Chap11pp

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

11

Output and Expenditure in the Short Run

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 62

Fluctuating Demand at Cisco Systems

11.1 Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

11.2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save.

11.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium.

11.4 Define the multiplier effect and use it to calculate changes in equilibrium GDP.

11.5 Understand the relationship between the aggregate demand curve and aggregate expenditure.

APPENDIX Apply the algebra of macroeconomic equilibrium.

Learning Objectives

In this chapter, we will explore the reasons for changes in aggregate expenditures and how these changes affect the level of total production in the economy.

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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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The Aggregate Expenditure Model

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

Aggregate Expenditure

Learning Objective 11.1

• Consumption (C)

• Planned Investment (I)

• Government Purchases (G)

• Net Exports (NX)

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Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports

Aggregate Expenditure


or:

AE = C + I + G + NX

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Inventories Goods that have been produced but not yet sold.

The Difference between Planned Investment and Actual Investment


Aggregate expenditure = GDP

Macroeconomic Equilibrium

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The Aggregate Expenditure ModelAdjustments to Macroeconomic Equilibrium


IF … THEN … AND …

Aggregate expenditure isequal to 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.

Table 11-1

The Relationship between Aggregate Expenditure and GDP

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Determining the Level of Aggregate Expenditure in the Economy


EXPENDITURE CATEGORYEXPENDITURE

(BILLIONS OF 2000 DOLLARS)

Consumption $8,091

Investment 1,946

Government 1,998

Net Exports −618

Table 11-2

Components of Real Aggregate Expenditure, 2006

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Consumption

FIGURE 11-1

Real Consumption, 1979–2006

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• Current disposable income

• Household wealth

• Expected future income

• The price level

• The interest rate

Consumption

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

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The most important determinant of consumption is the current disposable income of households.

Consumption

Current Disposable Income

Household Wealth

Consumption also depends on the wealth of households.

A household’s wealth is the value of its assets minus the value of its liabilities.

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Consumption also depends on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly.

Consumption

Expected Future Income

The Price Level

The price level measures the average prices of goods and services in the economy. Consumption is affected by changes in the price level.

The Interest Rate

When the interest rate is high, the reward to saving is increased, and households are likely to save more and spend less.

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FIGURE 11-2

The Relationship between Consumption and Income,1960– 2006


Consumption

The Consumption Function

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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 changes when disposable income changes.

YD

CMPC

income disposablein Change

nconsumptioin Change


Consumption


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income disposablein Change

nconsumptioin ChangeMPC

or

Change in consumption = Change in disposable income × MPC


Consumption


We can also use the MPC to determine how much consumption will change as income changes:

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We can rearrange the equation like this:

National income = GDP = Disposable income + Net taxes

Disposable income = National income − Net taxes


The Relationship between Consumption and National Income

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FIGURE 11-2




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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

TSCY

and

To simplify, we can assume that taxes are always a constant amount, in which case ΔT = 0, so the following is also true:

ΔY = ΔC + ΔS

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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

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Solved Problem 11-2Calculating 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 1,400 0.6 0.4

11,000 9,200 1,800 0.6 0.4

12,000 9,800 2,200 0.6 0.4

13,000 10,400 2,600 0.6 0.4

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FIGURE 11-4

Real Investment, 1979–2006


Planned Investment

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• Expectations of future profitability

• The interest rate

• Taxes

• Cash flow


Planned Investment

The four most important variables that determine the level of investment are:

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Expectations of Future Profitability

The optimism or pessimism of firms is an important determinant of investment spending.

The Interest Rate

A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending.


Planned Investment

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Planned Investment

Taxes

Firms focus on the profits that remain after they have paid taxes.

Cash Flow

Cash flow The difference between the cash revenues received by a firm and the cash spending by the firm.

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Cisco Rides the Roller Coaster of Information Technology Spending

Makingthe

Connection

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FIGURE 11-5

Real Government Purchases, 1979–2006


Government Purchases

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FIGURE 11-6

Real Net Exports, 1979–2006


Net Exports

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• 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


Net Exports

The following are the three most important variables that determine the level of net exports:

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Planned Investment

The Price Level in the United States Relative to the Price Levels in Other Countries

If inflation in the United States is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries.

The Growth Rate of GDP in the United States Relative to the Growth Rates of GDP in Other Countries

When incomes in the United States rise more slowly than incomes in other countries, net exports will rise.

