Determination of GDP in the Short Term

Lecture 3

Outline • Macroeconomic theory explains the deviation of

actual from potential GDP (i.e. GDP gap)• Determination of GDP in the short run depends

on the behaviour of key categories of (C, I, G, NX)• Consumption spending depends on disposable

income and wealth• Investment spending depends on real interest

rates and business confidence• A necessary condition for GDP to be in

equilibrium is that desired domestic spending is equal to actual output

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• The central problem for macroeconomic policy-makers is to decide how to manage the economy in such a way that inflation is kept under control while unemployment is also kept to a minimum

• Virtually all economies have some periods when actual GDP is growing faster than potential and other periods when it is growing more slowly than potential, or even falling

• In other words, actual economies exhibit cycles about the trend growth path

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• Periods of decline in actual GDP (or even when growth in actual GDP is below potential) are costly because they are associated with a loss of output that is gone forever

• Economic downturns do not typically lead to all citizens loosing some equal amount of income – rather, they lead to some people losing their jobs (or businesses) and thereby suffering loss of income and well-being

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• Unemployment is undesirable, and is commonly agreed that policy-makers should aim to sustain unemployment a low level

• The outcome of an excessive growth in demand relative to supply is inflation, which is disruptive to the economy

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Key Assumptions on Macro Theory• Aggregation across industries– In elementary macro economics, we assume the existence

of a single productive sector producing a homogeneous output

• Time-scale– Short run- the period during which the economy maintains

a deviation of actual from potential output, or a GDP gap. This deviation is associated with the existence of excess capacity and unemployment (recession), or with unsustainable output and inflation (boom)

– Analysis of the short run in macroeconomics is concerned with explaining why national output can deviate from its potential level. It is about the GDP gap and how to keep both positive and negative gaps as small as possible– That is, how do we keep actual GDP as close as possible to

potential GDP?

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Key Assumptions on Macro Theory

• Long run- a period sufficient to allow time for the automatic adjustment mechanisms to return economic activity to equilibrium after it has been disturbed by an exogenous shock– This equilibrium is reached when the economy

returns to producing the level of potential (or full employment) output

– We assume that the long run level of output is constant and is associated with a fixed capital stock and a fixed level of technical knowledge

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Temporary Assumptions• The price level– We assume that the price level (the money price of the

economy’s single output good) is fixed– Hence all variables must necessarily be measured in real

terms• Excess capacity– We assume the economy has excess capacity so that is not

constrained from producing more output by shortages of capital stock or labour

• Closed economy– We ignore the possibility that the output of the economy

can be sold overseas and that domestic consumers can buy foreign-produced goods

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Summarising Assumptions• We have a closed economy with a single

industrial sector, producing a homogeneous output, at a fixed price, with no government. There is also excess capacity, so there are no resource constraints preventing the expansion of national output

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What Determines Aggregate Spending

From actual to desired spending• Desired (planned/intended) spending – refers to what

people want to spend out of the resources that are at their command– Desired private consumption, desired investment, desired

government consumption, and desired exports (total desired spending on domestically produced goods and services, called aggregate spending, or AE = C + I + G + (X – IM))

• The National Accounts measure actual spending in each of the four categories: private consumption, investment, government consumption, and net exports. The theory of GDP determination deals with desired spending in each of these four categories

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What Determines Aggregate Spending II

Autonomous and Induced Spending• Autonomous (exogenous) spending –

components of aggregate spending that do not depend on current domestic incomes– Autonomous spending can and does change, but

such changes do not occur systematically in response to changes in income)

• Induced (or endogenous) spending – components of aggregate spending that do change in response to changes in income

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What Determines Aggregate Spending III

Desired private consumption spending• There are only two possible uses of disposable

income: consumption and saving. So when each individual decides how much to put to one use, she has automatically decided how much to put to the other use

• What determines the division between the amount that people decide to spend on goods and services for consumption and the amount that they decide to save?– Consumption function and saving function

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• Consumption function relates the total desired consumer spending of the personal sector to the variables that affect it

• Under the assumptions, there are no taxes– Individuals receive all income that is generated– Therefore, disposable income Yd is equal to national income, Y

• The term consumption function describes the relationship between private consumption and the variables that influence it. In the simplest theory, consumption spending is determined by current disposable income– When income is zero, a typical individual will still (via borrowing,

or drawing down savings) consume some minimal amount (i.e. autonomous)

– The higher a person’s income, the more he or she will want to consume (i.e. induced). Table

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The slope of the consumption function• Properties of the short-term consumption

function as follows– There is a break-even level of income at which

APC equals unity. – Below this level APC is greater than unity; above

it APC is less than unity. – Below the break-even level consumption exceeds

income, so consumers run down savings or borrow.

– Above the break-even level income exceeds consumption, so there is positive saving

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The slope of the consumption function• Properties of the short-term consumption

function as follows–MPC is greater than zero, but less than unity, for

all levels of income. – This means that for each additional GHȼ1 of

income, less than GHȼ1 is spent on consumption and the rest saved.

