Download The Income-Expenditure Model

C H A P T E R 11
The Income-Expenditure
Model
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
11-1
CHAPTER
The Income-Expenditure
Model
11
Heading into the global recession in 2007, the Chinese economy was
growing at the extraordinary rate of 11 percent per year.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 11
The Income-Expenditure
Model
APPLYING THE CONCEPTS
1
How do changes in the value of homes affect consumer spending?
Falling Home Prices, the Wealth Effect, and Decreased
Consumer Spending
2
What evidence does the long historical record provide about
multipliers?
Using Long-Term Macro Data to Measure Multipliers
3
How influential a figure was John Maynard Keynes?
John Maynard Keynes: A World Intellectual
4
How do countries benefit from growth in their trading partners?
The Locomotive Effect: How Foreign Demand Affects a
Country’s Output
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
11-3
C H A P T E R 11
The Income-Expenditure
Model
11.1
A SIMPLE INCOME-EXPENDITURE MODEL
Equilibrium Output
 FIGURE 11.1
The 45° Line
At any point on the
45° line, the
distance
to the horizontal axis
is the same as the
distance to the
vertical axis.
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11-4
C H A P T E R 11
The Income-Expenditure
Model
11.1
A SIMPLE INCOME-EXPENDITURE MODEL
(cont’d)
Equilibrium Output
• planned expenditures
•
Another term for total demand for goods and services.
equilibrium output
The level of GDP at which planned expenditure
equals the amount that is produced.
equilibrium output = y* = C + I = planned expenditures
 FIGURE 11.2
Determining Equilibrium Output
At equilibrium output y*, total
demand y* equals output y*.
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11-5
C H A P T E R 11
The Income-Expenditure
Model
11.1
A SIMPLE INCOME-EXPENDITURE MODEL
(cont’d)
Adjusting to Equilibrium Output
 FIGURE 11.3
Equilibrium Output
Equilibrium output (y*) is
determined at a, where demand
intersects the 45° line.
If output were higher (y1), it would
exceed demand and production
would fall.
If output were lower (y2), it would
fall short of demand and
production would rise.
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11-6
C H A P T E R 11
The Income-Expenditure
Model
11.2
THE CONSUMPTION FUNCTION
Consumer Spending and Income
• consumption function
The relationship between consumption
spending and the level of income.
C = Ca + by
• autonomous consumption
The part of consumption that does not
depend on income.
• marginal propensity to consume (MPC)
The fraction of additional income that
is spent.
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11-7
C H A P T E R 11
The Income-Expenditure
Model
11.2
THE CONSUMPTION FUNCTION (cont’d)
Consumer Spending and Income
 FIGURE 11.4
Consumption Function
The consumption
function relates desired
consumer spending to
the level of income.
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11-8
C H A P T E R 11
The Income-Expenditure
Model
11.2
THE CONSUMPTION FUNCTION (cont’d)
Changes in the Consumption Function
 FIGURE 11.5
Movements of the Consumption Function
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11-9
C H A P T E R 11
The Income-Expenditure
Model
11.2
THE CONSUMPTION FUNCTION (cont’d)
Changes in the Consumption Function
Two factors that can cause autonomous
consumption to change:
• Increases in consumer wealth will cause an
increase in autonomous consumption.
• Increases in consumer confidence will increase
autonomous consumption.
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11-10
C H A P T E R 11
The Income-Expenditure
Model
APPLICATION
1
FALLING HOME PRICES, THE WEALTH EFFECT, AND
DECREASED CONSUMER SPENDING
APPLYING THE CONCEPTS #1: How do changes in the
value of homes affect consumer spending?
Home equity is the difference between the home value and what is owed on the
mortgage.
▪ The largest component of net wealth for most families.
▪ Changes in home equity like other forms of wealth affect consumer spending.
From 1997 to mid-2006 housing prices rose by about 90 percent and consumer
wealth grew by $6.5 trillion.
This ended in 2006 as housing prices began to fall.
According to a review of studies by the Congressional Budget Office, each $1
decline in consumer wealth would lower consumption spending between $.02 and
$.07, or $21 to $72 billion of spending.
This would reduce economic growth 0.1 to 0.5 percent during 2007.
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11-11
C H A P T E R 11
The Income-Expenditure
Model
11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION
 FIGURE 11.6
Equilibrium Output and
the Consumption Function
Equilibrium output is determined
where the C + I line intersects
the 45° line.
