MODULE 26 (62) The Income-Expenditure Model

What You Will Learn 1 How planned aggregate spending determines income-expenditure equilibrium How the inventory adjustment process moves the economy to a new equilibrium after a change in planned aggregate spending 2

The Income-Expenditure Model Recall Changes in overall spending lead to changes in aggregate output The interest rate is fixed Taxes, government transfers, and government purchases are all zero Exports and imports are zero

The Income-Expenditure Model With no government and no foreign trade, there are two sources of spending, consumption and investment Two basic equations of national income accounting:

The Income-Expenditure Model Recall, the aggregate consumption function shows the relationship between disposable income and consumer spending

The Income-Expenditure Model Assume planned investment spending, Iplanned, is fixed Planned aggregate spending is the total amount of planned spending in the economy

The Income-Expenditure Model The level of planned aggregate spending in a given year depends on the level of real GDP in that year

The Income-Expenditure Model Figure Caption: Figure 26-1 (62-1): The Aggregate Consumption Function and Planned Aggregate Spending: The lower line, CF, is the aggregate consumption function constructed from the data in Table 62-1. The upper line, AEPlanned, is the planned aggregate spending line, also constructed from the data in Table 62-1. It is equivalent to the aggregate consumption function shifted up by $500 billion, the amount of planned investment spending, IPlanned.

The Income-Expenditure Model Real GDP equals AEPlanned at only one point in the table Planned aggregate spending can be different that real GDP only if there is unplanned inventory investment in the economy, Iunplanned

The Income-Expenditure Model

The Income-Expenditure Model If producers experience an unintended rise in inventories, they will reduce production If producers experience an unintended decrease in inventories, they will increase production These changes will eliminate the unanticipated changes in inventories and move the economy to the point where real GDP equals planned aggregate spending

The Income-Expenditure Model The only situation in which firms do not have the incentive to change output is when aggregate output, measured by real GDP, is equal to planned aggregate expenditure, or income-expenditure equilibrium The real GDP level at which income-expenditure equilibrium is called the income-expenditure equilibrium GDP, denoted Y*

The Income-Expenditure Equilibrium Figure Caption: Figure 26-2 (62-2): Income-Expenditure Equilibrium: Income–expenditure equilibrium occurs at E, the point where the planned aggregate spending line, AEPlanned, crosses the 45-degree line. At E, the economy produces real GDP of $2,000 billion per year, the only point at which real GDP equals planned aggregate spending, AEPlanned, and unplanned inventory investment, IUnplanned, is zero. This is the level of income–expenditure equilibrium GDP, Y*. At any level of real GDP less than Y*, AEPlanned exceeds real GDP. As a result, unplanned inventory investment, IUnplanned, is negative and firms respond by increasing production. At any level of real GDP greater than Y*, real GDP exceeds AEPlanned. Unplanned inventory investment, IUnplanned, is positive and firms respond by reducing production.

The Multiplier Process and Inventory Adjustment What happens when there is a shift of the planned aggregate spending line? Either IPlanned or the aggregate consumption function shifts

The Multiplier Process and Inventory Adjustment

The Multiplier Process and Inventory Adjustment Figure Caption: Figure 26-3 (62-3): The Multiplier: This figure illustrates the change in Y* caused by an autonomous increase in planned aggregate spending. The economy is initially at equilibrium point E1 with an income–expenditure equilibrium GDP, Y 1 * , equal to 2,000. An autonomous increase in AEPlanned of 400 shifts the planned aggregate spending line upward by 400. The economy is no longer in income–expenditure equilibrium: real GDP is equal to 2,000 but AEPlanned is now 2,400, represented by point X. The vertical distance between the two planned aggregate spending lines, equal to 400, represents IUnplanned =-400— the negative inventory investment that the economy now experiences. Firms respond by increasing production, and the economy eventually reaches a new income–expenditure equilibrium at E2 with a higher level of income–expenditure equilibrium GDP, Y 2* , equal to 3,000.

The Multiplier Process and Inventory Adjustment The process can be summarized:

The Paradox of Thrift In the paradox of thrift, households and firms cut their spending in anticipation of difficult economic times These actions depress the economy, leaving families worse off then if they hadn’t prepared

Economics in Action In 2001, an increase in consumer spending contributed to the end of that year’s recession The increase in consumer spending took manufacturers by surprise

Economics in Action Inventories and the End of a Recession

Summary In an economy with no foreign trade and no government, planned expenditures equals the sum of consumption spending and planned investment spending. Equilibrium GDP occurs when output in the economy is equal to consumption spending plus planned investment spending.

Summary If producers see that inventories are higher than planned, they will reduce production If producers see that inventories are lower than planned, they will increase production These two reactions result in income-expenditures equilibrium GDP If expenditures change, producers will see inventories change and the system will move back to equilibrium