The ShortRun Macro Model

1

• Chapter 10
• The Short-Run Macro Model

2
The Short-Run Macro Model

• Spending is very important in short-run
• Spending depends on income
• Income depends on Spending
• In short-run, spending depends on income, and
  income depends on spending
• Many ideas behind the model were originally
  developed by British economist John Maynard
  Keynes in 1930s
• Short-run macro model focuses on spending in
  explaining economic fluctuations
• Causing changes in total output and employment

3
Thinking About Spending

• Spending on what?
• - Households, whose spending is called
  consumption spending (C)
• Business firms, whose spending is called planned
  investment spending (IP)
• Government agencies, whose spending on goods and
  services is called government purchases (G)
• Foreigners, whose spending we measure as net
  exports (NX)

4
Consumption Spending

• Natural place for us to begin our look at
  spending is with its largest component
• Consumption spending
• Total consumption spending is sum of spending by
  over a hundred million U.S. households
• What determines total amount of consumption
  spending?

5
Disposable Income

• First thing that comes to mind is your income
• The more you earn, the more you spend
• Its not exactly your income per period that
  determines your spending
• But rather what you get to keep from that income
  after deducting any taxes you have to pay
• If we start with income you earn, deduct all tax
  payments, and then add in any transfer received,
  would get your disposable income
• Income you are free to spend or save as you wish
• Disposable Income Income Tax Payments
  Transfers Received
• Can be rewritten as
• Disposable Income Income (Taxes Transfers)
  or
• Disposable Income Income Net Taxes
• For almost any household, a rise in disposable
  incomewith no other changecauses a rise in
  consumption spending

6
Wealth

• Given your disposable income, how much of it will
  you spend and how much will you save?
• Will depend, in part, on your wealth
• Total value of your assets minus your outstanding
  liabilities
• In general, a rise in wealthwith no other
  changecauses a rise in consumption spending

7
The Interest Rate

• Interest rate is reward people get for saving, or
  what they have to pay when they borrow
• All else equal, a rise in interest rate causes a
  decrease in consumption spending
• Relationship between interest rate and
  consumption spending applies even for people who
  arent savers in the common sense of term
• Whether you are earning interest on funds youve
  saved, or paying interest on funds youve
  borrowed
• The higher the interest rate, the lower is
  consumption spending
• In macroeconomics, household saving is the part
  of disposable income that a household doesnt
  spend
• Whether its put in bank or used to pay off a loan

8
Expectations

• Expectations about future would affect your
  spending as well
• All else equal, optimism about future income
  causes an increase in consumption spending
• Other variables influence your consumption
  spending
• Including inheritances you expect to receive over
  your lifetime, and even how long you expect to
  live
• Disposable income, wealth, and interest rate are
  the three key variables
• In macroeconomics, we use phrases like
  disposable income, wealth, or consumption
  spending to mean the total disposable income,
  total wealth, and total consumption spending of
  all households in the economy combined
• All else equal, consumption spending increases
  when
• Disposable income rises
• Wealth rises
• Interest rate falls

9
Figure 1 U.S. Consumption and Disposable
Income, 1985-2002
10
Consumption and Disposable Income

• Of all the factors that influence consumption
  spending, most important and stable determinant
  is disposable income
• Relationship between consumption and disposable
  income is almost perfectly linearpoints lie
  remarkably close to a straight line
• This almost-linear relationship between
  consumption and disposable income has been
  observed in a wide variety of historical periods
  and a wide variety of nations
• Vertical intercept in Figure 2 is called
• Autonomous consumption spending
• Part of consumption spending that is independent
  of income

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Figure 2 The Consumption Function
Consumption Function
600
1,000
12
Consumption and Disposable Income

• Second important feature of Figure 2 is the slope
• Shows change along vertical axis divided by
  change along horizontal axis as we go from one
  point to another on the line
• Slope ? Consumption Disposable Income
• Economists have given this slope a special name
• Marginal propensity to consume, or MPC
• Can think of MPC in three different ways, but
  each of them has the same meaning
• Slope of consumption function
• Change in consumption divided by change in
  disposable income
• Amount by which consumption spending rises when
  disposable income rises by one dollar
• Logic suggests that the MPC should be larger than
  zero, but less than 1
• We will always assume that 0 lt MPC lt 1

