1

The Short-Run Macro Model Spending is very important in short-run

The more income households have, the more they will spend Spending depends on income

But the more households spend, the more output firms will produce More income they will pay to their workers

Thus, income depends on spending In short-run, spending depends on income, and income depends on

spending Many ideas behind the model were originally developed by British

economist John Maynard Keynes in 1930s Short-run macro model focuses on spending in explaining

economic fluctuations Explains how shocks that affect one sector influence other sectors

Causing changes in total output and employment

2

Thinking About Spending Spending on what? In short-run macro model, focus on spending in markets for

currently produced U.S. goods and services Things that are included in U.S. GDP

Need to organize our thinking about markets that contribute to GDP What’s the best way to categorize all these buyers into larger groups so

we can analyze their behavior? Macroeconomists have found that the most useful approach is to

divide those who purchase the GDP into four broad categories Households, whose spending is called consumption spending (C) Business firms, whose spending is called planned investment spending

(IP) Government agencies, whose spending on goods and services is called

government purchases (G) Foreigners, whose spending we measure as net exports (NX)

Should we look at nominal or real spending? When discuss “consumption spending,” we mean “real consumption

spending”

3

Consumption Spending Natural place for us to begin our look at

spending is with its largest component Consumption spending

Total consumption spending is sum of spending by over a hundred million U.S. households What determines total amount of consumption

spending? One way to answer is to start by thinking

about yourself or your family What determines your spending in any given

month, quarter, or year?

4

Disposable Income First thing that comes to mind is your income

The more you earn, the more you spend It’s not exactly your income per period that determines

your spending But rather what you get to keep from that income after

deducting any taxes you have to pay If we start with income you earn, deduct all tax payments,

and then add in any transfer received, would get your disposable income Income you are free to spend or save as you wish

Disposable Income = Income – Tax Payments + Transfers Received Can be rewritten as

Disposable Income = Income – (Taxes – Transfers) or Disposable Income = Income – Net Taxes

For almost any household, a rise in disposable income—with no other change—causes a rise in consumption spending

5

Wealth

Given your disposable income, how much of it will you spend and how much will you save? Will depend, in part, on your wealth

Total value of your assets minus your outstanding liabilities

In general, a rise in wealth—with no other change—causes a rise in consumption spending

6

The Interest Rate Interest rate is reward people get for saving, or

what they have to pay when they borrow All else equal, a rise in interest rate causes a decrease

in consumption spending Relationship between interest rate and

consumption spending applies even for people who aren’t “savers” in the common sense of term

Whether you are earning interest on funds you’ve saved, or paying interest on funds you’ve borrowed The higher the interest rate, the lower is consumption

spending In macroeconomics, household saving is the part of

disposable income that a household doesn’t spend Whether it’s put in bank or used to pay off a loan

7

Expectations Expectations about future would affect your spending as

well All else equal, optimism about future income causes an

increase in consumption spending Other variables influence your consumption spending

Including inheritances you expect to receive over your lifetime, and even how long you expect to live

Disposable income, wealth, and interest rate are the three key variables

In macroeconomics, we use phrases like “disposable income,” “wealth,” or “consumption spending” to mean the total disposable income, total wealth, and total consumption spending of all households in the economy combined All else equal, consumption spending increases when

Disposable income rises Wealth rises Interest rate falls

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Figure 1: U.S. Consumption and Disposable Income, 1985-2004

2000

1995

1990

1985

Rea

l C

on

sum

pti

on

Sp

end

ing

($

Bil

lio

ns)

5,000

6,000

4,000

3,000

7,000

Real Disposable Income ($ Billions)

3,000 4,000 5,000 6,000 7,000

9

Consumption and Disposable Income Of all the factors that influence consumption

spending, most important and stable determinant is disposable income

Relationship between consumption and disposable income is almost perfectly linear—points lie remarkably close to a straight line This almost-linear relationship between

consumption and disposable income has been observed in a wide variety of historical periods and a wide variety of nations

Vertical intercept in Figure 2 is called Autonomous consumption spending

Part of consumption spending that is independent of income

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Figure 2: The Consumption Function

ConsumptionFunction

1,000

600

The consumption function shows the (linear) relationship between real consumption spending and real disposable income

and the slope of the line (0.6) is the marginal propensity to consume.

Rea

l C

on

sum

pti

on

Sp

end

ing

($

Bil

lio

ns)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real Disposable Income ($ Billions)

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

The vertical intercept ($2,000 billion) is autonomous consumption spending . . .

