2 The Core of Macroeconomic Theory Chapter is chapter 8 and 9 in the splitChapter is chapter 10 and 11 in the splitChapter 24 is chapter 12Chapter 25 is chapter 13Chapter 26 is 14, we skip this chapter.
3 Aggregate Output and Aggregate Income (Y) Aggregate output is the total quantity of goods and services produced (or supplied) in an economy in a given period.Aggregate income is the total income received by all factors of production in a given period.
4 Aggregate Output and Aggregate Income (Y) Aggregate output (income) (Y) is a combined term used to remind you of the exact equality between aggregate output and aggregate income.When we talk about output (Y), we mean real output, or the quantities of goods and services produced, not the dollars in circulation.
5 Explaining Spending Behavior All income is either spent on consumption or saved in an economy in which there are no taxes.Saving / Aggregate Income - Consumption
6 Household Consumption and Saving Some determinants of aggregate consumption include:Household incomeHousehold wealthInterest ratesHouseholds’ expectations about the futureIn The General Theory, Keynes argued that household consumption is directly related to its income.
7 Household Consumption and Saving The slope of the consumption function (b) is called the marginal propensity to consume (MPC), or the fraction of a change in income that is consumed, or spent.
8 Household Consumption and Saving The fraction of a change in income that is saved is called the marginal propensity to save (MPS).Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,
9 An Aggregate Consumption Function Derived from the Equation C = 100 + An Aggregate Consumption Function Derived from the Equation C = YAt a national income of zero, consumption is $100 billion (a).For every $100 billion increase in income (DY), consumption rises by $75 billion (DC).
10 Consumption Function (alternative formulation) -Autonomous consumption-Marginal Propensity to Consume (MPC)If there is no government and no taxes then T=) and DI=Y-Disposable Income (DI) (Income - Net Taxes)
11 The Determinants of Consumption WealthAffects consumption expendituresThe price levelAffects real purchasing power of financial assetsThe interest rateCauses consumers to postpone consumptionExpectations (of income or prices)A more optimistic outlook on the economy will raise consumers’ expenditures$C’’CC’Y
12 Deriving a Saving Function from a Consumption Function Y-C=SAGGREGATE INCOME (Billions of Dollars)AGGREGATE CONSUMPTION (Billions of Dollars)AGGREGATE SAVING (Billions of Dollars)100-10080160-80175-75200250-50400600550508007001,000850150
13 Planned Investment (I) Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock.One component of investment—inventory change—is partly determined by how much households decide to buy, which is not under the complete control of firms.change in inventory = production – sales
14 Actual versus Planned Investment Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms.Actual investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories.
15 The Planned Investment Function For now, we will assume that planned investment is fixed. It does not change when income changes.When a variable, such as planned investment, is assumed not to depend on the state of the economy, it is said to be an autonomous variable.
16 Investment FunctionInvestment is autonomous (independent of income)
17 Present Value Internal Rate of Return The Present Value of a stream of paymentsWhere I can be interpreted as the internal rate of return
18 Present Value Internal Rate of Return The Present Value of a 100 million Lotto pay offInterest Rate Present Value6.0% ($60,790,582.46)7.0% ($56,677,976.21)8.0% ($53,017,996.00)9.0% ($49,750,573.90)10.0% ($46,824,600.46)15.0% ($35,991,155.97)20.0% ($29,217,478.40)
19 Investment and the Investment Function Nominalinterest rateAt this point investment is planned investment expenditures (I)Investment is closely linked to the interest rate, since interest represents the opportunity cost of investing in capitalThe investment function will shift with changes in expectations for business profitsD’DInvestment spending (I)
20 Autonomous Investment Although investment is related to the interest rate and business expectations, investment does not depend in any significant way on disposable incomeAs such, investment is “autonomous”However, changes in the interest rate or expectations for profits will still shift autonomous investment$I”II’Real disposable income
21 Determinants of Investment Below are all the things that can cause a shift in the investment functionThe interest rateExpectations of future profitsTechnology
22 Planned Aggregate Expenditure (AE) Planned aggregate expenditure is the total amount the economy plans to spend in a given period. It is equal to consumption plus planned investment.
