CHAPTER 12 AGGREGATE EXPENDITURE AND OUTPUT IN THE SHORT RUN
marginal propensity to save
- change in saving/change in disposable income - how much saving changes when disposable income changes - remember the marginal propensity to consume + this must equal 1. (why? because they're only two things you can do with money)
autonomous and induced expenditures
-one does not depend on the level of gdp (aut.) --> gov't spending, investment, snd net exports -consumption has both parts
the 45 degree line
The 45° line shows all the points that are equal distances from both axes. Points such as A and B, at which the quantity produced equals the quantity sold, are on the 45° line. Points such as C, at which the quantity sold is greater than the quantity produced, lie above the line. Points such as D, at which the quantity sold is less than the quantity produced, lie below the line. Remember that in macroeconomic equilibrium, aggregate output = aggregate demand for that output.
the multiplier effect in reverse
The 45°-line diagram can help to illustrate this process. Aggregate expenditures fell initially, due to the decrease in investment. This prompted a multiplied effect on equilibrium real GDP
aggregate expenditure is equal to GDP
adjustments to macroeconomic equilibrium when there's no unplanned change in inventories
price level and aggregate expenditure
aggregate expenditure inc price level demand rises: product's price will inc. production will inc increases in the price level will cause aggregate expenditure to fall, and decreases in the price level will cause aggregate expenditures to rise
actual investment
factors in inventories
inventories
final goods that have been made but not sold
aggregate expenditure is less than GDP
if there is an unexpected increase in inventories result? unemployment rises production falls
dollar rises in value relative to other currencies
imports are cheaper, and our exports are more expensive. imports rise and exports fall
aggregate expenditure is greater than GDP
inventories fall production and employment increase
consumption
is spending by households and firms on goods and services
if U.S. GDP grows faster than foreign GDP (flip scenario)
net exports decrease remember consumption is not exclusive if people are buying more it also includes foreign goods U.S. demand for imports rises faster than foreign demand for our exports.
if us price level rises faster than foreign price levels (flip scenario)
net exports decrease imports rise and exports fall because demand for imports goes up because domestic prices are much more expensive
planned investment
planned spending by firms on capital goods households on new homes
determinants of consumption
price level interest rate current disposable income future expected income household wealth(assets)
multiplier effect 2
real GDP increases by more than the change in autonomous expenditure
consumption and national income
GDP and national income are interchangeable as national income rises (gdp) so does consumption
multiplier effect
-autonomous expenditure so initial increases in autonomous expenditure results in increased consumption In the multiplier process, an increase in spending causes an increase in production and incomes, which leads to a further increase in spending. A decrease in spending causes a decrease in production and incomes, which leads to a further decrease in spending. An initial shock to demand from an increase in spending causes an increase in production and incomes, which leads to a further increase in spending. So we see that an initial shock to demand raises total spending, which leads to more production, which in turn raises incomes, which leads to even more spending, etc.
aggregate expenditure model
-short-run - relationship between total spending and real GDP - when price level is constant
formula for the multiplier
1/1-mpc 1/MPS
aggregate demand curve
A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure. price level and aggregate expenditure
Adjustment to Macroeconomic Equilibrium
In this economy, macroeconomic equilibrium occurs at $10 trillion. What if real GDP were lower, say $8 trillion? Aggregate expenditure would be higher than GDP, so inventories would fall. This would signal firms to increase production, increasing GDP. The reverse would occur if real GDP were above $10 trillion. Macroeconomic equilibrium occurs where the AE line crosses the 45° line, which occurs at GDP of $10 trillion. If GDP is less than $10 trillion, the corresponding point on the AE line is above the 45° line, planned aggregate expenditure is greater than total production, firms will experience an unplanned decrease in inventories, and GDP will increase. If GDP is greater than $10 trillion, the corresponding point on the AE line is below the 45° line, planned aggregate expenditure is less than total production, firms will experience an unplanned increase in inventories, and GDP will decrease.
