© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. Fernando & Yvonn Quijano Prepared by: Chapter 23 Output and Expenditure in the Short Run

© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. 2 of 53 Fluctuating Demand at Cisco Systems 23.1Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. 23.2Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. 23.3Use a 45°-line diagram to illustrate macroeconomic equilibrium. 23.4Define the multiplier effect and use it to calculate changes in equilibrium GDP. 23.5Understand the relationship between the aggregate demand curve and aggregate expenditure. APPENDIX Apply the algebra of macroeconomic equilibrium. Learning Objectives In this chapter, we will explore the reasons for changes in aggregate expenditures and how these changes affect the level of total production in the economy.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 53 Output and Expenditure in the Short Run Aggregate expenditure (AE) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 53 The Aggregate Expenditure Model Aggregate expenditure model A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming that the price level is constant. Aggregate Expenditure Learning Objective 23.1 Consumption (C) Planned Investment (I) Government Purchases (G) Net Exports (NX)

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 53 The Aggregate Expenditure Model Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports Aggregate Expenditure Learning Objective 23.1 or: AE = C + I + G + NX

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 53 The Aggregate Expenditure Model Inventories Goods that have been produced but not yet sold. The Difference between Planned Investment and Actual Investment Learning Objective 23.1 Aggregate expenditure = GDP Macroeconomic Equilibrium

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 53 The Aggregate Expenditure Model Adjustments to Macroeconomic Equilibrium Learning Objective 23.1 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 23-1 The Relationship between Aggregate Expenditure and GDP

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 EXPENDITURE CATEGORY EXPENDITURE (BILLIONS OF 2000 DOLLARS) Consumption$8,278 Investment1,826 Government2,022 Net Exports−556 Table 23-2 Components of Real Aggregate Expenditure, 2007

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 Consumption FIGURE 23-1 Real Consumption, 1979–2007

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 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:

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 The most important determinant of consumption is the current disposable income of households. Consumption Current Disposable Income Household Wealth Consumption also depends on the wealth of households. A household’s wealth is the value of its assets minus the value of its liabilities.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 Consumption also depends 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 to saving is increased, and households are likely to save more and spend less.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 53 Learning Objective 23.2 FIGURE 23-2 The Relationship between Consumption and Income, 1960– 2007 Determining the Level of Aggregate Expenditure in the Economy Consumption The Consumption Function

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 53 Learning Objective 23.2 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 The Consumption Function

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 53 Learning Objective 23.2 or Change in consumption = Change in disposable income × MPC Determining the Level of Aggregate Expenditure in the Economy Consumption The Consumption Function We can also use the MPC to determine how much consumption will change as income changes:

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 53 Learning Objective 23.2 We can rearrange the equation like this: National income = GDP = Disposable income + Net taxes Disposable income = National income − Net taxes Determining the Level of Aggregate Expenditure in the Economy The Relationship between Consumption and National Income

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 53 Learning Objective 23.2 FIGURE 23-3 The Relationship between Consumption and National Income Determining the Level of Aggregate Expenditure in the Economy The Relationship between Consumption and National Income

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 53 Learning Objective 23.2 National income = Consumption + Saving + Taxes Change in national income = Change in consumption + Change in saving + Change in taxes Y = C + S + T Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving and To simplify, we can assume that taxes are always a constant amount, in which case ΔT = 0, so the following is also true: ΔY = ΔC + ΔS

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 53 Learning Objective 23.2 Marginal propensity to save (MPS) The change in saving divided by the change in disposable income. Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving or, 1 = MPC + MPS

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 53 Solved Problem 23-2 Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save Learning Objective 23.2 NATIONAL INCOME AND REAL GDP (Y) CONSUMPTION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) $9,000$8,000$1,000—— 10,0008,6001, ,0009,2001, ,0009,8002, ,00010,4002,

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 53 Learning Objective 23.2 FIGURE 23-4 Real Investment, 1979–2007 Determining the Level of Aggregate Expenditure in the Economy Planned Investment

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 53 Learning Objective 23.2 Expectations of future profitability The 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:

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 53 Learning Objective 23.2 Expectations of Future Profitability The optimism or pessimism of firms is an important determinant of investment spending. The 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

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 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.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 53 Learning Objective 23.2 Cisco Rides the Roller Coaster of Information Technology Spending Making the Connection

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 53 Learning Objective 23.2 FIGURE 23-5 Real Government Purchases, 1979–2007 Determining the Level of Aggregate Expenditure in the Economy Government Purchases

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 53 Learning Objective 23.2 FIGURE 23-6 Real Net Exports, 1979–2007 Determining the Level of Aggregate Expenditure in the Economy Net Exports

