© 2005 Thomson C hapter 22 Equilibrium National Income

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Aggregate expenditure The equilibrium level of national income The relationship between saving and investment The income multiplier

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The relationship between aggregate expenditure and aggregate demand The paradox of thrift

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Equilibrium National Income Equilibrium price is determined by the equal contribution of both demand and costs of production. In particular, it is their interaction that determines equilibrium price.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Equilibrium National Income Similarly, the interaction of aggregate expenditure and aggregate supply contribute to equilibrium national income. In this case, however, aggregate expenditure plays a stronger role than aggregate supply.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e Interaction Between Consumers and Producers Aggregate expenditure Spending by consumers on consumption goods, spending by businesses on investment goods, spending by government, and spending by foreigners on net exports.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e Interaction Between Consumers and Producers Recall that the amount of consumer income spent on consumption and saving is represented by: Y = C + S

© 2005 Thomson 8 Interaction Between Consumers and Producers And recall that the amount of production goods and investment goods produced by producers is represented by: Y = C + I i where the subscript i indicates intended as distinct from actual.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Interaction Between Consumers and Producers If, by chance, what producers intend to produce for consumption turns out to be precisely what consumers intend to consume, the match between intended investment and savings is written as: I i = S

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Interaction Between Consumers and Producers The I = S equation describes the economy in macroequilibrium. No excess demand or supply exists. Aggregate expenditure equal aggregate supply.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e The Economy Moves Toward Equilibrium The national economy, if not already in equilibrium, is always moving toward it.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e The Economy Moves Toward Equilibrium Equilibrium level of national income C + I i = C + S, where saving equals intended investment.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e The Economy Moves Toward Equilibrium Unwanted inventories Goods produced for consumption that remain unsold.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e The Economy Moves Toward Equilibrium Actual investment (I a ) Investment spending that producers actually make – that is, intended investment (investment spending that producers intend to undertake), plus or minus unintended changes in inventories.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e EXHIBIT 1CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $900 BILLION

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion Suppose the economy is at Y = $900 billion, autonomous consumption = $60 billion, MPC = 0.80 and producers’ intended investment is $100 billion.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion 1. What are consumers’ consumption expenditures and savings in Exhibit 1? If Y = C + S and C = a + bY, then consumption expenditures (C) = $60 billion ($900 billion) = $780 billion.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion 1. What are consumers’ consumption expenditures and saving in Exhibit 1? If S = Y – C, then saving (S) = $900 billion - $780 billion = $120 billion.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion 2. What is intended production by producers? If C = Y - I i and I i = $100 billion, then intended production = $900 billion - $100 billion = $800 billion.

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion Producers’ intended production ($800 billion) - consumers’ consumption expenditures ($780 billion) = $20 billion. 3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion The $20 billion difference is described as unwanted inventories and must be absorbed as investment. 3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Exhibit 1: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $900 Billion 3. What is the difference between producers’ intended production and consumers’ consumption expenditures? Producers’ actual investment ($120 billion) ends up being greater than what they had intended to invest ($100 billion).

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e EXHIBIT 2CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $700 BILLION

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion Suppose national income changes to Y = $700 billion, but MPC, autonomous consumption and intended investment all remain the same.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion 1. What are consumers’ consumption expenditures? C = $60 billion ($700 billion) = $620 billion.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion 2. What is intended production by producers? C = $700 billion - $100 billion = $600 billion.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion Consumers’ consumption ($620 billion) - producers’ production ($600 billion) = $20 billion. 3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion The $20 billion difference must be converted from intended investment to consumption goods to meet demand. 3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 2: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $700 Billion 3. What is the difference between consumers’ consumption expenditures and producers’ intended production? Actual investment ends up being less than intended investment.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e EXHIBIT 3CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $800 BILLION

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Exhibit 3: Consumers’ and Producers’ Intentions and Activities, by Stages, When Y = $800 Billion What is the difference between production and consumers’ expenditures in Exhibit 3? Production and consumption are equal at $700 billion. The economy is in equilibrium.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Equilibrium National Income Aggregate expenditure curve (AE) A curve that shows the quantity of aggregate expenditures at different levels of national income or GDP.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Equilibrium National Income Aggregate expenditure curve (AE) The intersection of the 45° income curve and AE identifies the economy’s equilibrium position.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Equilibrium National Income When I i > S, producers hire more workers to replace depleted inventories. Y increases and continues to increase until I i = S. When S > I i, inventories build up and producers lay off workers. Y decreases until I i = S.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e EXHIBIT 4ATHE EQUILIBRIUM LEVEL OF NATIONAL INCOME

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e EXHIBIT 4BTHE EQUILIBRIUM LEVEL OF NATIONAL INCOME

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Exhibit 4: The Equilibrium Level of National Income At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4. i. Greater than ii. Less than

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Exhibit 4: The Equilibrium Level of National Income At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4. i. Greater than ii. Less than

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e Changes in Investment Change National Income Equilibrium As long as the consumption function and the investment demand function remain unchanged, there is no reason to suppose that the level of national income would move away from equilibrium.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Changes in Investment Change National Income Equilibrium Functions do change, however.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e EXHIBIT 5CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN INVESTMENT INCREASES TO $130 BILLION AND Y = $800 BILLION

