Chapter 12

Aggregate Expenditure Model

focuses on the short-run relationship between total spending and real GDP (price level is constant)

12.1.3 Macroeconomic Equilibrium

> is when, Aggregate expenditure = GDP

12.4: The Multiplier Effect

>Aggregate expenditure determines real GDP in the short run, and we have seen how the economy adjusts if it is not in equilibrium >any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium GDP. Autonomous expenditure does not depend on the level of GDP (shift in curve) >nonautonomous—or induced—component, which does depend on the level of GDP (movement up along the curve) Multiplier: The ratio of the increase in equilibrium real GDP to the increase in autonomous expenditure Multiplier Effect: the series of induced increases in consumption spending that results from an initial increase in autonomous expenditure >In this case, the multiplier is 1/(1−0.75),1/(1−0.75), or 4, which means that for each additional $1 of autonomous spending, equilibrium GDP will increase by $4

12.3.1: Showing A Recession On The 45°-Line Diagram

>At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment >As Figure 12.12 shows, if there is insufficient total spending, equilibrium will occur at a lower level of real GDP. In this situation, many firms will be operating below their normal capacity, and the unemployment rate will be above the natural rate of unemployment (recession)

12.2 Determining the Level of Aggregate Expenditure in the Economy

>Five most important variables that determine the level of consumption (services, nondurable, and durable goods): 1. Current disposable income: income remaining to households after they have paid the personal income tax and received government transfer payments 2. Household wealth: the value of its assets minus the value of its liabilities (when wealth increases, consumption increases, and vice versa) 3. Expected future income: We can conclude that current income explains current consumption (fairly stable) well but only when current income is not unusually high or unusually low compared with expected future income 4. The price level: measures the average prices of goods and services in the economy, therefore, as the price level rises, the real value of your wealth declines, and so will your consumption—at least a little (and vice versa) 5. The interest rate: When the real interest rate is high, the reward for saving is increased, and households are likely to save more and spend less

12.3: Graphing Macroeconomic Equilibriumases

>On the 45 degree line or Keynesian Cross, the horizontal axis measures real GDP and the vertical axis measures real aggregate expenditure

12.2.6: Government Purchases

>Total government purchases include all spending by federal, local, and state governments for goods and services (does not include transfer payments as gov. does not get anything in return)

12.3.2: The Important Role of Inventories

>firms accumulate excess inventories, then even if spending quickly returns to its normal level, firms will have to sell their excess inventories before they can return to producing at normal levels >But remember that planned aggregate expenditure equals the sum of consumption spending, planned investment spending, government purchases, and net exports, not consumption spending alone

Inventories

>goods that have been produced but have not yet been sold >Unplanned increase in inventories results from actual investment (of firms) being greater than planned investment

12.1.4 Adjustments to Macroeconomic Equilibrium

>if aggregate expenditure is greater than GDP, inventories will decline, causing GDP and total employment to increase >if aggregate expenditure is less than GDP, inventories will increase, causing GDP and total employment to decrease >Only when aggregate expenditure equals GDP will firms sell what they expected to sell

12.5 The Aggregate Demand Curve

>increases in the price level cause aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise 1. A rising price level decreases consumption by decreasing the real value of household wealth 2. If the price level in the United States rises relative to the price levels in other countries, U.S. exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall 3. When prices rise, firms and households need more money to finance buying and selling Aggregate Demand Curve: The relationship shown in Figure 12.15 between the price level and the quantity of real GDP demanded

12.1.2 The Difference Between Planned Investment and Actual Investment

>planned investment spending, rather than actual investment spending, is a component of aggregate expenditure >the amount businesses plan to spend on inventories may be different from the amount they actually spend >Note that actual investment will equal planned investment only when there is no unplanned change in inventories

