Download Chapter 22 - The Short

The Short-Run Macro Model
 Spending is very important in short-run
 The more income households have, the more they will
spend
 Spending depends on income
 But the more households spend, the more output firms
will produce
 More income they will pay to their workers

Thus, income depends on spending
 In short-run, spending depends on income, and income
depends on spending
 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
 Explains how shocks that affect one sector influence other
sectors
1
 Causing changes in total output and employment
Thinking About Spending




Spending on what?
In short-run macro model, focus on spending in markets for
currently produced U.S. goods and services

Things that are included in U.S. GDP

What’s the best way to categorize all these buyers into larger
groups so we can analyze their behavior?
Need to organize our thinking about markets that contribute
to 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)
Should we look at nominal or real spending?

When discuss “consumption spending,” we mean “real
consumption spending”
2
Consumption Spending
 Natural place for us to begin our look at
spending is with its largest component
 Consumption spending
 Total consumption spending is sum of
spending by over a hundred million U.S.
households
 What determines total amount of consumption
spending?
 One way to answer is to start by thinking
about yourself or your family
 What determines your spending in any given
month, quarter, or year?
3
Disposable Income
 First thing that comes to mind is your income
 The more you earn, the more you spend
 It’s not exactly your income per period that
determines your spending
 But rather what you get to keep from that income
after deducting any taxes you have to pay
 If we start with income you earn, deduct all tax
payments, and then add in any transfer received,
would get your disposable income
 Income you are free to spend or save as you wish

Disposable Income = Income – Tax Payments + Transfers
Received
 Can be rewritten as



Disposable Income = Income – (Taxes – Transfers) or
Disposable Income = Income – Net Taxes
For almost any household, a rise in disposable income—with
no other change—causes a rise in consumption spending 4
Wealth
 Given your disposable income, how
much of it will you spend and how
much will you save?
 Will depend, in part, on your wealth
 Total value of your assets minus your
outstanding liabilities
 In general, a rise in wealth—with no
other change—causes a rise in
consumption spending
5
The Interest Rate
 Interest rate is reward people get for saving, or
what they have to pay when they borrow
 All else equal, a rise in interest rate causes a
decrease in consumption spending
 Relationship between interest rate and
consumption spending applies even for people
who aren’t “savers” in the common sense of
term
 Whether you are earning interest on funds
you’ve saved, or paying interest on funds
you’ve borrowed
 The higher the interest rate, the lower is
consumption spending
 In macroeconomics, household saving is the part of
disposable income that a household doesn’t spend6
 Whether it’s put in bank or used to pay off a loan
Expectations

Expectations about future would affect your spending as
well


Other variables influence your consumption spending



All else equal, optimism about future income causes an
increase in consumption spending
Including inheritances you expect to receive over your lifetime,
and even how long you expect to live
Disposable income, wealth, and interest rate are the three
key variables
In macroeconomics, we use phrases like “disposable
income,” “wealth,” or “consumption spending” to mean the
total disposable income, total wealth, and total consumption
spending of all households in the economy combined

