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CHAPTER 9
The Income-Expenditure
Framework: Consumption and the
Multiplier
9-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What are “sticky” prices?
• What factors might make prices
sticky?
• When prices are sticky, what
determines the level of real GDP in
the short run?
9-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• When prices are sticky, what happens
to real GDP if some component of
aggregate demand falls?
• When prices are sticky, what happens
to real GDP if some component of
aggregate demand rises?
• What determines the size of the
spending multiplier?
9-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Real GDP in U.S. History
• The flexible-price model does not give
a complete picture of the
macroeconomy
– real GDP does not always grow by the
same rate as potential output
– the unemployment rate is not always at
the natural rate
– inflation is not always steady
9-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.1 - Real GDP per Worker and
Potential Output, 1960-2000
9-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Business Cycles
• Fluctuations in economic growth are
called business cycles
• A business cycle has two phases
– expansion or boom
• production, employment, and prices all grow
rapidly
– recession or depression
• production falls, unemployment rises, and
inflation falls
9-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Business Cycles
• To understand business cycles, we
need a model that does not always
guarantee full employment
• We will no longer assume that prices
are flexible
• Instead, prices will be assumed to be
“sticky”
– they will remain fixed at predetermined
levels as businesses expand or contract
production
9-7
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• Suppose that autonomous
consumption falls from $2,000 billion
to $1,800 billion per year
• In the flexible-price model, real GDP
would be unaffected
– the economy would remain at full
employment
– real GDP would equal potential output
9-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.2 - Labor Market Equilibrium
9-9
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the flexible-price model, a fall in
consumption means an increase in
savings
– the real interest rate falls
– the equilibrium level of investment and
net exports increases by $200 billion per
year
9-10
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.3 - The Effect on Savings of a Fall in
Consumption Spending in the Flexible-Price
Model
9-11
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• Under the flexible-price model, the
decline in the real interest rate will
lead to a decline in the velocity of
money
– the price level will fall
9-12
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the flexible-price model, the
consequences of a fall in consumers’
desired baseline consumption are
– a drop in consumption
– an increase in savings
– a decline in the real interest rate
– a rise in investment
– a rise in the value of the exchange rate
– a decline in the price level
9-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, a drop in
consumption leads to a drop in
aggregate demand
• As businesses see the demand for
their products falling, they cut back
production
– they will fire some of their workers
– incomes will fall
9-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, a drop in
consumption does not lead to an
increase in savings
– the increase in savings (from the fall in
consumption) is exactly offset by a
decrease in savings (from the fall in
income)
• The real interest rate is unaffected
– no change in investment or net exports
9-15
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.4 - The Effect on Savings of a Fall in
Consumption Spending in the Sticky-Price
Model
9-16
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, the
consequences of a fall in consumers’
desired baseline consumption are
– a drop in consumption
– a decline in production
– a decline in employment
– a decrease in national income
– no change in the real interest rate,
investment, or the exchange rate
9-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Expectations
• Price stickiness causes problems only
in the short run
• If individuals had time to foresee and
gradually adjust their wages and
prices to changes in aggregate
demand, sticky prices would not be a
problem
– both the stickiness of prices and the
failure to accurately foresee changes are
needed to create business cycles
9-18
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Short Run vs. Long Run
• In the short run, prices are sticky
– shifts in policy or in the economic
environment that affect the level of
aggregate demand will affect real GDP
and employment
• In the long run, prices are flexible
– individuals have time to react and adjust
to changes in policy or the economic
environment
– real GDP and employment are unaffected
9-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Menu costs are costs associated with
changing prices
– changing prices can be costly for a
variety of reasons
– managers and workers may prefer to
keep prices and wages stable as long as
the shocks that affect the economy are
relatively small
9-20
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Managers and workers lack full
