The goods market and the aggregate expenditures model
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The Goods Market and the Aggregate Expenditures Model. Chapter 8. The Historical Development of Modern Macroeconomics. The Great Depression of the 1930s led to the development of macroeconomics and aggregate demand tools to deal with recessions.

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The goods market and the aggregate expenditures model

The Goods Market and the Aggregate Expenditures Model

Chapter 8


The historical development of modern macroeconomics

The Historical Development of Modern Macroeconomics

  • The Great Depression of the 1930s led to the development of macroeconomics and aggregate demand tools to deal with recessions.

  • During the Depression, output fell by 30 percent and unemployment rose to 25 percent.


The historical development of modern macroeconomics1

The Historical Development of Modern Macroeconomics

  • Keynes is the author of The General Theory of Employment, Interest and Money, which provided the new framework for macroeconomic policy.

    • Keynes is pronounced “canes”


Classical economists

Classical Economists

  • The Classical economists' approach was laissez-faire (leave the market alone).

  • They believed the market was self-adjusting.

  • They concentrated on the long run and largely ignored the short run.


Classical economics

Classical Economics

  • They used microeconomic supply and demand arguments to explain the Great Depression.

  • Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.


The historical development of modern macroeconomics2

The Historical Development of Modern Macroeconomics

  • Before the Depression, the prominent ideology was laissez-faire -- keep the government out of the economy.

  • After the Depression, most people believed government should have a role in regulating the economy.


The layperson s explanation for unemployment

The Layperson's Explanation for Unemployment

  • Laypeople believed that the depression was caused by an oversupply of goods that glutted the market.

  • They wanted the government to hire the unemployed even if the work was not needed.


The layperson s explanation for unemployment1

The Layperson's Explanation for Unemployment

  • Classical economists opposed deficit spending, arguing that the money to create jobs had to be borrowed.

  • This money would have financed private economic activity and jobs, so everything would cancel out.


The essence of keynesian economics

The Essence of Keynesian Economics

  • Keynes thought that the economy could get stuck in a rut as wages and price level adjusted to sudden decreases in expenditures.


The essence of keynesian economics1

The Essence of Keynesian Economics

  • According to Keynes:

    a decrease in spending 

    job layoffs 

    fall in consumer demand 

    firms decrease production 

    more job layoffs 

    further fall in consumer demand,

    and so forth


Equilibrium income fluctuates

Equilibrium Income Fluctuates

  • Income is not fixed at the economy's long-run potential income – it fluctuates.

  • For Keynes there was a difference between equilibrium income and potential income.


Equilibrium income fluctuates1

Equilibrium Income Fluctuates

  • Equilibrium income – the level toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production.


Equilibrium income fluctuates2

Equilibrium Income Fluctuates

  • Potential income – the level of income that the economy technically is capable of producing without generating accelerating inflation.


Equilibrium income fluctuates3

Equilibrium Income Fluctuates

  • Keynes felt that at certain times the economy needed help to reach its potential income.

  • He believed that market forces would not work fast enough and would not be strong enough to get the economy out of a recession


Equilibrium income fluctuates4

Equilibrium Income Fluctuates

  • Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.


The paradox of thrift

The Paradox of Thrift

  • Incomes would fall as people lost their jobs causing both consumption and saving to fall as well.

  • The economy would reach a new equilibrium which could be at an almost permanent recession.


The paradox of thrift1

The Paradox of Thrift

  • Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.


The aggregate expenditures model

The Aggregate Expenditures Model

  • Using a few simplifying assumptions, economists can construct a model of the economy.

  • The Aggregate Expenditures (AE) Model looks at how real income is determined in an economy.


The aggregate expenditures model1

The Aggregate Expenditures Model

  • The AE model assumes that the price level is fixed, and explores how an initial shift in expenditures changes equilibrium output.

  • The AE model quantifies the effect of changes in aggregate expenditures on aggregate output.


Aggregate production

Aggregate Production

  • Aggregate production –the total amount of goods and services produced in every industry in an economy.

  • Production creates an equal amount of income.

  • Thus, actual production and actual income are always equal.


Aggregate production1

Aggregate Production

  • Graphically, aggregate production in the AE model is represented by a 45° line through the origin

  • At all points on this Aggregate Production Curve, income equals production.