All else equal, consumption spending increases when



Disposable income rises
Wealth rises
Interest rate falls
7
Figure 1: U.S. Consumption and
Disposable Income, 1985-2004
Real Consumption Spending
($ Billions)
7,000
2000
6,000
1995
5,000
1990
1985
4,000
3,000
3,000
4,000
5,000
6,000
7,000
Real Disposable Income ($ Billions)
8
Consumption and Disposable
Income
 Of all the factors that influence
consumption spending, most important and
stable determinant is disposable income
 Relationship between consumption and
disposable income is almost perfectly
linear—points lie remarkably close to a
straight line
 This almost-linear relationship between
consumption and disposable income has been
observed in a wide variety of historical periods
and a wide variety of nations
 Vertical intercept in Figure 2 is called
 Autonomous consumption spending
 Part of consumption spending that is
independent of income
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Real Consumption Spending
($ Billions)
Figure 2: The Consumption
Function
8,000
7,000
The consumption function shows the (linear)
relationship between real consumption
spending and real disposable income
Consumption
Function
6,000
5,000
600
4,000
3,000
2,000
1,000
1,000
The vertical intercept ($2,000
billion) is autonomous
consumption spending . . .
and the slope of the line
(0.6) is the marginal
propensity to consume.
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Real Disposable Income ($ Billions)
10
Consumption and Disposable
Income
 Second important feature of Figure 2 is the slope
 Shows change along vertical axis divided by change
along horizontal axis as we go from one point to
another on the line
 Slope = Δ Consumption ÷ Disposable Income
 Economists have given this slope a special name
 Marginal propensity to consume, or MPC
 Can think of MPC in three different ways, but each of
them has the same meaning
 Slope of consumption function
 Change in consumption divided by change in
disposable income
 Amount by which consumption spending rises when
disposable income rises by one dollar
 Logic suggests that the MPC should be larger than
zero, but less than 1
11
 We will always assume that 0 < MPC < 1
Representing Consumption with an
Equation
 Sometimes, we’ll want to use an equation
to represent straight-line consumption
function
 C = a + b x (Disposable Income)
 Where C is consumption spending
 Term a is vertical intercept of consumption
function
 Represents theoretical level of consumption
spending at disposable income=0, or
autonomous consumption spending
 Term b is slope of consumption function
 Marginal propensity to consume (MPC)
12
Consumption and Income
 Consumption function is an important building block
 Consumption is largest component of spending, and
disposable income is most important determinant of
consumption
 If government collected no taxes, total income and
disposable income would be equal
 So that relationship between consumption and income on the
one hand, and consumption and disposable income on the
other hand, would be identical
 Consumption-income line
 Line showing aggregate consumption spending at each level
of income or GDP
 When government collects a fixed amount of taxes from
household
 Line representing relationship between consumption and
income is shifted downward by amount of tax times marginal
propensity to consume (MPC)
13
 Slope of this line is unaffected by taxes and is equal to MPC
Figure 3: The ConsumptionIncome Line
Real Consumption
Spending ($ Billions)
ConsumptionIncome Line
B
A
5,600
5,000
2. The line has the same
slope as the consumption
4,000
function in Figure 2 . . .
3,000
1. To draw the consumption- 2,000
income line, we measure
real income (instead of real 1,000
disposable income) on the
horizontal axis.
600
1,000
3. but a different
vertical intercept.
2,000
4,000
6,000
8,000
Real Income ($ Billions)
14
Shifts in the Consumption-Income
Line
 If income increases and net taxes remain
unchanged, disposable income will rise, and
consumption spending will rise along with it
But consumption spending can also change for reasons
other than a change in income, causing consumption-income
line itself to shift
Mechanism works like this
15
Shifts in the Consumption-Income
Line
 Can summarize our discussion of changes
in consumption spending as follows
 When a change in income causes consumption
spending to change, we move along
consumption-income line
 When a change in anything else besides income
causes consumption spending to change, the
line will shift
 All changes that shift the line—other than a
change in taxes—work by increasing or
decreasing autonomous consumption (a)
16
Figure 4: A Shift in the
Consumption-Income Line
Real 8,000
Consumption
Spending ($ 7,000
Billions) 6,000
Consumption-Income Line
When Net Taxes = 500
5,000
4,000
3,000
Consumption-Income Line
When Net Taxes = 2,000
2,000
1,000
2,000
4,000
6,000
8,000
Real Income ($ Billions)
17
Table 3: Changes in Consumption
Spending and the Consumption–Income Line
18
Investment Spending
 In definition of GDP, word investment by itself
(represented by the letter “I” by itself) consists of
three components
 Business spending on plant and equipment
 Purchases of new homes
 Accumulation of unsold inventories
 In short-run macro model, we define (planned)
investment spending (IP) as
 Plant and equipment purchases by business firms,
and new home construction
 Inventory investment is treated as unintentional and
undesired
 Excluded from definition of investment spending
 For now, we regard investment spending (IP) as a
given value, determined by forces outside of our
model
