Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley Chapter 3 Spending, Income, and Interest Rates

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Spending, Income, and Interest Rates  Business Cycles and the Theory of Income Determination  Remember that minimizing fluctuations in real GDP is important. Revise the volatilia and stabilia cases.  Business cycles in USA Figure 3-1  Note that the goals of monetary policy is to dampen business cycle fluctuations and ensure a steady growth of real GDP.  This is, as shown in the above figure, is far from reality.  Ups and downs in real GDP are basically caused by changes in shocks to aggregate demand (a significant change in desired spending by consumers, business, government and foreigners).

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-1 Real GDP Growth in the United States, 1950–2004 Note that expansions in general lasts longer than recessions. Why?

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Improved performance of anti-cyclical fluctuations can be due to: 1. - demand shocks are smaller and less important 2. - monetary and fiscal policies become more effective 3. - a change in the conditions that make fiscal and monetary policies more effective.  Income determination, unemployment and the price level  Income determination and the price level  Shocks to AD can change either real GDP, the price level or both.  Changes in AS depends mainly on costs among other factors.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Suppose that the price level is fixed in the short run. All changes in AD cause changes in real GDP by the same amount in the same direction, since; ∆ real GDP = ∆ AD/fixed price level (1)  Is there any evidence to support the assumption that prices are fixed in the short run? 1. Price labels are printed and expensive to reprint 2. Prices of mail order catalogues are set for the entire season 3. Wages and salaries usually change every year and perhaps in more than that.  Therefore, changes in AD are directly translated into changes in real GDP.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  What we explain and what we take as given?  The variables to be explained in a model are called endogenous, while those which are taken as given are called exogenous.  What we will consider as exogenous:  The key instruments of monetary (money supply) and fiscal policies (G & Tax rates), exports and other potential causes of changes in demand shocks such as consumer and business confidence about the future are assumed to be exogenous.  We know that: E ≡ C+I+G+NX (2)  Now let us consider the components of E

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The consumption function  Starting with C as the only endogenous variable, C depends on disposable income (Y-T) such that, C = C a + c(Y-T) (3)  The fixed amount C a is autonomous consumption, which is completely independent of disposable income.  The change in C due to the change in (Y-T) depends on marginal propensity to consume (c).  c(Y-T) is the induced consumption. e.g., C = (Y-T)

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-2 A Simple Hypothesis Regarding Consumption Behavior Break-Even-Point

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  This function is shown in figure 3-2 below.  Note that: When disposable income is zero, total consumption consists of the autonomous part only C a. For any extra disposable income, C changes by.75 of that extra disposable income.  Induced saving and the marginal propensity to save:  Look at figure 3-2 again and note that. The distance between the consumption function and the 45 0 line is the total saving. To the right of point F saving is positive as (Y-T)>C.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  To the left of point F saving is negative as (Y-T)<C, i.e., people either withdraw from their saving accounts or borrow in order to consume. Note: S=(Y-T)-C = (Y-T)- C a -c(Y-T) S=- C a + (1-c)(Y-T)  In our example S= (Y-T)  (1-C) is the marginal propensity to save

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Autonomous consumption, the interest rate and the stock market  There are other factors that cause a change in autonomous consumption. These factors are: 1. Interest rates; C a rises when interest rate falls, and falls when interest rate rises. 2. Household wealth (the market value of houses, stocks, bonds and bank accounts minus liabilities); as wealth rises people will consume more even with fixed income (lower their savings). See figure 3-3  The economy in and out of equilibrium  To see how income is determined note that expenditure is not always what is desired or planned.  If some expenditure is unplanned, business firms will adjust production until the unplanned component is eliminated.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-3 Consumption, Saving, and Disposable Income, 1929–2004

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Total spending that is planned is E p, while the rest is unplanned or undesired (E – E p ). Assume that Investment is the only component that can contain an unplanned component, while the rest are always equal to their planned levels. E p = C + I p + G + NX  Or E p = C a +c(Y-T) + I p + G + NX  The word parameter is a value taken as given or known within a particular analysis. In the consumption function C a and c are parameters,

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Autonomous planned spending  Autonomous planned spending (A p ) is the spending that does not depend on total income (Y); i.e., A p = E – cY = C a – cT a + I p + G + NX (cY induced consumption)  -cTa is autonomous taxes that affect C (note that so far we consider taxes as autonomous).  So A p excludes induced spending only (C a – cT a + I p + G + NX)  Assume that I p = 1200, NX = -200, T=0, G=0, A p equals Ap = 500 – 0.75(0) – 200 = 1500