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion When intended investment increases, the supply of consumption goods decreases to $670 billion. What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion Consumers’ consumption expenditures remain at $700 billion. Consumers’ demand is greater than producers’ production. What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, when Investment Increases to $130 Billion and Y = $800 Billion What happens to the equilibrium level of national income when intended investment increases in Exhibit 5? In an effort to meet consumers’ demand, producers hire more workers and national income increases. The equilibrium also increases.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e EXHIBIT 6ADERIVING EQUILIBRIUM AT Y = $950 BILLION

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e EXHIBIT 6BDERIVING EQUILIBRIUM AT Y = $950 BILLION

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Exhibit 6: Deriving Equilibrium at Y = $950 Billion What is the equilibrium level of national income when intended investment increases to $130 billion in Exhibit 6? The equilibrium level increases to $950 billion, where I i = S.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Changes in Investment Change National Income Equilibrium The formula Y = (a + bY) + I i can be used to calculate equilibrium national income when specific values for autonomous consumption, MPC and intended investment are known.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e The Income Multiplier While consumption spending, MPC, and autonomous consumption have all remained relatively stable over time, investment spending has been volatile.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e The Income Multiplier Economists identify changes in aggregate expenditure, in particular investment spending, as the key to our understanding of why national income changes.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e The Income Multiplier Income multiplier The multiple by which income changes as a result of a change in aggregate expenditure. It is written as: multiplier = (change in Y)/(change in AE)

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e The Income Multiplier The size of the multiplier depends on the marginal propensity to consume. An initial change in investment sets in motion a chain of events that creates a larger change in national income.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e The Income Multiplier For example, suppose a business owner decides to invest $1,000 in a new technology. The producer of the technology receives an increase in income of $1,000. If MPC = 0.80, the technology producer’s consumption spending increases by $800.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e The Income Multiplier Suppose the $800 is then spent on a custom-made water bed. The carpenter that makes the water bed receives $800 of additional income. Based on MPC, we know that she will spend $640 and save the rest. The chain of events continues.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e EXHIBIT 7THE MAKING OF THE INCOME MULTIPLIER

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Exhibit 7: The Making of the Income Multiplier The additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds. i. Smaller and smaller ii. Bigger and bigger

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 7: The Making of the Income Multiplier The additions to national income in Exhibit 7 become _____ as economic activity progresses through successive rounds. i. Smaller and smaller. For example, in round 2, $800 is added. In round 3, $640 is added. ii. Bigger and bigger

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e The Income Multiplier The formula to determine the income multiplier is written: 1/(1 - MPC). Since (1 - MPC) = MPS, the formula can be written: 1/MPS.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e The Income Multiplier For example, for a $1,000 change in investment, when MPC = 0.80, the income multiplier is: 1/( ) = 1/(0.2) = 5. A $1,000 investment leads to a $5,000 change in national income.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e The Income Multiplier Just as increases in aggregate expenditure stimulate the economy, cuts in aggregate expenditure drag it down.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e The Income Multiplier Changes in the price level shift the AE curve, creating changes in the equilibrium level of national income. As the price level decreases, national income increases.

© 2005 Thomson 62 EXHIBIT 8 CONVERTING AGGREGATE EXPENDITURE TO AGGREGATE DEMAND

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Exhibit 8: Converting Aggregate Expenditure to Aggregate Demand What happens to the equilibrium national income when the price level decreases from AE 100 to AE 75 ? A decrease in the price level leads to an increase in aggregate expenditures and movement downward along the aggregate demand curve. National income increases from $800 billion to $1,000 billion.

© 2005 Thomson 64 EXHIBIT 9 THE MULTIPLIER EFFECT IN THE AE AND AD MODELS OF INCOME DETERMINATION

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Exhibit 9: The Multiplier Effect in the AE and AD Models of Income Determination If aggregate expenditure increases but the price level remains the same, what happens to aggregate demand? Aggregate demand increases, which results in an increase in national income.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e The Paradox of Thrift Some people believe that putting a higher percentage of their income into saving will provide greater economic security. This is not necessarily the case, however. By trying to save more, people may actually end up saving less, or at least saving no more.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e The Paradox of Thrift The paradox of thrift The more people try to save, the more income falls, leaving them with no more and perhaps even less saving.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e The Paradox of Thrift The intention to save more causes the saving curve to shift upwards. Saving then becomes greater than intended investment (S > I i ). The equilibrium level of national income falls.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e The Paradox of Thrift If the level of intended investment curve is horizontal, then the level of saving remains unchanged. If the intended investment curve is upward sloping, then the level of saving declines.

© 2005 Thomson 70 EXHIBIT 10THE PARADOX OF THRIFT

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Exhibit 10: The Paradox of Thrift 1. What happens to national income and saving when the saving curve shifts from S to S′ in panel a of Exhibit 10? National income falls from $800 billion to $650 billion. Saving remains unchanged.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Exhibit 10: The Paradox of Thrift 2. What happens to national income and saving in panel b when the saving curve shifts from S to S′? The equilibrium level of national income falls from $800 billion to $550 billion.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Exhibit 10: The Paradox of Thrift Because the intended investment curve is upward sloping, the shift in the saving curve causes a decline in the level of investment as well. 2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e Exhibit 10: The Paradox of Thrift Saving falls from $100 billion to $75 billion. 2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e The Paradox of Thrift Increased saving is not always detrimental to our economic health. If accompanied by increased investment, increased saving is both inevitable and desirable.