1. The Short-Run Macro Model
Spending is very important in short-run
The more income households have, the more they will spend
Spending depends on income
But the more households spend, the more output firms will produce
More income they will pay to their workers
Thus, income depends on spending
In short-run, spending depends on income, and income depends on spending
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
Explains how shocks that affect one sector influence other sectors
Causing changes in total output and employment

2. Thinking About Spending
Spending on what?
In short-run macro model, focus on spending in markets for currently produced U.S. goods and services
Things that are included in U.S. GDP
Need to organize our thinking about markets that contribute to GDP
What’s the best way to categorize all these buyers into larger groups so we can analyze their behavior?
Macroeconomists have found that the most useful approach is to divide those who purchase the GDP into four broad categories
Households, whose spending is called consumption spending (C)
Business firms, whose spending is called planned investment spending (IP)
Government agencies, whose spending on goods and services is called government purchases (G)
Foreigners, whose spending we measure as net exports (NX)
Should we look at nominal or real spending?
When discuss “consumption spending,” we mean “real consumption spending”

3. Consumption Spending
Natural place for us to begin our look at spending is with its largest component
Consumption spending
Total consumption spending is sum of spending by over a hundred million U.S. households
What determines total amount of consumption spending?
One way to answer is to start by thinking about yourself or your family
What determines your spending in any given month, quarter, or year?

4. Disposable Income First thing that comes to mind is your income
The more you earn, the more you spend
It’s not exactly your income per period that determines your spending
But rather what you get to keep from that income after deducting any taxes you have to pay
If we start with income you earn, deduct all tax payments, and then add in any transfer received, would get your disposable income
Income you are free to spend or save as you wish
Disposable Income = Income – Tax Payments + Transfers Received
Can be rewritten as
Disposable Income = Income – (Taxes – Transfers) or
Disposable Income = Income – Net Taxes
For almost any household, a rise in disposable income—with no other change—causes a rise in consumption spending

5. Wealth
Given your disposable income, how much of it will you spend and how much will you save?
Will depend, in part, on your wealth
Total value of your assets minus your outstanding liabilities
In general, a rise in wealth—with no other change—causes a rise in consumption spending

6. The Interest Rate
Interest rate is reward people get for saving, or what they have to pay when they borrow
All else equal, a rise in interest rate causes a decrease in consumption spending
Relationship between interest rate and consumption spending applies even for people who aren’t “savers” in the common sense of term
Whether you are earning interest on funds you’ve saved, or paying interest on funds you’ve borrowed
The higher the interest rate, the lower is consumption spending
In macroeconomics, household saving is the part of disposable income that a household doesn’t spend
Whether it’s put in bank or used to pay off a loan

7. Expectations
Expectations about future would affect your spending as well
All else equal, optimism about future income causes an increase in consumption spending
Other variables influence your consumption spending
Including inheritances you expect to receive over your lifetime, and even how long you expect to live
Disposable income, wealth, and interest rate are the three key variables
In macroeconomics, we use phrases like “disposable income,” “wealth,” or “consumption spending” to mean the total disposable income, total wealth, and total consumption spending of all households in the economy combined
All else equal, consumption spending increases when
Disposable income rises
Wealth rises
Interest rate falls

8. Figure 1: U.S. Consumption and Disposable Income, 1985-2004
Real Consumption Spending
($ Billions)
5,000
6,000
4,000
3,000
7,000
Real Disposable Income ($ Billions)
2000
1995
1990
1985

9. Consumption and Disposable Income
Of all the factors that influence consumption spending, most important and stable determinant is disposable income
Relationship between consumption and disposable income is almost perfectly linear—points lie remarkably close to a straight line
This almost-linear relationship between consumption and disposable income has been observed in a wide variety of historical periods and a wide variety of nations
Vertical intercept in Figure 2 is called
Autonomous consumption spending
Part of consumption spending that is independent of income

10. Figure 2: The Consumption Function
The consumption function shows the (linear) relationship between real consumption spending and real disposable income
Real Consumption Spending ($ Billions)
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
Real Disposable Income ($ Billions)
Consumption
Function
600
1,000
and the slope of the line (0.6) is the marginal propensity to consume.
The vertical intercept ($2,000 billion) is autonomous consumption spending . . .

