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The Short-Run Macro Model
© 2003 South-Western/Thomson Learning
The Short-Run Macro Model
In the short run, spending depends
on income, and income depends on
spending.
The Short-Run Macro Model
Short-Run Macro Model
A macroeconomic model that
explains how changes in spending
can affect real GDP in the short run
The Short-Run Macro Model
In the short-run macro model, we focus
on spending in markets for currently
produced U.S. goods and services—that
is, spending on things that are included
in U.S. GDP.
Real Spending
Four categories of buyers:
•Households: consumption spending (C)
•Businesses: investment spending (IP)
•Government Agencies: government
purchases (G)
•Foreigners: net exports (NX)
Consumption Spending
•Consumption and Disposable Income
•Consumption and Income
•Shifts in the Consumption-Income Line
Consumption Spending
Disposable Income
The part of household income that
remains after paying taxes
Disposable income = Income – Taxes
Consumption Spending
Consumption Function
A positively sloped relationship between
real consumption spending and real
disposable income
Determinants of Consumption
Spending
Real
Disposable
Income
+
Interest
Rate
–
+
Real
Wealth
Expectations
of Future Income
+
Real
Consumption
Spending
Consumption Function
Real
8,000
Consumption
Spending
($ Billions) 7,000
6,000
The consumption function shows
the (linear) relationship between
real consumption spending and
real disposable income.
Consumption
Function
The vertical intercept (here,
$2,000 billion) is autonomous
consumption spending ...
5,000
600
4,000
1,000
3,000
and the slope of the line
(here, 0.6) is the marginal
propensity to consume.
2,000
1,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Real Disposable Income ($ Billions)
Consumption Spending
Autonomous Consumption Spending
The part of consumption spending that
is independent of income; also, the
vertical intercept of the consumption
function
Consumption Spending
Marginal Propensity to Consume (MPC)
The amount by which consumption
spending rises when disposable income
rises by one dollar
Marginal Propensity to Consume
Marginal Propensity to Consume
(MPC) is also:
•the slope of the consumption function
•the change in consumption divided by
the change in disposable income
(C/YD)
Consumption Equation
C = a + bYD
where
a = vertical intercept of the consumption
function (representing theoretical level of
consumption spending at YD = 0)
b = the slope of the consumption function (or
the MPC)
Consumption and Income
Consumption-Income Line
A line showing aggregate
consumption spending at each level
of income or GDP
Consumption Income Line
Real
Consumption
Spending
($ Billions)
To draw the consumptionincome line, we measure
real income (instead of real
disposable income) on the
horizontal axis.
ConsumptionIncome
Line
5,600
B
5,000
4,000
A
The line has the same
slope as the consumption
function in Figure 3 ...
3,000
2,000
1,000
600
1,000
but a different
vertical intercept.
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real Income
($ Billions)
Shifts in the Consumption
Income Line
When government collects fixed amount of
taxes from households: line representing the
relationship between consumption and
income is shifted downward by amount of
tax times MPC
The slope of this line is unaffected by taxes,
and is equal to the MPC.
Movement Along the
Consumption Income Line
Income
Disposable
Income
Consumption
Spending
Movement
Rightward
Along the
ConsumptionIncome Line
Shifts in the Consumption
Income Line
Taxes
Disposable
Income
Consumption
at any income
level
Shift Upward
of the
ConsumptionIncome Line
Increases In Autonomous
Consumption
Autonomous
consumption
(a)
Consumption
at each level
of disposable
Income
Consumption
spending at
each income
level
Shift Upward
of the
ConsumptionIncome Line
Shift in the Consumption
Income Line
Real
8,000
Consumption
Spending
($ Billions) 7,000
Consumption–Income
Line When Taxes = 500
6,000
5,000
4,000
3,000
2,000
Consumption–Income
Line When Taxes = 2,000
1,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real Income
($ Billions)
Consumption Spending
When a change in income causes
consumption spending to change, we
move along the consumption-income
line.
When a change in anything else besides
income causes consumption spending to
change, the line will shift.
Getting to Total Spending
•Investment Spending
•Government Purchases
•Net Exports
•Summing Up: Aggregate Expenditure
•Income and Aggregate Expenditure
Investment Spending
Investment spending: plant and
equipment purchases by business firms,
and new home construction
Inventory investment: unintentional and
undesired, therefore excluded from the
definition of investment spending
Government Purchases
In the short-run macro model,
government purchases are treated as
a given value, determined by forces
outside of the model.
Net Exports
Net Exports =
Total Exports – Total Imports
