Macroeconomics Chapter 11

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MacroeconomicsChapter 11

• Income Expenditures Equilibrium

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Macroeconomic Equilibrium

• Macroeconomics uses many different models to
  analyze the sources of business cycles.
• The primary theme for all these models is
  macroeconomic equilibrium.
• Equilibrium means what it did when we talked
  about supply demand in Ch 3 a point of balance
  with no tendency to move.

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Macroeconomic Equilibrium

• In macroeconomics, equilibrium is the level of
  income expenditures that the whole economy
  moves towards (and remains at) until autonomous
  spending changes.

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Keynes Viewpoint

• Not all economists agree on how an economy
  reaches equilibrium.
• Prior to the Great Depression, economists
  believed an economy was always moving toward an
  equilibrium consistent with a high level of
  employed resources.
• Keynes did not believe this. Rather, he 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 argued when this
  occurred, the government should intervene by
  pumping money back into the economy to stimulate
  income output.
• The Keynesian model provides the foundation for
  the analysis in this chapter.

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How to Determine Equilibrium

• We will discuss two methods to find equilibrium
  in the economy
• Aggregate Expenditures Real GDP
• Leakages and Injections

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How do Aggregate Expenditures Affect Income, or
Real GDP?

• The AE function discussed in Ch 10 represents the
  planned expenditures at different levels of
  income, or real GDP.
• In reality, AE (planned spending) may not equal
  real GDP (real GDP must rise or fall to reach
  equilibrium).
• When AE exceed real GDP, real GDP rises.
• When AE are less than real GDP, real GDP falls.

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When AE 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?

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When AE Exceed Real GDP, Real GDP Rises

• 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 exceed real GDP, real GDP rises.

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When AE Exceed Real GDP, Real GDP Rises
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When AE Exceed Real GDP, Real GDP Rises
When AE exceed real GDP, real GDP will rise in
order to reach the equilibrium point.
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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.

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When AE is less than Real GDP, Real GDP Falls
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When AE is less than Real GDP, Real GDP Falls
When AE is less than real GDP, real GDP fall in
order to reach the equilibrium pint.
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Equilibrium

• The equilibrium level of real GDP is where AE
  Real GDP.
• This is the point on the graph where the 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.

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Leakages Injections

• Another way to determine equilibrium involves
  leakages and injections into the income flow
  (circular flow of income expenditures).
• Leakages and injections increase or reduce
  autonomous aggregate expenditures.
• Recap What are autonomous AE?

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Leakages

• 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.

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Injections

• 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.

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Equilibrium Page 253

• The equilibrium level of real GDP occurs where
  total leakages equal total injections
  (intersection).

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Equilibrium

• Equilibrium occurs at the level of real GDP
  where
• AE real GDP
• Leakages injections
• Both methods give you the same level of
  equilibrium in the economy.

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Changes in Equilibrium Income 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.

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The Spending Multiplier

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

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Example

• Lets say the govt. increases spending by 100
  million to boost national defense.
• This increase in govt. spending will boost the
  income of national defense employees by 100
  million.
• As the income of national defense employees
  increases, so does their consumption.
• Their increased consumption generates another
  round of changes and continues to multiply.

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Examplewhere MPC .60, MPS .30, MPI .10

• Consumption changes by the MPC x change in
  income.
• Imports change by the MPI x change in income.

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The Spending Multiplier

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

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Example - Continued

• Rather than computing the rounds of changes in
  income generated by a change in autonomous
  expenditures, we can use the spending multiplier
• Multiplier 1/MPS MPI
• 1/.30 .10
• 1/.40
• 2.5
• So a change in expenditures of 100 million will
  result in a total change in real GDP of 250
  million, 2.5 times the original change in
  expenditures.

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The Spending Multiplier in Reality

• In reality, the spending multiplier is
  oversimplified.
• Often, factors other than MPS MPI in the
  economy will affect the multiplier effect.
• Factors include
• Price changes
• Taxes
• Foreign repercussions

Both of these factors cause the spending
multiplier to be overstated
Cause the spending multiplier to be understated
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AE Aggregate Demand

• This chapter focused on the Keynesian model
  (approach to macroeconomic equilibrium focused on
  AE income).
• The problem with this model is that it is a
  fixed-price model (the supply of goods services
  will always adjust to AE).
• In reality, prices as well as production adjust
  to the differences between supply demand.

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AE Changes in Price Levels

• We know that the aggregate expenditures curve
  will shift when the price level changes because
  of the wealth effect, interest rate effect, the
  international trade effect (Ch 9).
• The changing price levels which shift the AE
  curve will allow us to derive our aggregate
  demand curve.

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• If the price level rises from P0 to P2 , this
  causes the AE curve to shift downward, thus, real
  GDP falls from 500 to 300 (remember, if price
  levels rise, this causes the purchasing power of
  our money to fall wealth effect so we will
  spend less).
• If the price level falls from P0 to P1, this will
  cause the AE curve to shift upward, thus, real
  GDP rises from 500 to 700 (when the price levels
  fall, the purchasing power of our money
  increases, so we will spend more).
• We connect our points for AD to derive our AD
  curve.
• This illustrates how changing prices can effect
  AE.