Download Real GDP

Outline:
•Summing up aggregate expenditure (AE)
•Income and aggregate expenditure
•Inventories and equilibrium GDP
•The 45 degree line
•Determining equilibrium real GDP
•Equilibrium real GDP and employment
•Effect of a change in planned investment (IP)
•The expenditure multiplier
We we say that a particular
component of spending is
autonomous, we mean it is
determined “outside” our
model and is independent of
current GDP or real income
We assume that planned investment (IP),
government expenditures (G), net taxes (T),
and net exports (NX) are autonomous
variables.
700
IP
500
400
G
NX
0
Real GDP
(1)
Income
or GDP
(2)
(3)
(4)
(5)
NX
(6)= (2)+(3)
+(4)+(5)
AE
C
IP
G
2,000
2,000
700
3,000
2,600
4,000
Inv. I
500
400
3,600
-1,600
700
500
400
4,200
-1,200
3,200
700
500
400
4,800
-800
5,000
3,800
700
500
400
5,400
-400
6,000
4,400
700
500
400
6,000
0
7,000
5,000
700
500
400
6,600
400
8,000
5,600
700
500
400
7,200
800
9,000
6,200
700
500
400
7,800
1,200
10,000
6,800
700
500
400
8,400
1,600
All figures in billions per year
(7)
C + IP + G + NX
C + IP + G
AE
(billions)
C + IP
C
2400
2000
1500
800
0
GDP
(billions)
AE
(Billions)
At every point on
the line, AE = GDP
7,000
5,000
450
0
5,000
7,000
Real GDP
(Billions)
A
AE
7,800
H
6,000
E
K
4,200
C + IP + G +
NX
J
450
0
3,000
6,000
9,000
GDP
•AE > GDP by vertical distance K-J
•Plans of producing and spending units do not
coincide
•Unplanned inventory investment = - $1,200
•Tendency for firms (on average) to step up the
pace of production and offer more employment
• GDP > AE by vertical distance A-H
•Plans of producing and spending units do not
coincide
•Unplanned inventory investment = $1,200
•Tendency for firms (on average) to scale back
the on production and offer less employment
•AE = GDP
•Plans of producing and spending units coincide.
•Unplanned inventory investment = 0
• No tendency for firms (on average) to step up
the pace of production and offer more
employment. Nor is there a tendency for firms to
scale back on production and offer less
employment.
Classical (Special) Case: Full
Employment Equilibrium
AE
C + IP + G
+ NX
AE touches
the 450 line at
potential GDP
Full employment
GDP
GDP
General (Keynesian) Case:
Underemployment Equilibrium
AE
A
C + IP + G + NX
H
Y*
Full employment
GDP
GDP
Equilibrium GDP and employment
AE
AE2
AE1
0
Employment
FE subscript
means “full
employment”
450
Y1
YFE
Real GDP
Production
function
LFE
L1
0
Y1
YFE
Real GDP
•Assume the economy is in equilibrium
when real GDP = $6,000.
•What would happen if, other things
being equal, planned investment (IP)
increased by $1,000?
How did a $1,000
change in IP bring
about a $2,500 change
in GDP?
AE
AE2
2
AE1
1
3,400
H
IP
2,400
GDP
450
0
6,000
8,500
GDP
It’s a bird
It’s a plane
No, it’s the multiplier
effect!
The Effect of a $1,000 Change in Investment
MPC = .6
3000
2750
2500
2250
2176
2000
2306
2500
2384
1960
1750
1500
1600
1250
1000
750
1000
500
250
0
1
2
3
4
5
6
Time Perio d
.
.
.
.
Chain of causation
When firms increase investment by $1,000
billion, sales revenues at investment goods
manufacturers (Boeing, Westinghouse,
Cincinnati Milacron) will increase by $1,000
billion
The $1,000 billion in revenue will be distributed as
factor payments to those supplying resources
necessary to produce capital goods—hence the
change in spending generates $1,000 in income
in the first round.
Now households have $1,00 in additional income.
What do they do with it? Their spending will increase
by the MPC times the change in income—that is:
C = .6  $1,000 = $600. Hence, households spend
$600 billion and save $400 billion
But the story does not end here, since
McDonalds’s, Disney, Kraft, American Airlines,
and Amheiser Busch will see their sales increase
by $600 billion, and will distribute $600 billion in
wages, salaries, rental income, and profits to
those who supplied resources necessary to
produce the additional consumer goods.
Those who earned additional income in
consumer goods industries will now
increase their spending. By how much?
C = .6  $600 = $320.
This will result in additional production
and factor payments. Spending will
then increase. And so on. And so on.
Round
Additional Spending
in This Round
(Billions)
Additional Spending in
All Rounds (Billions)
Initial increase in IP
1,000
1,000
2
3
4
600
360
216
1,600
1,960
2,176
5
6
.
130
78
.
2,306
2,384
.
.
.
.
All other rounds
Very close to 116
.
.
.
Very close to 2,500
Algebraic derivation of the multiplier
Based on what we have learned so far, we can say (all
figures in billions):
GDP = $1,000 + $6,000 + $360 + $216 + . . .
Factoring out $1,000 in IP, this becomes:
GDP = $1,000[1 + 0.6 + 0.36 + 0.216 + . . .]
= $1,000[1 + 0.6 + 0.62 + 0.63 + . . . ]
We know that the $1,000 is the change in IP and the MPC
is 0.6. To find the change in GDP resulting from any
change in IP and any MPC:
GDP = IP  [1 + (MPC) + (MPC)2 + (MPC)3 + . . .]
Let H be any variable with a value between 0 and 1.
We can show that the infinite sum:
1 + H2 + H3 + H4 + . . .
Always has a value of 1/(1 – H).
We can replace H with MPC or b, since 0 < b < 1.
Thus the multiplier is given by 1/(1- MPC).
Using the general formula, we can restate what
happens when investment spending changes:
1
GDP 
 I P
(1  MPC )