1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 21 The Simplest Short-Run Macro Model

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-2 In this chapter you will learn to 1. Describe the difference between desired expenditure and actual expenditure. 4. Describe the effect of a change in desired expenditure on equilibrium income, and explain how this change is reflected by the multiplier. 3. Describe the definition of equilibrium national income. 2. Explain how desired consumption and desired investment expenditures are determined.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-3 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 Desired Aggregate Expenditure

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-4 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 The sum is called desired aggregate expenditure: AE = C + I + G + NX Desired Aggregate Expenditure

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-5 Two possible uses of disposable income: - consumption (C) or saving (S) Desired Consumption Expenditure 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.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-6 Figure 21.1 Consumption and Disposable Income in the United States, 1980-2005

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-7 Figure 21.2 The Consumption and Saving Functions The simple consumption function is written as: C = a + bY D Note: the slope of this simple consumption function (b) is less than one.

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-8 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. Marginal Propensity to Consume

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-9 The average propensity to consume (APC) is equal to total consumption divided by total disposable income. APC = C/Y D EXTENSIONS IN THEORY 21.1 The Theory of the Consumption Function In the previous diagram, the APC falls as the level of income rises. Average Propensity to Consume

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-10 The Saving Function Since all disposable income is either consumed or saved, we have: APC + APS = 1 MPC + MPS = 1 Average propensity to save (APS): APS = S/Y D Marginal propensity to save (MPS): MPS =  S/  Y D

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-11 Figure 21.3 Shifts in the Consumption Function If consumption function shifts upward, the saving function must shift downward. What causes a shift? -  wealth -  interest rate -  expectations

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-12 Investment expenditure is the most volatile component of GDP: changes in investment expenditure are strongly associated with short-run fluctuations Desired Investment Expenditure the real interest rate changes in the level of sales business confidence Three important determinants of aggregate investment expenditure are:

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-13 Figure 21.4 The Volatility of Investment, 1970–2006

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-14 The real interest rate is the opportunity cost for: - investment in new plants and equipment - investment in inventories - investment in residential construction The Real Interest Rate Thus, all three components of desired investment expenditure are negatively related to the real interest rate, other things being equal.

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-15 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 When business confidence improves, firms want to invest now so as to reap future profits. Changes in Sales Business Confidence Business confidence and consumer confidence may feed off of one another. The Real Interest Rate

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-16 Figure 21.5 Desired Investment as Autonomous Expenditure

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-17 The AE function: - relates desired aggregate expenditure to actual national income AE = C + I The Aggregate Expenditure Function In the absence of government and international trade, desired aggregate expenditure is:

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-18 The investment function is: I = 75 The consumption function is: C = 30 + (0.8)Y The AE function is then given by: AE = C + I = 30 + (0.8)Y + 75 = 105 + (0.8)Y The Aggregate Expenditure Function: Example

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-19 The slope of the AE function = marginal propensity to spend: - in this simple model, it is just MPC Figure 21.6 The Aggregate Expenditure Function

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-20 Equilibrium 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

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-21 Table 21.1 Equilibrium National Income

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-22 Figure 21.7 Equilibrium National Income

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-23 Equilibrium national income is the 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: Y = AE(Y) Equilibrium National Income 600 300 105 300600 900 AE Actual National Income Desired AE 45º line

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-24 Figure 21.8 Shifts in the Aggregate Expenditure Function

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-25 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. APPLYING ECONOMIC CONCEPTS 21.1 The Multiplier: A Numerical Example

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-26 Simple multiplier = YY AA = 1 1-z Where z is the marginal propensity to spend out of national income and  A is the change in autonomous expenditure. Figure 21.9 The Simple Multiplier

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-27 Figure 21.10 The Size of the Simple Multiplier The larger is z, the steeper is the AE curve and the larger is the simple multiplier.

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-28 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 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

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 21-29 EXTENSIONS IN THEORY 21.2 The Algebra of the Simple Multiplier The Simple Multiplier