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Output and Expenditure in the Short Run

Aggregate expenditure (AE)The total amount of spending on the economy’s output:

AE = C + I + G + NX

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

Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y)

AE = C + I + G + NX = Y

The Aggregate Expenditure Model

Adjustments to Macroeconomic Equilibrium

Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

Real Consumption Expenditure, 1979 - 2009

Consumption follows a smooth, upward trend, interrupted only infrequently by recessions.

The most important variables that determine the level of C:

• Current disposable income

• Household wealth: Assets minus liabilities

Including equity in owner occupied houses?

- Do Changes in Housing Wealth
- Affect Consumption Spending?

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

The most important variables that determine the level of C:

- • 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 Relationship between Consumption and Income, 1960– 2008

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

When disposable income changes:

Change in consumption = ΔYD× MPC

The Relationship between Consumption and National Income

when net taxes are constant ΔYD = ΔNI

Income, Consumption, and Saving

National income = Consumption + Saving + Taxes

Y = C + S + T

Change in national income = Change in consumption + Change in saving + Change in taxes

If taxes are always a constant amount, ΔT = 0

ΔY = ΔC + ΔS

1 = MPC + MPS

Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save

Real Investment, 1979 - 2009

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.

The most important variables that determine the level of investment:

- • 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

Real Government Purchases, 1979 – 2009

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.

Real Net Exports, 1979–2006

Real Net Exports, 1979 – 2009

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.

The most important variables that determine the level of net exports:

• 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

Graphing Macroeconomic Equilibrium

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

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.

- The Multiplier in Reverse: The Great Depression of the 1930s

The multiplier effect contributed to the very high levels of unemployment during the Great Depression.

A Formula for the Multiplier

Y = C + I + G + NX

C depends on YD:

C = c0 + MPC x YD = c0 + MPC x (Y – T)

c0, I, G, T, and NX are autonomous—they do not depend on Y

Y = c0 + MPC x Y – MPC x T + I + G + NX

(1 – MPC) x Y = c0 + I + G – MPC x T + NX

Y = [1/(1 – MPC)] x [c0 + I + G – MPC x T + NX]

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.

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

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.

Aggregate demand curve

Aggregate expenditure (AE)

Aggregate expenditure model

Autonomous expenditure

Cash flow

Consumption function

Inventories

Marginal propensity to consume (MPC)

Marginal propensity to save (MPS)

Multiplier

Multiplier effect

1 Consumption function

2 Planned investment function

3 Government spending function

4 Net export function

5 Equilibrium condition

- The Algebra of Macroeconomic Equilibrium

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:

Or,Or,Or,

- The Algebra of Macroeconomic Equilibrium

Remember that is the multiplier. Therefore an alternative expression for equilibrium GDP is:

- The Algebra of Macroeconomic Equilibrium

Equilibrium GDP = Autonomous expenditure x Multiplier

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