chapter eleven

Output and Expenditure in the Short Run

Prepared by: Fernando & Yvonn Quijano

2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1st ed.

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.
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1 LEARNING OBJECTIVE

The Aggregate Expenditure Model

Aggregate expenditure model A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant.
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The Aggregate Expenditure Model

Aggregate Expenditure
Consumption (C) Planned Investment (I) Government Purchases (G)
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Net Exports (NX)

AE = C + I + G + NX
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The Aggregate Expenditure Model

The Difference between Planned Investment and Actual Investment Inventories Goods that have been produced, but not yet sold.
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Macroeconomic Equilibrium Aggregate Expenditure = GDP

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The Aggregate Expenditure Model

Adjustments to Macroeconomic Equilibrium
11 1 The Relationship Between Aggregate Expenditure and GDP

IF Aggregate expenditure is equal to GDP Aggregate expenditure is less than GDP Aggregate Expenditure is greater than GDP

THEN inventories are unchanged inventories rise inventories fall

AND the economy is in macroeconomic equilibrium. GDP and employment decrease. GDP and employment increase.

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2 LEARNING OBJECTIVE

Determining the Level of Aggregate Expenditure in the Economy

11 2 Components of Aggregate Expenditure, 2004

EXPENDITURE CATEGORY
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EXPENDITURE (BILLIONS OF 2000 DOLLARS) $7,589 1,810 1,952 -601

Consumption Investment Government Net Exports

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Determining the Level of Aggregate Expenditure in the Economy Consumption

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Real Consumption, 1979-2004

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Determining the Level of Aggregate Expenditure in the Economy Consumption

The five most important variables that determine the level of consumption are:

CURRENT DISPOSABLE INCOME HOUSEHOLD WEALTH EXPECTED FUTURE INCOME THE PRICE LEVEL THE INTEREST RATE

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Determining the Level of Aggregate Expenditure in the Economy

THE CONSUMPTION FUNCTION
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The Relationship between Consumption and Income, 1960-2004

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Determining the Level of Aggregate Expenditure in the Economy

THE CONSUMPTION FUNCTION

Consumption function The relationship between consumption spending and disposable income. Marginal propensity to consume (MPC) The slope of the consumption function: the amount by which consumption spending increases when disposable income increases.

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Change in consumption C MPC = = Change in disposable income YD

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Determining the Level of Aggregate Expenditure in the Economy The Relationship between Consumption and National Income Disposable income = National income Net taxes Or, rearranging the equation:
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National income = GDP = Disposable income + Net taxes

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Determining the Level of Aggregate Expenditure in the Economy The Relationship between Consumption and National Income
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The Relationship between Consumption and National Income

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Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving
National income = Consumption + Saving + Taxes Change in national income = Change in consumption + Change in saving + Change in taxes Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving, and T represents taxes, we can write: and,

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Y = C + S + T

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Y = C + S + T
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2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1st ed.

Determining the Level of Aggregate Expenditure in the Economy

Income, Consumption, and Saving
To simplify, we can assume that taxes are always a constant amount, in which case T = 0, so that:

Y = C + S
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Marginal propensity to save (MPS) The change in saving divided by the change in income.

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or,

Y C S = = Y Y Y
1 = MPC + MPS

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11 - 1
2 LEARNING OBJECTIVE

Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save
NATIONAL INCOME AND REAL GDP (Y) $9,000 10,000 11,000 CONSUMPTION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS)

$8,000 $8,600 $9,200 $9,800 $10,400

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12,000 13,000

MPC =

Change in consumption C = Change in income Y

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MPS =

Change in saving S = Change in income Y

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Determining the Level of Aggregate Expenditure in the Economy Planned Investment

11 - 4
Real Investment, 1979-2004

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Determining the Level of Aggregate Expenditure in the Economy Planned Investment

The four most important variables that determine the level of investment are:
EXPECTATIONS OF FUTURE PROFITABILITY THE INTEREST RATE

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TAXES CASH FLOW

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Cash flow The difference between the cash revenues received by the firm and the cash spending by the firm.
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Determining the Level of Aggregate Expenditure in the Economy

Government Purchases
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Real Government Purchases, 1979-2004

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Determining the Level of Aggregate Expenditure in the Economy

Net Exports

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Real Net Exports, 1979-2004

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Determining the Level of Aggregate Expenditure in the Economy Net Exports

The three most important variables that determine the level of net exports are:
THE PRICE LEVEL IN THE UNITED STATES RELATIVE

TO THE PRICE LEVELS IN OTHER COUNTRIES

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THE GROWTH RATE OF GDP IN THE UNITED STATES

RELATIVE TO THE GROWTH RATES OF GDP IN OTHER COUNTRIES OTHER CURRENCIES

THE EXCHANGE RATE BETWEEN THE DOLLAR AND

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3 LEARNING OBJECTIVE

Graphing Macroeconomic Equilibrium

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An Example of a 45- Line Diagram

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Graphing Macroeconomic Equilibrium

11 - 8
The Relationship between Aggregate Expenditure and GDP on a 45-Line Diagram

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Graphing Macroeconomic Equilibrium

11 - 9
Macroeconomic Equilibrium on the 45-Line Diagram

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Graphing Macroeconomic Equilibrium

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Macroeconomic Equilibrium

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Graphing Macroeconomic Equilibrium

Showing a Recession on the 45 -Line Diagram
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Showing a Recession on the 45 Line Diagram

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Graphing Macroeconomic Equilibrium

The Important Role of Inventories Whenever aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories.
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4 LEARNING OBJECTIVE