– For a straight-line consumption function, the MPC is constant at all levels of income

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The saving function• Once we know the dependence of consumption on

disposable income, we also automatically know the dependence of saving on disposable income

• We also have APS and MPS• There is a simple relationship between the saving and

consumption propensities• APC and APS must sum to unity (1), just like MPC and

MPS• Because income is either spent or saved, it follows that

the fractions of incomes consumed and saved must account for all income (APC + APS = 1)

• It also follows that the fractions of any increment to income consumed and saved must account for all of that increment (MPC + MPS = 1)

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• What happens when there is an unexpected rise in wealth?– Less of current disposable income needs to be saved for

the future– Will tend to cause a larger fraction of disposable income to

be spent on consumption and a smaller fraction to be saved

– This will shift the consumption function upward and saving function downward

• A fall in wealth– Increases the incentive to save in order to restore wealth– This shifts the consumption function downward and saving

function upward• What about interest rate and consumer spending?

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Desired investment Spending• Investment spending is the most volatile

component of GDP and• Changes in investment spending are strongly

associated with economic fluctuations• What is the relationship between Investment and

the Real interest rate• Other things being equal, the higher the real

interest rate, the higher is the cost of borrowing money for investment purposes and the less is the amount of desired investment spending

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• Inventory accumulation– The higher the real rate of interest, the lower is the

desired inventory of goods and materials. Changes in the rate of interest cause temporary bouts of investments (or disinvestment) as inventories are either increased or decreased

• Residential housing construction– Spending for residential construction tends to vary

negatively with interest rates

• Business fixed capital formation– Increase in real interest rates means that the

opportunity cost of investing in fixed capital had risen

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• Expectations and business confidence– Business investments depends in part on firms’

forecasts of the future state of the economy– When firms expect good times ahead they will

want to invest so as to reap future profits– When they expect bad times they will not invest,

because, given their expectations, there will be no payoff from doing so

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The Aggregate Spending Function

• The aggregate spending function relates the level of desired real spending to the level of real national income (real GDP)

• Generally, total desired spending on the nation’s output is the sum of desired private consumption, investment, government consumption, and net export spending –

AE = C + I = AE = 350 + 0.8Y • (Table)

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The propensity to spend out of national income• Marginal propensity to spend (c) – the fraction

of any increment to national income (GDP) that will be spent on purchasing domestic output

(∆AE/∆Y)– The slope of the AE function

• Marginal propensity not to spend (1 – c) – the fraction of an increment to national income that does not add to desired aggregate spending

• Note – know the difference between the MPC and MPS and MPnS and MPS

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Equilibrium GDP• When something is in equilibrium there is no

tendency for it to change, forces are acting on it, but they balance out, and the net result is no change– At any level of GDP at which aggregate desired

spending exceeds total output, there will be pressure for GDP to rise caused by:• Queues and unfulfilled order books• Extra sales after reduction in inventories

– At any level of GDP for which aggregate desired spending is less than total output, there will be pressure for GDP to fall

– The equilibrium level of GDP occurs where aggregate desired spending equals total output

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Changes in GDP

Suppose desired aggregate spending rises• This may be as a response to a change in GDP

(incomes) – movement along the AE function, or

• It may be the result of an increased desire to spend at each level of GDP – shift in the AE function

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Shifts in the Aggregate Spending Function• Upward Shifts– If individuals permanently increase their levels of

desired consumption spending at each level of disposable income

– A major company desires to invest in more fixed capital

• Two types of upward shift– If the same addition to spending occurs at all levels of

income the AE line shifts parallel to itself– If there is a change in the propensity to spend out of

national income, the slope of the AE line changes

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• Downward shifts– Decrease in the amount of consumption at each level of

income– Decrease in the amount of investment spending at each

level of income• 2 General Propositions of the theory of GDP

determination– A rise in the amount of desired aggregate spending that

is associated with each level of national income will increase equilibrium national output (GDP)

– A fall in the amount of desired aggregate spending that is associated with each level of national income will lower equilibrium national output (GDP)

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The Multiplier• We know how to predict the direction of changes in

GDP that will occur in response to various shifts in the aggregate spending function

• How can we predict the magnitude of these changes?• The multiplier is the measure of the magnitude of

changes in GDP induced by a given change in autonomous expenditure

• The ratio of the change in GDP to the change in autonomous spending

• The simple multiplier measures the change in equilibrium GDP that occurs in response to a change in autonomous spending at a constant price level

• Why is the multiplier greater than 1

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The size of the Multiplier• The larger the marginal propensity to spend,

the steeper is the aggregate spending function and the larger is the multiplier

K = ∆Y/∆A = 1/1 – c• The simple multiplier equals the reciprocal of

the marginal propensity not to spend

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Assignment

• Calculate GDP using the following information (where there is no government and no foreign trade): C = 100 + 0.8Y; I = 1,000.

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