income, consumption, and spending
Let's complete our discussion of consumption by exploring briefly the relationship between income, consumption, and saving. When households earn income, they either spend it on consumption, save it, or use it to pay taxes. Therefore, we have the following: National Income = consumption + saving + taxes When national income increases, there is, of necessity, some combination of a change in consumption, a change in saving, and a change in taxes. When income rises, all of these increase, and vice-versa. This gives us: ∆ Y = ∆ C + ∆ S + ∆ T If we assume taxes are always a constant amount no matter what the level of income is, then we get: ∆ Y = ∆ C + ∆ S Dividing this through by the change in Y (∆ Y), we get the following: ∆ Y ÷ ∆ Y = ∆ C ÷ ∆ Y + ∆ S ÷ ∆ Y Which gives us: 1 = MPC + MPS A part of every increase in income is consumed, and with taxes a constant, what is left over is saved.
multiplier effect
The multiplier effect occurs both for an increase and a decrease in planned aggregate expenditure. Because the multiplier is greater than 1, the economy is sensitive to changes in autonomous expenditure. The larger the MPC, the larger the value of the multiplier. Our model is somewhat simplified, omitting some real-world complications. For example, as real GDP changes, imports, inflation, interest rates, and income taxes will change.
aggregate demand
relationship price level and consumption But in macroeconomics we are talking of ALL prices rising or falling. When the overall level of prices rises, many (but not all) prices (including wages) rise together. And it is for this reason that we cannot use the ceteris paribus logic to draw the aggregate demand curve. The ceteris paribus logic explains the logic behind why the simple demand curve slopes downward, but not the logic behind why the aggregate demand curve slopes downward. An increase in the general level of prices will cause aggregate expenditures to fall (and vice versa) as we shall see in an upcoming slide. And the reasons for this are the following: People's demand for money is influenced by the level of income, the interest rate, and the price level. Let's focus on the price level. It is easy to understand why the price level affects the demand for money. If you want to buy a bag of chips ($2.00), a Hostess Twinkie ($1.00) and a big salami and Swiss cheese hero sandwich ($7.00), you would need $10.00 in your pocket or checkbook. However, if the price of each of these products doubles, you would need twice the original amount. So we see that the amount of money one needs to make any number of transactions depends upon the average price of those transactions. As prices (and wages) increase, people need to hold more money, as will firms need to hold more money. If prices and wages rise by 5% per year, we can expect the demand for money to rise by 5% as well. If the Federal Reserve does not increase the supply of money when prices rise, interest rates will rise, and this will lead to lower investment spending by businesses. The consumption link provides a second reason for the downward-sloping aggregate demand curve. Rising prices increase the demand for money, which leads to an increase in the interest rate (if the Fed does not increase the supply of money), which leads to a decrease in consumption (and planned investment). When consumption (and investment) fall, so too does output (GDP). The real wealth effect (or the real balances effect) is another reason behind the downward-sloping aggregate demand curve. We saw earlier that consumption depends in part upon wealth. The more wealth households have, the more goods and services they consume. And we saw earlier that the price level has an effect on some forms of wealth. Certainly if you have $10,000 in your money market account or in your checking account and prices increase by 5%, the sum of money you have is now worth 5% less because prices have risen by 5%. The purchasing power or real value of you sum of money has fallen by 5%. In addition, rising prices may affect the value of securities and housing (or not at all if securities prices and housing prices also rise by 5%). But the main point here is that rising prices adversely affect SOME forms of wealth. So we can summarize here by saying that a rise in prices lowers the real value of wealth, thus adversely affecting consumption and therefore leading to a decline in aggregate output. Finally, rising prices adversely affect the net export balance. Rising U.S. prices relative to prices abroad reduce exports and increase imports, so we see a third cause of the downward-sloping aggregate demand curve.
aggregate expenditure
- sum of consumption, planned investment, government purchases, and net exports -total spending the economy
paradox of thrift
An increase in saving is good, because saving is borrowed and spent on investment goods. More plant and equipment increases the capacity of the economy to produce goods and services. The key assumption is that savings will be borrowed and spent for investment purposes. If an increase in saving doesn't lead to more investment, we have the Paradox of Thrift. The attempt to save more may reduce GDP and leave actual saving unchanged.
determinants of aggregate expenditure summary
Consumption: rises when wealth rises, interest rates fall, disposable income rises, the availability of credit increases, and expectations about the future improve. Investment: increases when interest rates decline and expected rates of return from investments in capital rise. Government: government spending is determined exogenously. Net Exports: rise when incomes abroad rise, the dollar falls in value, and incomes in America fall.
