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Output and Expenditure in the Short Run Chapter 11: Output and Expenditure in the Short Run Aggregate expenditure (AE) The total amount of spending on the economy’s output: Aggregate Expenditure AE = C + I + G + NX • Consumption (C) • Planned Investment (I) • Government Purchases of Goods + Services (G) • Net Exports (NX) Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y) AE = C + I + G + NX = Y © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 54 Chapter 11: Output and Expenditure in the Short Run Components of Real Aggregate Expenditure, 2006 EXPENDITURE CATEGORY Consumption EXPENDITURE (BILLIONS OF 2000 DOLLARS) $8,091 Investment 1,946 Government 1,998 Net Exports −618 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 54 The Aggregate Expenditure Model Chapter 11: Output and Expenditure in the Short Run Adjustments to Macroeconomic Equilibrium Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected IF … Aggregate expenditure is equal to GDP Aggregate expenditure is less than GDP THEN … AND … inventories are unchanged the economy is in macroeconomic equilibrium. inventories rise GDP and employment decrease. Aggregate Expenditure is greater than GDP inventories fall GDP and employment increase. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 54 Chapter 11: Output and Expenditure in the Short Run Real Consumption Expenditure C = $C/CPI FIGURE 11-1 Real Consumption, 1979–2006 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 54 The most important variables that determine the level of consumption: Chapter 11: Output and Expenditure in the Short Run • Current disposable income • Household wealth: Assets minus liabilities • Expected future income People try to keep their consumption fairly steady from year-to-year save for a rainy day • The price level Higher price level reduces real value of monetary wealth • The interest rate High interest rate discourages spending on credit and encourages saving © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 54 The Consumption Function: The relation between consumption and disposable income Chapter 11: Output and Expenditure in the Short Run The Relationship between Consumption and Income, 1960– 2006 Marginal propensity to consume (MPC) The amount by which consumption spending changes when disposable income changes = slope of consumption function. Consumption Function © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 54 Chapter 11: Output and Expenditure in the Short Run The Consumption Function Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes. Change in consumptio n C MPC Change in disposable income YD We can also use the MPC to determine how much consumption will change as income changes: Change in consumptio n MPC Change in disposable income Change in consumption = Change in disposable income × MPC © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 54 Chapter 11: Output and Expenditure in the Short Run The Relationship between Consumption and National Income when net taxes are constant © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 54 Determining the Level of Aggregate Expenditure in the Economy Chapter 11: Output and Expenditure in the Short Run Income, Consumption, and Saving National income = Consumption + Saving + Taxes Y=C+S+T Change in national income = Change in consumption + Change in saving + Change in taxes Y C S T If taxes are always a constant amount, ΔT = 0 ΔY = ΔC + ΔS © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 54 Chapter 11: Output and Expenditure in the Short Run Income, Consumption, and Saving Marginal propensity to save (MPS) The change in saving divided by the change in disposable income. Y C S Y Y Y or, 1 = MPC + MPS MPS = 1 - MPC © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 54 Solved Problem 11-2 Chapter 11: Output and Expenditure in the Short Run Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save C MPC Y NATIONAL INCOME AND REAL GDP (Y) S MPS Y CONSUMPT ION SAVING (C) (S) $9,000 $8,000 1,000 10,000 8,600 1,400 11,000 9,200 1,800 12,000 9,800 2,200 13,000 10,400 2,600 MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) — — 0.6 0.4 0.6 0.4 0.6 0.4 0.6 0.4 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 54 Determining the Level of Aggregate Expenditure in the Economy Chapter 11: Output and Expenditure in the Short Run Planned Investment (I) Real Investment, 1979–2006 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 54 The most important variables that determine the level of investment: Chapter 11: Output and Expenditure in the Short Run • Expectations of future profitability Waves of optimism and pessimism • Major technology changes: new products & processes • The interest rate • Taxes • Cash flow • Current capacity utilization © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 54 Chapter 11: Output and Expenditure in the Short Run The “new” information economy of the 1990s © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 54 Chapter 11: Output and Expenditure in the Short Run Government Purchases (G) Real Government Purchases, 1979–2006 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 54 Chapter 11: Output and Expenditure in the Short Run Net Exports (NX) Real Net Exports, 1979–2006 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 54 Chapter 11: Output and Expenditure in the Short Run Net Exports (NX) The most important variables that determine the level of net exports: • The price level in the United States relative to the price levels in other countries • The growth rate of GDP in the United States relative to the growth rates of GDP in other countries • The exchange rate between the dollar and other currencies © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 