The aggregate production curve

Aggregate production

(production = income)

Real production

C

A

$4,000

Potential income

45º

0

$4,000

Real income

The Aggregate Production Curve


Aggregate expenditures

Aggregate Expenditures

  • Aggregateexpenditures – the total amount of spending on final goods and services in the economy:

    • Consumption – spending by households.

    • Investment – spending by business.

    • Spending by government.

    • Net foreign spending on Canadian goods – the difference between Canadian exports and imports.


Autonomous and induced expenditures

Autonomous and Induced Expenditures

  • Autonomous expenditures are expenditures that are independent of income.

    • Autonomous expenditures change because something other than income changes.

  • Induced expenditures – expenditures that change as income changes.


Autonomous and induced expenditures1

Autonomous and Induced Expenditures

  • Autonomous expenditures is the level of expenditures that would exist at zero income.

  • They remain constant at all levels of income.


Autonomous and induced expenditures2

Autonomous and Induced Expenditures

  • Induced expenditures are those that change as income changes.

  • When income rises, induced expenditures rise by less than the change in income.


Expenditures function

Expenditures Function

  • The relationship between expenditures and income can be expressed more concisely as an expenditures function.

  • An expenditures function is a representation of the relationship between aggregate expenditures and income.


The expenditures function

The Expenditures Function

  • The relationship between aggregate expenditures and income can be expressed mathematically:

    AE = AEo + mpcY

    AE = aggregate expenditures

    AEo = autonomous expenditures

    mpc = marginal propensity to consume

    Y = income


The marginal propensity to consume

The Marginal Propensity to Consume

  • Marginal propensity to consume (mpc) – the change in consumption that occurs with a change in income.

  • The mpc is between 0 and 1 because individuals tend to save a portion of an increase in income.


The marginal propensity to consume1

The Marginal Propensity to Consume

  • The mpc is the fraction spent from an additional dollar of income.


The marginal propensity to consume2

The Marginal Propensity to Consume

  • The marginal propensity to consume (mpc) is the ratio of a change in consumption (C) to a change in income (Y).


Expenditures function1

Expenditures Function

  • Autonomous expenditures is the sum of the autonomous components of expenditures:

    AE = C + I+ G + X – IM


Graphing the expenditures function

Graphing the Expenditures Function

  • The graphical representation of the expenditures function is called the aggregate expenditures curve.

  • The slope of the expenditures function tells us how much expenditures change with a particular change in income.


Graphing the expenditures function1

Aggregate production

AE = 1,000 + 0.8Y

AE = 2,000

Y = 2,500

45º

$8,750

$11,250

$14,000

Graphing the Expenditures Function

$12,200

10,000

8,000

Real expenditures (AE)

6,000

5,000

4,000

2,000

1,000

0

$5,000

Real income


Shifts in the expenditures function

Shifts in the Expenditures Function

  • The aggregate expenditure curve shifts when autonomous C, I, G, or (X – IM) change.

  • Autonomous Consumption expenditures respond to changes in:

    • interest rates

    • household wealth

    • expectations of future conditions


Shifts in the expenditures function1

Shifts in the Expenditures Function

  • Autonomous Investment is the most volatile component of GDP.

  • It responds to changes in:

    • interest rates

    • capital goods prices

    • consumer demand conditions

    • expectations regarding future economic conditions


Shifts in the expenditures function2

Shifts in the Expenditures Function

  • Autonomous exports and imports depend on foreign and domestic incomes and relative prices.

  • Autonomous Government expenditures may also change as policies change.


Determining the equilibrium level of aggregate income

Determining the Equilibrium Level of Aggregate Income

  • At equilibrium, planned expenditures must equal production.

  • Graphically, it is the income level at which AE equals AP.


Solving for equilibrium graphically

Aggregate production

$14,000

Aggregate expenditures

12,200

10,000

Real expenditures (AE)

8,000

5,000

2,600

AE0 = $1,000

1,000

45°

0

$2,000

$5,000

$10,000

$14,000

Real income

Solving for Equilibrium Graphically

AE = 1,000 + 0.8Y

E


Solving for equilibrium algebraically

Solving for Equilibrium Algebraically

  • In equilibrium, Y = AE.

  • Substituting in for aggregate expenditures, we have

    Y = AE0 + mpcY


Solving for equilibrium algebraically1

Solving for Equilibrium Algebraically

  • Now solve for equilibrium income:

    Y – mpcY = AE0

    Y (1 – mpc) = AE0

    Y = [ 1/ (1 – mpc) ] * AE0


The multiplier equation

The Multiplier Equation

  • The multiplier equation tells us that income equals the multiplier times autonomous expenditures.

