ch 8 macro

If exports exceed imports,

AE rises and equilibrium income rises. If imports exceed exports, AE falls and equilibrium income falls.

THE SPENDING MULTIPLIER

ALLOWS US TO DETERMINE HOW MUCH SPENDING IS NEEDED TO BOOST INCOME TO A SPECIFIC LEVEL.

AVERAGE PROPENSITY TO CONSUME (APC) AND SAVE (APS)

APC APS PERCENTAGE OF INCOME THAT IS SAVED (S / Y) PERCENTAGE OF INCOME THAT IS USED FOR CONSUMPTION (C / Y) Because Y = C + S, APC + APS = 1

THE GREAT DEPRESSION

At the height of the Great Depression, unemployment was 25% and the stock market fell 85%. Keynes argued for a significant increase in government spending. In the early 1940s, government spending rose 10 for WWII, and the Great Depression ended.

THE FULL AGGREGATE EXPENDITURES MODEL TAKES ALL SPENDING COMPONENTS INTO ACCOUNT

C + I + G + (X − M)

THE TWO COMPONENTS IN THE SIMPLE AE MODEL (AE = C + I)

CONSUMPTION ALMOST 70% OF AGGREGATE SPENDING: LARGE AND STABLE INVESTMENT ABOUT 15% OF AGGREGATE SPENDING: VOLATILE AND SENSITIVE TO ECONOMIC CONDITIONS

AGGREGATE EXPENDITURES

Consist of the components of GDP that are measured by spending: GDP = AE = C + I + G + (X − M) Consumption (C) is the largest component, representing nearly 70% of GDP. Consumption is the key factor in the AE model.

KEYNESIAN CONSUMPTION FUNCTION

Y = C + S CONSUMPTION (thousands) Saving is negative to the left of point a and positive to the right of point a. Consumption spending grows as income grows but not as fast. As income rises, savings rise as a percentage of income. Classical economists believe that interest rates determine saving, while Keynesians believe that income determines saving.

An increase of $100 in government spending

has the same effect on income as an increase in investment. Both are injections to the economy.

taxes

have less direct impact on income than an equivalent change in government spending because some of a tax is paid using savings, both of which are withdrawals

THE FOREIGN SECTOR IN THE KEYNESIAN MODEL IS ADDED THROUGH NET EXPORTS:

EXPORTS MINUS IMPORTS (X − M)

THE BALANCED BUDGET MULTIPLIER

Equal changes in government spending and taxation lead to an equal change in income. If a $1 billion increase in spending is financed by a $1 billion tax increase, GDP rises $1 billion regardless of the MPC. THE BALANCED BUDGET MULTIPLIER IS ALWAYS 1.

THE INSTABILITY OF INVESTMENT

Gross private domestic investment is much more volatile than consumption spending.

In a macroeconomic equilibrium:

I + G + X = S + T + M

PARADOX OF THRIFT

IF HOUSEHOLDS SAVE MORE, THE MULTIPLIER EFFECT LEADS TO REDUCED INCOME, LEADING TO LESS SAVING.

THE MULTIPLIER WORKS IN BOTH DIRECTIONS

A decrease in spending during an economic downturn can cause a larger drop in income. If consumers increase their saving during a recession, they may inadvertently make the recession worse because of the multiplier.

SPENDING INJECTIONS

INVESTMENT (I), GOVERNMENT SPENDING (G), AND EXPORTS (X).

investment

IS SPENDING BY BUSINESSES THAT ADDS TO THE PRODUCTIVE CAPACITY OF THE ECONOMY.

consumption

IS THE PORTION OF INCOME NOT SAVED: INCOME = C + S

OTHER DETERMINANTS OF CONSUMPTION

Income is the principal determinant of consumption and saving, but other factors can shift the consumption and saving schedules: Wealth Expectations about future prices and income Household debt Taxes

OTHER DETERMINANTS OF INVESTMENT

Investment demand also depends on: expectations about future revenues and return on investment. technological change. operating costs. capital goods on hand.

INVESTMENT DEMAND

Investment levels depend primarily on the rate of return on capital. Investments earning a high rate of return are those undertaken first. Interest rates also affect investment because most business investment is financed. As interest rates fall, investment rises.

AGGREGATE INVESTMENT SCHEDULE

Investment spending is autonomous (independent) of income.

JOHN MAYNARD KEYNES (1883-1946)

Known as the father of macroeconomics. Launched a critique of classical economics by focusing on spending as the key to growth. His writings still influence economic policy (e.g., stimulus policies).

SIMPLE AGGREGATE EXPENDITURES MODEL

Leaving out the government and foreign sectors, we ask the following questions: HOW MUCH WILL THE ECONOMY PRODUCE? WHAT IS THE MACROECONOMIC EQUILIBRIUM? WHAT CHANGES THE EQUILIBRIUM?

MARGINAL PROPENSITY TO CONSUME (MPC) AND SAVE (MPS)

MPC MPS THE CHANGE IN CONSUMPTION GIVEN A CHANGE IN INCOME (ΔC/ΔY) THE CHANGE IN SAVING GIVEN A CHANGE IN INCOME (ΔS/ΔY) Because Y = C + S, MPC + MPS = 1

THE MULTIPLIER EFFECT

Occurs when an initial amount of spending causes income to grow by a larger amount The multiplier is calculated as: 1 / (1 − MPC) The greater the MPC, the higher the spending multiplier.

THE CLASSICAL MODEL

Pre-1930s mainstream economic thought argued that: a laissez-faire (leave it alone) approach was best for the economy. the economy was self-correcting; it always adjusted to full employment by the forces of demand and supply. prices, wages, and interest rates were flexible.

SPENDING WITHDRAWALS

SAVINGS (S), TAXES (T), AND IMPORTS (M).

INFLATIONARY GAP

THE DECREASE IN AGGREGATE SPENDING NECESSARY TO BRING AN OVERHEATED ECONOMY BACK TO FULL EMPLOYMENT Inflationary pressures occur when an economy produces output above full employment. Excess spending results in higher prices, which can lead to other economic problems.

RECESSIONARY GAP

THE INCREASE IN AGGREGATE SPENDING NECESSARY TO BRING A DEPRESSED ECONOMY BACK TO FULL EMPLOYMENT This is not the total deficiency in GDP, which is called the GDP gap. The recessionary gap is the spending needed to close the GDP gap when boosted by the multiplier.

MACROECONOMIC EQUILIBRIUM

The economy is at equilibrium where injections of spending (investment) equal withdrawals (saving), or: I = S At this point, there is no reason for the economy to change its level of output or income.

THE GREAT DEPRESSION

The prolonged downturn challenged the classical perspective: John Maynard Keynes argued that government has an important role in stabilizing a distressed economy. Keynesians argued that prices and wages were sticky, or slow to adjust. Keynes published The General Theory... in 1936.