government purchases
IMP: -consistent growth in gov't spending -variables determined exogenously (policymakers) - NO transfer payments Government purchases are spending by federal, state, and local governments on goods and services, such as teachers' salaries, highways, and aircraft carriers. This does not include transfer payments (such as social security and Pell Grants), since those do not result in immediate production of new goods and services. Also, government receives no goods or services in exchange for transfer payments. Government spending is further divided into two categories: spending for things not subsequently used to produce other goods and services (such as education, national defense, and jurisprudence); and spending on goods and services that are subsequently used by either the public or the private sector to produce other goods and services (such as structures, equipment, software, and military hardware). Remember: government demand for goods and services is determined exogenously, by government policymakers. It does not respond to changes in prices, interest rates, or income. This means that government spending determinants are not related to the rest of macroeconomics.
price level affects aggregate expenditure
Rising price levels decrease the real value of household wealth, causing consumption to fall. If price levels rise in the U.S. faster than in other countries, U.S. exports fall and imports rise, causing net exports to fall. When prices rise, firms and households need more money to finance buying and selling. If the supply of money doesn't change, the interest rate must rise; this will cause investment spending to fall. when prices rise, the demand for money rises. People and businesses will want to switch a portion of their wealth into money in order to pay for the same quantity of transactions whose prices have now risen. If the Federal Reserve targets the supply of money and allows interest rates to change according to the demand for money, a fixed supply of money when money demand is increasing will cause interest rates to rise. So we see that higher prices cause interest rates to rise.
summarizing the multiplier effect
The multiplier effect occurs both for an increase and a decrease in planned aggregate expenditure. Because the multiplier is greater than 1, the economy is sensitive to changes in autonomous expenditure. The larger the MPC, the larger the value of the multiplier. Our model is somewhat simplified, omitting some real-world complications. For example, as real GDP changes, imports, inflation, interest rates, and income taxes will change.
multiplier
The value of the increase in equilibrium real GDP divided by the increase in autonomous expenditures slide 42 good example: Looked at differently, saving must equal investment. If investment rises by $100 billion, and the MPS = 0.25, then income and output must rise by $400 billion to create an additional $100 billion in new saving.
recession at the 45 degree line
When the aggregate expenditure line intersects the 45° line at a level of GDP below potential GDP, the economy is in recession. The figure shows that potential GDP is $10 trillion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $9.8 trillion, where the AE line intersects the 45° line. As a result, some firms will be operating below their normal capacity, and unemployment will be above the natural rate of unemployment. We can measure the shortfall in planned aggregate expenditure as the vertical distance between the AE line and the 45° line at the level of potential GDP. if equilibrium happens at potential gdp (full employment happens/natural rate of employment)
net exports
X-M foreign households spending on goods and services in the U.S. domestic households and firms spending on foreign goods and services
macroeconomic equilibrium
aggregate expenditure=GDP
value of the multiplier
change in GDP/ change in investment spending
determinants of net exports
exports - imports -net exports have been negative for the last few decades. The value i s higher (less negative)during a recession -price level in U.S. vs. price level in other countries - U.S. growth rate vs. growth rate in other countries - U.S. dollar exchange rate
keynesian cross
gdp on x-axis aggregate expenditure on y-axis points on the 45 degree line can be macroeconomic equilibrium (where planned aggregate expenditure=GDP) A key feature of the graph is two lines that cross, and because the diagram is based on the work of John Maynard Keynes, the diagram is called "The Keynesian Cross." And because a key feature of the diagram is two lines that cross (as we will see shortly), it is called the Keynesian Cross
determinants of planned investment
increased over time but not smoothly (recessions decrease investment more) expectations of future profitability interest rate taxes (decrease the money available for reinvestment) cash flow(cash revenue minus costs; most imp factor: profit and profit goes down in recessions )
government spending
is spending by the local, state, and federal government on goods and services
consumption function
the relationship between real disposable income and consumption suggests that consumers will spend a consistent fraction of a dollar on consumption slope is the marginal propensity to consume
marginal propensity to consume
the slope of the consumption function: the amount by which consumption spending changes when disposable income changes MPC= change in consumption/ change in disposable income
important role of inventories
we asked before why output rises when aggregate demand rises, and why does output fall when aggregate demand falls. And the answer is based on how businesses react to an unexpected change in their inventory holdings. inventory accumulation vs. depletion So, GDP >aggregate demand means inventory accumulation; GDP < aggregate demand means inventory depletion.
average propensity to consume
c/y ratio of consumption to disposable personal income fraction of total income