1. of 55 Copyright © 2008 Pearson Education Canada 1 Chapter 21 The Simplest Short-Run Macro Model

2. of 55 Copyright © 2008 Pearson Education Canada 2 In this chapter you will learn 1. the difference between desired expenditure and actual expenditure. 4. how a change in desired expenditure affects equilibrium income, and how this change is reflected by the multiplier. 3. how to define equilibrium national income. 2. the determinants of desired consumption and desired investment expenditures.

3. of 55 Copyright © 2008 Pearson Education Canada 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 21.1 DESIRED AGGREGATE EXPENDITURE Where are the ‘a’ subscripts? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

4. of 55 Copyright © 2008 Pearson Education Canada 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 Where are the ‘a’ subscripts? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

5. of 55 Copyright © 2008 Pearson Education Canada 5 What Does “Desired” Really Mean? “Desired” expenditure is not just a list of what consumers and firms would buy if they had no constraints on their spending — it is much more realistic than that. Desired expenditure is what consumers and firms would like to purchase, given their real-world constraints of income and market prices.

6. of 55 Copyright © 2008 Pearson Education Canada 6 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. Recall: disposable income (YD) is national income (Y) less taxes (T). What about taxes and imports? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

7. of 55 Copyright © 2008 Pearson Education Canada 7

8. of 55 Copyright © 2008 Pearson Education Canada 8 An Important Tool: the 45º line - our reference line 45º line YDYD 100 C Properties of the 45º line - bisects the quadrant - intercept of zero - slope of 1 100 200 MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

9. of 55 Copyright © 2008 Pearson Education Canada 9 C = a + bY D The simple consumption function is written as: 45º line YDYD aslope (b) C Note: the slope of this simple consumption function (b) is less than one. C = a +bY D where a represents autonomous consumption expenditure and bY D represents induced consumption expenditure. intercept (a) MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

10. of 55 Copyright © 2008 Pearson Education Canada 10 A numerical example: Consider C = a + bYd where a = 4000 and b =0.5 Yd = a + bYd = C $ 0$4000$ 0$ 4000 $ 5000$4000$ 2500$ 6500 $ 8000$4000$ 4000$ 8000 $10000$4000$ 5000$ 9000 $15000$4000$ 7500$11500 $20000$4000$10000$14000 MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

11. of 55 Copyright © 2008 Pearson Education Canada 11 Picture of the Consumption Function C Yd C= a + bYd $4000 $0 $5000 $6000 $8000 $20000 $14000 Intercept Break even MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

12. of 55 Copyright © 2008 Pearson Education Canada 12 Exercise: repeat the previous calculations and draw the graph using the following parameter values abyou should find 1)$50000.5intercept shifts up 2)$30000.5intercept shifts down 3)$40000.7slope rotates upwards 4)$40000.3slope rotates downwards MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

13. of 55 Copyright © 2008 Pearson Education Canada 13 C = a + bY D versus C = a + b’Y D where b’ > b Changes in the slope of the consumption function YDYD a C C = a + bY D C = a + b’Y D A change in slope causes a rotation of the line MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

14. of 55 Copyright © 2008 Pearson Education Canada 14 C = a + bY D versus C = a’ + bY D where a’ > a Changes in the intercept of the consumption function YDYD a C C = a + bY D C = a’ + bY D A change in the intercept causes a shift in the line a’ MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

15. of 55 Copyright © 2008 Pearson Education Canada 15 Shifts in the Consumption Function What might cause a shift in the consumption function (the amount of consumption desired by all households at all levels of income)? - change in wealth - change in interest rates - change in expectations - change in population size or age distribution - change in taste - ? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

16. of 55 Copyright © 2008 Pearson Education Canada 16 What about savings? If C = a + bYd and Yd = C + S then S= -a +(1-b)Yd Yd CSavings = Yd - C $ 0$ 4000-$4000 $ 5000$ 6500-$1500 $ 8000$ 8000 $ 0 $10000$ 9000 $1000 $15000$11500 $3500 $20000$14000 $6000 Calculate APS = S/YD MPS =  S/  YD MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

17. of 55 Copyright © 2008 Pearson Education Canada 17 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 denoted b in our expression and diagram The MPC is the slope of the consumption function. In the previous diagram, the MPC is the same at every level of income. MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

18. of 55 Copyright © 2008 Pearson Education Canada 18 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.

19. of 55 Copyright © 2008 Pearson Education Canada 19 150 300 450 300 450 600 45º line C 150300450600 0 -150 150 -30 S YDYD YDYD C S

20. of 55 Copyright © 2008 Pearson Education Canada 20 Since all disposable income is either consumed or saved, we have: APC + APS = 1 MPC + MPS = 1 Is our simple theory of the consumption function supported by empirical evidence? For some Canadian data on aggregate consumption and disposable income, look for “The Consumption Function in Canada” in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com

21. of 55 Copyright © 2008 Pearson Education Canada 21 150 300 450 300 450 600 45º line C0C0 150 300 450600 0 -150 150 -30 S0S0 YDYD YDYD C1C1 S1S1 30 If consumption function shifts upward, the saving function must shift downward. Shifts in the Consumption Function? What causes a shift? -  wealth -  interest rate -  expectations C S

22. of 55 Copyright © 2008 Pearson Education Canada 22 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: Recall: Investment refers to purchases of - capital stock (plant & equipment) - residential building - business inventories MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

23. of 55 Copyright © 2008 Pearson Education Canada 23

24. of 55 Copyright © 2008 Pearson Education Canada 24 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.

