 125 = 500
In general,
Y = Autonomous Spending/(1 – mpc)
= Autonomous Spending/mps
=AutonomousSpend/{marginal propensity to leak}
Spending Multiplier
• The spending multiplier measures the
change in equilibrium income (real GDP)
produced by change in autonomous
expenditures:
ΔY/ΔI
By how many dollars does real GDP change
for every dollar change in autonomous
expenditures?
1
1
Multiplier 

leakages MPS
Multiplier at Work
Introduce Government Spending: mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
0
0
0
100
25
50
175
Up
100
0
100
175
25
50
250
Up
200
0
200
250
25
50
325
Up
300
0
300
325
25
50
400
Up
400
0
400
400
25
50
475
Up
500
0
500
475
25
50
550
UP
Introduce Government Spending: mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
0
0
0
100
25
50
175
Up
100
0
100
175
25
50
250
Up
200
0
200
250
25
50
325
Up
300
0
300
325
25
50
400
Up
400
0
400
400
25
50
475
Up
500
0
500
475
25
50
550
UP
600
0
600
550
25
50
625
UP
Introduce Government Spending: mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
0
0
0
100
25
50
175
Up
100
0
100
175
25
50
250
Up
200
0
200
250
25
50
325
Up
300
0
300
325
25
50
400
Up
400
0
400
400
25
50
475
Up
500
0
500
475
25
50
550
UP
600
0
600
550
25
50
625
UP
700
0
700
625
25
50
700
No
Change
Now add a tax (leakage): mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
200
50
150
212.50
25
50
287.50
Up
300
50
250
287.50
25
50
362.5
Up
400
50
350
362.50
25
50
437.50
Up
500
50
450
437.50
25
50
512.50
UP
700
50
650
587.50
25
50
662.50
DOWN
Now add a tax (leakage): mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
200
50
150
212.50
25
50
287.50
Up
300
50
250
287.50
25
50
362.5
Up
400
50
350
362.50
25
50
437.50
Up
500
50
450
437.50
25
50
512.50
UP
600
50
550
512.50
25
50
587.50
DOWN
700
50
650
587.50
25
50
662.50
DOWN
Now add a tax (leakage): mpc = .75
(1)
Real
GDP
(Y)
(2)
Tax
(T)
(3)
Disposable
Income
(Yd)
(4)
Consumption
C=100+.75 Yd
(C)
(5)
Planned
Investment
(I)
(6)
Gov’t
Spending
(G)
(7)
Aggregate
Expenditure
(AE)
(8)
Change in
Real GDP
200
50
150
212.50
25
50
287.50
Up
300
50
250
287.50
25
50
362.5
Up
400
50
350
362.50
25
50
437.50
Up
500
50
450
437.50
25
50
512.50
UP
550
50
500
475.00
25
50
550.00
NO
Change
600
50
550
512.50
25
50
587.50
DOWN
700
50
650
587.50
25
50
662.50
DOWN
Government Spending Multiplier:
ΔY/ΔG = 1/(1 – mpc) = 1/mps
= 1/(1 - .75) = 1/.25 = 4 in our example
Tax Multiplier:
Y = C + I + G = a + mpc (Y – T) + I + G
(1 – mpc) Y = a + I + G – mpc T
Y = {1/(1-mpc)}{a + I + G – mpc T}
When tax is increased
ΔY = {1/(1-mpc)}{ - mpc ΔT}
ΔY/ ΔT = {- mpc/mps} ΔT
= - .75/.25 = - .75 x 4 = - 3 in our example