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Now we have learned that E p has two parts A p and cY, i.e., E p = A p + cY E p = Y  When is the economy in equilibrium  Only when Y equals E p, the economy will be in equilibrium, i.e., households, business firms, the government and the foreign sector want to spend exactly the income generated by current level of production.  If the economy is out of equilibrium, (out of line with planned expenditures) business firms will be forced to change their production. At equilibrium production and income are equal to their planned levels.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-4 How Equilibrium Income Is Determined

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University See figure 3-4  At point B income equals planned expenditure, (no pressures to change).  What happens out of equilibrium  The economy is out of equilibrium all points other than B. at point J, income is planned expenditure are 7500 (Autonomous planned spending Induced consumption spending 6000), i.e., there will be 500 of unsold products.  Though this is counted as investment, businesses do not desire it. (unintended inventory investment I u ). For this reason, they will cut production and income which moves the economy back to B.  Note: Y ≡ E ≡ E p + I u

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The economy will be at equilibrium when I u = 0, i.e., businesses produce exactly the amount that is demanded, or Y = E p Table 3-1 Comparison of the Economy’s “Always True” and Equilibrium Situations

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Determining equilibrium real GDP.  take cY from both sides of the above equation (Y = E p ) Y – cY = E p – cY (remember E p -cY=A p ) (1-c)Y = A p  Note that mps (s) = (1-c), hence; sY = A p (.25Y=1500)  Induced saving equal autonomous planned spending. Since this equation is obtained from equilibrium condition we can divide both sided by s to solve for equilibrium income such that; Y = A p /sor Y = 1500/.25 = 6000  1500 of induced savings are required to balance 1500 of autonomous planned spending.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The multiplier effect.  Any change in A p will cause a change in equilibrium income.  Suppose that businesses raise their investment by 500, i.e., A p increases from 1500 (A p0 ) to 2000 (A p1 ).  Calculating the multiplier New equilibrium Y1 = A p1 /s = 2000/.25 = 8000 Subtract from old Y0 = A p0 /s = 1500/.25 = 6000 Equals change in income ∆Y = ∆A p /s = 500/.25 = 2000  The multiplier k is ∆Y over ∆A p Multiplier k = ∆Y/∆A p = 1/s ∆Y/∆Ap = 1/.25 = 4  Look at the figure and note that k = ∆Y/∆A p = RJ/RB = 1/s k = 2000/500 = 4

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-5 The Change in Equilibrium Income Caused by a $500 Billion Increase in Autonomous Planned Spending Point B is no longer an equilibrium point

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Example of the multiplier effect in action  If planned expenditure rises, real income must rise by 1/s as much.  suppose that an airway company bought 4 billion of boeing aircrafts. This will raise Boeing workers income by 4 billion, out of which they will soon spend.75 on goods and services, that will raise output by 3 billion of consumer goods in the second round. A rise in income by 3 billion will raise spending by 2.25,….., and so on.  Total change in income = 4 x 1/.25 = 16 billion

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Sources of shifts in planned spending  What might cause actual real GDP to decline below the desired level?. A drop in planned investment is a major cause of actual real world recession and depressions.  All other components of autonomous planned spending, can change, (C a, cT a, I p, G, and NX).  Government spending and taxation  The government can adjust its expenditures and taxes to offset fluctuations in real GDP caused by movements in autonomous consumption, in planned investment and net exports. We know that; A p = E – cY = C a – cT a + I p + G + NX

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  A change in autonomous planned spending is; ∆A p = ∆C a – c ∆T a + ∆I p + ∆G + ∆NX  A $1 change in C a changes A p by $1 in the same direction  A $1 change in T a changes A p by $1 in the opposite direction  A $1 change in I p changes A p by $1 in the same direction  A $1 change in G changes A p by $1 in the same direction  A $1 change in NX changes A p by $1 in the same direction  Once a change in A p is calculated, the multiplier determines the resulting change in income. ∆Y = ∆A p /s

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Fiscal expansion  Suppose that the desired level of income is If the autonomous spending A p = 1500, real income is 6000, as shown at point B, but this is unsatisfactory as actual real GDP is 2000 lower than desired.  How fiscal policy correct for this situation through control over G? From 3.14, an increase in real income by 2000 is achieved by any action to raise A p by 500. There are two possibilities: 1. raise G by reduce autonomous tax revenue by A 500 rise in G will have the same impact as any other 500 increase in A p. k for ∆G is the same

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The government budget deficit and its financing  Any change in G or tax revenue has a consequence for the budget. We know that T-G ≡ I + NX – S (recall the magic equation)  and ∆T-∆G ≡ ∆I + ∆NX – ∆S 3.17  Assume that ∆Ca = ∆I = ∆NX = 0, and ∆T = 0, such that the only elements of 3.17 that are changing ∆S and ∆G.  ∆G is the value of fiscal stimulus. Now  ∆T - ∆G = ∆I + ∆NX – s(∆Y - ∆T)  0 - ∆G = –.25(∆Y - 0)  = –.25( ) = -500 (There is a deficit of 500)