11

Consumption and Disposable Income Second important feature of Figure 2 is the slope

Shows change along vertical axis divided by change along horizontal axis as we go from one point to another on the line

Slope = Δ Consumption ÷ Disposable Income Economists have given this slope a special name

Marginal propensity to consume, or MPC Can think of MPC in three different ways, but each of them

has the same meaning Slope of consumption function Change in consumption divided by change in disposable

income Amount by which consumption spending rises when

disposable income rises by one dollar Logic suggests that the MPC should be larger than zero, but

less than 1 We will always assume that 0 < MPC < 1

12

Representing Consumption with an Equation Sometimes, we’ll want to use an equation to

represent straight-line consumption function C = a + b x (Disposable Income)

Where C is consumption spending Term a is vertical intercept of consumption

function Represents theoretical level of consumption

spending at disposable income=0, or autonomous consumption spending

Term b is slope of consumption function Marginal propensity to consume (MPC)

13

Consumption and Income Consumption function is an important building block

Consumption is largest component of spending, and disposable income is most important determinant of consumption

If government collected no taxes, total income and disposable income would be equal So that relationship between consumption and income on the one

hand, and consumption and disposable income on the other hand, would be identical

Consumption-income line Line showing aggregate consumption spending at each level of

income or GDP When government collects a fixed amount of taxes from household

Line representing relationship between consumption and income is shifted downward by amount of tax times marginal propensity to consume (MPC)

Slope of this line is unaffected by taxes and is equal to MPC

14

Figure 3: The Consumption-Income Line

1. To draw the consumption-income line, we measure real income (instead of real disposable income) on the horizontal axis.

Consumption-Income Line

600

AB

Real Consumption Spending ($ Billions)

1,000

2,000

3,000

4,000

5,0005,600

Real Income ($ Billions)

2,000 4,000 6,000 8,000

1,000

2. The line has the same slope as the consumption function in Figure 2 . . .

3. but a different vertical intercept.

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Shifts in the Consumption-Income Line If income increases and net taxes remain

unchanged, disposable income will rise, and consumption spending will rise along with it

But consumption spending can also change for reasons other than a change in income, causing consumption-income line itself to shift

Mechanism works like this

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Shifts in the Consumption-Income Line Can summarize our discussion of changes

in consumption spending as follows When a change in income causes consumption

spending to change, we move along consumption-income line When a change in anything else besides income

causes consumption spending to change, the line will shift

All changes that shift the line—other than a change in taxes—work by increasing or decreasing autonomous consumption (a)

17

Figure 4: A Shift in the Consumption-Income Line

Consumption-Income Line When Net Taxes = 500

Consumption-Income Line When Net Taxes = 2,000

Real Consumption

Spending ($ Billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real Income ($ Billions)

2,000 4,000 6,000 8,000

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Table 3: Changes in ConsumptionSpending and the Consumption–Income Line

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Investment Spending

In definition of GDP, word investment by itself (represented by the letter “I” by itself) consists of three components Business spending on plant and equipment Purchases of new homes Accumulation of unsold inventories

In short-run macro model, we define (planned) investment spending (IP) as Plant and equipment purchases by business firms, and

new home construction Inventory investment is treated as unintentional and

undesired Excluded from definition of investment spending

For now, we regard investment spending (IP) as a given value, determined by forces outside of our model

20

Government Purchases

Include all goods and services that government agencies—federal, state, and local—buy during year In short-run macro model, government

purchases are treated as a given value Determined by forces outside of model

21

Net Exports If we want to measure total spending on

U.S. output, we must also consider international sector U.S. exports

But international trade in goods and services also requires us to make an adjustment to other components of spending

In sum, to incorporate international sector into our measure of total spending, we must add U.S. exports, and subtract U.S. imports Net Exports = Total Exports – Total Imports

22

Net Exports By including net exports, simultaneously

ensure that we have Included U.S. output that is sold to foreigners, and Excluded consumption, investment, and

government spending on output produced abroad For now, we regard net exports as a given

value, determined by forces outside of our analysis

Important to remember that net exports can be negative United States has had negative net exports since

1982 Imports are greater than exports

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Summing Up: Aggregate Expenditure Aggregate expenditure

Sum of spending by households, businesses, government, and foreign sector on final goods and services produced in United States

Aggregate expenditure = C + IP + G + NX C stands for household consumption spending, IP

for investment spending, G for government purchase, and NX for net exports

Plays a key role in explaining economic fluctuations Why?