The Exchange Rate Between the Dollar and Other Currencies

As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other countries rises, and the dollar price of foreign products sold in the United States falls.

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Graphing Macroeconomic Equilibrium


FIGURE 11-7

An Example of a 45°-Line Diagram

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FIGURE 11-8

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


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FIGURE 11-9

Macroeconomic Equilibrium on the 45°-Line Diagram

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FIGURE 11-10



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FIGURE 11-11

Showing a Recession on the 45°-Line Diagram

Showing a Recession on the 45°-Line Diagram

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Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories.

The Important Role of Inventories

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Business Attempts to Control Inventories, Then . . . and Now

Makingthe

Connection

Dell Computer uses supply chain management to keep its inventory low.

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Graphing Macroeconomic EquilibriumA Numerical Example of Macroeconomic Equilibrium

Real GDP

(Y)Consumption

(C)

Planned Investment

(I)


(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 0be in

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

Table 11-3


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Solved Problem 11-3Determining Macroeconomic Equilibrium


Real GDP

(Y)Consumption

(C)

Planned Investment

(I)


(G)

Net Exports

(NX)

Planned Aggregate

Expenditure(AE)

Unplanned Change in Inventories

$8,000 $6,200 $1,675 $1,675 $–500 $9,050 $–1,050

9,000 6,850 1,675 1,675 –500 9,700 –700

10,000 7,500 1,675 1,675 –500 10,350 –350

11,000 8,150 1,675 1,675 –500 11,000 0

12,000 8,800 1,675 1,675 –500 11,650 350

Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government (G) + Net exports (NX)

Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE)

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The Multiplier Effect

FIGURE 11-12


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Autonomous expenditure An 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 EffectTable 11-4

The Multiplier Effect in Action

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

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The Multiplier in Reverse: The Great Depression of the 1930s

Makingthe

Connection

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%

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The Multiplier EffectA Formula for the Multiplier

MPC1

1

MPC

1

1

eexpenditur autonomousin Change

GDP real mequilibriuin Change Multiplier

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The Multiplier EffectSummarizing 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 imports, inflation, and interest rates.

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Solved Problem 11-4Using the Multiplier Formula


REAL GDP (Y)

CONSUMPTION(C)

PLANNED INVESTMENT

(I)

GOVERNMENT PURCHASES

(G)NET EXPORTS

(NX)

$8,000 $6,900 $1,000 $1,000 –$500

9,000 7,700 1,000 1,000 –500

10,000 8,500 1,000 1,000 –500

11,000 9,300 1,000 1,000 –500

12,000 10,100 1,000 1,000 –500

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Solved Problem 11-4Using the Multiplier Formula (continued)


REALGDP (Y)

CONSUMPTION(C)

PLANNED INVESTMENT

(I)

GOVERNMENT PURCHASES

(G)

NET EXPORTS

(NX)

PLANNED AGGREGATE EXPENDITURE

(AE)

$8,000 $6,900 $1,000 $1,000 –$500 $8,400

9,000 7,700 1,000 1,000 –500 9,200

10,000 8,500 1,000 1,000 –500 10,000

11,000 9,300 1,000 1,000 –500 10,800

12,000 10,100 1,000 1,000 –500 11,600

Y

CMPC

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The Aggregate Demand Curve

FIGURE 11-13

The Effect of a Change in the Price Level on Real GDP

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FIGURE 11-14


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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.

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An Inside LOOK Consumer Spending and Business Inventories Send Positive Signals about GDP

Economy Slows but May Hold Seeds of Growth

A decrease in aggregate expenditure causes an unplanned increase in inventories and a decrease in real GDP.

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Aggregate demand curve

Aggregate expenditure (AE)

Aggregate expenditure model

Autonomous expenditure

Cash flow

Consumption function

Inventories

K e y T e r m s

Marginal propensity to consume (MPC)

Marginal propensity to save (MPS)

Multiplier

Multiplier effect

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The Algebra of Macroeconomic Equilibrium

Appendix

)(YMPCCC

1I

GG

XNNX

NXGICY

1 Consumption function

2 Planned investment function

3 Government spending function

4 Net export function

5 Equilibrium condition

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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

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Appendix

Remember that is the multiplier. Therefore an alternative

expression for equilibrium GDP is:

1

1 MPC

Equilibrium GDP = Autonomous expenditure x Multiplier

Chap11pp

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