Income and expenditures equilibrium

(P1B) What is looks like on graph Suppose real GDP is currently $500 billion. Assuming that the price level remains constant, this would mean that_____________ , which would send a signal to firms to___________. Look at the graph what does the GDP pair with on AE?

500 - 650 = -150 firms would experience a $150 billion reduction in inventories/increase production

(P2B) What is looks like on graph Suppose real GDP is currently $900 billion. Assuming that the price level remains constant, this would mean that_____________ , which would send a signal to firms to___________. Look at the graph what does the GDP pair with on AE?

900 - 750 = 150 firms would have excess inventories of $150 billion / decrease production

(S3C) The spending multiplier calculation

Multiplier = 1/leakages Or Multiplier = 1 / (MPS + MPI) (The leakages are the portion of the change in income that are saved (MPS) and the proportion of the change in income that is spent on imports. (MPI)

(P2A)Suppose the following table shows consumption (CC), investment (II), government purchases (GG), and net exports (NXNX) in a hypothetical economy for various levels of real GDP. Assume that the price level remains unchanged at all levels of real GDP. 1) Calculate AE (C + I + G + NX) 2) What is the equilibrium? (blank = blank)

1) 650, 675, 700, 725, 750 2) AE = 700/ GDP = 700

(P1A)Suppose the following table shows consumption (CC), investment (II), government purchases (GG), and net exports (NXNX) in a hypothetical economy for various levels of real GDP. Assume that the price level remains unchanged at all levels of real GDP. 1) Calculate AE (C + I + G + NX) 2) What is the equilibrium? (blank = blank)

1) 650, 700, 750, 800, 850 2) AE = 800/ GDP = 800

AE and changes in price levels

Aggregate expenditures curve will shift when the price level changes because of the wealth effect, interest rate effect, and the international trade effect. The changing price levels which shift the AE curve will allow us to derive our aggregate demand curve.

(S3A) The spending multiplier

Any change in autonomous expenditures is multiplied in to a larger change in equilibrium real GDP. In other words, if autonomous expenditures increase by $1, equilibrium real GDP increase by more than a dollar.

Keynes viewpoint

Believed an economy could come to rest at a level of GDP that was too low to offer employment for the entire labor force. Keynes believed the government should intervene by pumping money back into the economy to stimulate income and output.

Changes in equilibrium income and expenditures

Equilibrium is a point where there is no tendency to move; AE = real GDP. In reality, real GDP does move. If autonomous expenditures increase, then the equilibrium level of real GDP will increase. We use the spending multiplier to calculate this change in real GDP.

(P3A)The following graph shows the consumption function (C) for a hypothetical private closed economy and a 45-degree line along which aggregate expenditure equals real GDP (AE=Y). Recall that a private closed economy does not have government and does not trade with the rest of the world (so G=0 and (X-M)=0). In a private closed economy, real GDP is equal to disposable income. At the current real interest rate, the level of investment in this economy is equal to $75 billion at each level of real GDP. Use the blue line (circle symbols) to plot this economy's initial aggregate expenditure line, (C + I). Then, use the black point (X symbol) to indicate this economy's initial equilibrium output. Dashed drop lines will automatically extend to both axes. (Hint: You can see two of the coordinates along the consumption function by moussing over the green triangles on the graph.) At the level of equilibrium output you just indicated, the level of saving is equal to_________ . At an output level of $600 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production) At an output level of $650 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production)

$75 billion greater than/an unplanned decrease/Increasing production equal to/no change/Leaving production unchanged

This table shows some information on a private closed economy. Recall that a private closed economy is one that does not have a government and does not trade with the rest of the world. Therefore, the only components of aggregate expenditure are consumption (C) and planned investment spending (I). In this problem, assume that planned investment spending is independent of the economy's real GDP level. Also note that real GDP is equal to disposable income in a private closed economy. Real GDPConsumption savingsInvestmentAE Unplanned changes 500 455 45 120 _____ -75 600 _____ 70 120 650 _____ 700 605 ___ 120 725 _____ 800 680 120 120 800 _____ _____ 755 145 120 875 25 Real GDP - Savings = Consumption Real GDP - Consumption = Savings AE + Unplanned changes = Real GDP Tendency of Output? (Increase, decrease, equilibrium) True or False: The most fundamental assumption behind the aggregate expenditure model is that prices in the economy are flexible. (True/False) When aggregate expenditure is greater than real GDP, there is an unplanned _________ (increase/decrease) in business inventories. This unplanned change in inventories will cause the actual level of investment to be __________ (less/greater)than the planned level of investment (I), which will prompt firms to ________ (decrease/increase) employment and production.