Aggregate Expenditure (AE)
Aggregate Expenditure (AE)
The sum of spending by households,
business firms, the government, and
foreigners on final goods and services
produced in the United States
Aggregate Expenditure
Aggregate expenditure =
p
C + I + G + NX
Aggregate Expenditure
When income increases, aggregate
expenditure (AE ) will rise by the
MPC times the change in income.
Finding Equilibrium GDP
•Inventories and Equilibrium GDP
•Finding Equilibrium GDP with
a Graph
•Equilibrium GDP and Employment
Finding Equilibrium GDP
When aggregate expenditure is less than
GDP, output will decline in the future.
Thus, any level of output at which
aggregate expenditure is less than GDP
cannot be the equilibrium GDP.
Finding Equilibrium GDP
When aggregate expenditure is greater
than GDP, output will rise in the future.
Thus, any level of output at which
aggregate expenditure exceeds GDP
cannot be the equilibrium GDP.
Finding Equilibrium GDP
Equilibrium GDP
In the short run, the level of output at
which output and aggregate
expenditure are equal.
Inventories and Equilibrium
GDP
The change in inventories during any
period will always equal output minus
aggregate expenditure.
Inventories = GDP – AE
Inventories and Equilibrium
GDP
AE < GDP
Inventories>0
GDP
in future periods
AE > GDP
Inventories<0
GDP
in future periods
AE > GDP
Inventories=0
GDP No change in GDP
Finding Equilibrium GDP
The AE line is found by adding fixed
amounts of investment, government
purchases, and net exports to
consumption, as determined by the
consumption-income line.
The slope of the AE line is the MPC.
Finding Equilibrium GDP
Real
Aggregate 8,000
Expenditure
($ Billions)
7,000
6,000
p
C+I +G+NX
p
C+I +G
p
C+I
C
5,000
4,000
3,000
2,000
1,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real GDP
($ Billions)
Finding Equilibrium GDP
C
A
45°
0
B
Finding Equilibrium GDP
A 45 degree line is a translator line:
It allows us to measure any horizontal
distance as a vertical distance
instead.
Finding Equilibrium GDP
Real
Aggregate
Expenditure 9,000
($ Billions)
A
Increase in
Inventories
C+Ip+G+NX
8,000
H
7,000
E
6,000
5,000
Total
Output
K
4,000
Decrease
in Inventories
3,000
J
Aggregate
Expenditure
2,000
1,000
Aggregate
Expenditure
Total
Output
45°
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real GDP
($ Billions)
Finding Equilibrium GDP
At any output level at which the
aggregate expenditure line lies below the
45 degree line, aggregate expenditure is
less than GDP.
If firms produce any of these output
levels, their inventories will grow, and
they will reduce output in the future.
Finding Equilibrium GDP
At any output level at which the
aggregate expenditure line lies above the
45 degree line, aggregate expenditure
exceeds GDP.
If firms produce any of these output
levels, their inventories will decline, and
they will increase output in the future.
Finding Equilibrium GDP
Equilibrium GDP is the output level at
which the AE line intersects the 45 line.
If firms produce this output level, their
inventories will not change, and they will
be content to continue producing the
same level of output in the future.
Equilibrium GDP and
Employment
In the 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.
Equilibrium GDP and Employment
(a)
Aggregate
Expenditure
AElow
In the short run, equilibrium
GDP can be too low so that
equilibrium employment is
less than full employment ...
E
45°
Ye
Y FE
Real GDP
(b)
Employment
Production
Function
Le’
E’
LFE
Le
E
Ye
Ye’
Y FE
Real GDP
(c)
or too high so that equilibrium
employment is greater than
full employment.
Aggregate
Expenditure
E’
AEhigh
45°
YFE
Ye’
Real GDP
Equilibrium GDP and
Employment
In the short-run macro model, the
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.
What Happens
When Things Change?
•A Change in Investment Spending
•The Expenditure Multiplier
•The Multiplier in Reverse
•Other Spending Shocks
•A Graphical View of the Multiplier
•An Important Proviso About the Multiplier
A Change in Investment
Spending
An increase in investment spending
will set off a chain reaction, leading
to successive rounds of increased
spending and income.
A Change in Investment
Spending
Total
2,500
Spending
2,306
Each
2,176
Period
($ Billions)
1,960
1,600
1,000
1
2
3
4
5
...
Time
Periods
The Expenditure Multiplier
Expenditure Multiplier
The amount by which equilibrium real
GDP changes as a result of a one-dollar
change in autonomous consumption,
investment, or government purchases.
The Expenditure Multiplier
For any value of the MPC, the
formula for the expenditure
multiplier is
1/( 1 - MPC ).
The Expenditure Multiplier
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.
Other Spending Shocks
Changes in planned investment, government
purchases, net exports, or autonomous
consumption lead to a multiplier effect on
GDP.
The expenditure multiplier is what we
multiply the initial change in spending by in
order to get the change in equilibrium GDP.
Other Spending Shocks


