Download Suppose that something happens to change

Chapter 7
1
Suppose that something happens to change
The income-expenditure is the quickest way to see how small changes in
autonomous spending are amplified by changes in consumption spending into
large shifts in national income or product.
[Figure: income-expenditure diagram and the multiplier
Any shift in the planned expenditure line shifts the level at which national
income and aggregate demand are equal, by a multiple of the initial shift. Take
the shift in autonomous spending A and divide it by 1-c* (1 minus the marginal
propensity to spend). You then have the change in equilibrium national income.
1/(1-c*) is thus the multiplier.
Suppose that a boost to spending shifts the entire aggregate demand line upward
by an amount _A. Call the upward shift in the equilibrium level of national
income and aggregate demand _Y. Then
_Y = {1/(1-c*)} x _A
Chapter 7
2
where c* is the slope of the aggregate demand line on the income-expenditure
diagram, the marginal propensity to spend. Where does the expression
1/(1-c*)
come from? From simple algebra-look to the left. It is called the multipler. You
may sometimes see it denoted by a lowercase m or the Greek letter _.
Consumption
5.1 The Consumption Function
More than 60 percent of spending on final goods and services is consumption
spending--that is, spending by households on things they need, want, or enjoy.
People tend to spend more on consumption goods as their incomes rise. This
idea--that the level of consumption spending depends on income--is called the
consumption function. John Maynard Keynes, one of the most influential
macroeconomists of the twentieth century, put the idea at the center of
macroeconomics some 60 years ago. As incomes in the economy rise,
Chapter 7
3
consumption rises, but not by a full dollar for every dollar rise in national
income. The share of each extra dollar of income that flows into consumption
spending is called the marginal propensity to consume, or MPC.
Consumption spending also depends on the population's age and employment
distribution. Children and the elderly consume but don't earn. Furthermore,
consumption spending depends consumers' wealth as well as on their incomes: a
$100 billion boost to total wealth induces a $3 to $5 billion increase in
consumption spending, as consumers make purchases they otherwise would
have delayed.
In general the MPC will be less than one (rare will be the circumstance in which
consumers spend more than 100 percent of any increase in their incomes). It will
surely be greater than zero (it is not possible to think of circumstances in which
increases in income lead consumers to cut back). What the MPC will be depends
on the tax system, the distribution of income, opportunities to save, and a bunch
of other factors. In the United States today, the MPC is about one-half: if incomes
were to rise by $100 billion, consumption spending would rise by about $50
billion.
The MPC depends on the kinds of changes that happen to people's incomes. If
changes in incomes are thought likely to be permanent, then the marginal
Chapter 7
4
propensity to consume will be high: a $1 increase in incomes will lead to an
increase in consumption of about 80 cents. But if changes in income are thought
likely to be temporary, then the marginal propensity to consume will be low: a $1
increase in incomes will lead to an increase in consumption of only 30 cents or so.
Transitory increases in income have only small effects on consumption because
people seek to "smooth out" their consumption spending--most people feel it's
better to spend gradually over a year or a decade than to spend nearly all of their
resources at the beginning, and then nearly starve for the rest of the period. But
things are complicated because what looks like consumption smoothing from a
consumer's perspective can look like a great lumping-together of expenditures
from an economist's perspective. For example, consider a consumer who buys a
car to last for 10 years when her income goes up. Her marginal propensity to
consume may be more than 100 percent in the short run, yet from her perspective
she is smoothing her consumption because she will be "consuming" the car for a
long time to come. Even an expensive vacation taken now can be thought of as a
way of smoothing out consumption: the memories--and the pleasure they give-last for a long time.
5.2 Using the Consumption Function
When you use the consumption function, you will almost always want to
Chapter 7
5
simplify things by dividing consumption into two parts. One part (like the other
parts of demand) does not depend on the level of national income or GDP. A
second part is very close to the marginal propensity to consume, or MPC, times
the level of national income. (When we wish to emphasize that other parts of
GDP may depend a little on the level of income, we may speak of the marginal
propensity to spend, or MPS. But almost always the MPS is very close to the
MPC.)