Because over several quarters or even a few years, business firms tend to respond to changes in aggregate expenditure by changing their level of output

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Income and Aggregate Expenditure Relationship between income and spending is circular

Spending depends on income, and income depends on spending

We take up the first part of that circle How total spending depends on income

Notice that aggregate expenditure increases as income rises But notice also that rise in aggregate expenditure is

smaller than rise in income When income increases, aggregate expenditure (AE) will

rise by MPC times change in income ΔAE = MPC x Δ GDP

We’ve used ΔGDP to indicate change in total income Because GDP and total income are always the same

number

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Finding Equilibrium GDP Method of finding equilibrium in short-run is very

different from anything you’ve seen before Starting point in finding economy’s short-run

equilibrium is to ask ourselves what would happen, hypothetically, if economy were operating at different levels of output

When aggregate expenditure is less than GDP, output will decline in future Any level of output at which aggregate expenditure is

less than GDP cannot be equilibrium GDP When aggregate expenditure is greater than GDP,

output will rise in future Any level of output at which aggregate expenditure

exceeds GDP cannot be equilibrium GDP In short-run, equilibrium GDP is level of output at which

output and aggregate expenditure are equal

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Inventories and Equilibrium GDP When firms produce more goods than they sell, what

happens to unsold output? Added to their inventory stocks

Change in inventories during any period will always equal output minus aggregate expenditure

Find output level at which change in inventories is equal to zero AE < GDP ΔInventories > 0 GDP↓ in future periods AE > GDP ΔInventories < 0 GDP↑ in future periods AE = GDP ΔInventories = 0 No change in GDP

Equilibrium output level is one at which change in inventories equals zero

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Finding Equilibrium GDP With A Graph Figure 5 gives an even clearer picture

of how equilibrium GDP is determined Lowest line, C, is consumption-income

line Next line, labeled C + IP, shows sum of

consumption and investment spending at each income level

Next line adds government purchases to consumption and investment spending, giving us C + IP + G

Top line adds net exports, giving us C + IP + G + NX, or aggregate expenditure

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Figure 5: Deriving the Aggregate Expenditure Line

C + IP + GC + IP + G + NX

C + IP

C

2. then add planned investment (IP) . . .

1. Start with the consumption-income line,

5. to get the aggregate expenditure line.

3. government purchases (G) . . .

4. and net exports (NX) . . .

Real Aggregate

Expenditure ($ Billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real GDP ($ Billions)2,000 4,000 6,000 8,000

29

Finding Equilibrium GDP With A Graph

Figure 6 shows a graph in which horizontal and vertical axes are both measured in same units, such as dollars Also shows a line drawn at a 45° angle that

begins at origin 45° line is a translator line

Allows us to measure any horizontal distance as a vertical distance instead

Now we can apply this geometric trick to help us find the equilibrium GDP

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A

B

45°

0

2.we can translate any horizontal distance (such as 0B) . . .

3.into an equal vertical distance (BA).

1.Using a 45-degree line . . .

Fig. 6 Using a 45° Line to Translate Distances

31

Finding Equilibrium GDP With A Graph

Figure 7 shows how we can apply geometric trick to help us find equilibrium GDP

At any output level at which aggregate expenditure line lies below 45° line, aggregate expenditure is less than GDP If firms produce any of these out put levels, inventories will

grow, and they will reduce output in the future At any output level at which aggregate expenditure line lies

above 45° line, aggregate expenditure exceeds GDP If firms produce any of these output levels, inventories will

decline, and they will increase their output in the future We have thus found our equilibrium on graph

Equilibrium GDP is output level at which aggregate expenditure line intersects 45° line If firms produce this output level, their inventories will not

change, and they will be content to continue producing same level of output in the future

32

Figure 7: Determining Equilibrium Real GDP

A

Aggregate Expenditure

E

K

H

JAggregate Expenditure

Total Output

Increase in Inventories

45°

Real Aggregate Expenditure ($ Billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Real GDP ($ Billions)2,000 4,000 6,000 8,000

Decrease in Inventories

C + IP + G + NX

Total Output

33

Equilibrium GDP and Employment When economy operates at equilibrium, will it also be

operating at full employment? Not necessarily

It would be quite a coincidence if our equilibrium GDP happened to be output level at which entire labor force were employed

In short-run macro model, cyclical unemployment is caused by insufficient spending As long as spending remains low, production will remain low, and

unemployment will remain high In short-run macro model, economy can overheat because

spending is too high As long as spending remains high, production will exceed

potential output, and unemployment will be unusually low Aggregate expenditure line may be low, meaning that in

short-run, equilibrium GDP is below full employment Or aggregate expenditure may be high, meaning that in short-

run, equilibrium GDP is above full-employment level

34

Figure 8: Equilibrium GDP Can Be Less Than Full Employment GDP

$6,000

$7,000

$7,000

E

F

AELOW

75Million

$7,000

100Million

A

B

Aggregate Production Function

$6,000

and equilibrium employment is less than full employment.

When the aggregate expenditure line is low . . .