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 53 Learning Objective 23.2 The price level in the United States relative to the price levels in other countries The growth rate of GDP in the United States relative to the growth rates of GDP in other countries The exchange rate between the dollar and other currencies Determining the Level of Aggregate Expenditure in the Economy Net Exports The following are the three most important variables that determine the level of net exports:

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 53 Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 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. Net Exports

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 53 Graphing Macroeconomic Equilibrium Learning Objective 23.3 FIGURE 23-7 An Example of a 45°-Line Diagram

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 53 Learning Objective 23.3 FIGURE 23-8 The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram Graphing Macroeconomic Equilibrium

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 53 Graphing Macroeconomic Equilibrium Learning Objective 23.3 FIGURE 23-9 Macroeconomic Equilibrium on the 45°-Line Diagram

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 53 Learning Objective 23.3 FIGURE Macroeconomic Equilibrium Graphing Macroeconomic Equilibrium

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 53 Graphing Macroeconomic Equilibrium Learning Objective 23.3 FIGURE Showing a Recession on the 45°-Line Diagram

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 53 Graphing Macroeconomic Equilibrium Learning Objective 23.3 Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories. The Important Role of Inventories

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 53 Learning Objective 23.2 Business Attempts to Control Inventories, Then... and Now Making the Connection Dell Computer uses supply chain management to keep its inventory low.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 53 Learning Objective 23.3 Graphing Macroeconomic Equilibrium 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$8,700–$700increase 9,0006,8501,500 –5009,350 –350increase 10,0007,5001,500 –50010,000 0 be in equilibrium 11,0008,1501,500 –50010, decrease 12,0008,8001,500 –50011, decrease Don’t Let This Happen to YOU! Don’t Confuse Aggregate Expenditure with Consumption Spending Table 23-3 Macroeconomic Equilibrium

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 53 Solved Problem 23-3 Determining Macroeconomic Equilibrium Learning Objective 23.3 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$1,675 $–500$9,050$–1,050 9,0006,8501,675 –5009,700–700 10,0007,5001,675 –50010,350–350 11,0008,1501,675 –50011, ,0008,8001,675 –50011, Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government (G) + Net exports (NX) Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE)

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 39 of 53 Learning Objective 23.4 The Multiplier Effect FIGURE The Multiplier Effect

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 53 Learning Objective 23.4 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.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 53 Learning Objective 23.4 The Multiplier Effect Table 23-4 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

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 42 of 53 Learning Objective 23.4 The Multiplier in Reverse: The Great Depression of the 1930s Making the Connection The multiplier effect contributed to the very high levels of unemployment during the Great Depression. YEARCONSUMPTIONINVESTMENT NET EXPORTSREAL GDP UNEMPLOYMENT RATE 1929$661 billion$91.3 billion-$9.4illion$865 billion3.2% 1933$541 billion$17.0 billion-$10.2 billion$636 billion24.9%

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 43 of 53 Learning Objective 23.4 The Multiplier Effect A Formula for the Multiplier

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 44 of 53 Learning Objective 23.4 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 an increasing GDP can have on imports, inflation, and interest rates.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 45 of 53 Solved Problem 23-4 Using the Multiplier Formula Learning Objective 23.4 REAL GDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) $8,000$6,900$1,000 –$500 9,0007,7001,000 –500 10,0008,5001,000 –500 11,0009,3001,000 –500 12,00010,1001,000 –500

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 46 of 53 Solved Problem 23-4 Using the Multiplier Formula (continued) Learning Objective 23.4 REALGDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) PLANNED AGGREGATE EXPENDITURE (AE) $8,000$6,900$1,000 –$500$8,400 9,0007,7001,000 –5009,200 10,0008,5001,000 –50010,000 11,0009,3001,000 –50010,800 12,00010,1001,000 –50011,600

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 47 of 53 Learning Objective 23.5 The Aggregate Demand Curve FIGURE The Effect of a Change in the Price Level on Real GDP

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 48 of 53 Learning Objective 23.5 The Aggregate Demand Curve FIGURE The Aggregate Demand Curve Aggregate demand curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 49 of 53 An Inside LOOK Consumer Spending and Business Inventories Send Positive Signals about GDP Economy Slows but May Hold Seeds of Growth A decrease in aggregate expenditure causes an unplanned increase in inventories and a decrease in real GDP.

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 50 of 53 Aggregate demand curve Aggregate expenditure (AE) Aggregate expenditure model Autonomous expenditure Cash flow Consumption function Inventories K e y T e r m s Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier Multiplier effect

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 51 of 53 The Algebra of Macroeconomic Equilibrium Appendix 1 Consumption function 2 Planned investment function 3 Government spending function 4 Net export function 5 Equilibrium condition

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 52 of 53 The Algebra of Macroeconomic Equilibrium Appendix Or, Or, Or, The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

Chapter 23: Output and Expenditure in the Short Run © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 53 of 53 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