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Government Purchases
 Include all goods and services that
government agencies—federal, state,
and local—buy during year
 In short-run macro model, government
purchases are treated as a given value
 Determined by forces outside of model
20
Net Exports
 If we want to measure total spending on
U.S. output, we must also consider
international sector
 U.S. exports
 But international trade in goods and
services also requires us to make an
adjustment to other components of
spending
 In sum, to incorporate international sector
into our measure of total spending, we
must add U.S. exports, and subtract U.S.
imports
 Net Exports = Total Exports – Total Imports
21
Net Exports
 By including net exports, simultaneously
ensure that we have
 Included U.S. output that is sold to foreigners,
and
 Excluded consumption, investment, and
government spending on output produced
abroad
 For now, we regard net exports as a given
value, determined by forces outside of our
analysis
 Important to remember that net exports
can be negative
 United States has had negative net exports
since 1982
 Imports are greater than exports
22
Summing Up: Aggregate
Expenditure
 Aggregate expenditure
 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
 C stands for household consumption spending,
IP for investment spending, G for government
purchase, and NX for net exports
 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
23
Income and Aggregate Expenditure
 Relationship between income and spending is circular
 Spending depends on income, and income depends
on spending
 We take up the first part of that circle
 How total spending depends on income
 Notice that aggregate expenditure increases as
income rises
 But notice also that rise in aggregate expenditure is
smaller than rise in income
 When income increases, aggregate expenditure (AE)
will rise by MPC times change in income
 ΔAE = MPC x Δ GDP
 We’ve used ΔGDP to indicate change in total income
 Because GDP and total income are always the same
number
24
Finding Equilibrium GDP
 Method of finding equilibrium in short-run is very
different from anything you’ve seen before
 Starting point in finding economy’s short-run
equilibrium is to ask ourselves what would happen,
hypothetically, if economy were operating at different
levels of output
 When aggregate expenditure is less than GDP, output
will decline in future
 Any level of output at which aggregate expenditure is
less than GDP cannot be equilibrium GDP
 When aggregate expenditure is greater than GDP,
output will rise in future
 Any level of output at which aggregate expenditure
exceeds GDP cannot be equilibrium GDP
 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
 Change in inventories during any period will always
equal output minus aggregate expenditure
 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 one at which change in
inventories equals zero
26
Finding Equilibrium GDP With A
Graph
 Figure 5 gives an even clearer picture
of how equilibrium GDP is determined
 Lowest line, C, is consumption-income
line
 Next line, labeled C + IP, shows sum of
consumption and investment spending at
each income level
 Next line adds government purchases to
consumption and investment spending,
giving us C + IP + G
 Top line adds net exports, giving us C +
IP + G + NX, or aggregate expenditure
27
Figure 5: Deriving the Aggregate
Expenditure Line
Real 8,000
Aggregate
Expenditure 7,000
($ Billions)
6,000
5. to get the aggregate expenditure line.
C + IP + G + NX
C + IP + G
C + IP
C
4. and net exports (NX) . . .
5,000
4,000
3,000
3. government purchases (G) . . .
2,000
2. then add planned investment (IP) . . .
1,000
1. Start with the
consumptionincome line,
2,000
4,000
6,000
8,000
Real GDP ($ Billions)
28
Finding Equilibrium GDP With A
Graph
 Figure 6 shows a graph in which
horizontal and vertical axes are both
measured in same units, such as
dollars
 Also shows a line drawn at a 45° angle
that begins at origin
 45° line is a translator line
 Allows us to measure any horizontal distance
as a vertical distance instead
 Now we can apply this geometric trick
to help us find the equilibrium GDP
29
Fig. 6 Using a 45° Line to Translate
Distances
1. Using a 45-degree line . . .
A
3. into an equal
vertical distance
(BA).
2. we can translate
any horizontal
distance (such
as 0B) . . .
45°
0
B
30
Finding Equilibrium GDP With A
Graph
 Figure 7 shows how we can apply geometric trick to help
us find equilibrium GDP
 At any output level at which aggregate expenditure line
lies below 45° line, aggregate expenditure is less than
GDP
 If firms produce any of these out put levels, inventories
will grow, and they will reduce output in the future
 At any output level at which aggregate expenditure line
lies above 45° line, aggregate expenditure exceeds GDP
 If firms produce any of these output levels, inventories
will decline, and they will increase their output in the
future
 We have thus found our equilibrium on graph
 Equilibrium GDP is output level at which aggregate
expenditure line intersects 45° line
 If firms produce this output level, their inventories will not
change, and they will be content to continue producing same
31
level of output in the future
Figure 7: Determining Equilibrium
Real GDP
Increase in Inventories
Real Aggregate
Expenditure 9,000
($ Billions) 8,000
A
C + IP + G + NX
H
7,000
6,000
5,000
4,000
Decrease in
Inventories
K
1,000
Total Output
Aggregate Expenditure
3,000
2,000
E
Total
Output
45°
J
Aggregate
Expenditure
2,000 4,000 6,000 8,000
Real GDP ($ Billions)
32
Equilibrium GDP and Employment




