Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Chapter 3 Spending, Income, and Interest Rates

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-2 Figure 3-1 Real GDP Growth in the United States, 1950–2004

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-3 In economies there endogenous and exogenous variables Endogenous variables are variables that are explained by economy. Exogenous variables are variables that are taken AS GIVEN and not explained by the economy. For example, for this chapter we assume interest rates and investment are taken as given (exogenous) and we try to look at what happens the Consumption and output (GDP) ( both endogenous) whenexogenous variables change. We should distinguish between planned and unplanned. The latter ones might be different because of their impact on equilibrium.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-4 Consumption Function Consumption is a function of disposable income, that is income left after taxes have been paid off. C = Ca + c (Y-T) The Ca is the autonomous consumption, that is, the part of consumption independent of income. When Y-T =0, there is still a consumption C =Ca. How come this could be possible ? By borrowing of course. ΔC / Δ(Y-T) = c and you remember what it was...

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-5 Figure 3-2 A Simple Hypothesis Regarding Consumption Behavior

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-6 Figure 3-3 Consumption, Saving, and Disposable Income, 1929–2004

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-7 E p =C +I p + G+ NX The total expenditures can be broken down into two components. One component includes all expenditures which are planned, that is there is NO UNEXPECTED spending. The other component involves UNEXPECTED or UNPLANNED expenditures. The subscript “p” means planned. Here we assume ALL others are planned and Investment (I) however has planned (P) and unplanned (u) components. Since E p only includes planned expenditures, naturally only the planned component of Investment enter this equation. We can expand the C = C a +c(Y-T) so you remember the first term is autonomous component. The second term, that is c(Y-T) is induced component of consumption, that is as (Y-T) changes so does that part of consumption.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-8 We can now extract the autonomous component of total spending. Call autonomus component as A p. So A p = E p - cY = C a +cT a + I p + G+ NX Attention FOR THE TIME BEING we assume the taxes are autonomous so T = T a. On the right hand side of equation we see that autonomous spending consists of all planned spending that do not depend on income. What I have done above is simple: I subtracted the induced part of expenditures from all expenditures thus elaving the autonomous part. We know that economy is in equilibrium as long as actual expenditure (E) is equal to income. If ofr some reason either E > Y or Y > E there is disequilibrium, in the first case spending is more than income in the second case the opposite is true. In this case, in the next round production will adjust accordingly.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 3-9 Figure 3-4 How Equilibrium Income Is Determined

Copyright © 2006 Pearson Addison-Wesley. All rights reserved So how do we interpret this graph? When Y = 6000, there is equilibrium, that is the expenditures (C +G +I) are equal to total income. But when Y = 8000, at this level, pluging this into equation we find the spending is LESS than income. It can be calculated to be equal to What happens to $500, which is NOT spent.? This is called Inventory Investment and it is unplanned because this is value of goods waiting to be shipped to the customers but not SOLD. So stock of goods of that amount are piling up and business did not plan this way, that is why it is UNPLANNED. To bring the inventories back to its desired level, business react by cutting production. But Cutting production means.... Cutting incomes (less spent on labor and capital creating less income).

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Table 3-1 Comparison of the Economy’s “Always True” and Equilibrium Situations

Copyright © 2006 Pearson Addison-Wesley. All rights reserved We will use Y = E p +I u and this equality is true everywhere. Only at equilibrium when expenditures are equal to income the unpanned part vanishes. Now subtract cY from both sides and let us assume we are at the equilibrium so I u zero. Y-cY = Ep – cY Remember the right hand side is Ap. (1-c)Y = Ap İf c is marginal propensity to consume MPC, then (1-c) is MPS. So let us use “s” to represent MPS. The sY = Ap. Suppose MPC is 0.75 (out of every $1 increase in income, $0.75 extra is spent on consumption). Note that sY is a leakage so if it is equal to Ap, then saving is spent on autonomous spending. We can then rewrite Y = Ap/ s for equilibrium.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 3-5 The Change in Equilibrium Income Caused by a $500 Billion Increase in Autonomous Planned Spending

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Now business become optimistic about future.. And let us put numerical values in place of variables... Ca = 500, c = 0.75, Ip = 1200 and NX =-200..G and Ta are set equal to zero (no government expenditures and taxes).. Then Ap = (0) = Planned investment increase, say by $ Remembering the equality Y = Ap /s. Y = $1500 and since Ep = Ap +cY  Ep= Y We find initial equilibrium as Y = 1500 / 0.25 =6000. But Now business become optimistic about future...so additional investment (planned) is made, let us say =$500. Then Ap =$2000 so new Y = 2000/0.25 =8000. What do these mean

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 3-8 Relation of the Various Components of Autonomous Planned Spending to the Interest Rate

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Figure 3-9 Relation of the IS Curve to the Demand for Autonomous Spending