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The Short – Run Macro Model. The Short-Run Macro Model. In short-run, spending depends on income, and income depends on spending. The more income households have, the more they will spend. The more households spend, the more output firms will produce

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the short run macro model
The Short-Run Macro Model
  • In short-run, spending depends on income, and income depends on spending.
    • The more income households have, the more they will spend.
    • The more households spend, the more output firms will produce
      • More income they will pay to their workers.
  • 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.
review the categories of spending
Review the Categories of Spending
  • Macroeconomists have found that the most useful approach is to divide those who purchase the GDP into four broad categories
    • Households --- consumption spending (C)
    • Business firms --- planned investment spending (IP)
    • Government agencies --- government purchases (G)
    • Foreigners --- net exports (NX)
  • Nominal or real spending?
    • Real terms
  • What factors affect households’ spending?
    • Disposable income: Yd (= Y – T)
    • Wealth (= total assets – total liability)
    • Price level
    • Interest rate
      • When interest rate falls, consumption rises
    • Expectations about future
consumption and disposable income
Consumption and Disposable Income
  • Autonomous consumption spending
    • Consumption spending when disposable income is zero
  • Marginal propensity to consume, or MPC
    • The slope of the consumption function
    • MPC = Δ Consumption ÷ Δ Disposable Income
    • MPC measures by how much consumption spending rises when disposable income rises by one dollar
  • Logic and empirical evidence suggest that the MPC should be larger than zero, but less than 1
    • So, we assume that 0 < MPC < 1
representing consumption with an equation
Representing Consumption with an Equation
  • C = a + bYd
      • Where C is consumption spending
      • And a is the autonomous consumption spending
      • And b is the marginal propensity to consume (MPC)
  • Equation between consumption and total income

Since Yd = Y – T,

C = a + b(Y – T)

So,C = (a- bT) + bY

shifts in the consumption income line
Shifts in the Consumption-Income Line
  • 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.
i p g and nx
IP, G and NX
  • For now, in the short-run macro model, planned investment spending, government purchases, and net exports are all treated as given or fixed values.
summing up aggregate expenditure
Summing Up: Aggregate Expenditure
  • Aggregate expenditure (AE)
    • 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
  • AE 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.
finding equilibrium gdp
Finding Equilibrium GDP
  • When aggregate expenditure is less than GDP, inventories will increase and output will decline in future.
  • When aggregate expenditure is greater than GDP, inventories will decrease and output will rise in future.
  • In short-run, equilibrium GDP is level of output at which output and aggregate expenditure are equal.
inventories and equilibrium gdp
Inventories and Equilibrium GDP
  • When firms produce more goods than they sell, what happens to unsold output?
    • Added to their inventory stocks
  • 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 the one at which change in inventories equals zero.
equilibrium gdp and employment
Equilibrium GDP and Employment
  • When economy operates at equilibrium, will it also be operating at full employment?
    • Not necessarily

For instance, insufficient spending causes business firms to decrease their demand for labor.

    • Remember, in the long run (classical) macro model, it takes time for labor market to achieve full employment.
  • In the short-run model, it would be quite a coincidence if our equilibrium GDP happened to be the full employment output level.
  • In short-run macro model, output can be lower or higher than the full employment output level.
a change in investment spending
A Change in Investment Spending
  • Suppose the initial equilibrium GDP in an economy is $6,000 billion.
  • Now, business firms increase their investment spending on plant and equipment by $1,000 billion.
  • Then, firms that sell investment goods receive $1,000 billion as income, which is to be distributed as salary, rent, interest, and profit.
  • What will households do with their $1,000 billion in additional income?
    • Spend the money !
    • How much to spend depends crucially on marginal propensity to consume (MPC): let’s assume MPC = 0.6
a change in investment spending1
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. At this point, total income has increased by $1,000+$600=$1,600billion
    • With an MPC of 0.6, consumption spending will further rise by 0.6 x $600 billion = $360 billion, creating still more sales revenue for firms, and so on and so on…
  • At end of process, when economy has reached its new equilibrium.
    • Total spending and total output are considerably higher.
the expenditure multiplier
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
  • Value of expenditure multiplier depends on value of MPC
  • So, when the increase in planned investment spending is

ΔIP, the increase in total income (GDP) is calculated as:

the expenditure multiplier1
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.
spending shocks
Spending Shocks
  • Shocks to economy can come from other sources besides investment spending.
    • Government purchases (G)
    • Net exports (NX)
    • Autonomous consumption (a)
  • Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP.
spending shocks1
Spending Shocks
  • The effect of a change in spending on total income through expenditure multiplier
application the recession of 2007 09
Application: The Recession of 2007-09
  • December 2007 recession began
  • Aggregate expenditures declined
    • Consumption spending declined
    • Investment spending declined
    • Recessionary expenditure gap
application the recession of 2007 091
Application: The Recession of 2007-09
  • Federal government undertook Keynesian policies
    • Tax rebate checks
    • $787 billion stimulus package
say s law vs keynesian theory
Say’s Law vs. Keynesian Theory
  • Classical economics
    • Say’s Law
    • Economy will automatically adjust
    • Laissez-faire
  • Keynesian economics
    • Cyclical unemployment can occur
    • Economy will not correct itself
    • Government should actively manage macroeconomic instability
automatic stabilizers and the multiplier
Automatic Stabilizers and the Multiplier
  • Automatic stabilizers reduce size of multiplier and therefore reduce impact of spending shocks.
    • With milder fluctuations, economy is more stable.
  • Some real-world automatic stabilizers we’ve ignored in the simple, short-run macro model of this chapter
    • Taxes
    • Transfer payments
    • Interest rates
    • Imports
    • Forward-looking behavior
the role of saving
The Role of Saving
  • In long-run, saving has positive effects on economy.
  • But in short-run, automatic mechanisms of classical model do not keep economy operating at its potential.
  • In long-run, an increase in desire to save leads to faster economic growth and rising living standards.
    • In short-run, however, it can cause a recession that pushes output below its potential.
  • Two sides to the “saving coin”
    • Impact of increased saving is positive in long-run and potentially dangerous in short-run.
the effect of fiscal policy
The Effect of Fiscal Policy
  • In classical model fiscal policy—changes in government spending or taxes designed to change equilibrium GDP—is completely ineffective – crowding out effect.
  • 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.