Chapter 12

What is the multiplier effect? The multiplier formula? How does it appear in our model?

A change in autonomous expenditure leads to a larger change in real GDP. The change in equilibrium real GDP divided by the change in autonomous expenditures. Our model is somewhat simplified, omitting some real-world complications. For example, as real G D P changes, imports, inflation, interest rates, and income taxes will change.

What is the Aggregate Expenditure (AE) model? What are its four components?

A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. -Consumption (C): Spending by households on goods and services. -Planned investment (I): Planned spending by firms on capital goods and by households on new homes. -Government purchases (G): Spending by all levels of government on goods and services. -Net exports (NX): The value of exports minus the value of imports.

How do we describe equilibrium in our model of the "Pepsi" economy?

Any point on the 45° line could be an equilibrium—like points A or B. At point C, the economy's inventories of Pepsi are being depleted, and production must rise to restore equilibrium. At point D, inventories of Pepsi are growing, so production must fall.

What does macroeconomic equilibrium in the model tell us?

Equilibrium in the economy occurs when spending on output is equal to the value of output produced (aggregate expenditure = GDP). So macroeconomic equilibrium occurs when planned investment equals actual investment, i.e. no unplanned change in inventories.

What is the relation between the AE model and Aggregate Demand (AD)?

Increases in the price level will cause aggregate expenditure to fall; and decreases in the price level will cause aggregate expenditures to rise.

Are investment (I), gov't purchases (G) and net exports (NX) stable over time and what determines that?

Less stable over time because of recession. -Expectations of future profitability -The interest rate -Taxes -Cash flow -Recession -Price level in U.S. versus the price level in other countries -U.S. growth rate versus growth rate in other countries -U.S. dollar exchange rate

What does equilibrium look like when we include the components of AE in model? What does the model predict will happen when AE and GDP are different?

Only points on the 45° line can be a macroeconomic equilibrium, with planned aggregate expenditure equal to GDP. An unplanned decrease in inventories results in increasing production (increasing GDP). An unplanned increase in inventories results in decreasing production (decreasing GDP).

What is the difference between planned and actual investment in the model?

Our aggregate expenditure model uses planned investment, rather than actual investment. Planned investment = actual investment - unplanned change in inventories.

How do we show recession in the model? What is the role of inventories in determining equilibrium?

The equilibrium will occur below potential GDP — a recession. -When planned aggregate expenditure is less than real GDP, firms will experience unplanned increases in inventories. -Then even if spending returns to normal levels, firms have excess inventories to sell, and they will do this instead of increasing production to normal levels.

What is the marginal propensity to consume (MPC)? Marginal propensity to save (MPS)? What does their relation tell us?

The slope of the consumption function: the amount by which consumption spending changes when disposable income changes. The amount by which saving changes when disposal income changes. The marginal propensity to consume plus the marginal propensity to save must equal 1.

What is the "real life logic" behind the multiplier effect? What is the paradox of thrift?

When Brazil won the World Cup bid, they spent millions of dollars building new stadiums, hotels, and infrastructure. This created thousands of new jobs and more work in the construction business. As a result, there are more people employed and employees earned more. This is especially important because this meant they spent more on local goods and services. The more people spend on goods and services, the greater the multiplier effect and economic boost. What appears to be favorable in the long-run may be counterproductive in the short-run.

Is consumption (C) predictable over time? What are the determinants of consumption?

Yes; tread-line is steady, making it predictable. -Current disposable income -Household wealth -Expected future income -The price level -The interest rate