information about the state of the
economy
• They may confuse changes in
economy-wide spending with changes
in demand for their particular
products
– cut production rather than cutting the
price of the product
9-21
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• The level of prices is often determined
by “what is fair”
• Work effort and work intensity depend
on whether or not workers feel that
they are treated fairly
– most managers are reluctant to cut
wages
– if wages are sticky, firms will adjust
employment when aggregate demand
changes
9-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Managers and workers may suffer
from money illusion
– confuse changes in nominal prices with
changes in real prices
• firms react to higher nominal prices by
believing that it is profitable to produce more
• workers react to higher nominal wages by
searching more intensively for jobs and
working more hours
9-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier Process
• If prices are sticky, higher aggregate
demand boosts production
• Incomes rise
• Higher incomes give a further boost to
production which increases aggregate
demand even more
9-24
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.5 - The Multiplier Process
9-25
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Building Up Aggregate Demand
• Aggregate demand (planned
expenditure) has four components
– consumption (C)
– investment (I)
– government purchases (G)
– net exports (NX)
E  C  I  G  NX
9-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• As incomes rise, consumption
spending rises
– less than dollar for dollar
• The share of an extra dollar of income
that shows up as additional
consumption is equal to the marginal
propensity to consume times the
share of income that escapes taxation
C  C0  Cy (1 - t)Y
9-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.6 - The Consumption Function and
the Marginal Propensity to Consume
9-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• The slope of the consumption function
is smaller than the marginal
propensity to consume (Cy)
– because of the tax system, a one-dollar
increase in national income means less
than a one-dollar increase in disposable
income
9-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.7 - Consumption as a Function of
After-Tax Disposable Income
9-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• Example
– Cy = 0.75
– t = 0.40
– when Y = $8 trillion, C = $5.5 trillion
C  C0  Cy (1 - t)Y
C  C0  0.75(1 - 0.4)Y
C  C0  0.45Y
$5.5  C0  0.45($8)
$5.5  C0  $3.6
C0  $1.9
C  $1.9  0.45Y
9-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Other Components of
Aggregate Demand
• Investment is determined by the real
interest rate and assessments of
profitability made by firms’ managers
I  I0  Irr
• Government purchases is set by
politics
9-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Other Components of
Aggregate Demand
• Net exports are equal to gross exports
minus imports
– gross exports are a function of the real
exchange rate () and the level of foreign
real GDP (Yf )
NX  GX - IM  (Xf Y  X  )- IMy Y
f
9-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.8 - Components of Aggregate
Demand, 1995
9-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Components of Expenditure
• The components of aggregate demand
can be divided into two groups
– autonomous spending (A)
• components of aggregate demand that do not
depend directly on national income
– the marginal propensity to expend (MPE)
times the level of national income (Y)
9-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Components of Expenditure
E  [C0  Cy (1 - t)Y] I  G  [GX - IMy ]
E  [C0  I  G  GX]  [C y (1 - t)- IMy ]Y
E  A  MPE  Y
• A = autonomous expenditure
[A=C0+I+G+GX]
• MPE=marginal propensity to expend
[MPE=Cy(1-t)-IMy]
9-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.9 - The Income-Expenditure
Diagram
9-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Income-Expenditure
Diagram
• The intercept of the planned
expenditure or aggregate demand line
is the level of autonomous spending
(A)
– a change in the value of any component
of autonomous spending will shift the
planned expenditure line up or down
9-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.10 - An Increase in Autonomous
Spending
9-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Income-Expenditure
Diagram
• The slope of the planned expenditure
or aggregate demand line is the
marginal propensity to expend (MPE)
– changes in the marginal propensity to
consume (Cy), the tax rate (t), or in the
propensity to spend on imports (IMy) will
change the MPE and the slope of the
planned expenditure line
9-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.11 - An Increase in the Marginal
Propensity to Expend
9-41
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Calculating the MPE
• Example
– Cy = 0.75
– t = 0.40
– IMy = 0.15
MPE  [C y (1 - t)- IMy ]
MPE  [0.75(1 - 0.40) - 0.15]
MPE  [0.45 - 0.15]  0.30
9-42
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• The economy will be in equilibrium
when planned expenditure equals real
GDP
– there will be no short-run forces pushing
for an immediate expansion or
contraction of national income, real GDP,
and aggregate demand