At that level of output, y*,
desired spending equals output.
(autonomous consumption + investment)
equilibrium output 
(1  MPC)
(Ca  I )
y* 
(1  b)
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11-12
C H A P T E R 11
The Income-Expenditure
Model
11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (cont’d)
Saving and Investment
• savings function
The relationship between the level of
saving and the level of income.
S=y−C
y=C+I
y−C=I
S=I
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11-13
C H A P T E R 11
The Income-Expenditure
Model
11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (cont’d)
Saving and Investment
 FIGURE 11.7
Savings, Investment, and
Equilibrium Output
Equilibrium output is
determined at the level of
output, y*, where savings
equals investment.
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11-14
C H A P T E R 11
The Income-Expenditure
Model
11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (cont’d)
Understanding the Multiplier
 FIGURE 11.8
The Multiplier
When investment increases
from I0 to I1, equilibrium output
increases from y0 to y1.
The change in output (Δy) is
greater than the change in
investment (ΔI).
multiplier 
1
(1  MPC)
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11-15
C H A P T E R 11
The Income-Expenditure
Model
APPLICATION
2
USING LONG-TERM MACRO DATA TO MEASURE
MULTIPLIERS
APPLYING THE CONCEPTS #2: What evidence does
the long historical record provide about multipliers?
Estimating the effect of multipliers is difficult because governments do not
change spending and taxes much during normal economic times.
Looking at periods of major war buildup and aftermath revealed:
▪ Defense spending had a multiplier of less than one so the increase
in the economy was less than the government expenditure.
▪ There was evidence that the expenditures crowded out other
components of spending.
▪ The multiplier was larger during periods of greater unemployment.
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11-16
C H A P T E R 11
The Income-Expenditure
Model
11.4
GOVERNMENT SPENDING
AND TAXATION
Fiscal Multipliers
planned expenditures including government = C + I + G
 FIGURE 11.9
Government Spending, Taxes, and GDP
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11-17
C H A P T E R 11
The Income-Expenditure
Model
11.4
GOVERNMENT SPENDING
AND TAXATION (cont’d)
Fiscal Multipliers
1
multiplier for government spending 
(1  MPC)
The consumption function with taxes is
C  Ca  b(y  T )
The formula for the tax multiplier is
MPC
tax multiplier 
(1  MPC)
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11-18
C H A P T E R 11
The Income-Expenditure
Model
11.4
GOVERNMENT SPENDING
AND TAXATION (cont’d)
Using Fiscal Multipliers
Although it is very simple, our income-expenditure model illustrates some
important lessons:
• An increase in government spending will increase total planned
expenditures for goods and services.
• Cutting taxes will increase the after-tax income of consumers and will
also lead to an increase in planned expenditures for goods and
services.
• Policymakers need to take into account the multipliers for government
spending and taxes as they develop policies.
In the long run, of course, we are better off if government spends the money
wisely, such as on needed infrastructure such as roads and bridges. This is
an example of the principle of opportunity cost.
P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
11-19
C H A P T E R 11
The Income-Expenditure
Model
APPLICATION
3
JOHN MAYNARD KEYNES: A WORLD INTELLECTUAL
APPLYING THE CONCEPTS #3: How influential a figure was
John Maynard Keynes?
At King’s College in Cambridge, Keynes began a lifetime association with an
important group of writers and artists, the Bloomsbury group, which included
the well-regarded writer Virginia Woolf.
After World War I, he attended the Versailles Peace Conference and wrote a
book, The Economic Consequences of the Peace.
▪ It condemned the peace treaty and its negotiators.
▪ This book established Keynes as both a first-rate economic analyst and
a brilliant writer.
Between the wars, Keynes wrote his most famous work, The General
Theory of Employment, Interest, and Money, which challenged the
conventional wisdom that economies would automatically recover from
economic downturns.
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11-20
C H A P T E R 11
The Income-Expenditure
Model
11.4
GOVERNMENT SPENDING
AND TAXATION (cont’d)
Understanding Automatic Stabilizers
 FIGURE 11.10
Growth Rates of U.S.
GDP, 1871–2009
After World War II,
fluctuations in GDP
growth became
considerably smaller.
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11-21
C H A P T E R 11
The Income-Expenditure
Model
11.4
GOVERNMENT SPENDING
AND TAXATION (cont’d)
Understanding Automatic Stabilizers
C = Ca + b(1 − t)y
adjusted MPC = b(1 − t)
 FIGURE 11.11
Increase in Tax Rates
An increase in tax rates
decreases the slope of
the C + I + G line.
