Chapter 11 Summary

Tip #1.

A thorough understanding of the aggregate consumption function and the variables that shift the aggregate consumption function is essential. Make sure you review the aggregate consumption function and understand the relationship between consumer spending and autonomous consumer spending, the marginal propensity to consume, and disposable income. The consumption function will shift upward with increases in wealth or expected future disposable income. Figure 11.4 is a representation of an aggregrate consumption function: the slope of this function equals the MPC, and the y-intercept equals autonomous consumption spending, or A.

Objective #3.

An initial rise or fall in aggregate spending at a given level of GDP is an autonomous change in aggregate spending. This change in aggregate spending will result in a multiplier process where the total change in real GDP caused by the initial change in autonomous spending is equal to the multiplier times the initial change in autonomous aggregate spending. The simple multiplier developed in this chapter is equal to [1/(1 − MPC)]. Thus, the change in real GDP = [1/(1 − MPC)] × (change in autonomous aggregate spending).

Tip #3.

An understanding of investment spending and its components is a critical aspect of this chapter. Make sure you can distinguish between planned investment spending and unplanned inventory investment. In the macroeconomic model presented in this chapter, the mechanism that ensures the attainment of equilibrium is unplanned inventory adjustment. This concept is essential for understanding how this short-run model of the economy works. Figure 11.5 illustrates this inventory adjustment.

Objective #7.

Econometrics is the use of statistical techniques to analyze the fit between economic models and empirical data.

Objective #11.

In a closed economy with no government and a fixed aggregate price level, there are only two sources of aggregate demand (AD): consumer spending and investment spending. In this type of economy, aggregate disposable income, YD, equals GDP. Figure 11.3 illustrates a simple economy and the following points about that simple economy. In this economy planned aggregate spending, AEPlanned, or the total amount of planned spending in the economy, is comprised of consumption spending, C, and planned investment, IPlanned. • The slope of the AEPlanned line equals the MPC. • AEPlanned may differ from GDP because of the influence of unplanned aggregate spending in the form of unplanned inventory investment, IUnplanned. • Over time the economy moves to that point where AEPlanned equals GDP or the income-expenditure equilibrium.

Objective #10.

Inventories are the stock of goods that firms hold in anticipation of future sales and the stock of inputs firms hold in order to have a reliable, and at hand, supply of raw materials and spare parts. Inventory investment refers to the change in total inventories held in the economy during a given period of time. Inventory investment may be positive, negative, or equal to zero. Positive inventory investment indicates that the economy has added to its stock of inventories, while negative inventory investment indicates that the level of inventories in the economy has decreased. • Inventories fluctuate over time. Unintended changes in inventories, due to unpredicted fluctuations in sales, are referred to as unplanned inventory investment. • Thus, actual investment spending in an economy in any given period of time is comprised of two parts: planned investment spending, IPlanned, and unplanned inventory investment, IUnplanned. Positive unplanned inventory investment typically occurs in a slowing economy where actual expenditure on goods and services is less than forecasted expenditure. Negative unplanned inventory investment occurs in a growing economy where actual expenditure exceeds forecasted expenditure on goods and services. • Inventories play a key role in short-run macroeconomic models, and the behavior of firms' inventories often signals the future state of the economy.

Tip #2.

The 45-degree line in the Keynesian cross diagram provides a helpful visual tool for identifying the income-expenditure equilibrium GDP. The Keynesian cross diagram illustrates the relationship between AEPlanned and GDP: to the left of the point of intersection in the Keynesian cross, we know that AE is greater than GDP, inventories are falling, and firms will respond by increasing their production; to the right of the point of intersection in the Keynesian cross, we know that AE is less than GDP, inventories are rising, and firms will respond by decreasing their production. Figure 11.5, which follows, illustrates these points.

Objective #13.

The AE line, or AEPlanned, shifts in this simple model if there is a change in planned investment spending, IPlanned, or if there is a shift in the consumption function, C. Either shift triggers the multiplier process, so for a change in either variable there will be an even bigger change in the equilibrium level of GDP. This idea can be expressed as the change in the income-expenditure equilibrium GDP equals the multiplier times the change in planned aggregate spending. Recall that the multiplier in this simple model equals 1/ (1 − MPC).

Objective #9.