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The extra saving of 500 are to be used to buy government bonds that the government must sell to finance its 500 deficit, in order to raise real GDP BY  The tax multiplier  As an alternative to using G by 500, the government can reduce taxes by 667 to have the same impact. Thus; ∆Y = ∆A p /s = -cT a /s ∆Y=-(.75)(-667)/.25 = 500/.25 = 2000  The multiplier for a change in taxes is the income change divided by ∆T a : ∆Y/∆T a = ∆A p /s∆T a = -c∆T a /s∆T a = -c/s ∆Y/∆T a = -.75/.25 = -3.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Financing the tax cut  To see how the budget deficit due to a tax cut is financed we use the same equation:  ∆T - ∆G = ∆I + ∆NX – s(∆Y - ∆T)  = –.25(2000 – (-667))  = -.25(20667) = -667 (There is a deficit of 667)  The tax cut of 667 raised disposable income by 2667 or 667 extra savings is available for households to buy 667 government bonds.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The balanced budget multiplier  The government can stimulate the economy even if it needs to maintain a balanced budget. To see this add the G and T multipliers  Balanced budget multiplier 1/s + -c/s = 1-c/s = 1  this states that the balanced multiplier is one no matter what the value of c is.  How can monetary policy affect planned spending  For the time being we will take the interest rate as given, while converting autonomous consumption from an exogenous into an endogenous variable, but interest rate is still an exogenous variable.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Functions of interest rate  Interest rates help the economy allocate saving among alternative uses. For consumers it is the reward from abstaining from consumption, the higher the interest rate the greater the incentive to save. Also people will borrow less and purchase fewer goods.  Interest rates are central to the role of monetary policy, the government can affect the cost of funds to private borrowers by affecting interest rates  Types of interest rates.  Deposits short term interest rates; for deposits of 3 months or less; while long term interest rates; for a year or more.  Borrowed funds rates: short term rates on funds borrowed by the government (treasury bill rate), by business (commercial paper), and by banks (federal funds rate). There are long term rates on funds borrowed by the government (Treasury bond rate), by businesses (corporate bond rate) and by households (the mortgage rate).

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The relation of autonomous planned spending to the interest rate  I p depends on interest rates, since business firms attempt to profit by borrowing in order to buy investment goods. business can stay in the business only if earnings are enough to pay the interest on borrowed funds.  Example of an airline’s investment decision  If earnings on Boeing jet airliner is 10 m, while its cost is 50 m (interest, fuel, food...etc).  Earnings are 20% rate of return (10/50). If interest rate is 10%, return is sufficient to pay the interest expense.  Look at figure 3-6 which shows the rate of return on 1-5 planes  The first plane earn more because it is operated on the most profitable routs, compared to the second…etc.  Up to the third plane can be bought.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-6 The Payoff to Investment for an Airline and the Economy

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Interest rate and the rate of return line.  Figure 3-6 shows the relationship between interest rates and real private autonomous planned spending. Determination of the level of I p + C a is a two step process. First we plot the rate of return line. Second we find the level of I p +C a at the point where the rate of return crosses the interest rate level.  Business and consumer optimism  Can purchases change when interest rate is held constant? Certainly an increase in business and consumer optimism about expected payoff of additional purchases can shift the entire rate of return line to the RHS. See figure 3-7.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-7 Effect on Autonomous Planned Spending of an Increase in Business and Consumer Confidence

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The demand for autonomous planned spending  We know that autonomous spending is composed of 5 components. There is a negative relationship between interest rates and I p +C a, the other 3 do not depend on interest (G- cT a +NX). See figure 3-8.  Shifts in the Ap demand schedule  A change in G, T and NX shift the A p demand schedule. A shift in business expectations, and improvement in consumer confidence will also shift the Ap demand schedule.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-8 Relation of the Various Components of Autonomous Planned Spending to the Interest Rate

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The IS curve  A p depends on interest rate. Real GDP and real income depend on A p, therefore, real GDP and real income depend on interest rate. The IS curve shows the different combinations of interest rate and real income that are compatible with equilibrium.  How to derive the IS curve.  the LHS OF figure 3-9 shows the demand for Ap at different levels of interest rates. Assume that there are no G, T, and NX, so that Ap consists of Ip + Ca, both is negatively related to interest rate. Given a multiplier of 4, at different points of Ap, real income is determined.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 3-9 Relation of the IS Curve to the Demand for Autonomous Spending

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  What the IS curve shows  The IS shows different combinations of interest rate (r) and income (y), at which the market is in equilibrium when y = Ap. At any point out of the IS the economy is out of equilibrium.

Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University