1 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run

2 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run CHAPTER 12 Aggregate Expenditure and Output in the Short Run Because of its dependence on computer sales, Intel is vulnerable to the swings of the business cycle. Fernando Quijano Prepared by:

3 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run 12.1 The Aggregate Expenditure Model Understand how macroeconomic equilibrium is determined in the aggregate expenditure model Determining the Level of Aggregate Expenditure in the Economy Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and marginal propensity to save The Multiplier Effect Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. APPENDIX :The Algebra of Macroeconomic Equilibrium Apply the algebra of macroeconomic equilibrium. CHAPTER 12 Chapter Outline and Learning Objectives Aggregate Expenditure and Output in the Short Run

4 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Aggregate expenditure model A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. Aggregate Expenditure Consumption (C) Planned investment (I) Government purchases (G) Net exports (NX) Understand how macroeconomic equilibrium s determined in the aggregate expenditure model LEARNING OBJECTIVE

5 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports Aggregate Expenditure or: AE = C + I + G + NX Understand how macroeconomic equilibrium s determined in the aggregate expenditure model LEARNING OBJECTIVE

6 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Consumption FIGURE 12-1 Real Consumption Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Consumption follows a smooth, upward trend, interrupted only infrequently by brief recessions.

7 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Current disposable income Household wealth Expected future income The price level The interest rate Consumption The following are the five most important variables that determine the level of consumption: Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

8 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy The most important determinant of consumption is the current disposable income of households. Consumption Current Disposable Income Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

9 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run FIGURE 12-2 The Relationship between Consumption and Income, 1960– 2008 Determining the Level of Aggregate Expenditure in the Economy Consumption The Consumption Function Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Panel (a) shows the relationship between consumption and income. The points represent combinations of real consumption spending and real disposable income for the years between 1960 and In panel (b), we draw a straight line through the points from panel (a). The line, which represents the relationship between consumption and disposable income, is called the consumption function. The slope of the consumption function is the marginal propensity to consume.

10 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Consumption function The relationship between consumption spending and disposable income. Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes. Determining the Level of Aggregate Expenditure in the Economy Consumption Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE See Example in Class.

11 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run 11 of 61 © 2013 Pearson Education, Inc. Publishing as Prentice Hall National income = GDP = Disposable income + Net taxes Consumption and national income The distinction between national income and GDP is relatively minor; for this simple model, we will assume they are equal, and use the terms interchangeably. Since: where “net taxes” are equal to taxes minus transfer payments, we rearrange the terms to write: Disposable income = National income − Net taxes By definition, disposable income not spent is saved. Therefore we can write: National income = Consumption + Saving + Taxes Y = C + S + T

12 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run 12 of 61 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Now divide through by ∆Y: ∆S/ ∆Y is the amount by which savings changes, when (disposable) income changes. This is known as the marginal propensity to save. We can rewrite the equation above as: That is, the marginal propensity to consume plus the marginal propensity to save must equal 1. This is because part of any increase in income is consumed, and the rest is saved. 1 = MPC + MPS Any change in national income can be decomposed into changes in the items on the right hand side: ∆ Y = ∆ C + ∆ S + ∆ T We assume net taxes do not change, so ∆T = 0; then: ∆Y = ∆C + ∆S

13 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE What is the Marginal Propensity to Consume? What is the Marginal Propensity to Save?

14 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy The most important determinant of consumption is the current disposable income of households. Consumption Current Disposable Income Household Wealth Consumption depends in part on the wealth of households. A household’s wealth is the value of its assets minus the value of its liabilities. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

15 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Do Changes in Housing Wealth Affect Consumption Spending? Making the Connection Many macroeconomic variables, such as GDP, housing prices, consumption spending, and investment spending, rise and fall at about the same time during the business cycle YOUR TURN: Test your understanding by doing related problem 4.9 at the end of this chapter. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

16 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Consumption depends in part on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly. Consumption Expected Future Income The Price Level The price level measures the average prices of goods and services in the economy. Consumption is affected by changes in the price level. The Interest Rate When the interest rate is high, the reward for saving is increased, and households are likely to save more and spend less. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

17 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run FIGURE 12-4 Real Investment Determining the Level of Aggregate Expenditure in the Economy Planned Investment Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Investment is subject to larger changes than is consumption. Investment declined significantly during the recessions of 1980, 1981–1982, 1990–1991, 2001, and 2007–2009.

18 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Expectations of future profitability Interest rate Taxes Cash flow Determining the Level of Aggregate Expenditure in the Economy Planned Investment The four most important variables that determine the level of investment are: Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

19 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Expectations of Future Profitability The optimism or pessimism of firms is an important determinant of investment spending. Interest Rate A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. Determining the Level of Aggregate Expenditure in the Economy Planned Investment Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

20 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Planned Investment Taxes Firms focus on the profits that remain after they have paid taxes. Cash Flow Cash flow The difference between the cash revenues received by a firm and the cash spending by the firm. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE

21 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Intel Tries to Jump Off the Roller Coaster of Information Technology Spending Making the Connection YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Purchases of information processing equipment and software declined 8 percent during the 2001 recession and 12 percent during the 2007–2009 recession.

