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The Short-Run Macro
Model
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
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
• Causing changes in total output and employment
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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
• Need to organize our thinking about markets that contribute to GDP
– What’s the best way to categorize all these buyers into larger groups so
we can analyze their behavior?
• 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”
3
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?
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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
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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
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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 spend
• Whether it’s put in bank or used to pay off a loan
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Expectations
• Expectations about future would affect your spending as well
– All else equal, optimism about future income causes an increase in
consumption spending
• Other variables influence your 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
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Figure 1: U.S. Consumption and
Disposable Income, 1985-2002
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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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Figure 2: The Consumption
Function
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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
– We will always assume that 0 < MPC < 1
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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, or autonomous consumption
spending
• Term b is slope of consumption function
– Marginal propensity to consume (MPC)
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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)
– Slope of this line is unaffected by taxes and is equal to MPC
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Figure 3: The Consumption-Income
Line
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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
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Shifts in the Consumption-Income
Line
• By shifting relationship between
consumption and disposable income, we
shift relationship between consumption and
income as well
– Increases in autonomous consumption work
this way
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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 consumptionincome 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)
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Figure 4: A Shift in the
Consumption-Income Line
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Table 3: Changes in Consumption
Spending and the Consumption–Income Line
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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
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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
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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
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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
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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
26
Finding Equilibrium GDP
• Method of finding equilibrium in short-run is very different
from anything you’ve seen before in this text
• 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
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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
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Figure 5: Deriving the Aggregate
Expenditure Line
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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
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Figure 6: Using a 45° to Translate
Distances
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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 level of output in the
future
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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
• 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
– As long as spending remains low, production will remain low, and
unemployment will remain high
• 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 short-run,
equilibrium GDP is above full-employment 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
37
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
– What will happen?
• Sales revenue at firms that manufacture investment goods will
increase by $1,000 billion
• What will households do with their $1,000 billion in
additional income?
– What they will do depends crucially on marginal
propensity to consume (MPC)
• Assume MPC = 0.6
38
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 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
• 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
– 1 ÷ (1 – MPC)
• Using general formula for expenditure multiplier, can
restate what happens when investment spending
increases


1
P
GDP  
x

I

(
1

MPC
)


41
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
42
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
43
Other Spending Shocks
• Following four equations summarize how we use
expenditure multiplier to determine effects of
different spending shocks in short-run macro
model


1
P
GDP  
x

I

 (1 - MPC) 


1
GDP  
 x G
(1
MPC)




1
GDP  
 x NX
(1
MPC)




1
GDP  
x a

 (1 - MPC) 
44
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
45
Figure 11: A Graphical View of the
Multiplier
46
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
• Each of these automatic stabilizers reduces size of
multiplier
– Making it smaller than simple formulas given in this chapter
47
Automatic Stabilizers and the
Multiplier
• In real world, due to automatic stabilizers,
spending shocks have much weaker impacts on
economy than our simple multiplier formulas
would suggest
• One more automatic stabilizer—perhaps the most
important of all
– Passage of time
• In long-run, multipliers have a value of zero
– No matter what the change in spending or taxes, output
will return to full employment, so change in equilibrium
GDP will be zero
48
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
49
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
50
Using the Theory: The Recession of
2001
• Our most recent recession lasted from March
2001 to November 2001
• Investment spending and real GDP—which were
drifting downward before recession—fell sharply
during second quarter of 2001, and continued to
fall throughout year
• What caused this recession?
– And can our short run macro model help us understand
it?
• Decrease in investment spending is just the sort
of spending shock that shifts aggregate
expenditure line downward
51
Using the Theory: The Recession of
2001
• But what caused these successive decreases in
investment spending?
– There were at least three causes
• During much of late 1990s, there had been a boom in capital
equipment spending
– As existing businesses rushed to incorporate the Internet into
factories, offices, and their business practices
– But as 2000 ended and 2001 began, firms had begun to catch up
to new technology
• During 1990s the Internet and other new technologies made
public very optimistic about future profits of American
businesses
– Unfortunately, in late 2000 and early 2001, reality set in
• Terrorist attacks on World Trade Center and Pentagon on
September 11, 2001
52
Using the Theory: The Recession of
2001
• One abnormal feature of the recession of 2001
was behavior of consumption spending
– Ordinarily, as income falls in a recession, consumption
declines along with it
– Yet consumption spending actually rose during every
quarter of 2001
• Part of reason for upward shift was a ten-year tax
cut that went into effect in June of 2001
• Investment spending shock—and recession it
caused—are only half of the story of recession of
2001
– The other half—entirely ignored so far—is response of
government policymakers as they tried to prevent
economic storm from becoming a hurricane
53