Chapter 21: The Simplest Short-Run Macro Model Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 21.1Desired Aggregate Expenditure 1.explain the difference between desired and actual expenditure. 2.identify the determinants of desired consumption and desired investment. 21.2Equilibrium National Income 3.understand the meaning of equilibrium national income. 21.3Changes in Equilibrium National Income 4.explain how a change in desired expenditure affects equilibrium income through the "simple multiplier." Copyright © 2014 Pearson Canada Inc. 2 Chapter 21, Slide

21.1Desired Aggregate Expenditure The national accounts divide actual GDP into its components: - C a, I a, G a, and NX a. Total desired expenditure is divided into the same categories: desired consumption, C desired investment, I desired government purchases, G desired net exports, NX Copyright © 2014 Pearson Canada Inc. 3 Chapter 21, Slide

The sum is called desired aggregate expenditure: AE = C + I + G + NX Two types of expenditures: autonomous expenditures do not depend on the level of national income induced expenditures do depend on the level of national income 4 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Assumptions of the simplest short-run macro model: there is no trade with other countries there is no government the price level is constant By simplifying the model we are better able to understand its structure and therefore how more complex versions of the model work. 5 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Copyright © 2014 Pearson Canada Inc. 6 What Does "Desired" Really Mean? "Desired" expenditure is not just a list of what consumers and firms would buy if they had no constraints on their spending—it is much more realistic than that. Desired expenditure is what consumers and firms would like to purchase, given their real-world constraints of income and market prices. Chapter 21, Slide

Desired Consumption Expenditure Two possible uses of disposable income: consumption (C) or saving (S) In the simplest theory, consumption is determined primarily by current disposable income (Y D ). In more advanced theories, individuals are forward looking, and so consumption depends more on "lifetime" income. 7 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Fig Consumption and Disposable Income in Canada 8 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

The simple consumption function is written as: Note: the slope of this simple consumption function (b) is less than one. 9 Copyright © 2014 Pearson Canada Inc. 45º line YDYD aSlope = b C C Chapter 21, Slide

The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about. MPC =  C/  Y D The MPC is the slope of the consumption function. In the previous diagram, the MPC is the same at any level of income. 10 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

The average propensity to consume (APC) is equal to total consumption divided by total disposable income. APC = C/Y D In the previous diagram, the APC falls as the level of income rises. 11 Copyright © 2014 Pearson Canada Inc. EXTENSIONS IN THEORY 21-1 The Theory of the Consumption Function Chapter 21, Slide

Fig The Consumption and Saving Functions 12 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Since all of disposable income is either consumed or saved, we have APC + APS = 1 MPC + MPS = 1 13 Copyright © 2014 Pearson Canada Inc. MyEconLab Is our simple theory of the consumption function supported by empirical evidence? For some Canadian data on aggregate consumption and disposable income, look for The Consumption Function in Canada in the Additional Topics section of this book’s MyEconLab. Chapter 21, Slide

If consumption function shifts upward, the saving function must shift downward. What causes a shift?  wealth  interest rate  expectations 14 Copyright © 2014 Pearson Canada Inc. Fig Shifts in the Consumption Function Chapter 21, Slide

Desired Investment Expenditure Investment expenditure is the most volatile component of GDP:  changes in investment expenditure are strongly associated with short-run fluctuations Three important determinants of aggregate investment expenditure are: the real interest rate changes in the level of sales business confidence 15 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Fig The Volatility of Investment, 1981– Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

The Real Interest Rate The real interest rate is the opportunity cost for: investment in new plants and equipment investment in inventories investment in residential construction Thus, all three components of desired investment expenditure are negatively related to the real interest rate, other things being equal. 17 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Changes in Sales The higher the level of production and sales, the larger the desired stock of inventories:  changes in the rate of sales cause temporary bouts of investment in inventories Business Confidence When business confidence improves, firms want to invest now so as to reap future profits. Business confidence and consumer confidence may feed off of one another. 18 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

