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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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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*. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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) Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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) Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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) Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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. Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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: Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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: Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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 Copyright © 2012 Pearson Prentice Hall. All rights reserved. 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)] Copyright © 2012 Pearson Prentice Hall. All rights reserved. 11-38