The accelerator principle is the idea that a higher rate of growth in real GDP leads to higher planned investment spending. The higher rate of growth in real GDP typically indicates rapid growth in sales, leading businesses to quickly use up any excess productive capacity and resulting in higher planned investment spending.

Objective #5.

The aggregate consumption function illustrates the relationship between the aggregate disposable income in an economy and the level of aggregate consumer spending. This relationship is similar to the one depicted in the individual household consumption function. The aggregate consumption function is written as C = A + MPC × YD, where C is aggregate consumer spending, A is aggregate autonomous consumer spending, and YD is aggregate disposable income. The aggregate consumption function, C, indicates a positive relationship between the level of aggregate consumer spending and the level of aggregate disposable income. Figure 11.2 provides an example of an aggregate consumption function.

Objective #4.

The consumption function is an equation that shows the relationship between a household's current disposable income and its level of consumer spending. We can write a simple version of the consumption function for an individual household as c = a + MPC × yd, where c is individual household consumer spending, a is individual autonomous consumer spending or the level of consumer spending a household would do if its disposable income equaled zero, and yd is individual household current disposable income. In this equation individual autonomous consumption and yd are assumed to be constant. A graph of the individual household consumption function with disposable income on the horizontal axis and consumer spending on the vertical axis would have a slope equal to the MPC and a y-intercept equal to a. Figure 11.1 illustrates an example of an individual household consumption function. Consumer spending and disposable income are positively related to each other: as disposable income increases, consumer spending increases.

Objective #12.

The ideas in objective #11 can be expressed using equations. In this simple economy with no government sector, a fixed aggregate price level, and a given interest rate, GDP = C + I. Furthermore, investment spending, I, can be written as the sum of planned investment plus unplanned inventory investment or I = IPlanned + IUnplanned. Thus, GDP = C + IPlanned + IUnplanned. Planned aggregate spending, AEPlanned, is the sum of consumption spending plus planned investment or AEPlanned = C + IPlanned. Thus, GDP = AE + IUnplanned. • When GDP is greater than AEPlanned, this implies that IUnplanned is positive: the inventories of firms increase, and this acts as a signal to firms to decrease their production. Over time the economy moves back to the income-expenditure equilibrium. • When GDP is less than AEPlanned, this implies that IUnplanned is negative: the inventories of firms decrease, and this acts as a signal to firms to increase their production. Over time the economy moves back to the income-expenditure equilibrium. • When GDP equals AEPlanned, then the economy is at the income-expenditure equilibrium. At this equilibrium, IUnplanned equals zero and firms have no incentive to change their levels of production in the next period. We refer to this level of GDP as the income- expenditure equilibrium GDP. A 45-degree reference line helps identify the income- expenditure equilibrium GDP. When AEPlanned is graphed on the vertical axis and GDP is graphed on the horizontal axis, the income-expenditure equilibrium GDP is that level of GDP where the AE line intersects the 45-degree line. This diagram identifying the income-expenditure equilibrium GDP where AEPlanned equals GDP is called the Keynesian cross diagram. Figure 11.3 illustrates the Keynesian cross diagram. • The macroeconomy self-corrects when GDP is not equal to AEPlanned through inventory adjustment.

Objective #8.

The level of investment spending is a critical determinant of economic performance: most recessions result from a decrease in investment spending. In addition, declines in consumer spending are usually the result of a reaction to a fall in investment spending and the accompanying multiplier process. • The two most important factors determining the level of investment spending are interest rates and expected future real GDP. • The level of investment spending that businesses actually engage in is not always the level of investment spending that they have planned. • Planned investment spending refers to the investment spending firms plan to make during a given time period and is dependent primarily on the interest rate, the expected future level of real GDP, and the current level of productive capacity. • The level of interest rates determines whether or not a firm will undertake a particular investment project. Investment projects with a rate of return equal to or greater than the equilibrium interest rate will be funded, while those investment projects with a rate of return less than the equilibrium interest rate will not be funded. • Retained earnings refer to past profits that are used to finance investment spending. Even if the firm finances its investment spending using retained earnings, the firm still compares the rate of return for the investment project to the equilibrium interest rate. This interest rate reflects the opportunity cost of using the firm's retained earnings to fund the investment project rather than lending out the retained earnings and earning interest. • An increase in the market interest rate makes any given investment project less profitable, while a decrease in the market interest rate makes any given investment project more profitable. Therefore, planned investment spending is inversely related to the interest rate. Aggregate consumer spending, or C Aggregate disposable income, or YD Consumption function The slope of the consumption function is equal to the MPC.