In order to separate out the part of consumption spending that depends on
national product from the part that does not, we write the consumption function
as
C = C0 + cY
The total level of consumption (C) equals a component (C0) plus the marginal
propensity to consume (c; the MPC) times the level of national income (Y). And
when we draw the consumption function on a graph with national income on the
horizontal axis and consumption spending on the vertical axis, we draw it as a
straight line. The initial value C0 in this equation is called autonomous
consumption spending--these expenditures would be ongoing even if current
national income were equal to zero.
Chapter 7
6
Place Figure 5.1 here.
The fact that the consumption function has a positive slope creates a positive
feedback mechanism in the economy: As incomes rise, people spend more. As
people spend more, businesses hire more people, which causes incomes to rise
further, which causes people to spend more. Changes in spending are amplified
or multiplied--hence the idea of the multiplier, which will be discussed in detail in
Topic 6.
During booms, this multiplier induces an upward spiral in production (and also an acceleration of
inflation). In bad times it is a source of misery as those thrown out of work cut back on
consumption. Today's multiplier is tamer than it was because consumers now can borrow to keep
spending during a recession. In addition, the government's fiscal automatic stabilizers replace
lost incomes. These two features of the economy keep recessions now from being as destructive
as recessions back when.
The multiplier
The magnitude of the multiplier.
The income-expenditure diagram--sometimes also called the Keynesian Cross--is the
key to finding the short-run equilibrium level of aggregate demand--that is, the
level at which total production is equal to aggregate demand. On its vertical axis
we plot aggregate demand, or total planned expenditure. On its horizontal axis we
plot what the level of spending depends on: national income. (Note, however, that
at this level of analysis economists use the terms national income, national
Chapter 7
7
product, GDP, and so forth as synonyms.)
The dotted line on this income-expenditure diagram is often called the 45-degree
line because it starts at the bottom left corner of the diagram and marches toward
the top right corner, making an angle with the x-axis of 45 degrees. This dotted
45-degree line contains all the points on the diagram at which the x and y
variables are equal--at which the x-axis value, national income, is equal to the yaxis value, aggregate demand. When national income is equal to aggregate
demand, then total spending is equal to total production, and inventories are
neither rising nor falling. Thus the goods market of the economy is in equilibrium:
demand is equal to supply.
[[Place Fig. 6.1 about here.]]
The solid line on the diagram is the aggregate demand line. It shows what
households, businesses, the government, and the international (or net exports)
sector all taken together would like to spend at each conceivable level of national
income.
The point on the diagram at which the economy's goods market will be "in
equilibrium" is that point at which aggregate demand is equal to national
product, and at which households, businesses, government, and the international
sector are spending what they wish given their current level of income.
Chapter 7
8
Equilibrium is where the two lines cross: the point where the aggregate demand
line crosses the 45-degree line, the point on the aggregate demand line at which
national income (or product) is equal to aggregate demand.
If national income is not equal to aggregate demand, then there is excess supply
or excess demand for goods. Either the flow of production exceeds demand and
inventories are building up (and firms are about to cut production and lay off
workers), or demand exceeds the flow of product and inventories are falling (and
firms are about to expand production and hire workers).
The circular flow principle tells us that every piece of expenditure becomes
someone's income and every piece of income will be spent--spent on
consumption, taxed and spent by the government, or saved, that is, loaned out to
an individual or firm and then used to finance investment spending or net
exports. Whenever aggregate demand is less than national income, some people
will be planning to save and spend less than they earn. And some firms will be
producing more goods than they can sell and will lose money. Their inventories
will rise as unsold goods pile up in stores, factories, and along distribution
channels. These firms' behavior will have to change, either before or after they go
bankrupt. When they change their production, then national product, national
income, and aggregate demand will all change too. Some businesses will respond
Chapter 7
9
by cutting prices, trying to move more goods even at a reduced profit per good
sold. Economy-wide price inflation will be lower than had been previously
anticipated. Others will contract production to match demand, firing workers.
National product will shrink. As national product shrinks, household incomes
shrink. And as they shrink shrink, aggregate demand will shrink too.
Conversely, suppose aggregate demand adds up to more than national product.