23 Equilibrium Aggregate Output (Income) Equilibrium occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output.
24 Equilibrium Aggregate Output (Income) aggregate output / Y planned aggregate expenditure / AE / C + I equilibrium: Y = AE, or Y = C + IDisequilibria:Y > C + Iaggregate output > planned aggregate expenditure inventory investment is greater than planned actual investment is greater than planned investmentC + I > Y planned aggregate expenditure > aggregate output inventory investment is smaller than planned actual investment is less than planned investment
26 Equilibrium Aggregate Output (Income) Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C = Y.(1)(2)(3)(4)(5)(6)AGGREGATE OUTPUT (INCOME) (Y)AGGREGATE CONSUMPTION (C)PLANNED INVESTMENT (I)PLANNED AGGREGATE EXPENDITURE (AE) C + IUNPLANNED INVENTORY CHANGE Y - (C + I)EQUILIBRIUM? (Y = AE?)10017525200- 100No250275- 75400425- 25500475Yes600550575+ 25800700725+ 751,000850875+ 125
27 Equilibrium Aggregate Output (Income) (1)(2)There is only one value of Y for which this statement is true. We can find it by rearranging terms:(3)By substituting (2) and (3) into (1) we get:
28 The Saving/Investment Approach to Equilibrium If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium.
29 The S = I Approach to Equilibrium Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I).
30 The MultiplierThe multiplier is the ratio of the change in the equilibrium level of output to a change in some autonomous variable.An autonomous variable is a variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes.In this chapter, for example, we consider planned investment to be autonomous.
31 The MultiplierThe multiplier of autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.The size of the multiplier depends on the slope of the planned aggregate expenditure line.
32 The Multiplier Equation The marginal propensity to save may be expressed as:Because DS must be equal to DI for equilibrium to be restored, we can substitute DI for DS and solve:therefore,, or
33 The MultiplierAfter an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment.
34 The Size of the Multiplier in the Real World The size of the multiplier in the U.S. economy is about For example, a sustained increase in autonomous spending of $10 billion into the U.S. economy can be expected to raise real GDP over time by $14 billion.
35 The Paradox of ThriftWhen households become concerned about the future and decide to save more, the corresponding decrease in consumption leads to a drop in spending and income.Households end up consuming less, but they have not saved any more.
36 Government Expenditures and Autonomous Net Taxes We will assume that government expenditures (G) and net taxes (T) are autonomousThis assumption will keep our models from becoming overly complexIt will also allow us to easily analyze fiscal policy as both G and T changeIt would be possible to consider taxes that vary with GDP (income taxes)$GTReal income
37 Autonomous Net Exports (X - M) If both exports (X) and imports (M) are autonomous, then net exports are autonomous$X’’-M’’X-MX’-M’Real disposable income
38 Determinants of X-MThe following will cause a shift in the net export function.The Exchange RateIf the Dollar appreciates, then exports fall and imports rise, both causing net exports to fall, or shift down.Foreign GDP (Income)As foreign income rises, they import more goods from around the world including the US. So our exports will rise as we satisfy their demand for our goods.
39 Variable Imports $ Imports may very well be related to income This makes net exports decrease with income$X-MReal disposable income
41 Planned ExpendituresWhat about the behavior (the “plans”) of our economic actors?Consumption (C) is “planned” on the basis of disposable incomeInvestment (I) is “planned” based on the interest rate and business expectations (although it is autonomous with respect to GDP, or income)G and (X-M) are simply autonomousAccording to Keynes, aggregate planned expenditures (demand) determine output and income, even in the long run
42 The Income-Expenditure Model A relationship between aggregate income and planned aggregate expenditures that determines, for a given price level, where income (and GDP) equals planned expendituresThe aggregate expenditure function is a relationship showing the amount of planned spending for each level of incomeEquilibrium occurs in the model where planned aggregate expenditures equal income (GDP)Unintended changes in inventories play a key role
43 Planned Aggregate Expenditure (trillions of dollars)
44 Deriving Equilibrium Income and Output $45oC+I+G+(X-M)Equilibrium Real GDPReal GDP
45 The Simple Spending Multipliers $C+I’+G+(X-M)45oC+I+G+(X-M)ISimple spending multiplier = GDP/I = 1/(1-MPC) = 1/MPSGDPReal GDP
46 The Spending Multiplier and the Circular Flow (MPC = .8)
47 Keynes and the Great Depression John Maynard Keynes argued that prices and wages are not sufficiently flexible to ensure the full employment of resourcesFurthermore, Keynes argued that when resources (especially labor) are not fully employed (due to a lack of private investment expenditures), the government could provide offsetting expenditures as a means of stabilizing the economyThus, Keynesian economics places emphasis on planned expenditures and all its components
48 Appendix B--The Algebra of the Income and Expenditure Model
50 AppendixSlides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book.They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.