13
Representing Consumption with an Equation

• Sometimes, well want to use an equation to
  represent straight-line consumption function
• C a b x (Disposable Income)
• Where C is consumption spending
• Term a is vertical intercept of consumption
  function
• Represents theoretical level of consumption
  spending at disposable income 0, or autonomous
  consumption spending
• Term b is slope of consumption function
• Marginal propensity to consume (MPC)

14
Consumption and Income

• Consumption function is an important building
  block
• Consumption is largest component of spending, and
  disposable income is most important determinant
  of consumption
• If government collected no taxes, total income
  and disposable income would be equal
• So that relationship between consumption and
  income on the one hand, and consumption and
  disposable income on the other hand, would be
  identical
• Consumption-income line
• Line showing aggregate consumption spending at
  each level of income or GDP
• When government collects a fixed amount of taxes
  from household
• Line representing relationship between
  consumption and income is shifted downward by
  amount of tax times marginal propensity to
  consume (MPC)
• Slope of this line is unaffected by taxes and is
  equal to MPC

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Figure 3 The Consumption-Income Line
Consumption-Income Line
B
A
600
1,000
16
Shifts in the Consumption-Income Line

• Can summarize our discussion of changes in
  consumption spending as follows
• When a change in income causes consumption
  spending to change, we move along
  consumption-income line
• When a change in anything else besides income
  causes consumption spending to change, the line
  will shift
• All changes that shift the lineother than a
  change in taxeswork by increasing or decreasing
  autonomous consumption (a)

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Figure 4 A Shift in the Consumption-Income Line
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Table 3 Changes in ConsumptionSpending and the
ConsumptionIncome Line
19
Investment Spending

• In definition of GDP, word investment by itself
  (represented by the letter I by itself)
  consists of three components
• Business spending on plant and equipment
• Purchases of new homes
• Accumulation of unsold inventories
• In short-run macro model, we define (planned)
  investment spending (IP) as
• Plant and equipment purchases by business firms,
  and new home construction
• Inventory investment is treated as unintentional
  and undesired
• Excluded from definition of investment spending
• For now, we regard investment spending (IP) as a
  given value, determined by forces outside of our
  model

20
Government Purchases

• Include all goods and services that government
  agenciesfederal, state, and localbuy during
  year
• In short-run macro model, government purchases
  are treated as a given value
• Determined by forces outside of model

21
Net Exports

• If we want to measure total spending on U.S.
  output, we must also consider international
  sector
• U.S. exports
• But international trade in goods and services
  also requires us to make an adjustment to other
  components of spending
• In sum, to incorporate international sector into
  our measure of total spending, we must add U.S.
  exports, and subtract U.S. imports
• Net Exports Total Exports Total Imports

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Summing Up Aggregate Expenditure

• Aggregate expenditure
• Sum of spending by households, businesses,
  government, and foreign sector on final goods and
  services produced in United States
• Aggregate expenditure C IP G NX
• C stands for household consumption spending, IP
  for investment spending, G for government
  purchase, and NX for net exports
• Plays a key role in explaining economic
  fluctuations
• Why?
• Because over several quarters or even a few
  years, business firms tend to respond to changes
  in aggregate expenditure by changing their level
  of output

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Income and Aggregate Expenditure

• Relationship between income and spending is
  circular
• Spending depends on income, and income depends on
  spending
• We take up the first part of that circle
• How total spending depends on income
• Notice that aggregate expenditure increases as
  income rises
• But notice also that rise in aggregate
  expenditure is smaller than rise in income
• When income increases, aggregate expenditure (AE)
  will rise by MPC times change in income
• ?AE MPC x ? GDP
• Weve used ?GDP to indicate change in total
  income
• Because GDP and total income are always the same
  number

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Finding Equilibrium GDP

• When aggregate expenditure is less than GDP,
  output will decline in future
• Any level of output at which aggregate
  expenditure is less than GDP cannot be
  equilibrium GDP
• When aggregate expenditure is greater than GDP,
  output will rise in future
• Any level of output at which aggregate
  expenditure exceeds GDP cannot be equilibrium GDP
• In short-run, equilibrium GDP is level of output
  at which output and aggregate expenditure are
  equal