Full EmploymentPotential GDP

cyclical unemployment = 25 million

Aggregate Expenditure

($ Billions)

Real GDP ($ Billions)

Real GDP($ Billions)

Number of Workers

45°

equilibrium output ($6,000) is less than potential output,

35

Figure 9: Equilibrium GDP Can Be Greater Than Full-Employment GDP

$8,000

$8,000 H

$7,000$7,000

$7,000

$7,000B

Potential GDP

Aggregate Expenditure

($ Billions)

Real GDP ($ Billions)

AEHIGH

Real GDP($ Billions)

Number of Workers

Aggregate Production Function

100Million

Full Employment135

Million

When the aggregate expenditure line is high . . .

and equilibrium employ-ment is greater than full employment.equilibrium output ($8,000) is

greater than potential output,

F

E'

36

A Change in Investment Spending Suppose equilibrium GDP in an economy is $6,000

billion, and then business firms increase their investment spending on plant and equipment by $1,000 billion What will happen?

Sales revenue at firms that manufacture investment goods will increase by $1,000 billion

Each time a dollar in output is produced, a dollar of income (factor payment) is created

What will households do with their $1,000 billion in additional income? What they will do depends crucially on marginal propensity

to consume (MPC) Assume MPC = 0.6

37

A Change in Investment Spending When households spend an additional $600 billion, firms

that produce consumption goods and services will receive an additional $600 billion in sales revenue Which will become income for households that supply

resources to these firms With an MPC of 0.6, consumption spending will rise by

0.6 x $600 billion = $360 billion, creating still more sales revenue for firms, and so on and so on…

Increase in investment spending will set off a chain reaction Leading to successive rounds of increased spending and

income At end of process, when economy has reached its new

equilibrium Total spending and total output are considerably higher

38

Figure 10: The Effect of a Change in Investment Spending

1,600

1,9602,176

2,3062,500

1,000

InitialRise in

IP

AfterRound

2

AfterRound

3

AfterRound

4

AfterRound

5

Increase inAnnual GDP

AfterAll

Rounds

39

The Expenditure Multiplier Whatever the rise in investment spending, equilibrium

GDP would increase by a factor of 2.5, so we can write ΔGDP = 2.5 x ΔIP

Expenditure multiplier is number by which the change in investment spending must be multiplied to get change in equilibrium GDP

Value of expenditure multiplier depends on value of MPC

Simple formula we can use to determine multiplier for any value of MPC 1 / (1 – MPC)

Using general formula for expenditure multiplier, can restate what happens when investment spending increases

PI x )1(

1

MPC

GDP

40

The Expenditure Multiplier A sustained increase in investment

spending will cause a sustained increase in GDP

Multiplier process works in both directions Just as increases in investment spending

cause equilibrium GDP to rise by a multiple of the change in spending Decreases in investment spending cause

equilibrium GDP to fall by a multiple of the change in spending

41

Other Spending Shocks Shocks to economy can come from other sources

besides investment spending Suppose government agencies increased their

purchases above previous levels Besides planned investment and government

purchases, there are two other components of spending that can set off the same process An increase in net exports (NX) A change in autonomous consumption

Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP Expenditure multiplier is what we multiply initial

change in spending by in order to get change in equilibrium GDP

42

Other Spending Shocks Following four equations summarize how we

use expenditure multiplier to determine effects of different spending shocks in short-run macro model

PI x MPC) - (1

1

GDP

G x MPC) - (1

1

GDP

NX x MPC) - (1

1

GDP

a x MPC) - (1

1

GDP

43

A Graphical View of the Multiplier Figure 11 illustrates multiplier using aggregate

expenditure diagram

Spending x MPC) - (1

1

GDP

• An increase in autonomous consumption spending, investment spending, government purchases, or net exports will shift aggregate expenditure line upward by increase in spending– Causing equilibrium GDP to rise

• Increase in GDP will equal initial increase in spending times expenditure multiplier

44

Figure 11: A Graphical View of the Multiplier

F

E

$2,500Billion

Real GDP ($ Billions)2,000 4,000 6,000 8,000

Real Aggregate Expenditure ($ Billions)

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

45°

AE2

AE1

Increase inEquilibrium GDP

$1,000

45

The Effect of Fiscal Policy In classical model fiscal policy—changes in

government spending or taxes designed to change equilibrium GDP—is completely ineffective

In short-run, an increase in government purchases causes a multiplied increase in equilibrium GDP Therefore, in short-run, fiscal policy can actually

change equilibrium GDP Observation suggests that fiscal policy could, in

principle, play a role in altering path of economy Indeed, in 1960s and early 1970s, this was the

thinking of many economists But very few economists believe this today