CHAPTER 9 The Sticky-Price Income-Expenditure Framework: Consumption and the Multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights.

Questions What are “sticky” prices?
What factors might make prices sticky? When prices are sticky, what determines the level of real GDP in the short run? Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Questions When prices are sticky, what happens to real GDP if some component of planned total expenditure rises or falls? When exports, investment, or government purchases rise, in general GDP rises by a multiplied amount. What determines the size of the spending multiplier? Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Real GDP in U.S. History The flexible-price model does not give a complete picture of the macroeconomy real GDP does not always grow by the same rate as potential output the unemployment rate is not always at the natural rate inflation is not always steady Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.1 - Real GDP per Worker and Potential Output, 1960-2004
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycles Fluctuations in economic growth are called business cycles A business cycle has two phases expansion or boom production, employment, and prices all grow rapidly recession or depression production falls, unemployment rises, and inflation decelerates Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Cycles To understand business cycles, we need a model that does not always guarantee full employment We will no longer assume that prices are flexible Instead, prices will be assumed to be “sticky” they will remain fixed at predetermined levels as businesses expand or contract production Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

A Decrease in Autonomous Consumption (C0)
Suppose that autonomous consumption falls from $2,000 billion to $1,800 billion per year In the flexible-price model, real GDP would be unaffected the economy would remain at full employment real GDP would equal potential output Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.2 – Flexible-Price Logic: Labor Market Equilibrium
Real Wage Labor supply = labor force Economywide demand for labor Ld Equilibrium employment Market equilibrium real wage Employment Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

In the flexible-price model, a fall in consumption means an increase in savings the real interest rate falls the equilibrium level of investment and net exports increases by $200 billion per year Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.3 – Flexible-Price Logic: The Effect on Savings of a Fall in Consumption Spending
Real Interest Rate r Total Saving Investment Demand Flow of Funds through Financial Markets Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

In the flexible-price model, the consequences of a fall in consumers’ desired baseline consumption are a drop in consumption an increase in household savings a decline in the real interest rate a rise in investment a rise in the exchange rate a rise in net exports; a fall in foreign saving Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

In the sticky-price model, a drop in consumption leads to a drop in aggregate expenditure As businesses see spending on their products falling, they cut back production they will fire some of their workers incomes will fall Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

In the sticky-price model, a drop in consumption does not lead to an increase in savings the increase in savings (from the fall in consumption) is exactly offset by a decrease in savings (from the fall in income) The real interest rate is unaffected no change in investment or net exports Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.4 – Sticky-Price Logic: The Effect on Savings of a Fall in Consumption Spending
Real Interest Rate r Total Saving No change in the real interest rate Investment Demand Flow of Funds through Financial Markets No change in investment spending Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

In the sticky-price model, the consequences of a fall in consumers’ desired baseline consumption are a drop in consumption a decline in production a decline in employment a decrease in national income no change in the real interest rate, investment, or the exchange rate Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Expectations Price stickiness causes problems only in the short run
If individuals had time to foresee and gradually adjust their wages and prices to changes in expenditure, sticky prices would not be a problem both the stickiness of prices and the failure to accurately foresee changes are needed to create business cycles Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Short Run vs. Long Run In the short run, prices are sticky
shifts in policy or in the economic environment that affect the components of planned total expenditure will affect real GDP and employment In the long run, prices are flexible individuals have time to react and adjust to changes in policy or the economic environment real GDP and employment are unaffected Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Why Prices Are Sticky Menu costs are costs associated with changing prices changing prices can be costly for a variety of reasons managers and workers may prefer to keep prices and wages stable as long as the shocks that affect the economy are relatively small Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Why Prices Are Sticky Imperfect information causes a misperception of real and nominal price changes managers and workers lack full information about the state of the economy and may confuse changes in economy-wide spending with changes in demand for their particular products cut production rather than cutting the price of the product Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Why Prices Are Sticky The level of prices is often determined by “what is fair” Work effort and work intensity depend on whether or not workers feel that they are treated fairly most managers are reluctant to cut wages if wages are sticky, firms will adjust employment when demand changes Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Why Prices Are Sticky Managers and workers may suffer from money illusion confuse changes in nominal prices with changes in real prices firms react to higher nominal prices by believing that it is profitable to produce more workers react to higher nominal wages by searching more intensively for jobs and working more hours Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier Process
If prices are sticky, higher planned expenditure boosts production Incomes rise Higher incomes give a further boost to production which increases planned expenditure even more Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.5 - The Multiplier Process
An initial shock to planned expenditure raises total spending Higher spending raises production Higher production raises spending Higher income raises total spending still further Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Building Up Planned Total Expenditure
Planned total expenditure (PE) has four components consumption (C) investment (I) government purchases (G) net exports (NX) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Building Up Planned Total Expenditure
As long as prices are sticky, the level of real GDP is determined by the level of planned total expenditure not by the level of potential output (Y*) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Consumption Function
As incomes rise, consumption spending rises less than dollar for dollar The share of an extra dollar of disposable income that is added to consumption spending is equal to the marginal propensity to consume (Cy) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The slope of the consumption function is smaller than the marginal propensity to consume (Cy) because of the tax system, a one-dollar increase in national income means less than a one-dollar increase in disposable income Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.6 - The Consumption Function and the Marginal Propensity to Consume
Spending slope = Cy(1-t) National Income Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.7 - Consumption as a Function of After-Tax Disposable Income

Other Components of Total Expenditure
Investment (I) is determined by the real interest rate and assessments of profitability made by firms’ managers Government purchases (G) is set by politics Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Other Components of Total Expenditure
Net exports (NX) are equal to gross exports minus imports gross exports are a function of the real exchange rate () and the level of foreign real GDP (Yf) imports are a function of national income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.8 - Components of Total Expenditure