    Y = Multiplier X Autonomous expenditures


The multiplier equation1

The Multiplier Equation

  • The multiplier process amplifies changes in autonomous expenditures.

  • What forces are operating to ensure that the income level we determined is actually the equilibrium income level?


The multiplier process

The Multiplier Process

  • When aggregate production do not equal aggregate expenditures:

    Businesses change production levels,

    which changes income,

    which changes expenditures,

    which changes production,

    which changes income,

    • which changes . . . etc.


The multiplier process1

The Multiplier Process

  • The process ends when aggregate production equals aggregate expenditures.

  • Firms are selling all they produce, so they have no reason to change their production levels.


The multiplier process2

Aggregate production

A1

Aggregate expenditures

A2

C

B1

B2

45°

The Multiplier Process

C, I, G, (X – IM)

$14,000

$13,200

AE = 1,000 + 0.8Y

10,000

Real expenditures (AE)

6,000

2,000

0

$2,000

$5,000

$10,000

$14,000

Real income


The circular flow model and the multiplier process

The Circular Flow Model and the Multiplier Process

  • The circular flow model provides the intuition behind the multiplier process.

  • The flow of expenditures equals the flow of income.


The circular flow model and the multiplier process1

The Circular Flow Model and the Multiplier Process

  • Expenditures are injections into the circular flow.

  • The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow.

  • But there are withdrawals.


The circular flow model and the multiplier process2

The Circular Flow Model and the Multiplier Process

  • Economists use the term the marginal propensity of save (mps) to represent the percentage of income flow that is withdrawn from the economy for each round of the circular flow.


The circular flow model and the multiplier process3

The Circular Flow Model and the Multiplier Process

  • By definition:

    mpc + mps = 1

  • Alternatively expressed:

    mps = 1 - mpc

    multiplier = 1/mps


The circular flow model and the multiplier process4

Aggregate income

Households

Firms

Aggregate expenditures

The Circular Flow Model and the Multiplier Process


The ae model in action

The AE Model in Action

  • The AE model illustrates how a change in autonomous expenditures changes the equilibrium level of income.


The multiplier model in action

The Multiplier Model in Action

  • Autonomous expenditures are determined outside the model and are not affected by changes in income.

  • When autonomous expenditures shift, the multiplier process is called into play.


The steps of the multiplier process

The Steps of the Multiplier Process

  • The income adjustment process is directly related to the multiplier.

  • Any initial shock (a change in autonomous AE) is multiplied in the adjustment process.


The steps of the multiplier process1

The Steps of the Multiplier Process

  • The multiplier process repeats and repeats until a new equilibrium level is finally reached.


Shifts in the aggregate expenditure curve

C, I

Aggregateproduction

E0

AE0 = 832 + .8Y

$4,200

D AEA = $20

AE1 = 812 + .8Y

E0

$20

4,160

20

D AEA = $16

$16

D AEA = $12.8

12.8

4,100

E1

4,060

20

E1

832

$100

812

100

0

$4,060

$4,160

Real income

Shifts in the Aggregate Expenditure Curve


First five steps of four multipliers

mpc = 0.5

mpc = 0.75

100

100

75

56.25

50

42.19

31.64

25

12.5

6.25

Multiplier = 1/(1-0.5) = 2

Multiplier = 1/(1-0.75) = 4

First Five Steps of Four Multipliers


First five steps of four multipliers1

mpc = 0.8

mpc = 0.9

100

100

90

81

80

72.9

65.61

64

51.2

40.96

Multiplier = 1/(1-0.8) = 5

Multiplier = 1/(1-0.9) = 10

First Five Steps of Four Multipliers


Examples of the effect of shifts in aggregate expenditures

Examples of the Effect of Shifts in Aggregate Expenditures

  • There are many reasons for shifts in autonomous expenditures:

    • Natural disasters.

    • Changes in investment caused by technological developments.

    • Shifts in government expenditures.

    • Large changes in the exchange rate.


