Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-1 CHAPTER 9 The Income-Expenditure Framework: Consumption and the Multiplier

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-2 Questions What are sticky prices? What factors might make prices sticky? When prices are sticky, what determines the level of real GDP in the short run?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-3 Questions When prices are sticky, what happens to real GDP if some component of aggregate demand falls? When prices are sticky, what happens to real GDP if some component of aggregate demand rises? What determines the size of the spending multiplier?

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-4 Real GDP in U.S. History The flexible-price model does not give a complete picture of the macroeconomy –real GDP does not always grow by the same rate as potential output –the unemployment rate is not always at the natural rate –inflation is not always steady

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-5 Figure Real GDP per Worker and Potential Output,

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-6 Business Cycles Fluctuations in economic growth are called business cycles A business cycle has two phases –expansion or boom production, employment, and prices all grow rapidly –recession or depression production falls, unemployment rises, and inflation falls

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-7 Business Cycles To understand business cycles, we need a model that does not always guarantee full employment We will no longer assume that prices are flexible Instead, prices will be assumed to be sticky –they will remain fixed at predetermined levels as businesses expand or contract production

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-8 A Decrease in Autonomous Consumption (C 0 ) Suppose that autonomous consumption falls from $2,000 billion to $1,800 billion per year In the flexible-price model, real GDP would be unaffected –the economy would remain at full employment –real GDP would equal potential output

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-9 Figure Labor Market Equilibrium

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) In the flexible-price model, a fall in consumption means an increase in savings –the real interest rate falls –the equilibrium level of investment and net exports increases by $200 billion per year

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Effect on Savings of a Fall in Consumption Spending in the Flexible-Price Model

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) Under the flexible-price model, the decline in the real interest rate will lead to a decline in the velocity of money –the price level will fall

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) In the flexible-price model, the consequences of a fall in consumers desired baseline consumption are –a drop in consumption –an increase in savings –a decline in the real interest rate –a rise in investment –a rise in the value of the exchange rate –a decline in the price level

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) In the sticky-price model, a drop in consumption leads to a drop in aggregate demand As businesses see the demand for their products falling, they cut back production –they will fire some of their workers –incomes will fall

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) In the sticky-price model, a drop in consumption does not lead to an increase in savings –the increase in savings (from the fall in consumption) is exactly offset by a decrease in savings (from the fall in income) The real interest rate is unaffected –no change in investment or net exports

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Effect on Savings of a Fall in Consumption Spending in the Sticky-Price Model

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved A Decrease in Autonomous Consumption (C 0 ) In the sticky-price model, the consequences of a fall in consumers desired baseline consumption are –a drop in consumption –a decline in production –a decline in employment –a decrease in national income –no change in the real interest rate, investment, or the exchange rate

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Expectations Price stickiness causes problems only in the short run If individuals had time to foresee and gradually adjust their wages and prices to changes in aggregate demand, sticky prices would not be a problem –both the stickiness of prices and the failure to accurately foresee changes are needed to create business cycles

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Short Run vs. Long Run In the short run, prices are sticky –shifts in policy or in the economic environment that affect the level of aggregate demand will affect real GDP and employment In the long run, prices are flexible –individuals have time to react and adjust to changes in policy or the economic environment –real GDP and employment are unaffected

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Why Prices Are Sticky Menu costs are costs associated with changing prices –changing prices can be costly for a variety of reasons –managers and workers may prefer to keep prices and wages stable as long as the shocks that affect the economy are relatively small

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Why Prices Are Sticky Managers and workers lack full information about the state of the economy They may confuse changes in economy-wide spending with changes in demand for their particular products –cut production rather than cutting the price of the product

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Why Prices Are Sticky The level of prices is often determined by what is fair Work effort and work intensity depend on whether or not workers feel that they are treated fairly –most managers are reluctant to cut wages –if wages are sticky, firms will adjust employment when aggregate demand changes

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Why Prices Are Sticky Managers and workers may suffer from money illusion –confuse changes in nominal prices with changes in real prices firms react to higher nominal prices by believing that it is profitable to produce more workers react to higher nominal wages by searching more intensively for jobs and working more hours

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier Process If prices are sticky, higher aggregate demand boosts production Incomes rise Higher incomes give a further boost to production which increases aggregate demand even more

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Multiplier Process

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Building Up Aggregate Demand Aggregate demand (planned expenditure) has four components –consumption (C) –investment (I) –government purchases (G) –net exports (NX)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Consumption Function As incomes rise, consumption spending rises –less than dollar for dollar The share of an extra dollar of income that shows up as additional consumption is equal to the marginal propensity to consume times the share of income that escapes taxation

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Consumption Function and the Marginal Propensity to Consume

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Consumption Function The slope of the consumption function is smaller than the marginal propensity to consume (C y ) –because of the tax system, a one-dollar increase in national income means less than a one-dollar increase in disposable income

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Consumption as a Function of After-Tax Disposable Income

