Output and Expenditure in the Short Run

Aggregate expenditure (AE) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

AE = C + I + G + NX

Macroeconomic Equilibrium

AE = GDP = Y = C + I + G + NX

Unintended change in inventories:

The Difference between Planned Investment and Actual Investment

In macro-equilibrium, there is no unintended change in

Inventories: Actual Investment = Planned Investment.

Adjustments to Macroeconomic Equilibrium

IF … THEN … AND …

Aggregate expenditureequals GDP

inventories areunchanged

the economy is inmacroeconomic equilibrium.

Aggregate expenditure isless than GDP inventories rise

GDP and employmentdecrease.

Aggregate Expenditure isgreater than GDP inventories fall

GDP and employmentincrease.

The Relationship between Aggregate Expenditure (AE) and Output (GDP = Y)

EXPENDITURE CATEGORYEXPENDITURE

(BILLIONS OF 2000 DOLLARS)

Consumption $8,091

Investment 1,946

Government 1,998

Net Exports −618

Determining the Level of Aggregate Expenditure :

Consumption Spending (C)

FIGURE 11-1

• Current disposable income

• Household wealth

• Expected future income

• The price level

• The interest rate

Determinants of C

The Consumption Function

Relation between real consumption expenditure (C)

and real disposable income (DI)

Slope of consumption function

= Marginal propensity to consume

= MPC

income disposablein Change

nconsumptioin ChangeMPC

or

Change in consumption = Change in disposable income × MPC

Consumption

The Consumption Function

The MPC determines how much consumption changes as income changes:

The Relationship between Consumption and National Income

Disposable income = National income − Net taxes

or

National income = GDP = Disposable income + Net taxes

Y

C

National income = Consumption + Saving + Taxes

Change in national income = Change in consumption

+ Change in saving + Change in taxes

Y = C + S + T

Income, Consumption, and Saving

and

To simplify, we assume taxes are constant ΔT = 0, so

ΔY = ΔC + ΔS

ΔY = ΔC + ΔS + ΔT

Marginal propensity to save (MPS) The change in saving divided by the change in disposable income.

Income, Consumption, and Saving

Y

S

Y

C

Y

Y

or,

1 = MPC + MPS

Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save

Y

CMPC

Y

SMPS

NATIONAL INCOME AND REAL GDP (Y)

CONSUMPTION(C)

SAVING(S)

MARGINAL PROPENSITY TO CONSUME (MPC)

MARGINAL PROPENSITY TO SAVE (MPS)

$9,000 $8,000 $1,000— —

10,000 8,600 1,4000.6 0.4

11,000 9,200 1,8000.6 0.4

12,000 9,800 2,2000.6 0.4

13,000 10,400 2,6000.6 0.4

Determining the Level of Aggregate Expenditure in the Economy

Planned Investment

• Expectations of future profitability

•Waves of optimism and pessimism

•Animal Spirits

• The interest rate

• Cash flow

• Taxes

Determinants of Planned Investment Spending

Real Government Purchases, 1979–2006

Determining the Level of Aggregate Expenditure in the Economy

Government Purchases: It is what it is

Real Net Exports, 1979–2006

• The US price level relative to price levels in other countries

• The growth rate of US GDP relative to the growth rates of GDP in other countries

• The exchange rate between the dollar and other currencies

Net exports: Determinants

The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Graphing Macroeconomic Equilibrium

Graphing Macroeconomic Equilibrium

Macroeconomic Equilibrium on the 45°-Line Diagram

Showing a Recession on the 45°-Line Diagram

Showing a Recession on the 45°-Line Diagram

A Numerical Example of Macroeconomic Equilibrium

Real GDP

(Y)Consumption

(C)

Planned Investment

(I)

Government Purchases

(G)

Net Exports

(NX)

Planned Aggregate

Expenditure(AE)

Unplanned Change in Inventories

Real GDP Will …

$8,000 $6,200 $1,500 $1,500 – $500 $8,700 –$700 increase

9,000 6,850 1,500 1,500 –500 9,350 –350 Increase

10,000 7,500 1,500 1,500 –500 10,000 0 Equilibrium

11,000 8,150 1,500 1,500 –500 10,650 +350 decrease

12,000 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

When planned aggregate expenditure is less than output (real GDP), some firms will experience an unplanned increase in inventories. They will then reduce output.

When planned aggregate expenditure is greater than output (real GDP), some firms will experience an unplanned decrease in inventories. They will then increase output.

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.

The Multiplier Effect

Suppose MPC = ¾

The Multiplier Effect: MPC = ¾

 

ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT)

ADDITIONAL INDUCED

EXPENDITURE(CONSUMPTION)

TOTAL ADDITIONAL EXPENDITURE =

TOTAL ADDITIONAL GDP

ROUND 1 $100 billion $0 $100 billionROUND 2 0 75 billion 175 billionROUND 3 0 56 billion 231 billionROUND 4 0 42 billion 273 billionROUND 5 0 32 billion 305 billion

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.ROUND 10 0 8 billion 377 billion

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.ROUND 15 0 2 billion 395 billion

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ROUND 19 0 1 billion 398 billion

n 0 0 $400 billion

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%

The Multiplier Effect

1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases… like now!

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. It ignores the effects an increasing GDP has on taxes, imports, inflation, and interest rates.

MPC

1

1

eexpenditur autonomousin Change

GDP real mequilibriuin Change Multiplier

The Aggregate Demand Curve

The Effect of a Change in the Price Level on Real GDP…A rise in the price level

•reduces net exports

•reduces the purchasing power of monetary wealth

•reduces real money balances and raises interest rates

•higher interest rates appreciate currency and further reduce net exports

•A rise in the price level reduces AE and reduces Y

Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

The Algebra of Macroeconomic Equilibrium

Appendix

( )

1

1

Y C MPC(Y) I G NX

Y - MPC(Y) C I G NX

Y MPC C I G NX

C I G NXY

MPC

Or,

Or,

Or,

The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

C