The Aggregate Expenditure Function The AE function: relates desired aggregate expenditure to actual national income In the absence of government and international trade, desired aggregate expenditure is: AE = C + I 19 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Consider the following example. The consumption function is: C = 30 + (0.8)Y The investment function is: I = 75 The AE function is then given by: AE = C + I = 30 + (0.8)Y + 75  AE = (0.8)Y 20 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Fig The Aggregate Expenditure Function The slope of the AE function is the marginal propensity to spend: in this simple model, it is just MPC 21 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

21.2Equilibrium National Income If desired aggregate expenditure exceeds actual output: what is happening to inventories? there is pressure for output to rise If desired aggregate expenditure is less than actual output: what is happening to inventories? there is pressure for output to fall Copyright © 2014 Pearson Canada Inc. 22 Chapter 21, Slide

Table 21-1 Equilibrium National Income 23 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

In words: Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income. In this model, output is said to be demand determined. The equilibrium condition is: Y = AE(Y) 24 Copyright © 2014 Pearson Canada Inc. Fig Equilibrium National Income Chapter 21, Slide

25 Copyright © 2014 Pearson Canada Inc. MyEconLab A different, but equivalent, way of thinking about the equilibrium level of national income involves comparing desired saving with desired investment. For more details, look for Investment, Saving, and Equilibrium GDP in the Additional Topics section of this book's MyEconLab. Chapter 21, Slide

Shifts in the AE Function Two types of shifts can occur with the AE function: 1.The AE function can shift parallel to itself 2.The slope of the AE function can change 26 Copyright © 2014 Pearson Canada Inc. 21.3Changes in Equilibrium National Income (i) A parallel shift in AE (ii) A change in the slope of AE Chapter 21, Slide

The Multiplier The multiplier is a measure of the size of the change in equilibrium Y that results from a change in autonomous expenditure. In our simplest of macro models, the multiplier exceeds one. 27 Copyright © 2014 Pearson Canada Inc. APPLYING ECONOMIC CONCEPTS 21-1 A Simple Multiplier: A Numerical Example Chapter 21, Slide

where z is the marginal propensity to spend out of national income and  A is the change in autonomous expenditure. 28 Copyright © 2014 Pearson Canada Inc. Fig The Simple Multiplier Simple multiplier =  Y AA = 1 1-z Chapter 21, Slide

Fig The Size of the Simple Multiplier The larger is z, the steeper is the AE curve and the larger is the simple multiplier. 29 Copyright © 2014 Pearson Canada Inc. (i) Flat AE, multiplier = 1(ii) Intermediate case (iii) Steep AE, multiplier large Chapter 21, Slide

Economic Fluctuations as Self-Fulfilling Prophecies Households and firms base their desired investment and consumption partly on their expectations of the future:  changes in expectations can lead to real changes in the current state of the economy 30 Copyright © 2014 Pearson Canada Inc. EXTENSIONS IN THEORY The Algebra of the Simple Multiplier Chapter 21, Slide

Example: imagine that firms feel optimistic about the future this increases their desired investment, shifting up the AE curve this increases Y, justifying the initial optimism 31 Copyright © 2014 Pearson Canada Inc. Chapter 21, Slide

Review Consider the following aggregate expenditure function: AE = $300 billion + (0.87)Y. Assuming that we have no government, no international trade and desired investment is autonomous and is equal to $56 billion, then which of the following is the correct statement of the consumption function? A) C = $244 billion + (0.87)Y B) C = $356 billion + (0.87)Y C) C = $244 billion + (0.13)Y D) C = $300 billion + (0.13)Y E) C = $356 billion + (0.13)Y 32 © 2014 Pearson Education Canada Inc.

Review Refer to diagram. A shift in the aggregate expenditure function from AE0 to AE1 could be caused by A) a decrease in desired investment expenditures. B) an increase in desired investment expenditures. C) a fall in the marginal propensity to consume. D) a rise in the marginal propensity to consume. E) a rise in the multiplier. 33 © 2014 Pearson Education Canada Inc.

Review Consider the following information describing a closed economy with no government. Aggregate output is demand determined and the price level is constant. 1.Y = C + I 2.C = Y 3.I = 200 The simple multiplier in this economy is A) 2.0. B) 2.5. C) 3.0. D) 4.0. E) © 2014 Pearson Education Canada Inc.