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Consumption Function Example –C y = 0.75 –t = 0.40 –when Y = $8 trillion, C = $5.5 trillion

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Other Components of Aggregate Demand Investment is determined by the real interest rate and assessments of profitability made by firms managers Government purchases is set by politics

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Other Components of Aggregate Demand Net exports are equal to gross exports minus imports –gross exports are a function of the real exchange rate () and the level of foreign real GDP (Y f )

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Components of Aggregate Demand, 1995

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Components of Expenditure The components of aggregate demand can be divided into two groups –autonomous spending (A) components of aggregate demand that do not depend directly on national income –the marginal propensity to expend (MPE) times the level of national income (Y)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Components of Expenditure A = autonomous expenditure [A=C 0 +I+G+GX] MPE=marginal propensity to expend [MPE=C y (1-t)-IM y ]

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Income-Expenditure Diagram

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Income-Expenditure Diagram The intercept of the planned expenditure or aggregate demand line is the level of autonomous spending (A) –a change in the value of any component of autonomous spending will shift the planned expenditure line up or down

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure An Increase in Autonomous Spending

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Income-Expenditure Diagram The slope of the planned expenditure or aggregate demand line is the marginal propensity to expend (MPE) –changes in the marginal propensity to consume (C y ), the tax rate (t), or in the propensity to spend on imports (IM y ) will change the MPE and the slope of the planned expenditure line

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure An Increase in the Marginal Propensity to Expend

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Calculating the MPE Example –C y = 0.75 –t = 0.40 –IM y = 0.15

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Sticky-Price Equilibrium The economy will be in equilibrium when planned expenditure equals real GDP –there will be no short-run forces pushing for an immediate expansion or contraction of national income, real GDP, and aggregate demand

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Equilibrium in the Income- Expenditure Diagram, 1996

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Sticky-Price Equilibrium Equilibrium occurs when planned expenditure (E) is equal to real GDP (Y) Example –A = $5,600 billion –MPE = 0.30

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Sticky-Price Equilibrium If the economy is not on the 45- degree line, the economy is not in equilibrium –planned expenditure (E) does not equal real GDP (Y) If Y>E –there is excess supply of goods If Y<E –there is excess demand for goods

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Inventory Adjustment and Equilibrium: Goods Market Equilibrium and the Income-Expenditure Diagram

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Inventory Adjustment Excess supply –production > aggregate demand –inventories are rising rapidly –firms will cut production Excess demand –production < aggregate demand –inventories are being depleted –firms will expand production

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Inventory Adjustment Process: An Income-Expenditure Diagram

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier Suppose that autonomous spending increases –the planned expenditure line will shift up –planned expenditure > national income inventories would fall businesses would boost production –how much production would expand depends on the magnitude of the change in autonomous spending and the value of the multiplier

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure The Multiplier Effect

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier The value of the multiplier depends on the slope of the planned expenditure line –the higher is the MPE, the steeper is the planned expenditure line and the greater is the multiplier

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Figure Determining the Size of the Multiplier

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier Equilibrium means that

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier 1/[1-MPE] is the multiplier –it multiplies the upward shift in the planned expenditure line into a change in the equilibrium level of real GDP, total income, and aggregate demand –because autonomous spending is influenced by many factors, almost every change in economic policy or the economic environment will set the multiplier process in motion

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier Example –A = $5.6 trillion –MPE = 0.3 –A = $0.1 trillion

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved The Multiplier One factor that tends to minimize the multiplier is the governments fiscal automatic stabilizers –proportional taxes –social welfare programs An economy that is more open to world trade will have a smaller multiplier than a less open economy

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary Business-cycle fluctuations can push real GDP away from potential output and unemployment far away from its average rate If prices were perfectly and instantaneously flexible, there would be no such thing as business cycle fluctuations –models in which prices are sticky must play a large role in macroeconomics

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary There are a number of reasons that prices might be sticky –menu costs, imperfect information, concerns of fairness, or money illusion –there is no overwhelming evidence as to which is most important In the short run, while prices are sticky, the level of real GDP is determined by the level of aggregate demand

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The short-run equilibrium level of real GDP is that level at which aggregate demand (as a function of national income) is equal to the level of national income (real GDP) Two quantities summarize planned expenditure as a function of total income –the level of autonomous spending and the marginal propensity to expend (MPE)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The level of autonomous spending is the intercept of the planned expenditure function on the income- expenditure diagram –tells us what the level of planned expenditure would be if national income was zero

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The MPE is the slope of the planned expenditure function on the income- expenditure diagram –tells us how much planned expenditure increases for each one dollar increase in national income

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary The value of the MPE depends on the tax rate (t), the marginal propensity to consume (C y ), and the share of spending on imports (IM y )

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Summary In the simple macro models, an increase in any component of autonomous spending causes a more than proportional increase in real GDP –the result is the multiplier process The size of the multiplier depends on the MPE