C hapter 22 Equilibrium National Income © 2002 South-Western

2 Economic Principles Aggregate expenditure The equilibrium level of national income The relationship between saving and investment The income multiplier

3 Economic Principles The relationship between aggregate expenditure and aggregate demand The paradox of thrift

4 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.

5 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.

6 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.

7 Interaction Between Consumers and Producers Recall that the amount of consumer income spent on consumption and saving is represented by: Y = C + S.

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.

9 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.

10 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.

11 The Economy Moves Toward Equilibrium The national economy, if not already in equilibrium, is always moving toward it.

12 The Economy Moves Toward Equilibrium Equilibrium level of national income C + I i = C + S, where saving equals intended investment.

13 The Economy Moves Toward Equilibrium Unwanted inventories Goods produced for consumption that remain unsold.

14 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.

15 EXHIBIT 1CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $900 BILLION

16 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.

17 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.

18 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.

19 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.

20 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’ intended production ($800 billion) – consumers’ consumption expenditures ($780 billion) = $20 billion.

21 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? The $20 billion difference is described as unwanted inventories and must be absorbed as investment.

22 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).

23 EXHIBIT 2CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $700 BILLION

24 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.

25 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.

26 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.

27 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? Consumers’ consumption ($620 billion) – producers’ production ($600 billion) = $20 billion.

28 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? The $20 billion difference must be converted from intended investment to consumption goods to meet demand.

29 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.

30 EXHIBIT 3CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $800 BILLION

31 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.

32 Equilibrium National Income Aggregate expenditure curve (AE) A curve that shows the quantity of aggregate expenditures at different levels of national income or GDP.

33 Equilibrium National Income Aggregate expenditure curve (AE) The intersection of the 45 0 income curve and AE identifies the economy’s equilibrium position.

34 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.

35 EXHIBIT 4ATHE EQUILIBRIUM LEVEL OF NATIONAL INCOME

36 EXHIBIT 4BTHE EQUILIBRIUM LEVEL OF NATIONAL INCOME

37 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.

38 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.

39 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.

40 Changes in Investment Change National Income Equilibrium Functions do change, however.

41 EXHIBIT 5CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN INVESTMENT INCREASES TO $130 BILLION AND Y = $800 BILLION

42 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? When intended investment increases, the supply of consumption goods decreases to $670 billion.

43 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? Consumers’ consumption expenditures remain at $700 billion. Consumers’ demand is greater than producers’ production.

44 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.

45 EXHIBIT 6ADERIVING EQUILIBRIUM AT Y = $950 BILLION

46 EXHIBIT 6BDERIVING EQUILIBRIUM AT Y = $950 BILLION

47 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.

48 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.

49 The Income Multiplier While consumption spending, MPC, and autonomous consumption have all remained relatively stable over time, investment spending has been volatile.

50 The Income Multiplier Economists identify changes in aggregate expenditure, in particular investment spending, as the key to our understanding of why national income changes.

51 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).

52 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.

53 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.

54 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.

55 EXHIBIT 7THE MAKING OF THE INCOME MULTIPLIER

56 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.

57 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.

58 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.

59 The Income Multiplier For example, for a $1,000 change in investment, when MPC = 0.80, the income multiplier is: 1 / (1 – 0.80) = 1 / (0.2) = 5. A $1,000 investment leads to a $5,000 change in national income.

60 The Income Multiplier Just as increases in aggregate expenditure stimulate the economy, cuts in aggregate expenditure drag it down.

61 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.

62 EXHIBIT 8 CONVERTING AGGREGATE EXPENDITURE TO AGGREGATE DEMAND

63 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.

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

65 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.

66 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.

67 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.

68 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.

69 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.

70 EXHIBIT 10THE PARADOX OF THRIFT

71 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.

72 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.

73 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’? Because the intended investment curve is upward sloping, the shift in the saving curve causes a decline in the level of investment as well.

74 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’? Saving falls from $100 billion to $75 billion.

75 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.