False decrease/less/increase

(S4A)The spending multiplier and the GDP gap

Formula: GDP Gap: potential real GDP - actual real GDP The spending multiplier can also serve as a useful tool if the govt. wants to eliminate the GDP gap. In other words , if potential GDP is higher than actual GDP in the economy, the spending multiplier allows the govt. to forecast how much they need to increase autonomous expenditures in order to eliminate the GDP gap.

Equilibrium

The equilibrium level of real GDP is where AE = Real GDP. - This is the point on the graph where 45 degree line (all possible points where AE = real GDP) intersects the AE line (planned spending). Real GDP will increase or fall in order to reach the equilibrium level of expenditures in the economy. Once real GDP reaches equilibrium, it tends to stay there. Occurs at the level of real GDP where: AE (C + I + G + NX = real GDP Leakages = injections Both methods give the same level of equilibrium in the economy.

(P3B) Suppose the real interest rate falls and the level of investment in this economy increases by $50 billion. Use the blue line (circle symbols) to show the economy's aggregate expenditure line, (C + I), after the increase in investment. Then use the gray point (star symbol) to show the economy's new equilibrium output. Dashed drop lines will extend to both axes. Hint: Start with your aggregate expenditure line from the previous graph. Make sure the slope of the aggregate expenditure line is the same as the previous aggregate expenditure line you just plotted. You can check the slope of the line by clicking on the line after you plot it. The simple spending multiplier for this private closed economy is____ . (Simple spending multiplier)

2

(S3B) The spending multiplier example

Any change in autonomous expenditures is multiplied in to a larger change in equilibrium real GDP. In other words, if autonomous expenditures increase by $1, equilibrium real GDP increase by more than a dollar. MPC - MPI = Another round of spending Change in income * Another round of spending = change in income This would take to long use the spending multiplier

(S2A) When AE is less than Real GDP, Real GDP falls

As inventories increase firms will cut back production of goods and services. This will cause real GDP to fall. Thus, when AE is less than real GDP, real GDP falls.

(S2B) When AE is less than Real GDP, Real GDP falls

As inventories increase firms will cut back production of goods and services. This will cause real GDP to fall. Thus, when AE is less than real GDP, real GDP falls.

Leakages and injections

Equilibrium will occur where leakages and injections intersect (graphically). Leakages and injections increase or reduce autonomous aggregate expenditures.

How do Aggregate expenditures affect income, or real GDP?

In reality, AE (planned spending) may not equal real GDP (real GDP must rise or fall to reach equilibrium).

The spending multiplier in reality

In reality, the spending multiplier is oversimplified. Often, factors other than MPS and MPI in the economy will affect the multiplier effect. Factors include: Price changes Taxes Both these factors cause the spending multiplier to be overstated Foreign repercussions Cause the spending multiplier to be understated

Macroeconomic Equilibrium Equalilibrium - a point of balance with no tendency to move

Is the level of income and expenditures that the whole economy moves towards (and remains at) until autonomous spending changes.

AE and Aggregate demand

Keynesian model A problem with this model is that it is a fixed-price model (the supply of goods and services will always adjust to AE). In reality, prices as well as production adjust to the differences between supply and demand.

(P4A) The following graph shows the consumption function (C) for a hypothetical private closed economy and a 45-degree line along which aggregate expenditure equals real GDP (AE=Y). Recall that a private closed economy does not have government and does not trade with the rest of the world (so G=0 and (X-M)=0). In a private closed economy, real GDP is equal to disposable income. At the current real interest rate, the level of investment in this economy is equal to $100 billion at each level of real GDP. Use the blue line (circle symbols) to plot this economy's initial aggregate expenditure line, (C + I). Then, use the black point (X symbol) to indicate this economy's initial equilibrium output. Dashed drop lines will automatically extend to both axes. (Hint: You can see two of the coordinates along the consumption function by moussing over the green triangles on the graph.) Check out the points for Real GDP and consumption (AE = y). Real GDP C + I = AE 450 450 100 = _______ 700 600 100 = _______ At the level of equilibrium output you just indicated, the level of saving is equal to_______ . At an output level of $600 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production) At an output level of $650 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production)

Real GDP C + I = AE 450 450 100 = 550 (450,550) 700 600 100 = 700 (700,700) $100 billion less than/an unplanned increase/decreasing production equal to/no change/Leaving production unchanged