A Numerical Example of Macroeconomic Equilibrium

11 3 Macroeconomic Equilibrium Real GDP (Y) $8,000 9,000 10,000 Consumption (C) Planned Investment (I) $1,500 1,500 1,500 1,500 1,500 Government Purchases (G) $1,500 1,500 1,500 1,500 1,500 Net Exports (NX) $500 500 500 500 500 Planned Aggregate Expenditure (AE) $8,700 9,350 10,000 10,650 11,300 Unplanned Real GDP Change in Will Inventories $700 350 0 +350 +700 increase increase be in equilibrium decrease decrease

$6,200 6,850 7,500 8,150 8,800

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11,000 12,000

Dont Confuse Aggregate Expenditure with Consumption Spending

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11 - 2
4 LEARNING OBJECTIVE

Determining Macroeconomic Equilibrium

Real GDP (Y) $8,000 9,000 Consumption (C) Planned Investment (I) $1,675 1,675 1,675 1,675 1,675 Government Net Exports Purchases (NX) (G) $1,675 1,675 1,675 1,675 1,675 $500 500 500 500 500 Planned Aggregate Expenditure (AE) Unplanned Change in Inventories

$6,200 6,850 7,500 8,150 8,800

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10,000 11,000 12,000

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5 LEARNING OBJECTIVE

The Multiplier Effect

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The Multiplier Effect

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The Multiplier Effect

Autonomous expenditure Expenditure that does not depend on the level of GDP. Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

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The Multiplier Effect

11 4 The Multiplier Effect in Action

ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) Round 1 Round 2 Round 3 Round 4 Round 5 Round 10 Round 15 Round 19 n $100 billion 0 0 0 0 0 0 0 0

ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) $0 75 billion 56 billion 42 billion 32 billion 8 billion 2 billion 1 billion 0

TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP $100 billion 175 billion 231 billion 273 billion 305 billion 377 billion 395 billion 398 billion $400 billion
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11 - 3 The Multiplier in Reverse: The Great Depression of the 1930s

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The multiplier effect contributed to the very high levels of Year Consumption Investment Net Exports Real GDP Unemployment Rate unemployment 1929 $661 billion $91.3 billion -$9.4illion $865 billion 3.2% during the Great 1933 541 billion 17.0 billion -$10.2 billion 636 billion 24.9% Depression.
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The Multiplier Effect

A Formula for the Multiplier

1 1 MPC
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Change in equilibrium real GDP 1 Multiplier = = Change in autonomous expenditure 1 MPC

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The Multiplier Effect

Summarizing the Multiplier Effect
1.

The multiplier effect occurs both when autonomous expenditure increases and when it decreases. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. The larger the MPC, the larger the value of the multiplier.
1 The formula for the multiplier, 1 MPC , is oversimplified because it ignores some real world complications, such as the effect that an

1.

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1.

1.

increasing GDP can have on imports, inflation, and interest rates.

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11 - 3
5 LEARNING OBJECTIVE

Using the Multiplier Formula

REAL GDP (Y) $8,000 9,000 10,000 CONSUMPTION (C) $6,900 7,700 8,500 9,300 10,100 PLANNED INVESTMENT (I) $1,000 1,000 1,000 1,000 1,000 GOVERNMENT PURCHASES (G) $1,000 1,000 1,000 1,000 1,000 NET EXPORTS (NX) $500 500 500 500 500

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11,000 12,000

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11 - 3
5 LEARNING OBJECTIVE

Using the Multiplier Formula

REALG CONSUMPTION PLANNED GOVERNMENT NET DP (C) INVESTMENT PURCHASES EXPORTS (Y) (I) (G) (NX) $8,000 9,000 10,000 11,000 $6,900 7,700 8,500 9,300 10,100 $1,000 1,000 1,000 1,000 1,000 $1,000 1,000 1,000 1,000 1,000 $500 500 500 500 500 PLANNED AGGREGATE EXPENDITURE (AE) $8,400 9,200 10,000 10,800 11,600

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12,000

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Change in consumption C MPC = = Change in income Y

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6 LEARNING OBJECTIVE

The Aggregate Demand Curve

11 13a
The Effect of a Higher Price Level on Real GDP

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The Aggregate Demand Curve

11 13b
The Effect of a Lower Price Level on Real GDP

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The Aggregate Demand Curve

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Aggregate demand curve (AD) A curve showing 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.

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The Aggregate Demand Curve

The Effect of a Decrease in the Price Level on Real GDP
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The Aggregate Demand Curve

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Japans Consumers Show Signs of Life

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ET P AHC

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Aggregate demand curve (AD) Aggregate expenditure (AE) Aggregate expenditure model Autonomous expenditure Cash flow

Consumption function Inventories Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Multiplier effect
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2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1st ed.

Appendix 11A: The Algebra of Macroeconomic Equilibrium 1. C = C + MPC (Y ) 2. 3.

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Consumption function Investment function Government spending function Net export function Equilibrium condition

I =1

G=G

4. NX = N X 5. Y = C + I + G + NX

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Appendix 11A: The Algebra of Macroeconomic Equilibrium

The letters with bars represent fixed or autonomous values. So, example. Now, solving for equilibrium we get:

represents autonomous consumption, which had a value of 1000 in our original

Or,
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Y = C + MPC(Y) + I + G + N X Y - MPC(Y) = C + I + G + N X Y (1 MPC) = C + I + G + N X

Or, Or,

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C + I + G + NX Y= 1 MPC
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Appendix 11A: The Algebra of Macroeconomic Equilibrium

Remember that

1 1 MPC

is the multiplier. Therefore an

alternative expression for equilibrium GDP is:

Equilibrium GDP = Autonomous expenditure x multiplier

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