When economy operates at equilibrium, will it also be
operating at full employment?

Not necessarily

As long as spending remains low, production will remain low,
and unemployment will remain high
It would be quite a coincidence if our equilibrium GDP
happened to be output level at which entire labor force
were employed
In short-run macro model, cyclical unemployment is caused
by insufficient spending
In short-run macro model, economy can overheat because
spending is too high


As long as spending remains high, production will exceed
potential output, and unemployment will be unusually low
Aggregate expenditure line may be low, meaning that in
short-run, equilibrium GDP is below full employment

Or aggregate expenditure may be high, meaning that in shortrun, equilibrium GDP is above full-employment level
33
Figure 8: Equilibrium GDP Can Be
Less Than Full Employment GDP
Aggregate When the aggregate
Expenditure expenditure line is
($ Billions) low . . .
Real GDP
($ Billions)
F
$7,000
$6,000
equilibrium
output ($6,000)
is less than
potential output,
$7,000
$6,000
B
$7,000
E
45°
Aggregate
Production
Function
AELOW
Real GDP
($ Billions)
A
cyclical
unemployment
= 25 million
100
Million
75
Million
Number of
Workers
Potential GDP
Full Employment
and equilibrium employment is less than full employment.
34
Figure 9: Equilibrium GDP Can Be
Greater Than Full-Employment GDP
When the aggregate
Aggregate expenditure line is high . . . Real GDP
Expenditure
($ Billions)
($ Billions)
AEHIGH
E'
$8,000
$7,000
$7,000
F
$7,000
equilibrium output ($8,000) is
greater than potential output,
$7,000
Potential GDP
$8,000
H
B
Aggregate
Production
Function
and equilibrium employment is greater than full
employment.
Real GDP
($ Billions)
Number of
Workers
135
Million
100
Million
Full Employment
35
A Change in Investment Spending
 Suppose equilibrium GDP in an economy is
$6,000 billion, and then business firms
increase their investment spending on plant
and equipment by $1,000 billion
 What will happen?
 Sales revenue at firms that manufacture
investment goods will increase by $1,000 billion
 Each time a dollar in output is produced, a
dollar of income (factor payment) is created
 What will households do with their $1,000
billion in additional income?
 What they will do depends crucially on marginal
propensity to consume (MPC)
36
 Assume MPC = 0.6
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
 With an MPC of 0.6, consumption spending will rise
by 0.6 x $600 billion = $360 billion, creating still
more sales revenue for firms, and so on and so on…
 Increase in investment spending will set off a chain
reaction
 Leading to successive rounds of increased spending
and income
 At end of process, when economy has reached its new
equilibrium
 Total spending and total output are considerably
37
higher
Figure 10: The Effect of a Change
in Investment Spending
Increase in
Annual GDP
2,500
2,176
2,306
1,960
1,600
1,000
Initial
Rise in
IP
After
Round
2
After
Round
3
After
Round
4
After
Round
5
After
All
Rounds
38
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

1 / (1 – MPC)
 Expenditure multiplier is number by which the change
in investment spending must be multiplied to get
change in equilibrium GDP
 Value of expenditure multiplier depends on value of
MPC
 Simple formula we can use to determine multiplier for
any value of MPC
 Using general formula for expenditure multiplier, can
restate what happens when investment spending
increases


1
P
GDP  
x

I

(
1

MPC
)


39
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
40
change in spending
Other Spending Shocks
 Shocks to economy can come from other sources
besides investment spending
 Suppose government agencies increased their
purchases above previous levels
 Besides planned investment and government
purchases, there are two other components of
spending that can set off the same process
 An increase in net exports (NX)
 A change in autonomous consumption
 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
41
Other Spending Shocks
 Following four equations summarize how we
use expenditure multiplier to determine
effects of different spending shocks in shortrun macro model


1
GDP  
x IP

 (1 - MPC) 


1
GDP  
 x G
(1
MPC)




1
GDP  
 x NX
(1
MPC)




1
GDP  
x a

 (1 - MPC) 
42
A Graphical View of the Multiplier
 Figure 11 illustrates multiplier using aggregate
expenditure diagram


1
GDP  
x Spending

 (1 - MPC) 
• An increase in autonomous consumption spending,
investment spending, government purchases, or net exports
will shift aggregate expenditure line upward by increase in
spending
– Causing equilibrium GDP to rise
• Increase in GDP will equal initial increase in spending times
expenditure multiplier
43
Figure 11: A Graphical View of the
Multiplier
Real Aggregate
Expenditure 9,000
($ Billions) 8,000
F
AE2
AE1
7,000
6,000
E
5,000
$1,000
4,000
Increase in
Equilibrium GDP
3,000
2,000
$2,500
Billion
1,000
45°
2,000
4,000
6,000
8,000
Real GDP ($ Billions)
44
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
45