9-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.12 - Equilibrium in the IncomeExpenditure Diagram, 1996
9-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• Equilibrium occurs when planned
expenditure (E) is equal to real GDP
(Y)
Y  E  A  MPE  Y
A
Y E
1 - MPE
• Example
– A = $5,600 billion Y  E  $5,600  $8,000 billion
0.70
– MPE = 0.30
9-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• If the economy is not on the 45degree line, the economy is not in
equilibrium
– planned expenditure (E) does not equal
real GDP (Y)
• If Y>E
– there is excess supply of goods
• If Y<E
– there is excess demand for goods
9-46
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.13 - Inventory Adjustment and
Equilibrium: Goods Market Equilibrium and
the Income-Expenditure Diagram
9-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Inventory Adjustment
• Excess supply
– production > aggregate demand
– inventories are rising rapidly
– firms will cut production
• Excess demand
– production < aggregate demand
– inventories are being depleted
– firms will expand production
9-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.14 - The Inventory Adjustment
Process: An Income-Expenditure Diagram
9-49
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Suppose that autonomous spending
increases
– the planned expenditure line will shift up
– planned expenditure > national income
• inventories would fall
• businesses would boost production
– how much production would expand
depends on the magnitude of the change
in autonomous spending and the value of
the multiplier
9-50
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.17 - The Multiplier Effect
9-51
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• The value of the multiplier depends on
the slope of the planned expenditure
line
– the higher is the MPE, the steeper is the
planned expenditure line and the greater
is the multiplier
9-52
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.18 - Determining the Size of the
Multiplier
9-53
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Equilibrium means that
A
Y E
1 - MPE
1
Y  E 
 A
1 - MPE
1
Y  E 
 A
1- [Cy (1 - t)- IMy ]
9-54
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• 1/[1-MPE] is the multiplier
– it multiplies the upward shift in the
planned expenditure line into a change in
the equilibrium level of real GDP, total
income, and aggregate demand
– because autonomous spending is
influenced by many factors, almost every
change in economic policy or the
economic environment will set the
multiplier process in motion
9-55
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Example
– A = $5.6 trillion
– MPE = 0.3
Y  E  $9.0 trillion
– A = $0.1 trillion Y  E  $9.143 trillion
Y 0.143
multiplier 

 1.43
A
0.1
1
1
multiplier 

 1.43
1 - MPE 0.7
9-56
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• One factor that tends to minimize the
multiplier is the government’s fiscal
automatic stabilizers
– proportional taxes
– social welfare programs
• An economy that is more open to
world trade will have a smaller
multiplier than a less open economy
9-57
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Business-cycle fluctuations can push
real GDP away from potential output
and unemployment far away from its
average rate
• If prices were perfectly and
instantaneously flexible, there would
be no such thing as business cycle
fluctuations
– models in which prices are sticky must
play a large role in macroeconomics
9-58
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• There are a number of reasons that
prices might be sticky
– menu costs, imperfect information,
concerns of fairness, or money illusion
– there is no overwhelming evidence as to
which is most important
• In the short run, while prices are
sticky, the level of real GDP is
determined by the level of aggregate
demand
9-59
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The short-run equilibrium level of real
GDP is that level at which aggregate
demand (as a function of national
income) is equal to the level of
national income (real GDP)
• Two quantities summarize planned
expenditure as a function of total
income
– the level of autonomous spending and
the marginal propensity to expend (MPE)
9-60
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The level of autonomous spending is
the intercept of the planned
expenditure function on the incomeexpenditure diagram
– tells us what the level of planned
expenditure would be if national income
was zero
9-61
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The MPE is the slope of the planned
expenditure function on the incomeexpenditure diagram
– tells us how much planned expenditure
increases for each one dollar increase in
national income
9-62
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The value of the MPE depends on the
tax rate (t), the marginal propensity
to consume (Cy), and the share of
spending on imports (IMy)
MPE  Cy (1 - t)- IMy
9-63
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• In the simple macro models, an
increase in any component of
autonomous spending causes a more
than proportional increase in real GDP
– the result is the multiplier process
• The size of the multiplier depends on
the MPE
Y
1

A 1 - MPE
9-64
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.