25
Inventories and Equilibrium GDP

• When firms produce more goods than they sell,
  what happens to unsold output?
• Added to their inventory stocks
• Change in inventories during any period will
  always equal output minus aggregate expenditure
• Find output level at which change in inventories
  is equal to zero
• AE lt GDP ? ?Inventories gt 0 ? GDP? in future
  periods
• AE gt GDP ? ?Inventories lt 0 ? GDP? in future
  periods
• AE GDP ? ?Inventories 0 ? No change in GDP
• Equilibrium output level is one at which change
  in inventories equals zero

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Finding Equilibrium GDP With A Graph

• Figure 5 gives an even clearer picture of how
  equilibrium GDP is determined
• Lowest line, C, is consumption-income line
• Next line, labeled C IP, shows sum of
  consumption and investment spending at each
  income level
• Next line adds government purchases to
  consumption and investment spending, giving us C
  IP G
• Top line adds net exports, giving us C IP G
  NX, or aggregate expenditure

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Figure 5 Deriving the Aggregate Expenditure Line
C IP G NX
C IP G
C IP
C
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Finding Equilibrium GDP With A Graph

• Figure 6 shows a graph in which horizontal and
  vertical axes are both measured in same units,
  such as dollars
• Also shows a line drawn at a 45 angle that
  begins at origin
• 45 line is a translator line
• Allows us to measure any horizontal distance as a
  vertical distance instead
• Now we can apply this geometric trick to help us
  find the equilibrium GDP

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Finding Equilibrium GDP With A Graph

• Figure 7 shows how we can apply geometric trick
  to help us find equilibrium GDP
• At any output level at which aggregate
  expenditure line lies below 45 line, aggregate
  expenditure is less than GDP
• If firms produce any of these out put levels,
  inventories will grow, and they will reduce
  output in the future
• At any output level at which aggregate
  expenditure line lies above 45 line, aggregate
  expenditure exceeds GDP
• If firms produce any of these output levels,
  inventories will decline, and they will increase
  their output in the future
• We have thus found our equilibrium on graph
• Equilibrium GDP is output level at which
  aggregate expenditure line intersects 45 line
• If firms produce this output level, their
  inventories will not change, and they will be
  content to continue producing same level of
  output in the future

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Figure 7 Determining Equilibrium Real GDP
A
C IP G NX
H
E
K
Total Output
Aggregate Expenditure
J
Aggregate Expenditure
Total Output
45
31
Equilibrium GDP and Employment

• When economy operates at equilibrium, will it
  also be operating at full employment?
• Not necessarily
• It would be quite a coincidence if our
  equilibrium GDP happened to be output level at
  which entire labor force were employed
• In short-run macro model, cyclical unemployment
  is caused by insufficient spending
• As long as spending remains low, production will
  remain low, and unemployment will remain high
• In short-run macro model, economy can overheat
  because spending is too high
• As long as spending remains high, production will
  exceed potential output, and unemployment will be
  unusually low
• Aggregate expenditure line may be low, meaning
  that in short-run, equilibrium GDP is below full
  employment
• Or aggregate expenditure may be high, meaning
  that in short-run, equilibrium GDP is above
  full-employment level

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Figure 8 Equilibrium GDP Can Be Less Than Full
Employment GDP
Aggregate Production Function
AELOW
B
F
7,000
7,000
E
cyclical unemployment 25 million
6,000
A
45
7,000
100 Million
6,000
75 Million
Full Employment
Potential GDP
33
Figure 9 Equilibrium GDP Can Be Greater Than
Full-Employment GDP
AEHIGH
Aggregate Production Function
E'
H
8,000
B
7,000
7,000
F
7,000
7,000
100 Million
8,000
135 Million
Potential GDP
Full Employment
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A Change in Investment Spending

• Suppose equilibrium GDP in an economy is 6,000
  billion, and then business firms increase their
  investment spending on plant and equipment
• What will happen?
• Sales revenue at firms that manufacture
  investment goods will increase by 1,000 billion
• What will households do with their 1,000 billion
  in additional income?
• What they will do depends crucially on marginal
  propensity to consume (MPC)
• Assume MPC 0.6

35
A Change in Investment Spending

• When households spend an additional 600 billion,
  firms that produce consumption goods and services
  will receive an additional 600 billion in sales
  revenue
• Which will become income for households that
  supply resources to these firms
• With an MPC of 0.6, consumption spending will
  rise by 0.6 x 600 billion 360 billion,
  creating still more sales revenue for firms, and
  so on and so on
• Increase in investment spending will set off a
  chain reaction
• Leading to successive rounds of increased
  spending and income
• At end of process, when economy has reached its
  new equilibrium
• Total spending and total output are considerably
  higher