54 Learning Objective 11.3 Graphing Macroeconomic Equilibrium Chapter 11: Output and Expenditure in the Short Run FIGURE 11-8 The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 54 Chapter 11: Output and Expenditure in the Short Run Graphing Macroeconomic Equilibrium © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 54 Chapter 11: Output and Expenditure in the Short Run Graphing Macroeconomic Equilibrium © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 54 Learning Objective 11.3 Graphing Macroeconomic Equilibrium Chapter 11: Output and Expenditure in the Short Run Showing a Recession on the 45°-Line Diagram FIGURE 11-11 Showing a Recession on the 45°-Line Diagram © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 54 Chapter 11: Output and Expenditure in the Short Run Macroeconomic Equilibrium Consump tion (C) Govern Planned Unplan Planned ment Net Aggregate ned Invest Purchase Export Expendi Change ment s s ture in Invent (I) (G) (NX) (AE) ories Real GDP Will … $8,00 0 $6,200 $1,500 $1,500 – $500 $8,700 –$700 increase 9,000 6,850 1,500 1,500 –500 9,350 –350 increase Real GDP (Y) be in equili brium 10000 7,500 1,500 1,500 –500 10,000 0 11000 8,150 1,500 1,500 –500 10,650 +350 decrease 12000 8,800 1,500 1,500 –500 11,300 +700 decrease Don’t Let This Happen to YOU! Don’t Confuse Aggregate Expenditure with Consumption Spending © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 54 Chapter 11: Output and Expenditure in the Short Run The Multiplier Effect © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 54 Learning Objective 11.4 Chapter 11: Output and Expenditure in the Short Run The Multiplier Effect Autonomous expenditure An expenditure that does not depend on the level of GDP. Multiplier The increase in equilibrium real GDP in response to increase in autonomous expenditure, e.g. Expenditure multiplier = ΔY/ΔI Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC = Change in autonomous spending that sparks an expansion + Change in consumption spending induced by increasing output and income. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 54 Chapter 11: Output and Expenditure in the Short Run The Multiplier Effect in Action ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) ROUND 1 $100 billion ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) $0 TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP $100 billion ROUND 2 0 75 billion 175 billion ROUND 3 0 56 billion 231 billion ROUND 4 ROUND 5 . . . ROUND 10 . . . ROUND 15 . . . 0 0 . . . 0 . . . 0 . . . 42 billion 32 billion . . . 8 billion . . . 2 billion . . . 273 billion 305 billion . . . 377 billion . . . 395 billion . . . ROUND 19 0 1 billion 398 billion n 0 0 $400 billion © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 54 Making the Chapter 11: Output and Expenditure in the Short Run Connection The Multiplier in Reverse: The Great Depression of the 1930s The multiplier effect contributed to the very high levels of unemployment during the Great Depression. Year Consumption Investment Net Exports Real GDP Unemployment Rate 1929 $661 billion $91.3 billion -$9.4illion $865 billion 3.2% 1933 $541 billion $17.0 billion -$10.2 billion $636 billion 24.9% © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 54 The Multiplier Effect Chapter 11: Output and Expenditure in the Short Run A Formula for the Multiplier 1 1 MPC Change in equilibriu m real GDP 1 Multiplier Change in autonomous expenditur e 1 MPC © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 54 Chapter 11: Output and Expenditure in the Short Run Summarizing the Multiplier Effect 1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases. 2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. 3 The larger the MPC, the larger the value of the multiplier. 4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on taxes, imports, prices and interest rates. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 54 Chapter 11: Output and Expenditure in the Short Run The Aggregate Demand Curve The Effect of a Change in the Price Level on Real GDP © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 54 Chapter 11: Output and Expenditure in the Short Run Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure, holding constant all other factors that affect aggregate expenditure. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 54 Key Terms Chapter 11: Output and Expenditure in the Short Run Aggregate demand curve Aggregate expenditure (AE) Marginal propensity to consume (MPC) Autonomous expenditure Marginal propensity to save (MPS) Cash flow Multiplier Consumption function Multiplier effect Aggregate expenditure model Inventories © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 54 Appendix Chapter 11: Output and Expenditure in the Short Run The Algebra of Macroeconomic Equilibrium 1 C C MPC (Y ) Consumption function 2 I 1 Planned investment function 3 GG Government spending function 4 NX N X Net export function 5 Y C I G NX Equilibrium condition © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 54 Appendix Chapter 11: Output and Expenditure in the Short Run The Algebra of Macroeconomic Equilibrium The letters with bars over them represent fixed, or autonomous, values. So, C represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get: Y C MPC(Y) I G NX Or, Y - MPC(Y) C I G NX Or, Y (1 MPC ) C I G NX Or, C I G NX Y 1 MPC © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 54 Appendix Chapter 11: Output and Expenditure in the Short Run The Algebra of Macroeconomic Equilibrium 1 is the multiplier. Therefore an alternative 1 MPC expression for equilibrium GDP is: Remember that Equilibrium GDP = Autonomous expenditure x Multiplier © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 54