Lecture Five Introduction to the Short-run equilibrium Aggregate expenditure Consumption function Investment function

 Most firms “meet the demand” at a preset price  Because of this slow adjustment of prices, economy-wide spending changes are the major cause of output gaps  If gaps persist, firms may eventually respond (and gaps may then be eliminated)  The process of adjustment can be slow. Governments can and often take actions to speed up the elimination of the gaps.  Example: Al’s ice cream store (costs $ for new menus if we change prices to adapt to lower winter demand. Instead, we maintain prices and change quantity served) 2Lecture 5

 In the short run, firms meet the demand for their products at preset prices  Firms typically do not respond to every change in demand by changing their prices  Firms find it optimal to fix the price for some period of time and meet the demand at that price 3Lecture 5

 Aggregate Expenditure (AE)  Total planned spending on final goods and services  Four components ▪ Consumer expenditure (C) ▪ Investment (I) ▪ Government purchases (G) ▪ Net exports (NX)  In a closed private economy (no government and trade)  AE = C + I  It is a function of real GDP 4Lecture 5

AE Real GDP and Income Y = AE AE = C + I Short Run Equilibrium How to derive AE? 5Lecture 5

 The Consumption Schedule  Reflects the direct consumption-disposable income relationship  higher income  higher consumption  The Saving Schedule  S = Y – C (savings=income-consumption)  higher income  higher saving Illustrated… 6Lecture 5

C = C 0 + cY C0: autonomous consumption c: MPC = ΔC / ΔY 7Lecture 5

YCMPCS = Y - CMPS C = Y 8Lecture 5

Real Consumption C Real GDP and Income C = Y MPC = 40/50 = Lecture 5

YCMPCS = Y - CMPS MPS = 1 - MPC 10Lecture 5

 S = Y – C  S = Y – (C 0 + cY) = - C 0 + (1-c)Y = S 0 + sY Saving (S) Real GDP and Income (Y) S = Y Lecture 5

(1) GDP (Y=DI) (2) C (3) S (1)-(2) (4) APC (2)/(1) (5) APS (3)/(1) (6) MPC  (2)/  (1) (7) MPS  (3)/  (1) = /370 = /370 = /20= /20 = Lecture 5

Graphically presented.... Consumption Saving C S Disposable Income MPC = 15/20 = 0.75 MPS = 5/20 = 0.25 ΔC ($15) ΔY ($20) ΔS ($5) ΔY ($20) MPC + MPS = 1 13Lecture 5

 Wealth  Expectations  Real Interest Rates  Household Debt  Taxation 14Lecture 5

45 o C S Consumption Saving Disposable Income 15Lecture 5

45 o C C1C1 An increase in consumption... Consumption Saving Disposable Income S 16Lecture 5

45 o C S C1C1 An increase in consumption... S1S1 Causes a decrease decrease in saving Consumption Saving Disposable Income 17Lecture 5

45 o C C2C2 A decrease in consumption... Consumption Saving Disposable Income S 18Lecture 5

45 o C S C2C2 A decrease in consumption... S2S2 Causes an increase in saving Consumption Saving Disposable Income 19Lecture 5

 Expected Rate of Return, r  The Real Interest Rate  i = nominal rate - rate of inflation  crucial in making investment decisions  Investment Demand Curve 20Lecture 5

Investment (billions of dollars) Expected rate of net profit, r, and interest rate, i (percent) Investment demand curve ID 21Lecture 5

 Acquisition, Maintenance and Operating Costs  Business Taxes  Technological Change  Stock of Capital Goods on Hand  Expectations 22Lecture 5

Investment (billions of dollars) Expected rate of net profit, r, and interest rate, i (percent) ID 1 ID 0 ID 2 Increase in investment demand Decrease in investment demand 23Lecture 5

 Durability  Irregularity of Innovation  Variability of Profits  Variability of Expectations 24Lecture 5

25Lecture 5

GDP (billions of dollars) Investment (billions of dollars) 20 Investmentschedule IgIgIgIg 26Lecture 5

employment (millions) GDPCSIgIg AE AE = C + I 27Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories unplanned inventory change is the difference between production & AE unplanned 28Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories when inventories run down, production will increase 30Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output increase Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output increase increase increase increase increase equilibrium decrease decrease decrease decrease 32Lecture 5

employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output increase increase increase increase increase equilibrium decrease decrease decrease decrease 33Lecture 5

Equilibrium point 45 o Real domestic product, GDP (billions of dollars) C Aggregate Expenditure s (billions of dollars) C = $450 billion I g = $20 billion C + I g Aggregate expenditures Lecture 5

YCIAE = C + I C = Y I = 15 AE = C + I AE = Y + 15 AE = Y 35Lecture 5

45 o Real domestic product, GDP C Aggregate Expenditures C = Y C + I Aggregate expenditures AE = Y I = 15 36Lecture 5

 Assumption  AE = C + I  C = C 0 + cY  I = I g  Y = C + I = C 0 + cY + I g  Y – cY = C 0 + I g  Y e = (C 0 + I g ) / (1 – c) Assumption –C = Y –I = 15 AE = C + I = Y Y = AE Y = Y Y – 0.8Y = 35 Y e = 35 / (1 – 0.8) = Lecture 5

 Since AE = C + I  And Y = C + S  AE = Y I = S  Example : I = 15, C = Y  S = Y, I =15  S = I  Y = 15  Y e =175 38Lecture 5

Saving (S) Real GDP and Income (Y) S = -C 0 + (1-c)Y - C 0 0 YeYz I = I g 1.S = I 2.-C 0 + (1-c)Y = I g 3.Y e = (C 0 + I g ) / (1 – c) 39Lecture 5

 The equilibrium output is that out put which creates total spending just sufficient to produce that output  Other features of equilibrium GDP  Saving equals planned investment ▪ saving represents a leakage of spending ▪ investment can be thought of as an injection of spending  No unplanned changes in inventories 40Lecture 5

 Read Chapter 8 and 9.1, 9.2  Understand the numerical examples in the lecture  Home Work 5 41Lecture 5