Chapter 11: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1.

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© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 54

Output and Expenditure in the Short Run

Aggregate expenditure (AE) The total amount of spending on the economy’s output:

Aggregate Expenditure

• Consumption (C)

• Planned Investment (I)

• Government Purchases of Goods + Services (G)

• Net Exports (NX)

Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

AE = C + I + G + NX

Macroeconomic Equilibrium: Aggregate Expenditure = Output (Y)

AE = C + I + G + NX = Y

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EXPENDITURE CATEGORY

EXPENDITURE(BILLIONS OF 2000 DOLLARS)

Consumption $8,091

Investment 1,946

Government 1,998

Net Exports −618

Components of Real Aggregate Expenditure, 2006

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The Aggregate Expenditure ModelAdjustments to Macroeconomic Equilibrium

IF … THEN … AND …

Aggregate expenditure isequal to GDP

inventories areunchanged

the economy is inmacroeconomic equilibrium.

Aggregate expenditure isless than GDP inventories rise

GDP and employmentdecrease.

Aggregate Expenditure isgreater than GDP inventories fall

GDP and employmentincrease.

Actual investment in a year can differ from planned investment: businesses “invest” in unintended inventories if sales fall short of what they expected

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Real Consumption Expenditure C = $C/CPI

FIGURE 11-1

Real Consumption, 1979–2006

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• Current disposable income

• Household wealth: Assets minus liabilities

• Expected future income

People try to keep their consumption fairly steady from year-to-year save for a rainy day

• The price level

Higher price level reduces real value of monetary wealth

• The interest rate

High interest rate discourages spending on credit and encourages saving

The most important variables that determine the level of consumption:

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The Relationship between Consumption and Income,

1960– 2006

The Consumption Function: The relation between consumption and disposable income

Consumption Function

Marginal propensity to consume (MPC) The amount by which consumption spending changes when disposable income changes = slope of consumption function.

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Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

YD

CMPC

income disposablein Change

nconsumptioin Change

The Consumption Function

We can also use the MPC to determine how much consumption will change as income changes:

income disposablein Change

nconsumptioin ChangeMPC

Change in consumption = Change in disposable income × MPC

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The Relationship between Consumption and National Income

when net taxes are constant

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National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving + Change in taxes

Y = C + S + T

Determining the Level of Aggregate Expenditure in the Economy

Income, Consumption, and Saving

TSCY If taxes are always a constant amount, ΔT = 0

ΔΔY = Y = ΔΔC + C + ΔΔSS

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Marginal propensity to save (MPS) The change in saving divided by the change in disposable income.

Income, Consumption, and Saving

Y

S

Y

C

Y

Y

or,

1 = MPC + MPS

MPS = 1 - MPC

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Solved Problem 11-2Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save

Y

CMPC

Y

SMPS

NATIONAL INCOME AND REAL GDP (Y)

CONSUMPTION(C)

SAVING(S)

MARGINAL PROPENSITY TO CONSUME (MPC)

MARGINAL PROPENSITY TO

SAVE (MPS)

$9,000 $8,000 1,000

— —

10,000 8,600 1,4000.6 0.4

11,000 9,200 1,8000.6 0.4

12,000 9,800 2,2000.6 0.4

13,000 10,400 2,6000.6 0.4

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Real Investment, 1979–2006

Determining the Level of Aggregate Expenditure in the Economy

Planned Investment (I)

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• Expectations of future profitability

Waves of optimism and pessimism

• Major technology changes: new products & processes

• The interest rate

• Taxes

• Cash flow

• Current capacity utilization

The most important variables that determine the level of investment:

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The “new” information economy of the 1990s

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Real Government Purchases, 1979–2006

Government Purchases (G)

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Real Net Exports, 1979–2006

Net Exports (NX)

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• The price level in the United States relative to the price levels in other countries

• The growth rate of GDP in the United States relative to the growth rates of GDP in other countries