12.2.2 The Volatility of Consumer Spending on Durables

>some categories of consumption spending are much more volatile than is consumption spending as a whole >Spending on durable goods like cars and RVs is volatile for several reasons: 1. Durable goods are long-lived: people can postpone purchases if they think expansion is ending 2. Good substitutes exist 3. High prices make them risky purchases 4. Pent-up demand typically follows a recession 5. Interest rates fluctuate Consumption Function: consumption is a function of disposable income Marginal Propensity to Consume (MPC, slope of the line) = change in consumption/change in disposable income

12.2.7 Net Exports

>taking the value of spending by foreign firms and households on goods and services produced in the United States and subtracting the value of spending by U.S. firms and households on goods and services produced in other countries >Net exports usually increase when the U.S. economy is in a recession and fall when the U.S. economy is in an expansion. >Three most important variables that determine the level of net exports: 1. The price level in the United States relative to the price levels in other countries: If the inflation rate is lower in U.S. than other nations, then a slower price level increase leads to high demand for the U.S. products and an increase in exports and decrease in imports 2. The growth rate of GDP in the United States relative to the growth rates of GDP in other countries: As GDP increases in the United States, the incomes of households rise, leading them to purchase more goods and services 3. The exchange rate between the dollar and other currencies: An increase in the value of the dollar will reduce exports and increase imports, so net exports will fall. A decrease in the value of the dollar will increase exports and reduce imports, so net exports will rise. The other 70 percent of world trade is the import and export of intermediate inputs.

12.4.2: Summarizing the Multiplier Effect

At Equilibrium, Y= (Autonomous Consumption + Induced Consumption) + Investment + Gov. Spending Induced Consumption = Marginal Propensity to Consume x Disposable Income = MPC x (Y-Taxes) 1. The multiplier effect occurs both when autonomous expenditure increases and when it decreases 2. Because of the multiplier effect, a decline in spending and production in one sector of the economy can lead to declines in spending and production in many other sectors of the economy 3. The larger the MPC, the larger the value of the multiplier 4. The formula for the multiplier, 1/(1−MPC),1/(1−MPC), is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes

12.2.5: Planned Investment

Four most important variables that determine the level of investment: 1. Expectations of future profitability: the optimism or pessimism of firms is an important determinant of investment spending (optimism increases in expansions) 2. The interest rate: A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending 3. Taxes: A reduction in the corporate income tax increases the after-tax profitability of investment spending. An increase in the corporate income tax decreases the after-tax profitability of investment spending. Investment tax incentives increase investment spending because they reduce firms' taxes when they buy new investment goods. 4. Cash flow: difference between the cash revenues received by a firm and the cash spending by the firm, The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment >Consumption follows a smooth upward trend while investment has significant fluctuations

12.2.4: Income, Consumption, and Saving

National income=Consumption+Saving+Taxes or Y=C+S+T and ΔY=ΔC+ΔS+ΔT and ΔY=ΔC+ΔS (if we assume that taxes are constant, then change in T is 0) Marginal Propensity to Save (MPS): amount by which saving changes when disposable income changes 1=MPC+MPS

!2.2.3 The Relationship between Consumption and National Income

Net Taxes: Taxes minus government transfer payments National income=GDP=Disposable income+Net taxes (here we are using national income and GDP interchangeably) MPC will be the same value when using national income or disposable income

12.4.3: The Paradox of Thrift

Paradox of Thrift: John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving. Keynes called this outcome the paradox of thrift because what appears to be something favorable to the long-run performance of the economy might be counterproductive in the short run.

12.3.4: A Numerical Example of Macroeconomic Equilibrium

See pages 416

Aggregate Expenditure

total spending in the economy

12.1 The Aggregate Expenditure Model

· In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure · Keynes identified four components of aggregate expenditure that together equal GDP: AE=C+I+G+NX (I here is planned investment)

Notes

· When total spending in the economy and total production of goods and services increase by the same amount, firms sell what they expect to sell · When total spending is greater than total production of goods and services, firms will increase production · When total spending is less than total production of goods and services, firms lay off workers and cut back on production