Chapters 10 & 11 Aggregate Expenditures

Short Run Macro Model -- John Maynard Keyenes’ model explaining how changes in spending affects real GDP (spending affects business fluctuations) -- The short run is devoted to analyzing business fluctuations -- Assumption is that spending is the only variable influencing real GDP (all others held constant)

Planned Aggregate Expenditure Model Planned Aggregate Expenditure (PAE) -- total amount of planned spending in the economy Planned Aggregate Expenditure Model -- model defining the relationship between total planned spending and real GDP (price level held constant) -- used to explain business fluctuations -- shows that real GDP is determined by planned aggregate expenditures 4 categories of Planned Aggregate Expenditure 1) Consumption (C)3) Gov’t Purchases 2) Planned Investment (I P )4) Net Exports (X n ) PAE = C + I P + G + X n

Macroeconomic Equilibrium -- When Planned Aggregate Expenditure = GDP (total planned spending) (total output) Other Scenarios 1) When planned aggregate expenditure > GDP -- typically results in decrease in inventories and increase in GDP and employment (surge in sales causes an increase in production  inc in employment) 2) When planned aggregate expenditure < GDP -- typically results in increase in inventories and decrease in GDP and employment (drop in sales causes excess inventories leading to less production and unemployment)

Components of Planned Aggregate Expenditure I] Consumption Spending -- largest component Variables influencing consumption spending 1) Disposable Income (Y D ) -- main determinant Y D = Income + Transfer Payments – Taxes Y D = Income + Transfer Payments – Taxes -- as Y D ↑, consumption spending ↑ -- as Y D ↓, consumption spending ↓ 2) Price Level -- increase in price level causes consumption ↓ -- decrease in price level causes consumption ↑

Variables influencing consumption spending, cont. 3) Interest Rate (r) -- as r ↑, consumption spending ↓ (people are more willing to save) -- as r ↓, consumption spending ↑ -- interest rate has a larger effect on durable goods 4) Wealth Wealth = Assets - Liabilities -- as wealth ↑, consumption spending ↑ -- as wealth ↓, consumption spending ↓ 5) Expectations about Futures -- Optimistic about future earnings, consumption spending ↑ -- Concerned about future earnings, consumption spending ↓

Consumption Spending and Disposable Income -- close relationship between consumption and disposable income Consumption Function -- a positive linear relationship between consumption spending and disposable income

Point Real Disposable Income (Y D ) in billions $ Real Consumption Spending (C) in billions $ A$$ B C D E

Equation of Consumption Function C = a + bY D where a = C intercept b = slope b = slope 2 Important Characteristics 1) Intercept -- level of consumption where Y D (disposable income) = 0 or pt A -- known as autonomous consumption spending -- amount of consumption spending independent of disposable income -- amount of consumption spending independent of disposable income -- includes items such as wealth and interest rates (those other items affecting consumption) -- changes in autonomous consumption causes parallel shifts in the consumption function (i.e. slope remains the same)

2) Slope -- slope is rise/run or slope = ∆C/∆Y D -- since consumption function is linear, slope is constant Finding slope: Pt C  Y D = 200 C = 180 Pt D  Y D = 300 C = slope of consumption function is known as Marginal Propensity to Consume (MPC) MPC = Interpretation -- amount by which consumption spending ↑ for every $1 increase in disposable income (consumption spending increases by $ for every $ increase in disposable income)

-- 0 < MPC < 1 as disposable income ↑, consumption ↑ but consumers will not spend entire increase in income Restating Equation to find ∆C as Income Changes ∆C = MPC * ∆Y D ∆C = MPC * ∆Y D Example: If MPC =.75 and ∆Y D is $5 billion, find ∆C ∆C = Interpretation: a $ billion increase in income will cause consumption to increase by $ billion.