11. Consumption and Disposable Income
Second important feature of Figure 2 is the slope
Shows change along vertical axis divided by change along horizontal axis as we go from one point to another on the line
Slope = Δ Consumption ÷ Disposable Income
Economists have given this slope a special name
Marginal propensity to consume, or MPC
Can think of MPC in three different ways, but each of them has the same meaning
Slope of consumption function
Change in consumption divided by change in disposable income
Amount by which consumption spending rises when disposable income rises by one dollar
Logic suggests that the MPC should be larger than zero, but less than 1
We will always assume that 0 < MPC < 1

12. Representing Consumption with an Equation
Sometimes, we’ll want to use an equation to represent straight-line consumption function
C = a + b x (Disposable Income)
Where C is consumption spending
Term a is vertical intercept of consumption function
Represents theoretical level of consumption spending at disposable income=0, or autonomous consumption spending
Term b is slope of consumption function
Marginal propensity to consume (MPC)

13. Consumption and Income
Consumption function is an important building block
Consumption is largest component of spending, and disposable income is most important determinant of consumption
If government collected no taxes, total income and disposable income would be equal
So that relationship between consumption and income on the one hand, and consumption and disposable income on the other hand, would be identical
Consumption-income line
Line showing aggregate consumption spending at each level of income or GDP
When government collects a fixed amount of taxes from household
Line representing relationship between consumption and income is shifted downward by amount of tax times marginal propensity to consume (MPC)
Slope of this line is unaffected by taxes and is equal to MPC

14. Figure 3: The Consumption-Income Line
Real Consumption Spending ($ Billions)
1,000
2,000
3,000
4,000
5,000
5,600
Real Income ($ Billions)
6,000
8,000
Consumption-Income Line B
2. The line has the same slope as the consumption function in Figure A
600
1,000
1. To draw the consumption-income line, we measure real income (instead of real disposable income) on the horizontal axis.
3. but a different vertical intercept.

15. Shifts in the Consumption-Income Line
If income increases and net taxes remain unchanged, disposable income will rise, and consumption spending will rise along with it
But consumption spending can also change for reasons other than a change in income, causing consumption-income line itself to shift
Mechanism works like this

16. Shifts in the Consumption-Income Line
Can summarize our discussion of changes in consumption spending as follows
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
All changes that shift the line—other than a change in taxes—work by increasing or decreasing autonomous consumption (a)

17. Figure 4: A Shift in the Consumption-Income Line
Real Consumption Spending ($ Billions)
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
Real Income ($ Billions)
Consumption-Income Line When Net Taxes = 500
Consumption-Income Line When Net Taxes = 2,000

18. Table 3: Changes in Consumption Spending and the Consumption–Income Line

19. Investment Spending
In definition of GDP, word investment by itself (represented by the letter “I” by itself) consists of three components
Business spending on plant and equipment
Purchases of new homes
Accumulation of unsold inventories
In short-run macro model, we define (planned) investment spending (IP) as
Plant and equipment purchases by business firms, and new home construction
Inventory investment is treated as unintentional and undesired
Excluded from definition of investment spending
For now, we regard investment spending (IP) as a given value, determined by forces outside of our model

20. Government Purchases
Include all goods and services that government agencies—federal, state, and local—buy during year
In short-run macro model, government purchases are treated as a given value
Determined by forces outside of model

21. Net Exports
If we want to measure total spending on U.S. output, we must also consider international sector
U.S. exports
But international trade in goods and services also requires us to make an adjustment to other components of spending
In sum, to incorporate international sector into our measure of total spending, we must add U.S. exports, and subtract U.S. imports
Net Exports = Total Exports – Total Imports

22. Net Exports
By including net exports, simultaneously ensure that we have
Included U.S. output that is sold to foreigners, and
Excluded consumption, investment, and government spending on output produced abroad
For now, we regard net exports as a given value, determined by forces outside of our analysis
Important to remember that net exports can be negative
United States has had negative net exports since 1982
Imports are greater than exports

23. Summing Up: Aggregate Expenditure
Sum of spending by households, businesses, government, and foreign sector on final goods and services produced in United States
Aggregate expenditure = C + IP + G + NX
C stands for household consumption spending, IP for investment spending, G for government purchase, and NX for net exports
Plays a key role in explaining economic fluctuations
Why?
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

