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C hapter 22. Equilibrium National Income. Economic Principles. Aggregate expenditure The equilibrium level of national income The relationship between saving and investment The income multiplier. Economic Principles. The relationship between aggregate expenditure and aggregate demand

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c hapter 22

Chapter 22

Equilibrium National Income

economic principles
Economic Principles
  • Aggregate expenditure
  • The equilibrium level of national income
  • The relationship between saving and investment
  • The income multiplier

Gottheil - Principles of Economics, 4e

economic principles1
Economic Principles
  • The relationship between aggregate expenditure and aggregate demand
  • The paradox of thrift

Gottheil - Principles of Economics, 4e

equilibrium national income
Equilibrium National Income

Equilibrium price is determined by the equal contribution of both demand and costs of production. In particular, it is their interaction that determines equilibrium price.

Gottheil - Principles of Economics, 4e

equilibrium national income1
Equilibrium National Income

Similarly, the interaction of aggregate expenditure and aggregate supply contribute to equilibrium national income. In this case, however, aggregate expenditure plays a stronger role than aggregate supply.

Gottheil - Principles of Economics, 4e

interaction between consumers and producers
Interaction Between Consumers and Producers

Aggregate expenditure

  • Spending by consumers on consumption goods, spending by businesses on investment goods, spending by government, and spending by foreigners on net exports.

Gottheil - Principles of Economics, 4e

interaction between consumers and producers1
Interaction Between Consumers and Producers

Recall that the amount of consumer income spent on consumption and saving is represented by:

Y = C + S

Gottheil - Principles of Economics, 4e

interaction between consumers and producers2
Interaction Between Consumers and Producers

And recall that the amount of production goods and investment goods produced by producers is represented by:

Y = C + Ii

where the subscript i indicates intended as distinct from actual.

interaction between consumers and producers3
Interaction Between Consumers and Producers

If, by chance, what producers intend to produce for consumption turns out to be precisely what consumers intend to consume, the match between intended investment and savings is written as:

Ii = S

Gottheil - Principles of Economics, 4e

interaction between consumers and producers4
Interaction Between Consumers and Producers

The I = S equation describes the economy in macroequilibrium. No excess demand or supply exists. Aggregate expenditure equal aggregate supply.

Gottheil - Principles of Economics, 4e

the economy moves toward equilibrium
The Economy Moves Toward Equilibrium

The national economy, if not already in equilibrium, is always moving toward it.

Gottheil - Principles of Economics, 4e

the economy moves toward equilibrium1
The Economy Moves Toward Equilibrium

Equilibrium level of national income

  • C + Ii = C + S, where saving equals intended investment.

Gottheil - Principles of Economics, 4e

the economy moves toward equilibrium2
The Economy Moves Toward Equilibrium

Unwanted inventories

  • Goods produced for consumption that remain unsold.

Gottheil - Principles of Economics, 4e

the economy moves toward equilibrium3
The Economy Moves Toward Equilibrium

Actual investment (Ia)

  • Investment spending that producers actually make – that is, intended investment (investment spending that producers intend to undertake), plus or minus unintended changes in inventories.

Gottheil - Principles of Economics, 4e

slide15

EXHIBIT 1 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $900 BILLION

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

Suppose the economy is at Y = $900 billion, autonomous consumption = $60 billion, MPC = 0.80 and producers’ intended investment is $100 billion.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion1
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

1. What are consumers’ consumption expenditures and savings in Exhibit 1?

  • If Y = C + S and C = a + bY, then consumption expenditures (C) = $60 billion + 0.8 ($900 billion) = $780 billion.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion2
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

1. What are consumers’ consumption expenditures and saving in Exhibit 1?

  • If S = Y – C, then saving (S) = $900 billion - $780 billion = $120 billion.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion3
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

2. What is intended production by producers?

  • If C = Y - Iiand Ii= $100 billion, thenintended production= $900 billion - $100 billion = $800 billion.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion4
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

  • Producers’ intended production ($800 billion) - consumers’ consumption expenditures ($780 billion) = $20 billion.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion5
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

  • The $20 billion difference is described as unwanted inventories and must be absorbed as investment.

Gottheil - Principles of Economics, 4e

exhibit 1 consumers and producers intentions and activities by stages when y 900 billion6
Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion

3. What is the difference between producers’ intended production and consumers’ consumption expenditures?

  • Producers’ actual investment ($120 billion) ends up being greater than what they had intended to invest ($100 billion).

Gottheil - Principles of Economics, 4e

slide23

EXHIBIT 2 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $700 BILLION

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

Suppose national income changes to Y = $700 billion, but MPC, autonomous consumption and intended investment all remain the same.

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion1
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

1. What are consumers’ consumption expenditures?

  • C = $60 billion + 0.8 ($700 billion) = $620 billion.

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion2
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

2. What is intended production by producers?

  • C = $700 billion - $100 billion = $600 billion.