51 Household Consumption and Saving The relationship between consumption and income is called the consumption function.For an individual household, the consumption function shows the level of consumption at each level of household income.
52 Income, Consumption, and Saving (Y, C, and S) A household can do two, and only two, things with its income: It can buy goods and services—that is, it can consume—or it can save.Saving (S) is the part of its income that a household does not consume in a given period. Distinguished from savings, which is the current stock of accumulated saving.
53 An Aggregate Consumption Function Derived from the Equation C = 100 + An Aggregate Consumption Function Derived from the Equation C = YAGGREGATE INCOME, Y (BILLIONS OF DOLLARS)AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS)100801601752002504005508007001,000850
54 Aggregate Demand and Changes in the Price Level An increase in the price level has a negative impact on real GDP for three reasonsAs the price level increases the real value of fixed financial assets is diminished. This reduces consumption demand and GDP.An increase in the price level puts upward pressure on interest rates and downward pressure on investmentAs the price level increases, foreign goods become more attractiveOf course all of these effects are reversed for a decrease in the price level
55 The Aggregate Demand Curve YPAE (P)45oAE’’ (P’’)AE’ (P’)P’P’’AD
56 Shifts in the Aggregate Demand Curve PC+I’+G+(X-M)45oC+I+G+(X-M)YPADAD’Y
57 Appendix A--Variable Net Exports X-MReal GDPC+I+GPC+I+G+(X-M)Real GDP
58 The Circular Flow of Income and Expenditure aggregate income = GDPtransfer paymentstaxesDisposable incomeFinancialmarketsconsumption (C)SInvestment (I)Gov’t (G)X-MC+I+G+X-M
59 Review Terms and Concepts actual investment aggregate income aggregate output aggregate output (income) (Y) autonomous variable change in inventory consumption function desired, or planned, investment (I) equilibriumidentity investment marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier paradox of thrift planned aggregate expenditure (AE) saving (S)
61 Classical EconomistsA group of 18th- and 19th-century economists who believed that recessions and depressions were short-run phenomena that corrected themselves through natural market forces; thus the economy was self-adjusting
62 ConsumptionConsumption is the portion of disposable income that is spent and not savedConsumption spending bears a close relationship to disposable incomeConsumption makes up the largest share of aggregate planned expendituresApproximately 2/3 of GDP
63 The Consumption and Savings Functions $CCDIMPC = C/DI$real disposable incomeSMPS = S/DIreal disposable income
64 The Marginal Propensity to Consume and Save The marginal propensity to consume (MPC) is the fraction of a change in income that is spent on added consumptionThe marginal propensity to save (MPS) is the fraction of a change in income that is devoted to added savings0 < MPC < 1MPS = 1 - MPC
65 Planned Versus Actual Investment Planned investment is the amount of investment firms plan to undertake during a yearActual investment is the amount of investment actually undertaken during a yearActual investment equals planned investment plus unplanned changes in inventories
66 The Income Half of the Circular Flow Since profits (the difference between expenditures on output and production-related costs) are paid to firms’ owners, GDP equals income: GDP = Aggregate IncomeSince disposable income is aggregate income minus taxes (less transfer payments), GDP must equal disposable income (DI) plus net taxes (T): GDP = Aggregate income = DI + T
67 The Expenditure Half of the Circular Flow Disposable income is either spent on consumption (C) or put into savings (S): DI = C + SFrom an earlier chapter, aggregate expenditure has four componentsConsumption (C), Investment (I), Government Purchases (G) , Net Exports (X - M)As a result, C + I + G + ( X - M ) = GDP
68 Leakages Equal Injections The two equalities for GDP written together give, GDP = Y=DI + T = C + I + G + ( X - M )Since S = DI - C S + T + M = I + G + X (leakages = injections)
69 Leakages and Injections A leakage is any diversion of income from the domestic spending streamAn injection is any payment of income other than by firms, or any spending other than by domestic households