Then businesses are selling more than they are making. Inventories fall. Some
businesses will respond by boosting prices, trying to earn more profit per good
sold. The inflation of prices in the economy as a whole will be higher than
anticipated. Other firms will expand production to match demand, hiring more
workers. As they hire more workers, household incomes will grow. And as they
grow, aggregate demand will grow too.
6.3 The Multiplier
As we know, the aggregate demand line--as already noted, also called the
planned expenditure or the total expenditure line--on the income-expenditure
diagram shows how much consumers, investors, and the government plan to
spend for each level of total economy-wide national income. You calculate where
the aggregate demand line is by adding up the four components of aggregate
demand: consumption (C) (calculated from the consumption function),
Chapter 7
10
investment spending (I), government purchases of goods and services, and net
exports (NX).
Begin adding up the components of aggregate demand with government
purchases. Government purchases do not depend too much on total national
income (but see Section 6.6 on automatic stabilizers). Thus, on the incomeexpenditure diagram the government purchases line--G--is a flat horizontal line.
It was a level of $1,411 billion per year in 1996.
To government spending add investment spending--I. Investment spending is
slightly procyclical: when production is high firms have more profits and they
use some of these extra profits to boost investment. To G + I add net exports, NX,
that is, the difference between exports and imports. Net exports are
countercyclical--when national product and income are high, imports are high,
and so net exports tend to be negative. The sum of government purchases,
investment, and net exports is a near-horizontal line on the income-expenditure
diagram, because to the extent that any of the components vary with the level of
national income, they tend to cancel each other out.
Of the four components of GDP, only the consumption portion depends strongly
on the level of national income. Adding consumption spending to the sum of the
other three produces the aggregate demand line on the income-expenditure
Chapter 7
11
diagram.
The increase in total spending on all categories of aggregate demand--C, I, G, and
NX--resulting from an additional dollar of national product is called the marginal
propensity to spend, or MPS. And the slope of this aggregate demand line will be
approximately (but not exactly) the same as the marginal propensity to consume,
the MPC.
Start at that spot on the horizontal axis corresponding to some possible value of
national product and income, and look upward until you reach the aggregate
demand line. That vertical height is the level of total spending corresponding to
that level of national income: the level of total spending that people in the
economy would plan to undertake if their level of national income were that
given by the value on the x-axis.
The slope of the aggregate demand line is important because it determines the
size of the multiplier: the steeper the aggregate demand line, the greater the
multiplier. And it is the multiplier that can amplify small shocks to spending
patterns into large changes in total production and incomes.
Suppose that something shifts the aggregate demand line up or down on the
income-expenditure diagram. Perhaps consumption shifts because the
government has cut or raised taxes. Or maybe government purchases changed.
Chapter 7
12
What would then happen to the equilibrium level of aggregate demand and
national product? It would change, and it would change in the same direction:
An upward shift in the position of the aggregate demand line would increase
equilibrium national product. A downward shift would decrease the level of
national product at which inventories are in balance. And it would change by a
multiple of the upward or downward shift in the aggregate demand line--a
multiple of the initial change in spending that set the process in motion. Hence
the name multiplier.
The first thing to happen in response to an upward shift in the aggregate
demand line would be that aggregate demand--at the prevailing level of
production, national product, and national income--would be suddenly larger
than national product. Businesses would find themselves selling more than they
were making. Their inventories would fall.
Some businesses, seeing their inventories fall, would begin to boost their prices
or to boost prices faster than they had previously planned. This would tend to
boost inflation. Other businesses would boost production, in an attempt to keep
their inventories from being exhausted and to bring production back into balance
with sales by selling more rather than by raising prices. Suppose that in the
following month the economy's businesses then expand production so that this
Chapter 7
13
month's production matches last month's total spending. Are inventories stable?
Is the economy back in equilibrium?
No, it is not.
The increase in production has been possible only because firms have hired more
workers, and paid them more. So the increase in production is associated with an
increase in national income. And higher total economy-wide incomes raise
planned expenditure.
There would still be a gap between aggregate demand and national product:
inventories would still be falling. So there must be a second-round increase in
national product, as firms once again try to match production to aggregate
demand. Then there must be a third-round increase. Then a fourth. And so on.
