1

The Short-Run Macro Model

• Short-run macro model– Macroeconomic model– Changes in spending– Affect real GDP– Short run

• Short run– Spending depends on income– Income depends on spending

2

Consumption Spending

• Consumption spending increases when:– Disposable income rises– Wealth rises– Interest rate falls– Optimistic about the future

3

Consumption and Disposable Income

• Consumption function– Relationship between consumption and

disposable income – Positive slope

• Autonomous consumption spending– Part of consumption spending – Independent of income– Vertical intercept - consumption function

4

U.S. Consumption and Disposable Income

• Figure 1 U.S. Consumption and Disposable Income, 1985–2005

5

Consumption and Disposable Income

• Marginal propensity to consume (MPC)– Slope of the consumption function– Amount by which consumption spending

rises when disposable income rises by one dollar

1MPC0income eΔDisposabl

onΔConsumptiMPC

6

Consumption and Disposable Income

• Representing the consumption with an equation

– C - consumption spending– a - autonomous consumption spending– b - MPC

Income) e(Disposabl b a C

7

The Consumption Function

ConsumptionFunction

1,000600

The consumption function shows the (linear) relationship between real consumption spending and real disposable income

and the slope of the line (0.6) is the marginal propensity to consume.

Rea

l Con

sum

ptio

n S

pend

ing

($

billi

ons)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real Disposable Income ($ billions)1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

The vertical intercept ($2,000 billion) is autonomous consumption spending . . .

• Figure 2 The Consumption Function

8

Consumption and Income

• Consumption–income line– Aggregate consumption spending at

each level of income or GDP– Slope = MPC– If Tax is fixed, it shifts downward by

MPC Tax

9

The Consumption-Income Line

1. To draw the consumption-income line, we measure real income (instead of real disposable income) on the horizontal axis.

Consumption-Income Line

600

AB

Real Consumption Spending ($ billions)

1,000

2,000

3,000

4,000

5,0005,600

Real Income ($ billions)2,000 4,000 6,000 8,000

1,000

2. The line has the same slope as the consumption function in Figure 2 . . .

3. but a different vertical intercept.

• Figure 3 The Consumption-Income Line

10

Shifts in the Consumption-Income Line

• Move along – Change in income - changes

consumption spending

• Shift– Change in anything else except income –

changes consumption spending

line income -nconsumptio thealong rightwardMovement spendingn Consumptio

income Disposable Income

11

Shifts in the Consumption-Income Line

• Table 3 Shifts in the Consumption-Income Line

12

Shift the Consumption-Income Line

Consumption-Income Line When Net Taxes = $500 billion

Consumption-Income Line When Net Taxes = $2,000 billion

Real Consumption

Spending ($ billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real Income ($ billions)2,000 4,000 6,000 8,000

• Figure 4 A Shift in the Consumption-Income Line

13

Getting to Total Spending

• Investment Spending– Given

• Government purchases – Given

• Net exports = Total exports - Total imports– Given

14

Income and Aggregate Expenditure

• Aggregate expenditure=C+Ip+G+NX• Income increases

– Aggregate expenditure increases

ΔGDPMPCΔAE

15

Deriving the Aggregate Expenditure Line

C + IP + GC + IP + G + NX

C + IP

C

2. then add planned investment (IP) . . .

1. Start with the consumption-income line,

5. to get the aggregate expenditure line.

3. government purchases (G) . . .

4. and net exports (NX) . . .

Real Aggregate

Expenditure ($ billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real GDP ($ billions)2,000 4,000 6,000 8,000

• Figure 5 Deriving the Aggregate Expenditure Line

16

Finding Equilibrium GDP

• Equilibrium GDP in the short run– Output = aggregate expenditure

• Change in inventory– ΔInventories = GDP - AE

GDPin change No0sInventorieGDPAEGDP0sInventorieGDP AE

GDP0sInventorieGDP AE

17

Using a 45° to Translate Distances• Figure 6 Using a 45° to Translate Distances

450 B

A

1. Using a 45° line …

2. we can translateAny horizontaldistance (such as

0B) …

3. into an equal verticaldistance (BA).

