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

2.  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

3.  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

4.  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

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

6.  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

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

8. YCMPCS = Y - CMPS 020 5060 100 150140 200180 C = 20 + 0.8 Y 8Lecture 5

9. Real Consumption C Real GDP and Income C = 20 + 0.8Y MPC = 40/50 = 0.8 50100 20 60 100 9Lecture 5

10. YCMPCS = Y - CMPS 020-20 50600.8-100.2 100 0.800.2 1501400.8100.2 2001800.8200.2 MPS = 1 - MPC 10Lecture 5

11.  S = Y – C  S = Y – (C 0 + cY) = - C 0 + (1-c)Y = S 0 + sY Saving (S) Real GDP and Income (Y) S = -20 + 0.2Y -20 -10 0 50100 11Lecture 5

12. (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) 370375 390 410405 430420 450435 470450 490465 510480 530495 370 - 375 = -5 - 5 0 51015 20 25 30 35 375/370 = 1.01 1.01 1.00.99.98.97.96.95.94.93 -5/370 = -.01 -.01.00.01.02.03.04.05.06.07 15/20=.75.75.75.75.75.75.75.75.75.75 5/20 =.25.25.25.25.25.25.25.25.25.25 12Lecture 5

13. 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

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

15. 45 o C S Consumption Saving Disposable Income 15Lecture 5

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

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

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

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

20.  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

21. Investment (billions of dollars) Expected rate of net profit, r, and interest rate, i (percent) 16 14 12 10 8 6 4 2 0 Investment demand curve 5 10 15 20 25 30 35 40 ID 21Lecture 5

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

23. 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

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

25. 25Lecture 5

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

27. employment (millions) GDPCSIgIg AE 2.5370375-520395 5.0390 020410 7.5410405520425 10.04304201020440 12.54504351520455 15.047045020 470 17.54904652520485 20.05104803020500 22.55304953520515 25.05505104020530 AE = C + I 27Lecture 5

28. employment (millions) GDPCSIgIg AEunplanned  inventories 2.5370375-520395 5.0390 020410 7.5410405520425 10.04304201020440 12.54504351520455 15.047045020 470 17.54904652520485 20.05104803020500 22.55304953520515 25.05505104020530 unplanned inventory change is the difference between production & AE unplanned 28Lecture 5

29. employment (millions) GDPCSIgIg AEunplanned  inventories 2.5370375-520395-25 5.0390 020410 7.5410405520425 10.04304201020440 12.54504351520455 15.047045020 470 17.54904652520485 20.05104803020500 22.55304953520515 25.05505104020530 29Lecture 5

30. employment (millions) GDPCSIgIg AEunplanned  inventories 2.5370375-520395-25 5.0390 020410-20 7.5410405520425-15 10.04304201020440-10 12.54504351520455-5 15.047045020 4700 17.54904652520485+5 20.05104803020500+10 22.55304953520515+15 25.05505104020530+20 when inventories run down, production will increase 30Lecture 5

31. employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output 2.5370375-520395-25increase 5.0390 020410-20 7.5410405520425-15 10.04304201020440-10 12.54504351520455-5 15.047045020 4700 17.54904652520485+5 20.05104803020500+10 22.55304953520515+15 25.05505104020530+20 31Lecture 5

32. employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output 2.5370375-520395-25increase 5.0390 020410-20increase 7.5410405520425-15increase 10.04304201020440-10increase 12.54504351520455-5increase 15.047045020 4700equilibrium 17.54904652520485+5decrease 20.05104803020500+10decrease 22.55304953520515+15decrease 25.05505104020530+20decrease 32Lecture 5

33. employment (millions) GDPCSIgIg AEunplanned  inventories tendency of output 2.5370375-520395-25increase 5.0390 020410-20increase 7.5410405520425-15increase 10.04304201020440-10increase 12.54504351520455-5increase 15.047045020 4700equilibrium 17.54904652520485+5decrease 20.05104803020500+10decrease 22.55304953520515+15decrease 25.05505104020530+20decrease 33Lecture 5

34. Equilibrium point 45 o Real domestic product, GDP (billions of dollars) 470 370 390 410 430 450 470 490 510 530 550 C Aggregate Expenditure s (billions of dollars) C = $450 billion I g = $20 billion C + I g Aggregate expenditures 370 390 410 430 450 470 490 510 530 34Lecture 5

35. YCIAE = C + I 02015 506015 100 15 15014015 20018015 C = 20 +0.8 Y I = 15 AE = C + I AE = 20 + 0.8 Y + 15 AE = 35 + 0.8 Y 35Lecture 5

36. 45 o Real domestic product, GDP C Aggregate Expenditures C = 20 + 0.8Y C + I Aggregate expenditures AE = 35 + 0.8 Y I = 15 36Lecture 5

37.  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 = 20 + 0.8Y –I = 15 AE = C + I = 35 + 0.8Y Y = AE Y = 35 + 0.8Y Y – 0.8Y = 35 Y e = 35 / (1 – 0.8) = 175 37Lecture 5

38.  Since AE = C + I  And Y = C + S  AE = Y I = S  Example : I = 15, C = 20 + 0.8 Y  S = - 20 + 0.2 Y, I =15  S = I  -20 + 0.2 Y = 15  Y e =175 38Lecture 5

39. 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

40.  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

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