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Output and Expenditure in the Short Run Aggregate expenditure (AE) The total amount of spending on the economy’s output: Aggregate Expenditure Consumption (C) Planned Investment (I) Government Purchases of Goods + Services (G) Net Exports (NX) Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected AE = C + I + G + NX Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y) AE = C + I + G + NX = Y

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Components of Real Aggregate Expenditure, 2008

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The Aggregate Expenditure Model Adjustments to Macroeconomic Equilibrium IF …THEN …AND … Aggregate expenditure is equal to GDP inventories are unchanged the economy is in macroeconomic equilibrium. Aggregate expenditure is less than GDPinventories rise GDP and employment decrease. Aggregate Expenditure is greater than GDPinventories fall GDP and employment increase. Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

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Real Consumption Expenditure, 1979 - 2009 Consumption follows a smooth, upward trend, interrupted only infrequently by recessions.

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Current disposable income Household wealth: Assets minus liabilities Including equity in owner occupied houses? The most important variables that determine the level of C:

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Do Changes in Housing Wealth Affect Consumption Spending? Making the Connection Many macroeconomic variables, such as GDP, housing prices, consumption spending, and investment spending, rise and fall at about the same time during the business cycle

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Current disposable income Household wealth: Assets minus liabilities Including equity in owner occupied houses? Expected future income People try to keep their consumption fairly steady from year-to-year save for a rainy day The price level Higher price level reduces real value of monetary wealth The interest rate High interest rate discourages spending on credit/encourages saving New, gotta-have styles and products The most important variables that determine the level of C:

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The Relationship between Consumption and Income, 1960– 2008 The Consumption Function

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Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes. The Consumption Function When disposable income changes: Change in consumption = ΔY D × MPC

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For a textbook economy: The Relationship between Consumption and National Income when net taxes are constant ΔY D = ΔNI

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National income = Consumption + Saving + Taxes Change in national income = Change in consumption + Change in saving + Change in taxes Y = C + S + T Income, Consumption, and Saving If taxes are always a constant amount, ΔT = 0 ΔY = ΔC + ΔS 1 = MPC + MPS

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Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save NATIONAL INCOME AND REAL GDP (Y) CONSUMPT ION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) $9,000$8,0001,000 —— 10,0008,6001,400 0.60.4 11,0009,2001,800 0.60.4 12,0009,8002,200 0.60.4 13,00010,4002,600 0.60.4

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Real Investment, 1979 - 2009 Planned Investment = I Investment is subject to larger changes than is consumption. Investment declined significantly during the recessions of 1980, 1981–1982, 1990–1991, 2001, and 2007–2009.

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Expectations of future profitability Waves of optimism and pessimism Major technology changes: new products & processes The interest rate Taxes Cash flow Retained earnings for financing investment Current capacity utilization The most important variables that determine the level of investment:

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Real Government Purchases, 1979 – 2009 Government Purchases = G Government purchases grew steadily for most of the 1979–2009 period, with the exception of the early 1990s, when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992.

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Real Net Exports, 1979–2006 Net Exports (NX)

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Real Net Exports, 1979 – 2009 Net Exports = NX Net exports were negative in most years between 1979 and 2009. Net exports have usually increased when the U.S. economy is in recession and decreased when the U.S. economy is expanding, although they fell during most of the 2001 recession.

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The price level in the United States relative to the price levels in other countries The growth rate of GDP in the United States relative to the growth rates of GDP in other countries The exchange rate between the dollar and other currencies Net Exports (NX) The most important variables that determine the level of net exports:

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The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram Graphing Macroeconomic Equilibrium

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Showing a Recession on the 45°-Line Diagram

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Real GDP (Y) Consump tion (C) Planned Invest ment (I) Govern ment Purchases (G) Net Export (NX) Planned Aggregate Expenditur e (AE) Unplan ned Change in Invent ories Real GDP Will … $8,000$6,200$1,500 – $500$8,700–$700increase 9,0006,8501,500 –5009,350 –350increase 100007,5001,500 –50010,000 0 be in equili brium 110008,1501,500 –50010,650 +350decrease 120008,8001,500 –50011,300 +700decrease Macroeconomic Equilibrium

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The Multiplier Effect

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Learning Objective 11.4 The Multiplier Effect Autonomous expenditure An expenditure that does not depend on the level of GDP. Multiplier The increase in equilibrium real GDP in response to increase in autonomous expenditure, e.g. Expenditure multiplier = ΔY/ΔI Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC = Change in autonomous spending that sparks an expansion + Change in consumption spending induced by increasing output and income.

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The Multiplier Effect in Action ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP ROUND 1$100 billion$0$100 billion ROUND 2075 billion 175 billion ROUND 3056 billion 231 billion ROUND 4042 billion 273 billion ROUND 5032 billion 305 billion........................ ROUND 1008 billion 377 billion........................ ROUND 1502 billion 395 billion........................ ROUND 1901 billion 398 billion n00$400 billion

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The Multiplier in Reverse: The Great Depression of the 1930s Making the Connection The multiplier effect contributed to the very high levels of unemployment during the Great Depression. YearConsumptionInvestmentNet ExportsReal GDPUnemployment Rate 1929$661 billion$91.3 billion-$9.4illion$865 billion3.2% 1933$541 billion$17.0 billion-$10.2 billion$636 billion24.9%

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The Multiplier Effect A Formula for the Multiplier Y = C + I + G + NX C depends on Y D : C = c 0 + MPC x Y D = c 0 + MPC x (Y – T) c 0, I, G, T, and NX are autonomous—they do not depend on Y Y = c 0 + MPC x Y – MPC x T + I + G + NX (1 – MPC) x Y = c 0 + I + G – MPC x T + NX Y = [1/(1 – MPC)] x [c 0 + I + G – MPC x T + NX]

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Summarizing the Multiplier Effect 1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases. 2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. 3 The larger the MPC, the larger the value of the multiplier. 4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on taxes, imports, prices and interest rates.

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The Aggregate Demand Curve The Effect of a Change in the Price Level on Real GDP

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Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure, holding constant all other factors that affect aggregate expenditure.

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Aggregate demand curve Aggregate expenditure (AE) Aggregate expenditure model Autonomous expenditure Cash flow Consumption function Inventories K e y T e r m s Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Multiplier effect

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The Algebra of Macroeconomic Equilibrium Appendix 1 Consumption function 2 Planned investment function 3 Government spending function 4 Net export function 5 Equilibrium condition

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The Algebra of Macroeconomic Equilibrium Appendix Or, Or, Or, The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

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The Algebra of Macroeconomic Equilibrium Appendix Remember that is the multiplier. Therefore an alternative expression for equilibrium GDP is: Equilibrium GDP = Autonomous expenditure x Multiplier

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