The effect of shifts in aggregate expenditures

The Effect of Shifts in Aggregate Expenditures

  • An understanding of these shifts can be enhanced by tying them to the formula:

    AE = C + I + G + X - IM


Upward shift of ae

Real expenditures

Aggregate production

AE1

$4,210

30

AE0

4,090

1,052.5

30

1,022.5

$120

0

$4,090

$4,210

Real income

Upward Shift of AE


Downward shift of ae

Aggregate production

AE0

$4,152

AE1

30

4,062

30

1,412

1,382

$90

$4,062

$4,152

Downward Shift of AE

Real expenditures

0

Real income


Real world examples

Real World Examples

  • Canada in 2000.

  • Japan in the 1990s.

  • The 1930s depression.


Canada in 2000

Canada in 2000

  • Consumer confidence rose substantially causing autonomous consumption expenditures to increase more than economists had predicted.

  • While economists had expected the economy to grow slowly, it boomed.


Japan in the 1990s

Japan in the 1990s

  • Aggregate income and production fell during the 1990s.

    • A dramatic rise in the yen cut Japanese exports.

    • Autonomous consumption decreased as consumers’ confidence fell

    • Suppliers responded by laying off workers and cutting production.


The 1930s depression

The 1930s Depression

  • The 1929 stock market crash, which continued into 1930, threw the financial markets into chaos.

  • This resulted in a downward shift of the AE curve.


The 1930s depression1

The 1930s Depression

  • Frightened business people decreased investment and laid off workers.

  • Frightened consumers decreased autonomous consumption and increased savings, thereby increasing withdrawals from the system.

  • Governments cut spending to balance their budgets, as tax revenue declined.


The 1930s depression2

The 1930s Depression

  • Business people responded by decreasing output, which decreased income, starting a downward cycle, thereby confirming the fears of the businesspeople.

  • The process continued until the economy settled at a low-level equilibrium, far below the potential level of income.


The 1930s depression3

The 1930s Depression

  • The process caused the paradox of thrift, whereby individuals attempting to save more, spent less, and caused income to decrease.

  • They ended up saving not more, but less.


Ae model is not a complete model

AE Model Is Not a Complete Model

  • The AE model determines income given autonomous expenditures.

  • These autonomous expenditures, however, are determined by economic variables which are not in our simple model.


Ae model is not a complete model1

AE Model Is Not a Complete Model

  • The AE model uses aggregate expenditures to determine equilibrium income.

  • It does not explain production.

  • It assumes firms can supply the output demanded.


Model of aggregate demand

Model of Aggregate Demand

  • Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers responding to changes in demand.

  • Expansion of this line of thought has led to the real business cycle theory of the economy.


Model of aggregate demand1

Model of Aggregate Demand

  • Real business cycle theory of the economy – changes in aggregate supply are the principle way for real income to change.


Prices are fixed

Prices are Fixed

  • The multiplier model assumes that the price level is fixed.

  • The price level can change in response to changes in aggregate demand.


Does not include expectations

Does Not Include Expectations

  • People's forward-looking expectations make the adjustment process much more complicated.

  • Most people, however, act upon their expectations of the future.

  • Business people may not automatically cut back production and lay-off workers if they think a fall in sales is temporary.


Forward looking expectations complicate the adjustment process

Forward-Looking Expectations Complicate the Adjustment Process

  • Rational expectations model – captures the effect expectations have on individuals’ behaviour.

  • Expectations can be self-fulfilling.


Consumption behaviour

Consumption Behaviour

  • People may base their spending on lifetime income, not yearly income.

  • Permanent income hypothesis -- the hypothesis that expenditures are determined by permanent or lifetime income.


Expanded ae model

Expanded AE Model

  • We can increase the power of our AE model by adding more detail.

  • For example, adding taxes to the model

    • Changes consumption expenditures.

    • Introduces government budget deficits and surpluses.

    • Changes the multiplier.


Budget surplus function

Budget Surplus Function

Budget Surplus

T - G

0

Income


Expanded ae model1

Expanded AE Model

  • Adding income-induced imports

    • Changes import spending.

    • Changes net exports,

      • and introduces trade surpluses and deficits.

    • Changes the multiplier.


Expanded ae model2

Expanded AE Model

  • The marginal propensity to import (mpi) gives the increase in import spending from an additional $1 of disposable income.

    • Disposable = after-tax

  • Mpi lies between 0 and 1


The goods market and the aggregate expenditures model1

The Goods Market and the Aggregate Expenditures Model

End of Chapter 8


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