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion3
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

  • Consumers’ consumption ($620 billion) - producers’ production ($600 billion) = $20 billion.

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion4
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

  • The $20 billion difference must be converted from intended investment to consumption goods to meet demand.

Gottheil - Principles of Economics, 4e

exhibit 2 consumers and producers intentions and activities by stages when y 700 billion5
Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

  • Actual investment ends up being less than intended investment.

Gottheil - Principles of Economics, 4e

slide30

EXHIBIT 3 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $800 BILLION

Gottheil - Principles of Economics, 4e

exhibit 3 consumers and producers intentions and activities by stages when y 800 billion
Exhibit 3: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $800 Billion

What is the difference between production and consumers’ expenditures in Exhibit 3?

  • Production and consumption are equal at $700 billion. The economy is in equilibrium.

Gottheil - Principles of Economics, 4e

equilibrium national income2
Equilibrium National Income

Aggregate expenditure curve (AE)

  • A curve that shows the quantity of aggregate expenditures at different levels of national income or GDP.

Gottheil - Principles of Economics, 4e

equilibrium national income3
Equilibrium National Income

Aggregate expenditure curve (AE)

  • The intersection of the 45° income curve and AE identifies the economy’s equilibrium position.

Gottheil - Principles of Economics, 4e

equilibrium national income4
Equilibrium National Income
  • When Ii > S, producers hire more workers to replace depleted inventories. Y increases and continues to increase until Ii = S.
  • When S > Ii, inventories build up and producers lay off workers. Y decreases until Ii = S.

Gottheil - Principles of Economics, 4e

slide35

EXHIBIT 4A THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

Gottheil - Principles of Economics, 4e

slide36

EXHIBIT 4B THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

Gottheil - Principles of Economics, 4e

exhibit 4 the equilibrium level of national income
Exhibit 4: The Equilibrium Level of National Income

At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4.

i. Greater than

ii. Less than

Gottheil - Principles of Economics, 4e

exhibit 4 the equilibrium level of national income1
Exhibit 4: The Equilibrium Level of National Income

At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4.

i. Greater than

ii. Less than

Gottheil - Principles of Economics, 4e

changes in investment change national income equilibrium
Changes in Investment Change National Income Equilibrium

As long as the consumption function and the investment demand function remain unchanged, there is no reason to suppose that the level of national income would move away from equilibrium.

Gottheil - Principles of Economics, 4e

changes in investment change national income equilibrium1
Changes in Investment Change National Income Equilibrium

Functions do change, however.

Gottheil - Principles of Economics, 4e

slide41

EXHIBIT 5 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN INVESTMENT INCREASES TO $130 BILLION AND Y = $800 BILLION

Gottheil - Principles of Economics, 4e

slide42
Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

  • When intended investment increases, the supply of consumption goods decreases to $670 billion.

Gottheil - Principles of Economics, 4e

slide43
Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

  • Consumers’ consumption expenditures remain at $700 billion. Consumers’ demand is greater than producers’ production.

Gottheil - Principles of Economics, 4e

slide44
Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

  • In an effort to meet consumers’ demand, producers hire more workers and national income increases. The equilibrium also increases.

Gottheil - Principles of Economics, 4e

slide45

EXHIBIT 6A DERIVING EQUILIBRIUM AT Y = $950 BILLION

Gottheil - Principles of Economics, 4e

slide46

EXHIBIT 6B DERIVING EQUILIBRIUM AT Y = $950 BILLION

Gottheil - Principles of Economics, 4e

exhibit 6 deriving equilibrium at y 950 billion
Exhibit 6: Deriving Equilibrium at Y = $950 Billion

What is the equilibrium level of national income when intended investment increases to $130 billion in Exhibit 6?

  • The equilibrium level increases to $950 billion, where Ii = S.

Gottheil - Principles of Economics, 4e

changes in investment change national income equilibrium2
Changes in Investment Change National Income Equilibrium

The formula Y = (a + bY) + Iican be used to calculate equilibrium national income when specific values for autonomous consumption, MPC and intended investment are known.

Gottheil - Principles of Economics, 4e

the income multiplier
The Income Multiplier

While consumption spending, MPC, and autonomous consumption have all remained relatively stable over time, investment spending has been volatile.

Gottheil - Principles of Economics, 4e

the income multiplier1
The Income Multiplier

Economists identify changes in aggregate expenditure, in particular investment spending, as the key to our understanding of why national income changes.

Gottheil - Principles of Economics, 4e

the income multiplier2
The Income Multiplier

Income multiplier

  • The multiple by which income changes as a result of a change in aggregate expenditure. It is written as:
  • multiplier = (change in Y)/(change in AE)

Gottheil - Principles of Economics, 4e

the income multiplier3
The Income Multiplier

The size of the multiplier depends on the marginal propensity to consume. An initial change in investment sets in motion a chain of events that creates a larger change in national income.