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Figure 10 The Effect of a Change in Investment
Spending
2,500
2,306
2,176
1,960
1,600
1,000
Initial Rise in IP
After Round 2
After Round 3
After Round 4
After Round 5
After All Rounds
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The Expenditure Multiplier

• Whatever the rise in investment spending,
  equilibrium GDP would increase by a factor of
  2.5, so we can write
• ?GDP 2.5 x ?IP
• Expenditure multiplier is number by which the
  change in investment spending must be multiplied
  to get change in equilibrium GDP
• Value of expenditure multiplier depends on value
  of MPC
• Simple formula we can use to determine multiplier
  for any value of MPC
• 1 (1 MPC)
• Using general formula for expenditure multiplier,
  can restate what happens when investment spending
  increases

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The Expenditure Multiplier

• A sustained increase in investment spending will
  cause a sustained increase in GDP
• Multiplier process works in both directions
• Just as increases in investment spending cause
  equilibrium GDP to rise by a multiple of the
  change in spending
• Decreases in investment spending cause
  equilibrium GDP to fall by a multiple of the
  change in spending

39
Other Spending Shocks

• Shocks to economy can come from other sources
  besides investment spending
• Suppose government agencies increased their
  purchases above previous levels
• Besides planned investment and government
  purchases, there are two other components of
  spending that can set off the same process
• An increase in net exports (NX)
• A change in autonomous consumption
• Changes in planned investment, government
  purchases, net exports, or autonomous consumption
  lead to a multiplier effect on GDP
• Expenditure multiplier is what we multiply
  initial change in spending by in order to get
  change in equilibrium GDP

40
Other Spending Shocks

• Following four equations summarize how we use
  expenditure multiplier to determine effects of
  different spending shocks in short-run macro model

41
A Graphical View of the Multiplier

• Figure 11 illustrates multiplier using aggregate
  expenditure diagram

• An increase in autonomous consumption spending,
  investment spending, government purchases, or net
  exports will shift aggregate expenditure line
  upward by increase in spending
• Causing equilibrium GDP to rise
• Increase in GDP will equal initial increase in
  spending times expenditure multiplier

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Figure 11 A Graphical View of the Multiplier
AE2
F
AE1
E
1,000
Increase in Equilibrium GDP
2,500 Billion
45
43
Automatic Stabilizers and the Multiplier

• Automatic stabilizers reduce size of multiplier
  and therefore reduce impact of spending shocks
• With milder fluctuations, economy is more stable
• Some real-world automatic stabilizers weve
  ignored in the simple, short-run macro model of
  this chapter
• Taxes
• Transfer payments
• Interest rates
• Imports
• Forward-looking behavior
• Each of these automatic stabilizers reduces size
  of multiplier
• Making it smaller than simple formulas given in
  this chapter

44
Automatic Stabilizers and the Multiplier

• In real world, due to automatic stabilizers,
  spending shocks have much weaker impacts on
  economy than our simple multiplier formulas would
  suggest
• One more automatic stabilizerperhaps the most
  important of all
• Passage of time
• In long-run, multipliers have a value of zero
• No matter what the change in spending or taxes,
  output will return to full employment, so change
  in equilibrium GDP will be zero

45
The Role of Saving

• In long-run, saving has positive effects on
  economy
• But in short-run, automatic mechanisms of
  classical model do not keep economy operating at
  its potential
• In long-run, an increase in desire to save leads
  to faster economic growth and rising living
  standards
• In short-run, however, it can cause a recession
  that pushes output below its potential
• Two sides to the saving coin
• Impact of increased saving is positive in
  long-run and potentially dangerous in short-run

46
The Effect of Fiscal Policy

• In classical model fiscal policychanges in
  government spending or taxes designed to change
  equilibrium GDPis completely ineffective
• In short-run, an increase in government purchases
  causes a multiplied increase in equilibrium GDP
• Therefore, in short-run, fiscal policy can
  actually change equilibrium GDP
• Observation suggests that fiscal policy could, in
  principle, play a role in altering path of
  economy
• Indeed, in 1960s and early 1970s, this was the
  thinking of many economists
• But very few economists believe this today