Topic 5 1 The Short – Run Macro Model

2 The Short-Run Macro Model In short-run, spending depends on income, and income depends on spending. –The more income households have, the more they will spend. –The more households spend, the more output firms will produce More income they will pay to their workers. Many ideas behind the model were originally developed by British economist John Maynard Keynes in 1930s. –Short-run macro model focuses on spending in explaining economic fluctuations.

3 Review the Categories of Spending Macroeconomists have found that the most useful approach is to divide those who purchase the GDP into four broad categories –Households --- consumption spending (C) –Business firms --- planned investment spending (I P ) –Government agencies --- government purchases (G) –Foreigners --- net exports (NX) Nominal or real spending? –Real terms

4 Consumption What factors affect households’ spending? –Disposable income: Y d (= Y – T) –Wealth (= total assets – total liability) –Price level –Interest rate When interest rate falls, consumption rises –Expectations about future

5 Figure: U.S. Consumption and Disposable Income,

6 Figure: The Consumption Function

7 Consumption and Disposable Income Autonomous consumption spending –Consumption spending when disposable income is zero Marginal propensity to consume, or MPC –The slope of the consumption function –MPC = Δ Consumption ÷ Δ Disposable Income –MPC measures by how much consumption spending rises when disposable income rises by one dollar Logic and empirical evidence suggest that the MPC should be larger than zero, but less than 1 –So, we assume that 0 < MPC < 1

Consumption and Saving The marginal propensity to consume (MPC) is equal to the change in consumption associated with a given change in income. The marginal propensity to save (MPS) is equal to the change in saving associated with a given change in income. 8

Consumption and Saving MPC and MPS will always sum to 1, since the only thing that can be done with additional income is to either spend it or save it. MPC + MPS = 1 9

10 Representing Consumption with an Equation C = a + b  Y d Where C is consumption spending And a is the autonomous consumption spending And b is the marginal propensity to consume (MPC) Equation between consumption and total income Since Y d = Y – T, C = a + b  (Y – T) So, C = (a- b  T) + b  Y

11 Figure: The Consumption-Income Line

12 Shifts in the Consumption-Income Line –When a change in income causes consumption spending to change, we move along consumption- income line. –When a change in anything else besides income causes consumption spending to change, the line will shift.

13 Figure: A Shift in the Consumption- Income Line

14 I P, G and NX For now, in the short-run macro model, planned investment spending, government purchases, and net exports are all treated as given or fixed values.

15 Summing Up: Aggregate Expenditure Aggregate expenditure (AE) –Sum of spending by households, businesses, government, and foreign sector on final goods and services produced in United States –Aggregate expenditure = C + I P + G + NX AE plays a key role in explaining economic fluctuations –Why? Because over several quarters or even a few years, business firms tend to respond to changes in aggregate expenditure by changing their level of output.

16 Finding Equilibrium GDP When aggregate expenditure is less than GDP, inventories will increase and output will decline in future. When aggregate expenditure is greater than GDP, inventories will decrease and output will rise in future. In short-run, equilibrium GDP is level of output at which output and aggregate expenditure are equal.

17 Inventories and Equilibrium GDP When firms produce more goods than they sell, what happens to unsold output? –Added to their inventory stocks Find output level at which change in inventories is equal to zero. –AE 0  GDP↓ in future periods –AE > GDP  ΔInventories < 0  GDP↑ in future periods –AE = GDP  ΔInventories = 0  No change in GDP Equilibrium output level is the one at which change in inventories equals zero.

18 Figure: Deriving the Aggregate Expenditure Line

19 Figure: Using a 45° to Translate Distances

20 Figure: Determining Equilibrium Real GDP

21 Equilibrium GDP and Employment When economy operates at equilibrium, will it also be operating at full employment? –Not necessarily For instance, insufficient spending causes business firms to decrease their demand for labor. –Remember, in the long run (classical) macro model, it takes time for labor market to achieve full employment. In the short-run model, it would be quite a coincidence if our equilibrium GDP happened to be the full employment output level. In short-run macro model, output can be lower or higher than the full employment output level.