Gottheil - Principles of Economics, 4e

the income multiplier4
The Income Multiplier

For example, suppose a business owner decides to invest $1,000 in a new technology. The producer of the technology receives an increase in income of $1,000. If MPC = 0.80, the technology producer’s consumption spending increases by $800.

Gottheil - Principles of Economics, 4e

the income multiplier5
The Income Multiplier

Suppose the $800 is then spent on a custom-made water bed. The carpenter that makes the water bed receives $800 of additional income. Based on MPC, we know that she will spend $640 and save the rest. The chain of events continues.

Gottheil - Principles of Economics, 4e

slide55

EXHIBIT 7 THE MAKING OF THE INCOME MULTIPLIER

Gottheil - Principles of Economics, 4e

exhibit 7 the making of the income multiplier
Exhibit 7: The Making of the Income Multiplier

The additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds.

i. Smaller and smaller

ii. Bigger and bigger

Gottheil - Principles of Economics, 4e

exhibit 7 the making of the income multiplier1
Exhibit 7: The Making of the Income Multiplier

The additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds.

i. Smaller and smaller. For example, in round 2, $800 is added. In round 3, $640 is added.

ii. Bigger and bigger

Gottheil - Principles of Economics, 4e

the income multiplier6
The Income Multiplier

The formula to determine the income multiplier is written:

1/(1 - MPC).

Since (1 - MPC) = MPS, the formula can be written:

1/MPS.

Gottheil - Principles of Economics, 4e

the income multiplier7
The Income Multiplier

For example, for a $1,000 change in investment, when MPC = 0.80, the income multiplier is:

1/(1 - 0.80) = 1/(0.2) = 5.

A $1,000 investment leads to a $5,000 change in national income.

Gottheil - Principles of Economics, 4e

the income multiplier8
The Income Multiplier

Just as increases in aggregate expenditure stimulate the economy, cuts in aggregate expenditure drag it down.

Gottheil - Principles of Economics, 4e

the income multiplier9
The Income Multiplier

Changes in the price level shift the AE curve, creating changes in the equilibrium level of national income. As the price level decreases, national income increases.

Gottheil - Principles of Economics, 4e

exhibit 8 converting aggregate expenditure to aggregate demand
Exhibit 8: Converting Aggregate Expenditure to Aggregate Demand

What happens to the equilibrium national income when the price level decreases from AE100to AE75?

  • A decrease in the price level leads to an increase in aggregate expenditures and movement downward along the aggregate demand curve. National income increases from $800 billion to $1,000 billion.

Gottheil - Principles of Economics, 4e

exhibit 9 the multiplier effect in the ae and ad models of income determination
Exhibit 9: The Multiplier Effect in the AE and AD Models of Income Determination

If aggregate expenditure increases but the price level remains the same, what happens to aggregate demand?

  • Aggregate demand increases, which results in an increase in national income.

Gottheil - Principles of Economics, 4e

the paradox of thrift
The Paradox of Thrift

Some people believe that putting a higher percentage of their income into saving will provide greater economic security. This is not necessarily the case, however. By trying to save more, people may actually end up saving less, or at least saving no more.

Gottheil - Principles of Economics, 4e

the paradox of thrift1
The Paradox of Thrift

The paradox of thrift

  • The more people try to save, the more income falls, leaving them with no more and perhaps even less saving.

Gottheil - Principles of Economics, 4e

the paradox of thrift2
The Paradox of Thrift

The intention to save more causes the saving curve to shift upwards. Saving then becomes greater than intended investment (S > Ii). The equilibrium level of national income falls.

Gottheil - Principles of Economics, 4e

the paradox of thrift3
The Paradox of Thrift
  • If the level of intended investment curve is horizontal, then the level of saving remains unchanged.
  • If the intended investment curve is upward sloping, then the level of saving declines.

Gottheil - Principles of Economics, 4e

exhibit 10 the paradox of thrift
Exhibit 10: The Paradox of Thrift

1. What happens to national income and saving when the saving curve shifts from S to S′ in panel a of Exhibit 10?

  • National income falls from $800 billion to $650 billion. Saving remains unchanged.

Gottheil - Principles of Economics, 4e

exhibit 10 the paradox of thrift1
Exhibit 10: The Paradox of Thrift

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

  • The equilibrium level of national income falls from $800 billion to $550 billion.

Gottheil - Principles of Economics, 4e

exhibit 10 the paradox of thrift2
Exhibit 10: The Paradox of Thrift

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

  • Because the intended investment curve is upward sloping, the shift in the saving curve causes a decline in the level of investment as well.

Gottheil - Principles of Economics, 4e

exhibit 10 the paradox of thrift3
Exhibit 10: The Paradox of Thrift

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

  • Saving falls from $100 billion to $75 billion.

Gottheil - Principles of Economics, 4e

the paradox of thrift4
The Paradox of Thrift

Increased saving is not always detrimental to our economic health. If accompanied by increased investment, increased saving is both inevitable and desirable.

Gottheil - Principles of Economics, 4e