(P4B) Suppose the real interest rate falls and the level of investment in this economy decreases by $50 billion. Use the blue line (circle symbols) to show the economy's aggregate expenditure line, (C + I), after the increase in investment. Then use the gray point (star symbol) to show the economy's new equilibrium output. Dashed drop lines will extend to both axes. 100 - 50 = 50 Hint: Start with your aggregate expenditure line from the previous graph. Make sure the slope of the aggregate expenditure line is the same as the previous aggregate expenditure line you just plotted. You can check the slope of the line by clicking on the line after you plot it. Real GDP C + I = AE 450 450 50 = _______ 700 600 50 = _______ The simple spending multiplier for this private closed economy is____ . (Simple spending multiplier)

Real GDP C + I = AE 450 450 50 = 500 (450,500) 700 600 50 = 650 (700,650) 2.5

(S4B)Recessionary Gap formula

The formula for the recessionary gap tells us the increase in expenditures necessary to reach potential GDP. Formula: GDP/Spending Multiplier So, if our GDP gap is $200, and our spending multiplier is 2.5, the govt. can eliminate the GDP GAP by increasing spending by: $200/2.5 = $80 (recessionary gap)

This table shows some information on a private closed economy. Recall that a private closed economy is one that does not have a government and does not trade with the rest of the world. Therefore, the only components of aggregate expenditure are consumption (C) and planned investment spending (I). In this problem, assume that planned investment spending is independent of the economy's real GDP level. Also note that real GDP is equal to disposable income in a private closed economy. Real GDPConsumption savingsInvestmentAE Unplanned changes 100 100 0 100 _____ -100 200 _____ 50 100 250 _____ 300 200 ___ 100 300 _____ 400 250 150 100 350 _____ _____ 300 200 100 400 100 Real GDP - Savings = Consumption Real GDP - Consumption = Savings AE + Unplanned changes = Real GDP Tendency of Output? (Increase, decrease, equilibrium) True or False: The most fundamental assumption behind the aggregate expenditure model is that prices in the economy are fixed. When aggregate expenditure is less than real GDP, there is an unplanned __________ (increase/decrease) in business inventories. This unplanned change in inventories will cause the actual level of investment to be __________ (less/greater) than the planned level of investment (I), which will prompt firms to __________ (increase/decrease) employment and production.

True increase/greater/decrease

(S1A) When Aggregate expenditures exceed real GDP, Real GDP rises

When planned spending on goods and services is greater than the current value of output, this causes the production of goods and services to increase (GDP increases). - This means that more goods and services are being purchased than are being produced. How can this happen???? - Goods in the past must be sold (in other words, inventories decrease). - When inventories decrease, manufacturers increase production, raising the real level of GDP. -Thus, when AE exceeds real GDP, real GDP rises.

(S1B) When Aggregate expenditures exceed real GDP, Real GDP rises

When planned spending on goods and services is greater than the current value of output, this causes the production of goods and services to increase (GDP increases). - This means that more goods and services are being purchased than are being produced. How can this happen???? - Goods in the past must be sold (in other words, inventories decrease). - When inventories decrease, manufacturers increase production, raising the real level of GDP. -Thus, when AE exceeds real GDP, real GDP rises.

Injections

Will increase autonomous AE. Injections offset the leakages. 3 injections: - Investment ~ Household saving generates money for investments - Government spending ~ Taxes collected by govt. are spent on goods and services - Exports ~ Exports bring foreign expenditures into the domestic economy

Leakages

Will reduce autonomous AE. Three leakages: - Savings ~ The more households save, the less they spend. This could decrease C, thus causing the equilibrium level of real GDP to fall. - Taxes ~ Transfer income away from households, thus, higher taxes can cause decrease in C, lowering equilibrium level of real GDP. - Imports ~ Spending on imports means less money to spend on domestic goods, thus an increase in imports will decrease X, causing equilibrium real GDP to fall.

The following graph shows the aggregate expenditure line (AE) for an economy with a current equilibrium output of $400 billion and a potential output of $600 billion. The economy is experiencing ____________ . The absolute value of the GDP gap in this economy is _________ . Because the simple spending multiplier for this economy is _____ , closing the GDP gap would require a __________ .

a recessionary gap 600 - 400 = 200 1 / (1 -.75) = 4 200 / 4 = 50 $200 billion 4.00 $50 billion increase in investment spending