Components of Expenditure
The components of total expenditure can be divided into two groups autonomous spending (A) components of total expenditure that do not depend directly on national income the marginal propensity to expend (MPE) times the level of national income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Components of Expenditure
A = autonomous expenditure [A=C0+I+G+GX] MPE=marginal propensity to expend [MPE=Cy(1-t)-IMy] Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.9 - The Income-Expenditure Diagram
Planned Expenditure Planned-expenditure line slope = MPE Autonomous spending National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Income-Expenditure Diagram
The y-intercept of the planned expenditure line is the level of autonomous spending (A) a change in the value of any component of autonomous spending will shift the planned expenditure line up or down Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.10 – An Increase in Autonomous Spending
Planned Expenditure New planned-expenditure line Old planned-expenditure line Change in autonomous spending Old autonomous spending National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Income-Expenditure Diagram
The slope of the planned expenditure line is the marginal propensity to expend (MPE) changes in the marginal propensity to consume (Cy), the tax rate (t), or in the propensity to spend on imports (IMy) will change the MPE and the slope of the planned expenditure line Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.11 – An Increase in the Marginal Propensity to Expend
Planned Expenditure New planned- expenditure line High MPE Old planned-expenditure line Low MPE Autonomous spending National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the MPE Example Cy = 0.75 t = 0.40 IMy = 0.15

Sticky-Price Equilibrium
The economy will be in equilibrium when planned expenditure equals real GDP there will be no short-run forces pushing for an immediate expansion or contraction of national income, real GDP, or total expenditure Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.12 – Equilibrium on the Income-Expenditure Diagram
Planned Expenditure 45-degree line Planned-expenditure Equilibrium National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

If the economy is not on the 45-degree line, the economy is not in equilibrium planned expenditure (PE) does not equal real GDP (Y) If Y>PE there is excess supply of goods If Y<PE there is excess demand for goods Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventory Adjustment Excess supply Excess demand
production > planned expenditure inventories are rising rapidly firms will cut production Excess demand production < planned expenditure inventories are being depleted firms will expand production Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure Inventory Adjustment and Equilibrium: Goods Market Equilibrium and the Income-Expenditure Diagram Planned Expenditure 45-degree line Rising inventories Planned-expenditure Equilibrium Falling inventories National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventory Adjustment Suppose that businesses see their inventories declining they will respond by boosting production to equal last month’s planned expenditure This will not bring the economy into goods market equilibrium Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.14 – The Inventory Adjustment Process: An Income-Expenditure Diagram
Planned Expenditure 45-degree line Planned-expenditure New expenditure Initial expenditure National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier Suppose that autonomous spending increases
the planned expenditure line will shift up planned expenditure > national income inventories would fall businesses would boost production how much production would expand depends on the magnitude of the change in autonomous spending and the value of the spending multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Figure 9.17 – The Multiplier Effect
Planned Expenditure change in component of planned expenditure change in equilibrium national income National Income (Y) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier The value of the multiplier depends on the slope of the planned expenditure line the higher is the MPE, the steeper is the planned expenditure line and the greater is the multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier Equilibrium means that

The Multiplier 1/[1-MPE] is the multiplier
it multiplies the upward shift in the planned expenditure line into a change in the equilibrium level of real GDP, total income, and aggregate demand because autonomous spending is influenced by many factors, almost every change in economic policy or the economic environment will set the multiplier process in motion Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier Example A = $5.6 trillion MPE = 0.3 A = $0.1 trillion

The Multiplier One factor that tends to minimize the multiplier is the tax system taxes are proportional rather than lump-sum when GDP is high, the government collects more in tax revenue than it would with a lump-sum tax when GDP is low, the government collects less in tax revenue than it would with a lump-sum tax Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier An economy that is more open to world trade will have a smaller multiplier than a less open economy the more open the economy, the greater is the marginal propensity to expend on imports Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier The multiplier for a closed economy would be

Chapter Summary Business-cycle fluctuations can push real GDP away from potential output and unemployment far away from its average rate If prices were perfectly and instantaneously flexible, there would be no such thing as business cycle fluctuations models in which prices are sticky must play a large role in macroeconomics Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary There are a number of reasons that prices might be sticky menu costs, imperfect information, concerns of fairness, or money illusion there is no overwhelming evidence as to which is most important In the short run, while prices are sticky, the level of real GDP is determined by the level of planned total expenditure Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary The short-run equilibrium level of real GDP is that level at which planned total expenditure (as a function of national income) is equal to the level of national income (real GDP) Two quantities summarize planned total expenditure as a function of total income the level of autonomous spending and the marginal propensity to expend (MPE) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary The level of autonomous spending is the intercept of the planned expenditure function on the income-expenditure diagram it tells us what the level of planned expenditure would be if national income was zero Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary The MPE is the slope of the planned expenditure function on the income-expenditure diagram it tells us how much planned expenditure increases for each $1 increase in national income Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary The value of the MPE depends on the tax rate (t), the marginal propensity to consume (Cy), and the share of spending on imports (IMy) Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Summary In the simple macro models, an increase in any component of autonomous spending causes a more than proportional increase in real GDP this is the multiplier process The size of the multiplier depends on the MPE Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 9 The Sticky-Price Income-Expenditure Framework: Consumption and the Multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights.

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CHAPTER 9 The Sticky-Price Income-Expenditure Framework: Consumption and the Multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights.

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Presentation on theme: "CHAPTER 9 The Sticky-Price Income-Expenditure Framework: Consumption and the Multiplier Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights."— Presentation transcript:

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