18

Determining Equilibrium Real GDP

• If AE line – below the 45° line– AE<GDP– Inventories increase– Reduce output in the future

• If AE line – above the 45° line– AE>GDP– Inventories decline– Increase output in the future

19

Determining Equilibrium Real GDP• Figure 7 Determining Equilibrium Real GDP

45

12,000

8,000

4,000 8,000 12,000

4,000 J

E

A C+IP+G+NX

TotalOutput Aggregate

Expenditure

Increase inInventories

H

K

AggregateExpenditureTotal

Output

Decrease inInventories

20

Determining Equilibrium Real GDP

• Equilibrium GDP– AE line intersects the 45° line– Inventories will not change– Produce the same level of output in the

future

21

Equilibrium GDP and Employment

• Equilibrium GDP – Not necessarily full employment

• Cyclical unemployment – low spending– Low production– High unemployment

• Overheat economy – too high spending– Production > potential output– Unusually low unemployment

22

A Change in Investment Spending

• Increase investment spending– Sales revenue increases– Income/disposable income increases– Consumption spending increases

• Expenditure multiplier – Change in equilibrium real GDP– For $1 change in C, IP, G, or NX

MPC)(11Multiplier

23

A Change in Investment Spending

1,600

1,9602,176

2,3062,500

1,000

InitialRise in

IP

AfterRound

2

AfterRound

3

AfterRound

4

AfterRound

5

Increase inAnnual GDP

AfterAll

Rounds

• Figure 10 The Effect of a Change in Investment Spending

24

A Change in Investment Spending

• Increase investment spending– GDP increases by more than the initial

increase in investment• Decrease investment spending

– GDP falls by more than the change in spending

PΔIMPC)(11ΔGDP

25

A Graphical View of the Multiplier

• An increase in C, IP, G, or NX – Shift the AE line upward by the initial

increase in spending– Equilibrium GDP rises:

ΔSpendingMPC)(11ΔGDP

26

A Graphical View of the Multiplier

F

E

$2,500Billion

4,000 8,000 12,000

4,000

8,000

12,000

Real GDP($ billions)

Real Aggregate Expenditure ($ billions)

45°

AE2

AE1

Increase inEquilibrium GDP

$1,000

• Figure 11 A Graphical View of the Multiplier

27

Automatic Stabilizers and the Multiplier

• Automatic stabilizers– Reduce the size of the multiplier– Diminish the impact of spending changes

• Taxes.• Transfer payments• Interest rates• Imports• Forward-looking behavior

• Long-run: Multiplier = 0

28

Counterycyclical Fiscal Policy

• Short run– Demand-side effects on output and

employment• Countercyclical fiscal policy

– Change G or T• To reverse or prevent a recession or a boom

• ΔGDP=Multiplier×ΔG

29

Counterycyclical Fiscal Policy

A

B

9,000 10,000 Real GDP ($ billions)

Real Aggregate Expenditure ($ billions)

45°

AE1

AE2

• Figure 12 Counterycyclical Fiscal Policy

(Full-EmploymentOutput)

(RecessionOutput)

30

Problems with Counterycyclical Fiscal Policy

• Timing Problems• Irreversibility• Reaction of the Federal Reserve

31

The Recession of 2001

• Investment spending - downward– Decreased sharply during the second

quarter – Continued to fall throughout the year. – Shift AE line downward

• GDP - almost no growth– Dropped during the third quarter

• Employment fell

32

The Recession of 2001• Figure 13 The Recession of 2001

33

The Recession of 2001

• Internet - prompted investment began to fall.• Internet based new businesses - bankrupt• The terrorist attacks of September 11, 2001• Abnormal: consumption spending increased

– 10-year tax cut - June 2001– The Federal Reserve

34

Appendix 1

• Finding Equilibrium GDP Algebraically

b1NXGIbTaY

AEYNXGICAE

bY)bTa(C

)TY(baCTYY

bYaC

PP

D

D

35

Appendix 2: Tax Multiplier

• Tax multiplier = -(Spending multiplier-1)

TMPC-1MPC-GDP

MPC-1MPC-MultiplierTax