25. of 55 Copyright © 2008 Pearson Education Canada 25 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.

26. of 55 Copyright © 2008 Pearson Education Canada 26 The Investment Function Desired investment is treated as autonomous – completely unrelated to the current level of Y We can writeI = I Were I is determined by - real interest rates - expectations (confidence) - changes in sales MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

27. of 55 Copyright © 2008 Pearson Education Canada 27 Investment Function (the picture) Desired Investment I Actual National Income Y I 0 200 150 100 I’ I’’ interest rate falls expectations improve sales increase interest rate rises expectations worsen sales decrease MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

28. of 55 Copyright © 2008 Pearson Education Canada 28 Our Story – a simplified version We will now start to tell our story (build our macroeconomic model). Our story has one key purpose: to explain what determines the level of aggregate economic activity (the size of the GDP or Y) – and to understand what might cause Y to increase and what might cause Y to decrease? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

29. of 55 Copyright © 2008 Pearson Education Canada 29 The Aggregate Expenditure Function Now what if we get rid of the Government and foreign economies? A Lou Dobbs economy (or perhaps the Fox Network economy). Desired aggregate expenditure, or more simply Aggregate Expenditure (AE). AE = C+I+G+(X-IM) This is termed a closed economy with no government MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

30. of 55 Copyright © 2008 Pearson Education Canada 30 Domestic Households Domestic Firms Factor income: wages, rents profits Y D = Y Revenue from sales of final G & S = C + I A closed economy with no government Savings Investment Consumption Financial markets MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

31. of 55 Copyright © 2008 Pearson Education Canada 31 The aggregate expenditure function relates the level of desired aggregate expenditure to the level of actual national income (through actual national income’s influence on C) AE = C + I The Aggregate Expenditure Function becomes In the absence of government and international trade, desired aggregate expenditure is just equal to C + I. (Note the distinction between desired aggregate expenditure and actual national income.) MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

32. of 55 Copyright © 2008 Pearson Education Canada 32 AE = C + I But, C= a + bY D (the consumption function) and Y D = Y (no government – no taxes) Therefore AE = a + bY + I AE = a + I + bY The aggregate expenditure function relates the level of desired aggregate expenditure to the level of actual national income. But how? Through actual national income’s influence on C (Note the distinction between desired aggregate expenditure and actual national income.) MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

33. of 55 Copyright © 2008 Pearson Education Canada 33 Consider the following example. 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 ==> AE = 105 + (0.8)Y

34. of 55 Copyright © 2008 Pearson Education Canada 34 600 300 105 300600 900 AE =C + I Actual National Income Desired Aggregate Expenditure The slope of the AE function is the marginal propensity to spend. In the simplest model with no taxes and no international trade, this is just the MPC. 75 30 C I MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

35. of 55 Copyright © 2008 Pearson Education Canada 35 Exercise Repeat the above calculations and graphing for the following economies 1) C = 30 + (0.8)Y and I = 125 2) C = 60 + (0.8)Y and I = 75 3) C = 30 + (0.6)Y and I = 75 MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

36. of 55 Copyright © 2008 Pearson Education Canada 36 The AE function combines the spending plans of households and firms. It shows, for any level of actual national income, the level of desired aggregate spending. What happens to AE if the consumption function shifts up or down? What happens to AE if the slope of the consumption function increases or decrease? What happens to AE if the investment function shifts up or down? What happens to AE if the slope of the investment function increases or decrease? (We will assume that it is always zero?) Summary MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

37. of 55 Copyright © 2008 Pearson Education Canada 37 21.2 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 MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007 Recall: desired aggregate expenditure is what buyers want to buy during the period (C+I) actual output is what firms actually produce during the period (Y)

38. of 55 Copyright © 2008 Pearson Education Canada 38 Copyright © 2005 Pearson Education Canada Inc. Equilibrium occurs where aggregate desired expenditure equals actual national income (output). MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

39. of 55 Copyright © 2008 Pearson Education Canada 39 How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is greater than desired AE? AE < Y - Firms cannot sell all that they are producing - Inventories build up (this is unintended I) - This is the firms’ signal that a decrease in output is necessary - Firms decrease output until AE=Y MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

40. of 55 Copyright © 2008 Pearson Education Canada 40 How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is less than desired AE? AE > Y - Firms are selling more than they are producing - Inventories are being run down (this is unintended I) - This is the firms’ signal that an increase in output is necessary - Firms increase output until AE=Y MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