24. Income and Aggregate Expenditure
Relationship between income and spending is circular
Spending depends on income, and income depends on spending
We take up the first part of that circle
How total spending depends on income
Notice that aggregate expenditure increases as income rises
But notice also that rise in aggregate expenditure is smaller than rise in income
When income increases, aggregate expenditure (AE) will rise by MPC times change in income
ΔAE = MPC x Δ GDP
We’ve used ΔGDP to indicate change in total income
Because GDP and total income are always the same number

25. Finding Equilibrium GDP
Method of finding equilibrium in short-run is very different from anything you’ve seen before
Starting point in finding economy’s short-run equilibrium is to ask ourselves what would happen, hypothetically, if economy were operating at different levels of output
When aggregate expenditure is less than GDP, output will decline in future
Any level of output at which aggregate expenditure is less than GDP cannot be equilibrium GDP
When aggregate expenditure is greater than GDP, output will rise in future
Any level of output at which aggregate expenditure exceeds GDP cannot be equilibrium GDP
In short-run, equilibrium GDP is level of output at which output and aggregate expenditure are equal

26. Inventories and Equilibrium GDP
When firms produce more goods than they sell, what happens to unsold output?
Added to their inventory stocks
Change in inventories during any period will always equal output minus aggregate expenditure
Find output level at which change in inventories is equal to zero
AE < GDP  ΔInventories > 0  GDP↓ in future periods
AE > GDP  ΔInventories < 0  GDP↑ in future periods
AE = GDP  ΔInventories = 0  No change in GDP
Equilibrium output level is one at which change in inventories equals zero

27. Finding Equilibrium GDP With A Graph
Figure 5 gives an even clearer picture of how equilibrium GDP is determined
Lowest line, C, is consumption-income line
Next line, labeled C + IP, shows sum of consumption and investment spending at each income level
Next line adds government purchases to consumption and investment spending, giving us C + IP + G
Top line adds net exports, giving us C + IP + G + NX, or aggregate expenditure

28. Figure 5: Deriving the Aggregate Expenditure Line
Real Aggregate Expenditure ($ Billions)
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
Real GDP ($ Billions)
5. to get the aggregate expenditure line.
C + IP + G + NX
C + IP + G
4. and net exports (NX) . . .
C + IP C
3. government purchases (G) . . .
2. then add planned investment (IP) . . .
1. Start with the consumption-income line,

29. Finding Equilibrium GDP With A Graph
Figure 6 shows a graph in which horizontal and vertical axes are both measured in same units, such as dollars
Also shows a line drawn at a 45° angle that begins at origin
45° line is a translator line
Allows us to measure any horizontal distance as a vertical distance instead
Now we can apply this geometric trick to help us find the equilibrium GDP

30. Fig. 6 Using a 45° Line to Translate Distances
1. Using a 45-degree line . . . A
3. into an equal vertical distance (BA).
2. we can translate any horizontal distance (such as 0B) . . .
45° B

31. Finding Equilibrium GDP With A Graph
Figure 7 shows how we can apply geometric trick to help us find equilibrium GDP
At any output level at which aggregate expenditure line lies below 45° line, aggregate expenditure is less than GDP
If firms produce any of these out put levels, inventories will grow, and they will reduce output in the future
At any output level at which aggregate expenditure line lies above 45° line, aggregate expenditure exceeds GDP
If firms produce any of these output levels, inventories will decline, and they will increase their output in the future
We have thus found our equilibrium on graph
Equilibrium GDP is output level at which aggregate expenditure line intersects 45° line
If firms produce this output level, their inventories will not change, and they will be content to continue producing same level of output in the future

32. Figure 7: Determining Equilibrium Real GDP
Increase in Inventories
Real Aggregate Expenditure
($ Billions)
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
Real GDP ($ Billions) A
C + IP + G + NX H E
Decrease in Inventories K
Total Output
Aggregate Expenditure J
Aggregate Expenditure
Total Output
45°

33. Equilibrium GDP and Employment
When economy operates at equilibrium, will it also be operating at full employment?
Not necessarily
It would be quite a coincidence if our equilibrium GDP happened to be output level at which entire labor force were employed
In short-run macro model, cyclical unemployment is caused by insufficient spending
As long as spending remains low, production will remain low, and unemployment will remain high
In short-run macro model, economy can overheat because spending is too high
As long as spending remains high, production will exceed potential output, and unemployment will be unusually low
Aggregate expenditure line may be low, meaning that in short-run, equilibrium GDP is below full employment
Or aggregate expenditure may be high, meaning that in short-run, equilibrium GDP is above full-employment level