This lowers output and
reduces the multiplier.
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11-22
C H A P T E R 11
The Income-Expenditure
Model
11.5
EXPORTS AND IMPORTS
To modify our model to include the effects of world spending on exports
and U.S. spending on imports, we need to take two steps:
1 Add exports, X, as another source of demand for U.S. goods and
services.
2 Subtract imports, M, from total spending by U.S. residents. We will
assume that imports, like consumption, increase with the level of
income.
M = my
• marginal propensity to import
The fraction of additional income that
is spent on imports.
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11-23
C H A P T E R 11
The Income-Expenditure
Model
11.5
EXPORTS AND IMPORTS (cont’d)
 FIGURE 11.12
U.S. Equilibrium Output
in an Open Economy
Output is determined
when the demand for
domestic goods equals
output.
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11-24
C H A P T E R 11
The Income-Expenditure
Model
11.5
EXPORTS AND IMPORTS (cont’d)
 FIGURE 11.13
How Increases in Exports and Imports Affect U.S. GDP
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11-25
C H A P T E R 11
The Income-Expenditure
Model
APPLICATION
4
THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND
AFFECTS A COUNTRY’S OUTPUT
APPLYING THE CONCEPTS #4: How do countries
benefit from growth in their trading partners?
From the early 1990s until quite recently, the United States was what
economists term the “locomotive” for global growth.
• Our demand for foreign products increased.
• U.S. imports increased along with output during this period.
• The increased demand fueled exports in foreign countries and
promoted their growth.
Studies have shown that the increase in demand for foreign goods
was actually more pronounced for developing countries than for
developed countries.
Conclusion: The United States was truly a locomotive, pulling the
developing countries along.
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11-26
C H A P T E R 11
The Income-Expenditure
Model
11.6
THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE
 FIGURE 11.14
Deriving the Aggregate
Demand Curve
As the price level falls
from P0 to P1, planned
expenditures increase,
which increases the
level of output from y0
to y1.
The aggregate demand
curve shows the
combination of prices
and equilibrium output.
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11-27
C H A P T E R 11
The Income-Expenditure
Model
11.6
THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE
(cont’d)
 FIGURE 11.15
Shifts in Aggregate Demand
As government spending
increases from G0 to G1,
planned expenditures
increase, which raises output
from y0 to y1.
At the price level P0, this
shifts the aggregate demand
curve to the right, from AD0
to AD1.
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11-28
C H A P T E R 11
The Income-Expenditure
Model
KEY TERMS
autonomous consumption
marginal propensity to consume (MPC)
consumption function
marginal propensity to import
equilibrium output
planned expenditures
savings function
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11-29
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
•Formula for Equilibrium Output
1
2
3
4
5
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11-30
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•The Multiplier for Investment
For the original level of investment at I0, we have
For a new level of investment at I1, we have
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11-31
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•The Multiplier for Investment
Substituting for the levels of output, we have
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11-32
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•The Multiplier for Investment
Finally, because (I1 − I0) is the change in investment, ΔI, we can write
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
11-33
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•Another Way to Derive the Formula for the Multiplier
y  $1  ($1  b)  ($1  b2 )  ($1  b 3 )...
or
The term in parentheses is an infinite series whose value is equal to
Substituting this value for the infinite series, we have the expression
for the multiplier:
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11-34
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•Government Spending and Taxes
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11-35
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•Government Spending and Taxes
Using this formula and the method just outlined, we can find the
multiplier for changes in government spending and the multiplier for
changes in taxes:
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11-36
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•Balanced-Budget Multiplier
1
b
balanced-budget multiplier 

(1  b) (1  b)
(1  b)

(1  b)
1
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11-37
C H A P T E R 11
The Income-Expenditure
Model
APPENDIX A
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER (cont’d)
•Equilibrium Output with Government Spending,
Taxes, and the Foreign Sector
output  planned expenditures  (C  I  G  X  M )
C  Ca  b(y  T )
M  mY
y  Ca  b(y  T )  I  G  X  mY
y  (b  m)y  Ca  bT  I  G  X
y[1  (b  m)]  Ca  bT  I  G  X
(Ca  bT  I  G  X
y* 
[1  (b  m)]
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11-38