22 Figure: Short-Run Equilibrium GDP < Full Employment GDP

23 Figure: Short-Run Equilibrium GDP > Full- Employment GDP

24 A Change in Investment Spending Suppose the initial equilibrium GDP in an economy is $6,000 billion. Now, business firms increase their investment spending on plant and equipment by $1,000 billion. Then, firms that sell investment goods receive $1,000 billion as income, which is to be distributed as salary, rent, interest, and profit. What will households do with their $1,000 billion in additional income? –Spend the money ! –How much to spend depends crucially on marginal propensity to consume (MPC): let’s assume MPC = 0.6

25 A Change in Investment Spending When households spend an additional $600 billion, firms that produce consumption goods and services will receive an additional $600 billion in sales revenue. –Which will become income for households that supply resources to these firms. At this point, total income has increased by $1,000+$600=$1,600billion –With an MPC of 0.6, consumption spending will further rise by 0.6 x $600 billion = $360 billion, creating still more sales revenue for firms, and so on and so on… At end of process, when economy has reached its new equilibrium. –Total spending and total output are considerably higher.

26 Figure: The Effect of a Change in Investment Spending

27 The Expenditure Multiplier Whatever the rise in investment spending, equilibrium GDP would increase by a factor of 2.5, so we can write –ΔGDP = 2.5 x ΔI P Value of expenditure multiplier depends on value of MPC So, when the increase in planned investment spending is ΔI P, the increase in total income (GDP) is calculated as:

28 The Expenditure Multiplier A sustained increase in investment spending will cause a sustained increase in GDP. Multiplier process works in both directions. –Just as increases in investment spending cause equilibrium GDP to rise by a multiple of the change in spending. Decreases in investment spending cause equilibrium GDP to fall by a multiple of the change in spending.

29 Spending Shocks Shocks to economy can come from other sources besides investment spending. –Government purchases (G) –Net exports (NX) –Autonomous consumption (a) Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP.

30 Spending Shocks The effect of a change in spending on total income through expenditure multiplier

31 Tax Multiplier A change in taxes will have less of a direct impact on income, employment, and output than will an equivalent change in I, G, NX, or autonomous consumption.

32 Balanced Budget Multiplier Foundations of the balanced budget multiplier:  Equal changes in government spending and taxation lead to an equal change in income. Equivalently, the balanced budget multiplier is equal to 1.  If spending and taxes are increased by the same amount, income grows by this amount.

33 Figure: A Graphical View of the Multiplier

Application: The Recession of December 2007 recession began Aggregate expenditures declined Consumption spending declined Investment spending declined Recessionary expenditure gap

Application: The Recession of Federal government undertook Keynesian policies Tax rebate checks $787 billion stimulus package

Say’s Law vs. Keynesian Theory Classical economics Say’s Law Economy will automatically adjust Laissez-faire Keynesian economics Cyclical unemployment can occur Economy will not correct itself Government should actively manage macroeconomic instability

37 Automatic Stabilizers and the Multiplier Automatic stabilizers reduce size of multiplier and therefore reduce impact of spending shocks. –With milder fluctuations, economy is more stable. Some real-world automatic stabilizers we’ve ignored in the simple, short-run macro model of this chapter –Taxes –Transfer payments –Interest rates –Imports –Forward-looking behavior

38 The Role of Saving In long-run, saving has positive effects on economy. But in short-run, automatic mechanisms of classical model do not keep economy operating at its potential. In long-run, an increase in desire to save leads to faster economic growth and rising living standards. –In short-run, however, it can cause a recession that pushes output below its potential. Two sides to the “saving coin” –Impact of increased saving is positive in long-run and potentially dangerous in short-run.

39 The Effect of Fiscal Policy In classical model fiscal policy—changes in government spending or taxes designed to change equilibrium GDP— is completely ineffective – crowding out effect. In short-run, an increase in government purchases causes a multiplied increase in equilibrium GDP. –Therefore, in short-run, fiscal policy can actually change equilibrium GDP. –Observation suggests that fiscal policy could, in principle, play a role in altering path of economy. Indeed, in 1960s and early 1970s, this was the thinking of many economists. –But very few economists believe this today.