The Short

1
Chapter 23

• The Short Run Macro Model

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The Short-Run Macro Model

• In short-run, spending depends on income, and
  income depends on spending.
• The more income households have, the more they
  will spend.
• The more households spend, the more output firms
  will produce
• More income they will pay to their workers.
• 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.

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Review the Categories of Spending

• Macroeconomists have found that the most useful
  approach is to divide those who purchase the GDP
  into four broad categories
• Households --- consumption spending (C)
• Business firms --- planned investment spending
  (IP)
• Government agencies --- government purchases (G)
• Foreigners --- net exports (NX)
• Nominal or real spending?
• Real terms

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Consumption

• What factors affect households spending?
• Disposable income Yd ( Y T)
• Wealth ( total assets total liability)
• Price level
• Interest rate
• When interest rate falls, consumption rises
• Expectations about future

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Figure U.S. Consumption and Disposable Income,
1985-2002
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Figure The Consumption Function
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Consumption and Disposable Income

• Autonomous consumption spending
• Consumption spending when disposable income is
  zero
• Marginal propensity to consume, or MPC
• The slope of the consumption function
• MPC ? Consumption ? Disposable Income
• MPC measures by how much consumption spending
  rises when disposable income rises by one dollar
• Logic and empirical evidence suggest that the MPC
  should be larger than zero, but less than 1
• So, we assume that 0 lt MPC lt 1

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Representing Consumption with an Equation

• C a b?Yd
• Where C is consumption spending
• And a is the autonomous consumption spending
• And b is the marginal propensity to consume (MPC)
• Equation between consumption and total income
• Since Yd Y T,
• C a b?(Y T)
• So, C (a- b?T) b?Y

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Figure The Consumption-Income Line
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Shifts in the Consumption-Income Line

• 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.

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Figure A Shift in the Consumption-Income Line
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IP, G and NX

• For now, in the short-run macro model, planned
  investment spending, government purchases, and
  net exports are all treated as given or fixed
  values.

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Summing Up Aggregate Expenditure

• Aggregate expenditure (AE)
• 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
• AE 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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Finding Equilibrium GDP

• When aggregate expenditure is less than GDP,
  inventories will increase and output will decline
  in future.
• When aggregate expenditure is greater than GDP,
  inventories will decrease and output will rise in
  future.
• In short-run, equilibrium GDP is level of output
  at which output and aggregate expenditure are
  equal.

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Inventories and Equilibrium GDP

• When firms produce more goods than they sell,
  what happens to unsold output?
• Added to their inventory stocks
• 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 the one at which
  change in inventories equals zero.

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Figure Deriving the Aggregate Expenditure Line
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Figure Using a 45 to Translate Distances
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Figure Determining Equilibrium Real GDP
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Equilibrium GDP and Employment

• When economy operates at equilibrium, will it
  also be operating at full employment?
• Not necessarily
• For instance, insufficient spending causes
  business firms to decrease their demand for
  labor.
• Remember, in the long run (classical) macro
  model, it takes time for labor market to achieve
  full employment.
• In the short-run model, it would be quite a
  coincidence if our equilibrium GDP happened to be
  the full employment output level.
• In short-run macro model, output can be lower or
  higher than the full employment output level.

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Figure Short-Run Equilibrium GDP lt Full
Employment GDP
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Figure Short-Run Equilibrium GDP gt
Full-Employment GDP
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A Change in Investment Spending

• Suppose the initial equilibrium GDP in an economy
  is 6,000 billion.
• Now, business firms increase their investment
  spending on plant and equipment by 1,000
  billion.
• Then, firms that sell investment goods receive
  1,000 billion as income, which is to be
  distributed as salary, rent, interest, and
  profit.
• What will households do with their 1,000 billion
  in additional income?
• Spend the money !
• How much to spend depends crucially on marginal
  propensity to consume (MPC) lets assume MPC
  0.6

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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. At this point,
  total income has increased by 1,0006001,600bi
  llion
• With an MPC of 0.6, consumption spending will
  further rise by 0.6 x 600 billion 360
  billion, creating still more sales revenue for
  firms, and so on and so on
• At end of process, when economy has reached its
  new equilibrium.
• Total spending and total output are considerably
  higher.

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Figure The Effect of a Change in Investment
Spending
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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
• Value of expenditure multiplier depends on value
  of MPC
• So, when the increase in planned investment
  spending is
• ?IP, the increase in total income (GDP) is
  calculated as

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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.

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Spending Shocks

• Shocks to economy can come from other sources
  besides investment spending.
• Government purchases (G)
• Net exports (NX)
• Autonomous consumption (a)
• Changes in planned investment, government
  purchases, net exports, or autonomous consumption
  lead to a multiplier effect on GDP.

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Spending Shocks

• The effect of a change in spending on total
  income through expenditure multiplier

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Figure A Graphical View of the Multiplier
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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

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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.

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The Effect of Fiscal Policy

• In classical model fiscal policychanges in
  government spending or taxes designed to change
  equilibrium GDPis completely ineffective
  crowding out effect.
• 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.