Consumption and National Income (Y) -- Rewriting relationship between consumption and disposable income to show relationship between national income and consumption Y D = Y – Net Taxes Y D = Y – Net Taxes where Net taxes = Taxes – Transfer Payments where Net taxes = Taxes – Transfer Payments Y = National Income = GDP Y = National Income = GDP then Y = GDP = Y D + Net taxes Assumption: Taxes are a fixed amount

Real National Income or Real GDP (billions $) Net Taxes (billions $) Real Disposable Income (Y D ) in billions $ Real Consumption Spending (C) in billions $ $$$$

Consumption Income Line -- A line showing consumption spending at each level of national income (Y) or GDP

Unique Characteristic Slope of Consumption Line and Consumption Function are the same -- slope is unaffected by changes in taxes (parallel curves) -- occurs only when taxes are fixed -- Since slope of consumption function = MPC = ∆C/∆Y D, and slope of consumption lines = slope of consumption function, MPC can also be written as ∆C/∆Y. Essentially then the change in disposable income is the same as the change in national income. ∆Y = 100 ∆C = 70 same as ∆Y D = 100 ∆C = 70 ∆Y = 100 ∆C = 70 same as ∆Y D = 100 ∆C = 70 Slope = 70/100 or.7

Movement Along the Consumption-Income Line -- If income ↑, and taxes remained unchanged, consumption spending ↑ Influence of ∆ Taxes on Consumption-Income Line -- If taxes ↓  Disposable Income ↑  causing consumption at every income level to ↑, causing consumption-income line to shift upward. Note: Consumption changes by MPC x ∆T at any income level Example: If taxes decrease by $10 billion, at income level of $250 billion, curve will shift upward to a point where consumption would change by.7 x 10 or $7 billion to $187 billion.

Components of Planned Aggregate Expenditure II] Planned Investment Spending (I P ) -- Business purchase of plant and equipment and household purchases of new home construction -- Excludes inventories because they are typically unplanned  therein lies the distinction between actual vs. planned inventories a) actual investment > planned investment when there is an unplanned increase in inventories b) actual investment < planned investment when there is an unplanned decrease in inventories c) actual investment = planned investment when there is no planned change in inventories

Variables Determining Level of Investment 1)Expectations of Future Profits -- machinery, buildings and other big purchase items involve much planning and make up a big part of capital expenditures thus future state of the economy has a big influence on firm’s decision Pending Recession  postpone buying investment goods Pending Expansion  buy or move forward with purchase of investment goods

Variables Determining Level of Investment, cont. 2) Interest rate -- Borrowing or financing remains a viable option as a means to gain the funds for purchasing investment goods; therefore, the interest rate remains a key variable in this decision. -- spans not only businesses but households (new home construction) -- the higher the interest rate, the less motivated firms are to borrow or finance for purchase of investment goods

Variables Determining Level of Investment, cont. 3) Taxes -- Federal Gov’t imposes taxes on profits of firms. a) Corporate Income Tax -- A decrease in the corporate income tax increases the after tax profitability of investment spending making investment spending attractive -- An increase in the corporate income tax reduces the after tax profitability making of investment spending making investment spending less attractive b) Investment Tax Incentives -- Provides firms with a tax reduction for monies spent on investments --Provides addt’l incentive to engage in investment spending

Variables Determining Level of Investment, cont. 4) Cash Flow (Cash Revenue Received – Cash Spending) -- Firms may decide to use their own cash to fund investment spending -- Cash flow is the amount of money on hand to make these particular purchases -- In expansionary periods, firms experience more profitability hence greater cash flow than in recessionary periods. The increased cash flow makes investment spending an attractive option in the booming periods.

Components of Planned Aggregate Expenditure III] Government Purchases -- Spending by Federal, State and Local Gov’t IV] Net Exports -- Net Exports = TTL Exports – TTL Imports Net Exports are influenced by the following: 1) Price level in U.S. vs Price Level in Other Countries -- when inflation rate is lower in U.S. vs other nations  prices of U.S. goods are increasing slower than that of other countries making U.S. goods more attractive. Boosts exports while reducing imports (causing net exports to ↑)

2) Growth rate of GDP in U.S. vs other countries -- when incomes in U.S. increase faster than other countries  U.S. consumers’ purchase of foreign goods will be greater than that of foreign consumers’ purchase of U.S. goods. Leads to ↓ in net exports since exports ↓ and imports ↑ 3) Exchange Rate: As the value of the dollar increases, foreign currency price of U.S. goods in other countries increase & dollar price of foreign products sold in U.S. drops causing ↑ in imports and ↓ in exports causing net exports to fall

Example: Euro ( €) and U.S. dollar exchange rate is.64 Euros = $1.00 Product that is $1.00 in U.S. is ___ Euros in Europe and 1 Euro product in Europe is $ in U.S. If exchange rate ↑ to ____ Euros = $1.00, product that is $1.00 in U.S. is now ____ Euros in Europe causing quantity demanded in Europe to drop. However, the 1 Euro product in Europe now sells for $____ in U.S. increasing quantity demanded in U.S. Result: Imports ↑ Exports ↓ (Net Exports ↓)

