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Chapter 22
The Short – Run Macro Model
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The Short-Run Macro Model
• In short-run, spending depends on income, and income
depends on spending
– The more income households have, the more they will spend
– But the more households spend, the more output firms will produce
• More income they will pay to their workers
• Many ideas behind the model were originally developed by
British economist John Maynard Keynes in 1930s
– Short-run macro model focuses on spending in explaining
economic fluctuations
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Review the Categories of Spending
• In short-run macro model, we focus on spending in
markets for currently produced U.S. goods and services
– Things that are included in U.S. GDP
• Macroeconomists have found that the most useful
approach is to divide those who purchase the GDP into
four broad categories
– Households, whose spending is called consumption spending (C)
– Business firms, whose spending is called planned investment
spending (IP)
– Government agencies, whose spending on goods and services is
called government purchases (G)
– Foreigners, whose spending we measure as net exports (NX)
• Nominal or real spending?
– Real terms
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Consumption
• What factors affect households’ spending?
– Disposable income (= total income – net taxes)
– Wealth (= total assets – total liability)
– Interest rate
• When interest rate falls, consumption rises
– Expectations about future
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Figure 1: U.S. Consumption and
Disposable Income, 1985-2002
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Figure 2: The Consumption
Function
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Consumption and Disposable
Income
• Autonomous consumption spending
– Consumption spending when disposable income is zero
• Marginal propensity to consume, or MPC
– The slope of the consumption function
– MPC = Δ Consumption ÷ Δ Disposable Income
– MPC measures by how much consumption spending rises when
disposable income rises by one dollar
• Logic and empirical evidence suggest that the MPC should
be larger than zero, but less than 1
– So, we assume that 0 < MPC < 1
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Representing Consumption with an
Equation
• C = a + b(Disposable Income)
• Where C is consumption spending
• And a is the autonomous consumption spending
• And b is the marginal propensity to consume (MPC)
• Equation between consumption and total income
Since Disposable income = total income – net taxes,
C = a + b(Total income – Net taxes)
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Figure 3: The Consumption-Income
Line
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Shifts in the Consumption-Income
Line
– When a change in income causes consumption
spending to change, we move along consumptionincome line
– When a change in anything else besides income
causes consumption spending to change, the line will
shift
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Figure 4: A Shift in the
Consumption-Income Line
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IP, G and NX
• For now, in the short-run macro model,
planned investment spending, government
purchases, and net exports are all treated
as given or fixed values
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Summing Up: Aggregate Expenditure
• Aggregate expenditure (AE)
– Sum of spending by households, businesses,
government, and foreign sector on final goods and
services produced in United States
– Aggregate expenditure = C + IP + G + NX
• AE plays a key role in explaining economic
fluctuations
– Why?
• Because over several quarters or even a few years, business
firms tend to respond to changes in aggregate expenditure by
changing their level of output
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Finding Equilibrium GDP
• When aggregate expenditure is less than GDP, inventories
will increase and output will decline in future
• When aggregate expenditure is greater than GDP,
inventories will decrease and output will rise in future
• In short-run, equilibrium GDP is level of output at which
output and aggregate expenditure are equal
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Inventories and Equilibrium GDP
• When firms produce more goods than they sell, what
happens to unsold output?
– Added to their inventory stocks
• Find output level at which change in inventories is equal to
zero
– AE < GDP  ΔInventories > 0  GDP↓ in future periods
– AE > GDP  ΔInventories < 0  GDP↑ in future periods
– AE = GDP  ΔInventories = 0  No change in GDP
• Equilibrium output level is the one at which change in
inventories equals zero
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Figure 5: Deriving the Aggregate
Expenditure Line
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Figure 6: Using a 45° to Translate
Distances
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Figure 7: Determining Equilibrium
Real GDP
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Equilibrium GDP and Employment
• When economy operates at equilibrium, will it also be operating at full
employment?
– Not necessarily
For instance, insufficient spending causes business firms to decrease their demand
for labor
– Remember, in the long run (classical) macro model, it takes time for labor
market to achieve full employment
• In the short-run model, it would be quite a coincidence if our
equilibrium GDP happened to be the full employment output level
• In short-run macro model, output can be lower or higher than the full
employment output level
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Figure 8: Equilibrium GDP Can Be
Less Than Full Employment GDP
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Figure 9: Equilibrium GDP Can Be
Greater Than Full-Employment GDP
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A Change in Investment Spending
• Suppose the initial equilibrium GDP in an economy is
$6,000 billion
• Now, business firms increase their investment spending on
plant and equipment by $1,000 billion
• Then, firms that sell investment goods receive $1,000
billion as income, which is to be distributed as salary, rent,
interest, and profit
• What will households do with their $1,000 billion in
additional income?
– Spend the money !
– How much to spend depends crucially on marginal propensity to
consume (MPC): let’s assume MPC = 0.6
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A Change in Investment Spending
• When households spend an additional $600 billion, firms
that produce consumption goods and services will receive
an additional $600 billion in sales revenue
– Which will become income for households that supply resources to
these firms. At this point, total income has increased by
$1,000+$600=$1,600billion
– With an MPC of 0.6, consumption spending will further rise by 0.6 x
$600 billion = $360 billion, creating still more sales revenue for
firms, and so on and so on…
• At end of process, when economy has reached its new
equilibrium
– Total spending and total output are considerably higher
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Figure 10: The Effect of a Change in
Investment Spending
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The Expenditure Multiplier
• Whatever the rise in investment spending, equilibrium
GDP would increase by a factor of 2.5, so we can write
– ΔGDP = 2.5 x ΔIP
• Value of expenditure multiplier depends on value of MPC
Expenditur e Multiplier 
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1 - MPC
• So, when the increase in planned investment spending is
ΔIP, the increase in total income (GDP) is calculated as:


1
P
GDP  
x

I

 (1  MPC ) 
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The Expenditure Multiplier
• A sustained increase in investment
spending will cause a sustained increase in
GDP
• Multiplier process works in both directions
– Just as increases in investment spending cause
equilibrium GDP to rise by a multiple of the
change in spending
• Decreases in investment spending cause equilibrium
GDP to fall by a multiple of the change in spending
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Spending Shocks
• Shocks to economy can come from other sources besides
investment spending
– Government purchases (G)
– Net exports (NX)
– Autonomous consumption (a)
• Changes in planned investment, government purchases,
net exports, or autonomous consumption lead to a
multiplier effect on GDP
– Expenditure multiplier is what we multiply initial change in
spending by in order to get change in equilibrium GDP
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Spending Shocks
• The effect of a change in spending on total
income through expenditure multiplier


1
GDP  
x IP

 (1 - MPC) 


1
GDP  
x G

 (1 - MPC) 


1
GDP  
x NX

 (1 - MPC) 


1
GDP  
 x a
(1
MPC)


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Figure 11: A Graphical View of the
Multiplier
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Automatic Stabilizers and the
Multiplier
• Automatic stabilizers reduce size of multiplier and
therefore reduce impact of spending shocks
– With milder fluctuations, economy is more stable
• Some real-world automatic stabilizers we’ve ignored in the
simple, short-run macro model of this chapter
–
–
–
–
–
Taxes
Transfer payments
Interest rates
Imports
Forward-looking behavior
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The Role of Saving
• In long-run, saving has positive effects on economy
• But in short-run, automatic mechanisms of classical model
do not keep economy operating at its potential
• In long-run, an increase in desire to save leads to faster
economic growth and rising living standards
– In short-run, however, it can cause a recession that pushes output
below its potential
• Two sides to the “saving coin”
– Impact of increased saving is positive in long-run and potentially
dangerous in short-run
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The Effect of Fiscal Policy
• In classical model fiscal policy—changes in government
spending or taxes designed to change equilibrium GDP—
is completely ineffective
• In short-run, an increase in government purchases causes
a multiplied increase in equilibrium GDP
– Therefore, in short-run, fiscal policy can actually change
equilibrium GDP
– Observation suggests that fiscal policy could, in principle, play a
role in altering path of economy
• Indeed, in 1960s and early 1970s, this was the thinking of
many economists
– But very few economists believe this today
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