41. of 55 Copyright © 2008 Pearson Education Canada 41 Equilibrium Mechanism Illustrated 600 300 105 300600 900 AE Desired Aggregate Expenditure 45º line Equilibrium national income is that level of national income at which desired aggregate expenditure equals actual national income. At an actual national income of 300, AE > Y (How do you know?) therefore inventories are falling and firms expand output. Actual National Income At an actual national income of 900, AE <Y (How do you know?) therefore inventories are increasing and firms decrease output. MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

42. of 55 Copyright © 2008 Pearson Education Canada 42 600 300 105 300600 900 AE Actual National Income Desired A.E. 45º line In words: Equilibrium national income is that 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 is: Y = AE(Y)

43. of 55 Copyright © 2008 Pearson Education Canada 43 Remember! INVENTORIES! MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

44. of 55 Copyright © 2008 Pearson Education Canada 44 A different, but equivalent, way of thinking about the equilibrium level of national income involves comparing desired saving with desired investment. For more details, look for “Investment, Saving, and Equilibrium GDP” in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com

45. of 55 Copyright © 2008 Pearson Education Canada 45 21.3 CHANGES IN EQUILIBRIUM NATIONAL INCOME ‘Movement along’ vs. ‘shifts’ in the AE Function e1e1 AE Y0Y0 Y1Y1 YY ee e0e0 AE 0 Y0Y0 Y1Y1  e´´ AE 1  e´ Y Y AE MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

46. of 55 Copyright © 2008 Pearson Education Canada 46 e´ 1 Y0Y0 Y1Y1 e0e0 AE 0 Y0Y0 Y1Y1 AE 1 AE 0 AE 1 e1e1 AE =Y E1E1 E0E0 E1E1 E0E0 e0e0 e2e2 Two types of ‘shifts’ can occur with the AE function: 1. The AE function can shift parallel to itself 2. The slope of the AE function can change (should not really be called a ‘shift’) YY AE MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

47. of 55 Copyright © 2008 Pearson Education Canada 47 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 For example, a $1 billion increase in desired investment expenditure will increase the equilibrium level of national income by more than $1 billion. MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

48. of 55 Copyright © 2008 Pearson Education Canada 48 e´ 1 Y0Y0 Y1Y1 e0e0 AE 0 AE 1 e1e1 AE =Y E1E1 E0E0 AA YY 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. Y AE

49. of 55 Copyright © 2008 Pearson Education Canada 49 Y0Y0 Y1Y1 AE 0 AE 1 AE =Y E1E1 E0E0 AA YY Y0Y0 Y1Y1 AE 0 AE 1 AE =Y E1E1 E0E0 AA YY The larger is z, the steeper is the AE curve and the larger is the simple multiplier. AE Y Y

50. of 55 Copyright © 2008 Pearson Education Canada 50 Example of the multiplier and its use e´ 1 Y0Y0 Y1Y1 e0e0 AE 0 AE 1 e1e1 AE =Y E1E1 E0E0 AA YY YY AA = multiplier x If we know that the multiplier is 4 and we know that the  A is $500 million, then we can calculate that the  Y is going to be $2,000 million Y AE What is the value of the multiplier in the real world? Canada = 1.20 or so Windsor = ? Maybe 1.06 MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

51. of 55 Copyright © 2008 Pearson Education Canada 51 Another example of the multiplier and its use e´ 1 Y0Y0 Y1Y1 e0e0 AE 0 AE 1 e1e1 AE =Y E1E1 E0E0 AA YY What if the marginal propensity to spend (z) is 0.75 and GM decides to build a new auto plant for $500 million, what would the change in equilibrium Y be? Simple multiplier = YY AA = 1 1-z So the multiplier is 1 / (1-0.75) = 1 / 0.25 = 4 The change in equilibrium Y will be 4 x $500 million = $2,000 million ($2 billion).  A = $500 million and  Y=$2,000 million Y AE MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

52. of 55 Copyright © 2008 Pearson Education Canada 52 EXTENSIONS IN THEORY 21-2 The Algebra of the Simple Multiplier Politicians in Canada and elsewhere are often heard “talking up” their economies. This can be understood by examining the role that expectations play in booms and recessions. For more on this topic, look for “Recessions and Booms as Self- Fulfilling Prophecies” in the Additional Topics section of this book’s MyEconLab. www.myeconlab.com

53. of 55 Copyright © 2008 Pearson Education Canada 53 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

54. of 55 Copyright © 2008 Pearson Education Canada 54 Now imagine the opposite scenario. It should be clear that if firms and households are pessimistic about the future in large numbers, the ensuing change in their behaviour will lead to a self-fulfilling prophecy of reduced national income. Could the Prime Minister (or the Governor of the Bank of Canada) ever announce to the country that they might have made a ‘big’ mistake? For example: suppose that government analysts report to the Prime Minister that having signed the Kyoto Accord might result in a recession. MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007

55. of 55 Copyright © 2008 Pearson Education Canada 55