1. ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall The Short-Run Macro Model

2. 2 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

3. 3 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 (I P ) –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”

4. 4 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?

5. 5 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

6. 6 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

7. 7 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

8. 8 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

9. 9 Figure 1: U.S. Consumption and Disposable Income, 1985-2002

10. 10 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

11. 11 Figure 2: The Consumption Function

12. 12 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

13. 13 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, or autonomous consumption spending Term b is slope of consumption function –Marginal propensity to consume (MPC)

14. 14 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

15. 15 Figure 3: The Consumption-Income Line

16. 16 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

17. 17 Shifts in the Consumption-Income Line By shifting relationship between consumption and disposable income, we shift relationship between consumption and income as well –Increases in autonomous consumption work this way

18. 18 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)

19. 19 Figure 4: A Shift in the Consumption-Income Line

20. 20 Table 3: Changes in Consumption Spending and the Consumption–Income Line

21. 21 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 (I P ) 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 (I P ) as a given value, determined by forces outside of our model

22. 22 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

23. 23 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

24. 24 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

25. 25 Summing Up: Aggregate Expenditure Aggregate expenditure –Sum of spending by households, businesses, government, and foreign sector on final goods and services produced in United States –Aggregate expenditure = C + I P + G + NX C stands for household consumption spending, I P 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

26. 26 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

27. 27 Finding Equilibrium GDP Method of finding equilibrium in short-run is very different from anything you’ve seen before in this text 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

28. 28 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 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

29. 29 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 + I P, shows sum of consumption and investment spending at each income level –Next line adds government purchases to consumption and investment spending, giving us C + I P + G –Top line adds net exports, giving us C + I P + G + NX, or aggregate expenditure

30. 30 Figure 5: Deriving the Aggregate Expenditure Line

31. 31 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

32. 32 Figure 6: Using a 45° to Translate Distances

33. 33 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

34. 34 Figure 7: Determining Equilibrium Real GDP

35. 35 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

36. 36 Figure 8: Equilibrium GDP Can Be Less Than Full Employment GDP

37. 37 Figure 9: Equilibrium GDP Can Be Greater Than Full-Employment GDP

38. 38 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 –What will happen? Sales revenue at firms that manufacture investment goods will increase by $1,000 billion 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

39. 39 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

40. 40 Figure 10: The Effect of a Change in Investment Spending

41. 41 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 ΔI P 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

42. 42 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

43. 43 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

44. 44 Other Spending Shocks Following four equations summarize how we use expenditure multiplier to determine effects of different spending shocks in short-run macro model

45. 45 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

46. 46 Figure 11: A Graphical View of the Multiplier

47. 47 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 chapter –Taxes –Transfer payments –Interest rates –Imports –Forward-looking behavior Each of these automatic stabilizers reduces size of multiplier –Making it smaller than simple formulas given in this chapter

48. 48 Automatic Stabilizers and the Multiplier In real world, due to automatic stabilizers, spending shocks have much weaker impacts on economy than our simple multiplier formulas would suggest One more automatic stabilizer—perhaps the most important of all –Passage of time In long-run, multipliers have a value of zero –No matter what the change in spending or taxes, output will return to full employment, so change in equilibrium GDP will be zero

49. 49 The Role of Saving In 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

50. 50 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

51. 51 Using the Theory: The Recession of 2001 Our most recent recession lasted from March 2001 to November 2001 Investment spending and real GDP—which were drifting downward before recession—fell sharply during second quarter of 2001, and continued to fall throughout year What caused this recession? –And can our short run macro model help us understand it? Decrease in investment spending is just the sort of spending shock that shifts aggregate expenditure line downward

52. 52 Using the Theory: The Recession of 2001 But what caused these successive decreases in investment spending? –There were at least three causes During much of late 1990s, there had been a boom in capital equipment spending –As existing businesses rushed to incorporate the Internet into factories, offices, and their business practices –But as 2000 ended and 2001 began, firms had begun to catch up to new technology During 1990s the Internet and other new technologies made public very optimistic about future profits of American businesses –Unfortunately, in late 2000 and early 2001, reality set in Terrorist attacks on World Trade Center and Pentagon on September 11, 2001

53. 53 Using the Theory: The Recession of 2001 One abnormal feature of the recession of 2001 was behavior of consumption spending –Ordinarily, as income falls in a recession, consumption declines along with it –Yet consumption spending actually rose during every quarter of 2001 Part of reason for upward shift was a ten-year tax cut that went into effect in June of 2001 Investment spending shock—and recession it caused—are only half of the story of recession of 2001 –The other half—entirely ignored so far—is response of government policymakers as they tried to prevent economic storm from becoming a hurricane