22 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run FIGURE 12-5 Real Government Purchases Determining the Level of Aggregate Expenditure in the Economy Government Purchases Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Government purchases grew steadily for most of the 1979–2009 period, with the exception of the early 1990s, when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992.

23 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run FIGURE 12-6 Real Net Exports Determining the Level of Aggregate Expenditure in the Economy Net Exports Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE Net exports were negative in most years between 1979 and Net exports have usually increased when the U.S. economy is in recession and decreased when the U.S. economy is expanding, although they fell during most of the 2001 recession.

24 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Net Exports The Price Level in the United States Relative to the Price Levels in Other Countries If inflation in the United States is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries. The Growth Rate of GDP in the United States Relative to the Growth Rates of GDP in Other Countries When incomes in the United States rise more slowly than incomes in other countries, net exports will rise. The Exchange Rate Between the Dollar and Other Currencies As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other countries rises, and the dollar price of foreign products sold in the United States falls. Learning Objective 12.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save LEARNING OBJECTIVE The following are the three most important variables that determine the level of net exports:

25 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Inventories Goods that have been produced but not yet sold. The Difference between Planned Investment and Actual Investment Aggregate expenditure = GDP Macroeconomic Equilibrium Understand how macroeconomic equilibrium s determined in the aggregate expenditure model LEARNING OBJECTIVE Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government purchases (G) + Net exports (NX) See Example in Class.

26 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run A Numerical Example of Macroeconomic Equilibrium REAL GDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) PLANNED AGGREGATE EXPENDITURE (AE) UNPLANNED CHANGE IN INVENTORIES REAL GDP WILL … $8,000$6,200$1,500 – $500 9,0006,8501,500 –500 10,0007,5001,500 –500 11,0008,1501,500 –500 12,0008,8001,500 –500 Don’t Let This Happen to YOU! Don’t Confuse Aggregate Expenditure with Consumption Spending Table 12-3 YOUR TURN: Test your understanding by doing related problem 3.10 at the end of this chapter LEARNING OBJECTIVE Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE) Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government purchases (G) + Net exports (NX)

27 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Adjustments to Macroeconomic Equilibrium IF …THEN …AND … Aggregate expenditure is equal to GDP inventories are unchanged the economy is in macroeconomic equilibrium. Aggregate expenditure is less than GDPinventories rise GDP and employment decrease. Aggregate expenditure is greater than GDPinventories fall GDP and employment increase. Table 12-1 The Relationship between Aggregate Expenditure and GDP Understand how macroeconomic equilibrium s determined in the aggregate expenditure model LEARNING OBJECTIVE

28 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier Effect Autonomous expenditure An expenditure that does not depend on the level of GDP. Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

29 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier Effect Table 12-4 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 2075 billion 175 billion ROUND 3056 billion 231 billion ROUND 4042 billion 273 billion ROUND 5032 billion 305 billion ROUND 1008 billion 377 billion ROUND 1502 billion 395 billion ROUND 1901 billion 398 billion n00$400 billion Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

30 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier in Reverse: The Great Depression of the 1930s YEARCONSUMPTIONINVESTMENTNET EXPORTSREAL GDPUNEMPLOYMENT RATE 1929$737 billion$102 billion-$11 billion$977 billion3.2% 1933$601 billion$19 billion-$12 billion$716 billion24.9% Making the Connection The multiplier effect contributed to the very high levels of unemployment during the Great Depression. YOUR TURN: Test your understanding by doing related problem 4.9 at the end of this chapter. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

31 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier Effect A Formula for the Multiplier Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

32 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier Effect 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 increases in GDP have on imports, inflation, interest rates, and individual income taxes. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

33 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run Solved Problem 12-3 Determining Macroeconomic Equilibrium Real GDP (Y) Consumption (C) Planned Investment (I) Government Purchases (G) Net Exports (NX) Planned Aggregate Expenditure (AE) Unplanned Change in Inventories $8,000$6,200$1,850$1,500$–500 9,0006,8501,8501,500–500 10,0007,5001,8501,500–500 11,0008,1501,8501,500–500 12,0008,8001,8501,500–500 Learning Objective 12.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium LEARNING OBJECTIVE Suppose there is an autonomous increase in investment spending of $350 billion. What will be the new macroequilibrium in the economy?

34 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Multiplier Effect The Paradox of Thrift In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving. Keynes referred to this outcome as the paradox of thrift because what appears to be something favorable to the long- run performance of the economy might be counterproductive in the short run. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP LEARNING OBJECTIVE

35 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 12: Aggregate Expenditure and Output in the Short Run The Algebra of Macroeconomic Equilibrium Appendix Remember that is the multiplier. Therefore an alternative expression for equilibrium GDP is: Equilibrium GDP = Autonomous expenditure x Multiplier Apply the algebra of macroeconomic equilibrium. LEARNING OBJECTIVE