Objective #2.

The marginal propensity to consume, or the MPC, measures the increase in consumer spending that occurs if current disposable income increases by $1. The MPC can be calculated as the change in consumer spending divided by the change in disposable income. The MPC is a number between 0 and 1. The marginal propensity to save, or the MPS, is the fraction of an additional dollar of disposable income that is saved. The MPS is equal to (1 −MPC).

Objective #14.

The paradox of thrift refers to how individuals concerned about a potential economic downturn may worsen that economic downturn when they choose to act prudently and increase their level of saving. It is a paradox, since what is "good," households saving their money, produces a "bad," an economy with a more severe recession.

Objective #6.

The two principal causes of shifts in the aggregate consumption function are changes in expected future disposable income and wealth. The life cycle hypothesis theorizes that consumers plan their spending over a lifetime, and as a result try to smooth, or even out, their consumption spending over the course of their entire lives. The permanent income hypothesis holds that consumer spending is ultimately dependent on the income people expect to have over the long term rather than on their current income. • An increase in expected future disposable income or wealth causes the vertical intercept A, aggregate autonomous consumer spending, to increase, and this results in an upward shift of the aggregate consumption function. Similarly, a decrease in expected future disposable income or wealth causes the aggregate consumption function to shift down.

Tip #4.

This chapter develops the concept of the multiplier and it considers the impact of the multiplier on the macroeconomic model presented in this chapter. The text starts with a relatively simple economic model to develop important economic concepts like the multiplier. Review the definition of the multiplier, its calculation, and then practice using this concept in questions provided in the text and the study guide. Figure 11.6 illustrates this multiplier effect. The economy is initially producing Y1. When there is an increase in autonomous spending, this causes AEPlanned to shift up by an amount equal to this change in spending. This leads to a higher equilibrium level of output, Y2. The multiplier equals the ratio of this change in aggregate output divided by the change in autonomous spending.

Objective #1.

This chapter makes four simplifying assumptions in building a model of income and expenditure. These assumptions are: • Producer prices are fixed and therefore any change in aggregate spending results in a change in aggregate output or real GDP. Given this assumption, real GDP and nominal GDP are equivalent since the aggregate price level is fixed and does not change. • The interest rate is given in this simple model. • Government spending and taxes are equal to zero. • Exports and imports are equal to zero.

Keynesian cross

a diagram that identifies income-expenditure equilibrium as the point where the planned aggregate spending line crosses the 45-degree line.

income-expenditure equilibrium

a situation in which aggregate output, measured by real GDP, is equal to planned aggregate spending and firms have no incentive to change output.

consumption function

an equation showing how an individual household's consumer spending varies with the household's current disposable income.

autonomous change in aggregate spending

an initial rise or fall in aggregate spending at a given level of real GDP.

inventories

stocks of goods and raw materials held to satisfy future sales.

marginal propensity to save (MPS)

the fraction of an additional dollar of disposable income that is saved; MPS is equal to 1 − MPC.

marginal propensity to consume (MPC)

the increase in consumer spending when disposable income rises by $1. Because consumers normally spend part but not all of an additional dollar of disposable income, MPC is between 0 and 1.

planned investment spending

the investment spending that firms intend to undertake during a given period. Planned investment spending may differ from actual investment spending due to unplanned inventory investment.

income-expenditure equilibrium GDP

the level of real GDP at which real GDP equals planned aggregate spending.

accelerator principle

the proposition that a higher rate of growth in real GDP results in a higher level of investment spending, and a lower growth rate in real GDP leads to lower planned investment spending.

multiplier

the ratio of total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change.

aggregate consumption function

the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending.

actual investment spending

the sum of planned investment spending and unplanned inventory investment.

planned aggregate spending

the total amount of planned spending in the economy; includes consumer spending and planned investment spending.

inventory investment

the value of the change in total inventories held in the economy during a given period. Unlike other types of investment spending, inventory investment can be negative, if inventories fall.

unplanned inventory investment

unplanned changes in inventories, which occur when actual sales are more or less than businesses expected.