Income and Planned Aggregate Expenditure (data in billions $) Pt Real Income / Real GDP (Y) CG IPIPIPIP XnXnXnXnPAE ∆ Unplanned Inventories A B C D E

Notes: 1) Assume I P, G and NX are fixed 2) ∆ inventories = Real GDP – PAE 3) As Y ↑, PAE ↑, but ∆PAE < ∆Y Example: Pt C to Pt D Example: Pt C to Pt D ∆PAE = ∆Y = ∆PAE = ∆Y = Why? Consumption is only variable that is not fixed and consumption and income are related by the MPC Why? Consumption is only variable that is not fixed and consumption and income are related by the MPC

Finding Equilibrium Real GDP Using PAE and Inventories Pt Real Income or Real GDP (in billions) Planned Aggregate Expenditure (in billions) ∆ inventories (in billions) A B C D E

Finding Equilibrium Real GDP Using PAE and Inventories a) When PAE > Real GDP  ∆ Inventories < 0  Real GDP or output ↑ in future Example: Pt B PAE = $ billion and Real GDP = $ billion PAE = $ billion and Real GDP = $ billion Result: Inventories are depleting so output ↑ in future b) When PAE < Real GDP  ∆ Inventories > 0  Real GDP or output ↓ in future Example: Pt D PAE = $ billion and Real GDP = $ billion PAE = $ billion and Real GDP = $ billion Result: Inventories are increasing so output ↓ in future c) Equilibrium occurs where PAE = Real GDP or ∆ Inventories = 0 -- occurs at Pt C -- Firms are selling what they produce

Graphing Equilibrium -- Use of 45° Line Properties -- At Pt B, distance along horizontal axis (DA) = distance along vertical axis (DC) or distance DA = distance DC -- Distance DA = distance AB

Using PAE curve and 45° line to find equilibrium

a) 45° Line is above PAE Curve At Real GDP = $450 billion: -- From 45° line, real GDP is distance FG -- PAE is $390 billion or distance FE Since real GDP > PAE, inventories are accumulating Since real GDP > PAE, inventories are accumulating ∆ inventories = GDP – PAE or distance EG Thus real GDP ↓

b) 45° Line is below PAE Curve At Real GDP = $50 billion: -- From 45° line, real GDP is distance HI -- AE is $110 billion or distance AI Since real GDP < PAE, inventories are shrinking Since real GDP < PAE, inventories are shrinking ∆ inventories = GDP – PAE or distance AH Thus real GDP ↑

c) 45° Line intersects PAE Curve (Equilibrium) At Real GDP = $250 billion: -- PAE curve intersects 45° Line or PAE = Real GDP -- ∆ inventories = 0 -- Occurs at Pt C

Impact When Fixed Variables Change 1) Impact of ∆ in investment spending -- Find the impact of an increase in I P of $10 billion on real GDP and PAE (Assume equilibrium or real GDP = PAE and Assume MPC =.3) -- When firms ↑ I P of $10 billion  $10 billion of goods becomes factor payments for those firms supplying goods. -- MPC determines how much income is spent by households. The income that is spent becomes the next set of factor payments -- This cycle continues as shown on next slide

Round Addt’l Spending Cumulative Per Round Spending Per Round Spending Initial$10 billion (I P ) $10 billion Round 2$3 billion (C)$13 billion (MPC x previous spending) Round 3$.9 billion (C)$13.9 billion (MPC x previous spending)... ≈ $14.3 billion

Expenditure Multiplier -- In total, I P ↑ by $10 billion and overall spending (PAE) and real output ↑ by an amount greater than I P. -- Specifically, ∆ real GDP or ∆PAE = 1.43 x ∆ I P where 1.43 is expenditure multiplier Derivation of Expenditure Multiplier # by which ∆ I P must be multiplied to find ∆ equilibrium GDP# by which ∆ I P must be multiplied to find ∆ equilibrium GDP Multiplier = 1/(1-MPC)Multiplier = 1/(1-MPC) Example: If I P ↑ by $12 billion and MPC =.6 ∆ real GDP = ____________ ∆ real GDP = ____________

Expenditure Multiplier Effect for other fixed variables: a) ∆ real GDP =(1/1-MPC) x ∆G b) ∆ real GDP =(1/1-MPC) x ∆NX