Each increase in national product increases national income and raises aggregate
demand. On the income-expenditure diagram, national product chases aggregate
demand up and to the right along the income-expenditure diagram.
Where does the process come to an end? It ends when both income and
expenditure have risen to the level at which the new, higher aggregate demand
line crosses the 45-degree income equals expenditure line. But note that the total
rise in national product is a multiple of the original gap between total spending
and national product--hence the name multiplier.
Chapter 7
14
The same multiplier process works just as well in reverse. If aggregate demand
fell below national product, inventories would be rising. Rising inventories
would lead to phone calls from retailers, distributors, and dealers. They would
say, "Cancel our next order. We have too much." Businesses would cancel orders
for raw materials, and lay off workers. Workers fired from their jobs would lose
their incomes, and so they would spend less. Production and expenditure chase
each other down the income-expenditure graph until the economy reached its
new goods market equilibrium, that is, where spending is as desired given
income, where total expenditure matches income, where inventories are no
longer rising but are in balance, and where the new, lower aggregate demand
line crosses the 45-degree line on the income-expenditure diagram.
Note that there is nothing to force the economy to be in short-run equilibrium
between goods and market. Total expenditure can exceed national product and
national income and inventories can fall for as long as a year. The reverse can
also happen--production can run ahead of sales for as long as a year. There are
strong forces pushing the economy toward short-run equilibrium: businesses
don't like to lose money by producing things that they cannot sell or by not
having things on hand that they could sell. Still, it takes considerable time for
businesses to expand or cut back production.
Chapter 7
15
6.4 The Size of the Multiplier
How large is the multiplier? The size of the multiplier depends on the size of the
MPS--the slope of the aggregate demand line on the income-expenditure
diagram. And the MPS depends on the MPC.
Suppose that the MPS is equal to the MPC is equal to c. Then any upward or
downward shift in the aggregate demand line by an amount x will generate a
shift in equilibrium national product equal to x / (1-c). The quantity 1 / (1 - c) is
the multiplier. Clearly, the higher the MPC c--the closer it is to one--the larger
will be the multiplier.
Why is the multiplier what it is? Why this factor 1 / (1 - c)? The easiest way to
understand this is to work through the process. Suppose that we start out with
an upward shift in the aggregate demand line of an amount x so that there is
now an $x gap between aggregate demand and national product.
Suppose we increase national product and income by $1. What effect does this
have on this gap between aggregate demand and national product?
Well, a $1 increase in national product increases national product by $1. But a $1
increase in national product and national income increases total planned
expenditure by $c. So the new gap at $1 higher national income and product is
Chapter 7
16
$x - $1 - $c = $x - $(1 - c).
A $1 increase in national product has closed the gap between aggregate demand
and national product by $(1 - c). So to close an $x gap requires an increase in
national product of
$x / (1 - c)
6.5 The Value of the Multiplier
Today's multiplier is smaller than multipliers in the past because of the
government's fiscal automatic stabilizers. These automatic stabilizers are the chief
factor tending to make modern business cycles--that is, fluctuations in
production and unemployment--appear to be less severe than earlier business
cycles.
When national product and national income drop, income tax and social security
tax collections fall automatically. Thus, the fall in consumers' disposable income
is only two-thirds as great as the fall in national income and the fall in
consumption is only two-thirds as large as it would be in the absence of
automatic stabilizers. In other words, the MPC in response to a change in
national income is smaller than it used to be because of this cushioning effect of
the tax system.
Chapter 7
17
Because the fall in consumption is smaller, the multiplier is smaller. Disturbances
to spending are not amplified as much as they used to be. And so shocks to the
economy tend to cause smaller business cycles.
The government and the multiplier
International trade and the multiplier
The income-expenditure diagram is also the tool for seeing the Keynesian consumption
multiplier in action. It shows how small changes in government policy, investors' expectations,
or any other nonconsumption part of total spending are amplified by changes in consumption
spending into large shifts in national income or product. As you can see at the left, shifting the
aggregate demand line upward or downward shifts the level at which national income and
aggregate demand are equal, by a multiple of the small shift-hence the name "multiplier."