• The exchange rate between the dollar and other currencies

Net Exports (NX)

The most important variables that determine the level of net exports:

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Learning Objective 11.3

FIGURE 11-8

The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Graphing Macroeconomic Equilibrium

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FIGURE 11-11

Showing a Recession on the 45°-Line Diagram

Showing a Recession on the 45°-Line Diagram

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Real GDP

(Y)

Consump tion(C)

Planned Invest ment

(I)

Govern ment

Purchases

(G)

Net Export

s(NX)

Planned Aggregate Expendi

ture(AE)

Unplan ned

Change in Invent

ories

Real GDP

Will …

$8,000 $6,200 $1,500 $1,500

– $500 $8,700 –$700 increase

9,000 6,850 1,500 1,500 –500 9,350 –350 increase

10000 7,500 1,500 1,500 –500 10,000 0

be in equili brium

11000 8,150 1,500 1,500 –500 10,650 +350 decrease

12000 8,800 1,500 1,500 –500 11,300 +700 decrease

Don’t Let This Happen to YOU!Don’t Confuse Aggregate Expenditure with Consumption Spending

Macroeconomic Equilibrium

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The Multiplier Effect

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The Multiplier Effect

Autonomous expenditure An expenditure that does not depend on the level of GDP.

Multiplier The increase in equilibrium real GDP in response to increase in autonomous expenditure, e.g.

Expenditure multiplier = ΔY/ΔI

Multiplier effect The process by which an increase in autonomous

expenditure leads to a larger increase in real GDP: ΔY = ΔI + ΔC

= Change in autonomous spending that sparks an expansion

+

Change in consumption spending induced by increasing output and income.

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The Multiplier Effect in Action

ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT)

ADDITIONAL INDUCED

EXPENDITURE(CONSUMPTION)

TOTAL ADDITIONAL EXPENDITURE =

TOTAL ADDITIONAL GDP

ROUND 1 $100 billion $0 $100 billion

ROUND 2 0 75 billion 175 billion




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n 0 0 $400 billion

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The Multiplier in Reverse: The Great Depression of the 1930s

Makingthe

Connection

The multiplier effect contributed to the very high levels of unemployment during the Great Depression.

Year Consumption Investment Net Exports Real GDP Unemployment Rate

1929 $661 billion $91.3 billion -$9.4illion $865 billion 3.2%

1933 $541 billion $17.0 billion -$10.2 billion $636 billion 24.9%

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The Multiplier EffectA Formula for the Multiplier

MPC1

1

MPC

1

1

eexpenditur autonomousin Change

GDP real mequilibriuin Change Multiplier

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Summarizing the Multiplier Effect

1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

3 The larger the MPC, the larger the value of the multiplier.

4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on taxes, imports, prices and interest rates.

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The Aggregate Demand Curve

The Effect of a Change in the Price Level on Real GDP

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Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure, holding constant all other factors that affect aggregate expenditure.

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Aggregate demand curve

Aggregate expenditure (AE)

Aggregate expenditure model

Autonomous expenditure

Cash flow

Consumption function

Inventories

K e y T e r m s

Marginal propensity to consume (MPC)

Marginal propensity to save (MPS)

Multiplier

Multiplier effect

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The Algebra of Macroeconomic Equilibrium

Appendix

)(YMPCCC

1I

GG

XNNX

NXGICY

1 Consumption function

2 Planned investment function

3 Government spending function

4 Net export function

5 Equilibrium condition

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Appendix

( )

1

1

Y C MPC(Y) I G NX

Y - MPC(Y) C I G NX

Y MPC C I G NX

C I G NXY

MPC

Or,

Or,

Or,

The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

C

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Appendix

Remember that is the multiplier. Therefore an alternative

expression for equilibrium GDP is:

1

1 MPC

Equilibrium GDP = Autonomous expenditure x Multiplier

Chapter 11: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1.

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