2 The Short-Run Macro Model In short-run, spending depends on income, and income depends on spending.The more income households have, the more they will spend.The more households spend, the more output firms will produceMore income they will pay to their workers.Many ideas behind the model were originally developed by British economist John Maynard Keynes in 1930s.Short-run macro model focuses on spending in explaining economic fluctuations.
3 Review the Categories of Spending Macroeconomists have found that the most useful approach is to divide those who purchase the GDP into four broad categoriesHouseholds --- consumption spending (C)Business firms --- planned investment spending (IP)Government agencies --- government purchases (G)Foreigners --- net exports (NX)Nominal or real spending?Real terms
4 Consumption What factors affect households’ spending? Disposable income: Yd (= Y – T)Wealth (= total assets – total liability)Price levelInterest rateWhen interest rate falls, consumption risesExpectations about future
5 Figure: U.S. Consumption and Disposable Income, 1985-2002
7 Consumption and Disposable Income Autonomous consumption spendingConsumption spending when disposable income is zeroMarginal propensity to consume, or MPCThe slope of the consumption functionMPC = Δ Consumption ÷ Δ Disposable IncomeMPC measures by how much consumption spending rises when disposable income rises by one dollarLogic and empirical evidence suggest that the MPC should be larger than zero, but less than 1So, we assume that 0 < MPC < 1
8 Representing Consumption with an Equation C = a + bYdWhere C is consumption spendingAnd a is the autonomous consumption spendingAnd b is the marginal propensity to consume (MPC)Equation between consumption and total incomeSince Yd = Y – T,C = a + b(Y – T)So, C = (a- bT) + bY
10 Shifts in the Consumption-Income Line When a change in income causes consumption spending to change, we move along consumption-income line.When a change in anything else besides income causes consumption spending to change, the line will shift.
12 IP, G and NXFor now, in the short-run macro model, planned investment spending, government purchases, and net exports are all treated as given or fixed values.
13 Summing Up: Aggregate Expenditure Aggregate expenditure (AE)Sum of spending by households, businesses, government, and foreign sector on final goods and services produced in United StatesAggregate expenditure = C + IP + G + NXAE plays a key role in explaining economic fluctuationsWhy?Because over several quarters or even a few years, business firms tend to respond to changes in aggregate expenditure by changing their level of output.
14 Finding Equilibrium GDP When aggregate expenditure is less than GDP, inventories will increase and output will decline in future.When aggregate expenditure is greater than GDP, inventories will decrease and output will rise in future.In short-run, equilibrium GDP is level of output at which output and aggregate expenditure are equal.
15 Inventories and Equilibrium GDP When firms produce more goods than they sell, what happens to unsold output?Added to their inventory stocksFind output level at which change in inventories is equal to zero.AE < GDP ΔInventories > 0 GDP↓ in future periodsAE > GDP ΔInventories < 0 GDP↑ in future periodsAE = GDP ΔInventories = 0 No change in GDPEquilibrium output level is the one at which change in inventories equals zero.
16 Figure: Deriving the Aggregate Expenditure Line
19 Equilibrium GDP and Employment When economy operates at equilibrium, will it also be operating at full employment?Not necessarilyFor instance, insufficient spending causes business firms to decrease their demand for labor.Remember, in the long run (classical) macro model, it takes time for labor market to achieve full employment.In the short-run model, it would be quite a coincidence if our equilibrium GDP happened to be the full employment output level.In short-run macro model, output can be lower or higher than the full employment output level.
20 Figure: Short-Run Equilibrium GDP < Full Employment GDP
21 Figure: Short-Run Equilibrium GDP > Full-Employment GDP
22 A Change in Investment Spending Suppose the initial equilibrium GDP in an economy is $6,000 billion.Now, business firms increase their investment spending on plant and equipment by $1,000 billion.Then, firms that sell investment goods receive $1,000 billion as income, which is to be distributed as salary, rent, interest, and profit.What will households do with their $1,000 billion in additional income?Spend the money !How much to spend depends crucially on marginal propensity to consume (MPC): let’s assume MPC = 0.6
23 A Change in Investment Spending When households spend an additional $600 billion, firms that produce consumption goods and services will receive an additional $600 billion in sales revenue.Which will become income for households that supply resources to these firms. At this point, total income has increased by $1,000+$600=$1,600billionWith an MPC of 0.6, consumption spending will further rise by 0.6 x $600 billion = $360 billion, creating still more sales revenue for firms, and so on and so on…At end of process, when economy has reached its new equilibrium.Total spending and total output are considerably higher.
24 Figure: The Effect of a Change in Investment Spending
25 The Expenditure Multiplier Whatever the rise in investment spending, equilibrium GDP would increase by a factor of 2.5, so we can writeΔGDP = 2.5 x ΔIPValue of expenditure multiplier depends on value of MPCSo, when the increase in planned investment spending isΔIP, the increase in total income (GDP) is calculated as:
26 The Expenditure Multiplier A sustained increase in investment spending will cause a sustained increase in GDP.Multiplier process works in both directions.Just as increases in investment spending cause equilibrium GDP to rise by a multiple of the change in spending.Decreases in investment spending cause equilibrium GDP to fall by a multiple of the change in spending.
27 Spending ShocksShocks to economy can come from other sources besides investment spending.Government purchases (G)Net exports (NX)Autonomous consumption (a)Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP.
28 Spending ShocksThe effect of a change in spending on total income through expenditure multiplier
30 Application: The Recession of 2007-09 December 2007 recession beganAggregate expenditures declinedConsumption spending declinedInvestment spending declinedRecessionary expenditure gap
31 Application: The Recession of 2007-09 Federal government undertook Keynesian policiesTax rebate checks$787 billion stimulus package
32 Say’s Law vs. Keynesian Theory Classical economicsSay’s LawEconomy will automatically adjustLaissez-faireKeynesian economicsCyclical unemployment can occurEconomy will not correct itselfGovernment should actively manage macroeconomic instability
33 Automatic Stabilizers and the Multiplier Automatic stabilizers reduce size of multiplier and therefore reduce impact of spending shocks.With milder fluctuations, economy is more stable.Some real-world automatic stabilizers we’ve ignored in the simple, short-run macro model of this chapterTaxesTransfer paymentsInterest ratesImportsForward-looking behavior
34 The Role of SavingIn long-run, saving has positive effects on economy.But in short-run, automatic mechanisms of classical model do not keep economy operating at its potential.In long-run, an increase in desire to save leads to faster economic growth and rising living standards.In short-run, however, it can cause a recession that pushes output below its potential.Two sides to the “saving coin”Impact of increased saving is positive in long-run and potentially dangerous in short-run.
35 The Effect of Fiscal Policy In classical model fiscal policy—changes in government spending or taxes designed to change equilibrium GDP—is completely ineffective – crowding out effect.In short-run, an increase in government purchases causes a multiplied increase in equilibrium GDP.Therefore, in short-run, fiscal policy can actually change equilibrium GDP.Observation suggests that fiscal policy could, in principle, play a role in altering path of economy.Indeed, in 1960s and early 1970s, this was the thinking of many economists.But very few economists believe this today.