1
P
GDP  


I

 (1  MPC) 
Other Spending Shocks


1
GDP  


G

 (1  MPC) 
Other Spending Shocks


1
GDP  


NX

 (1  MPC) 
Other Spending Shocks


1
GDP  


a

 (1  MPC) 
A Graphical View of the
Multiplier
Real
Aggregate
Expenditure 9,000
($ Billions)
AE2
F
AE1
8,000
7,000
6,000
E
5,000
$1,000
4,000
Increase in
Equilibrium
GDP
3,000
2,000
$2,500
Billion
1,000
45°
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Real GDP
($ Billions)
A Graphical View of the
Multiplier


1
GDP  
 Spending

 (1  MPC) 
Other Spending Shocks
An increase in autonomous consumption
spending, investment spending,
government purchases, or net exports
will shift the aggregate expenditure line
upward by the increase in spending,
causing GDP to rise.
Automatic Stabilizers
Automatic Stabilizers
Forces that reduce the size of the
expenditure multiplier and diminish the
impact of spending shocks
Real-World Automatic
Stabilizers
•Taxes
•Transfer Payments
•Interest Rates
•Prices
•Imports
•Forward-looking Behavior
Real-World Automatic
Stabilizers
In the real world, due to automatic
stabilizers, spending shocks have
much weaker impacts on the
economy than our simple multiplier
formulas would suggest.
Real-World Automatic
Stabilizers
In the long run, our multipliers have a
value of zero: No matter what the change
in spending or taxes, output will return to
full employment, so the change in
equilibrium GDP will be zero.
Comparing Models:
Long Run and Short Run
•The Role of Saving
•The Effect of Fiscal Policy
The Role of Saving
In the long run, an increase in the desire
to save leads to faster economic growth
and rising living standards.
In the short run, an increase in the desire
to save can cause a recession that pushes
output below its potential.
The Effect of Fiscal Policy
In the short run, an increase in
government purchases causes a
multiplied increase in equilibrium GDP,
so can change equilibrium GDP.
In the long run, fiscal policy is
ineffective.
The Tax Multiplier
The tax multiplier is 1.0 less than the
spending multiplier, and negative in sign.
Tax multiplier =
– (spending multiplier - 1)
The Tax Multiplier
 MCP
Tax multiplier 
(1  MPC)
The Tax Multiplier
 MPC
GDP 
 T
1  MPC