34. Figure 8: Equilibrium GDP Can Be Less Than Full Employment GDP
Aggregate Expenditure ($ Billions)
Real GDP ($ Billions)
When the aggregate expenditure line is low . . .
Real GDP
($ Billions)
Number of Workers
AELOW
Aggregate Production Function B F
$7,000
$7,000 E
$6,000
cyclical
unemployment
= 25 million A
equilibrium output ($6,000) is less than potential output,
45°
$7,000
100
Million
$6,000 75
Million
Potential GDP
Full Employment
and equilibrium employment is less than full employment.

35. Figure 9: Equilibrium GDP Can Be Greater Than Full-Employment GDP
When the aggregate expenditure line is high . . .
Aggregate Expenditure ($ Billions)
Real GDP ($ Billions)
Real GDP
($ Billions)
Number of Workers
AEHIGH
Aggregate Production Function E' H
$8,000 B
$7,000
$7,000 F
$7,000
and equilibrium employ-
ment is greater than full employment.
equilibrium output ($8,000) is greater than potential output,
$7,000
100
Million
$8,000
135
Million
Potential GDP
Full Employment

36. A Change in Investment Spending
Suppose equilibrium GDP in an economy is $6,000 billion, and then business firms increase their investment spending on plant and equipment by $1,000 billion
What will happen?
Sales revenue at firms that manufacture investment goods will increase by $1,000 billion
Each time a dollar in output is produced, a dollar of income (factor payment) is created
What will households do with their $1,000 billion in additional income?
What they will do depends crucially on marginal propensity to consume (MPC)
Assume MPC = 0.6

37. 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
With an MPC of 0.6, consumption spending will rise by 0.6 x $600 billion = $360 billion, creating still more sales revenue for firms, and so on and so on…
Increase in investment spending will set off a chain reaction
Leading to successive rounds of increased spending and income
At end of process, when economy has reached its new equilibrium
Total spending and total output are considerably higher

38. Figure 10: The Effect of a Change in Investment Spending
Increase in
Annual GDP
2,500
2,306
2,176
1,960
1,600
1,000
Initial
Rise in IP
After
Round 2
After
Round 3
After
Round 4
After
Round 5
After
All
Rounds

39. The Expenditure Multiplier
Whatever the rise in investment spending, equilibrium GDP would increase by a factor of 2.5, so we can write
ΔGDP = 2.5 x ΔIP
Expenditure multiplier is number by which the change in investment spending must be multiplied to get change in equilibrium GDP
Value of expenditure multiplier depends on value of MPC
Simple formula we can use to determine multiplier for any value of MPC
1 / (1 – MPC)
Using general formula for expenditure multiplier, can restate what happens when investment spending increases

40. 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

41. Other Spending Shocks
Shocks to economy can come from other sources besides investment spending
Suppose government agencies increased their purchases above previous levels
Besides planned investment and government purchases, there are two other components of spending that can set off the same process
An increase in net exports (NX)
A change in autonomous consumption
Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP
Expenditure multiplier is what we multiply initial change in spending by in order to get change in equilibrium GDP

42. Other Spending Shocks
Following four equations summarize how we use expenditure multiplier to determine effects of different spending shocks in short-run macro model

43. A Graphical View of the Multiplier
Figure 11 illustrates multiplier using aggregate expenditure diagram
An increase in autonomous consumption spending, investment spending, government purchases, or net exports will shift aggregate expenditure line upward by increase in spending
Causing equilibrium GDP to rise
Increase in GDP will equal initial increase in spending times expenditure multiplier

44. Figure 11: A Graphical View of the Multiplier
Real GDP ($ Billions)
2,000
4,000
6,000
8,000
Real Aggregate Expenditure
($ Billions)
1,000
3,000
5,000
7,000
9,000
AE2 F
AE1 E
$1,000
Increase in
Equilibrium GDP
$2,500
Billion
45°

45. The Effect of Fiscal Policy
In classical model fiscal policy—changes in government spending or taxes designed to change equilibrium GDP—is completely ineffective
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