1. The Income-Expenditure Framework: Consumption and the Multiplier
CHAPTER 9
The Income-Expenditure Framework: Consumption and the Multiplier
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2. Questions What are “sticky” prices?
What factors might make prices sticky?
When prices are sticky, what determines the level of real GDP in the short run?
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3. Questions
When prices are sticky, what happens to real GDP if some component of aggregate demand falls?
When prices are sticky, what happens to real GDP if some component of aggregate demand rises?
What determines the size of the spending multiplier?
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4. Real GDP in U.S. History
The flexible-price model does not give a complete picture of the macroeconomy
real GDP does not always grow by the same rate as potential output
the unemployment rate is not always at the natural rate
inflation is not always steady
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5. Figure 9.1 - Real GDP per Worker and Potential Output, 1960-2000
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6. Business Cycles
Fluctuations in economic growth are called business cycles
A business cycle has two phases
expansion or boom
production, employment, and prices all grow rapidly
recession or depression
production falls, unemployment rises, and inflation falls
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7. Business Cycles
To understand business cycles, we need a model that does not always guarantee full employment
We will no longer assume that prices are flexible
Instead, prices will be assumed to be “sticky”
they will remain fixed at predetermined levels as businesses expand or contract production
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8. A Decrease in Autonomous Consumption (C0)
Suppose that autonomous consumption falls from $2,000 billion to $1,800 billion per year
In the flexible-price model, real GDP would be unaffected
the economy would remain at full employment
real GDP would equal potential output
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9. Figure 9.2 - Labor Market Equilibrium
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10. A Decrease in Autonomous Consumption (C0)
In the flexible-price model, a fall in consumption means an increase in savings
the real interest rate falls
the equilibrium level of investment and net exports increases by $200 billion per year
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11. Figure 9.3 - The Effect on Savings of a Fall in Consumption Spending in the Flexible-Price Model
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12. A Decrease in Autonomous Consumption (C0)
Under the flexible-price model, the decline in the real interest rate will lead to a decline in the velocity of money
the price level will fall
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13. A Decrease in Autonomous Consumption (C0)
In the flexible-price model, the consequences of a fall in consumers’ desired baseline consumption are
a drop in consumption
an increase in savings
a decline in the real interest rate
a rise in investment
a rise in the value of the exchange rate
a decline in the price level
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14. A Decrease in Autonomous Consumption (C0)
In the sticky-price model, a drop in consumption leads to a drop in aggregate demand
As businesses see the demand for their products falling, they cut back production
they will fire some of their workers
incomes will fall
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15. A Decrease in Autonomous Consumption (C0)
In the sticky-price model, a drop in consumption does not lead to an increase in savings
the increase in savings (from the fall in consumption) is exactly offset by a decrease in savings (from the fall in income)
The real interest rate is unaffected
no change in investment or net exports
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16. Figure 9.4 - The Effect on Savings of a Fall in Consumption Spending in the Sticky-Price Model
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17. A Decrease in Autonomous Consumption (C0)
In the sticky-price model, the consequences of a fall in consumers’ desired baseline consumption are
a drop in consumption
a decline in production
a decline in employment
a decrease in national income
no change in the real interest rate, investment, or the exchange rate
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18. Expectations Price stickiness causes problems only in the short run
If individuals had time to foresee and gradually adjust their wages and prices to changes in aggregate demand, sticky prices would not be a problem
both the stickiness of prices and the failure to accurately foresee changes are needed to create business cycles
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19. Short Run vs. Long Run In the short run, prices are sticky
shifts in policy or in the economic environment that affect the level of aggregate demand will affect real GDP and employment
In the long run, prices are flexible
individuals have time to react and adjust to changes in policy or the economic environment
real GDP and employment are unaffected
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20. Why Prices Are Sticky
Menu costs are costs associated with changing prices
changing prices can be costly for a variety of reasons
managers and workers may prefer to keep prices and wages stable as long as the shocks that affect the economy are relatively small
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21. Why Prices Are Sticky
Managers and workers lack full information about the state of the economy
They may confuse changes in economy-wide spending with changes in demand for their particular products
cut production rather than cutting the price of the product
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22. Why Prices Are Sticky
The level of prices is often determined by “what is fair”
Work effort and work intensity depend on whether or not workers feel that they are treated fairly
most managers are reluctant to cut wages
if wages are sticky, firms will adjust employment when aggregate demand changes
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23. Why Prices Are Sticky
Managers and workers may suffer from money illusion
confuse changes in nominal prices with changes in real prices
firms react to higher nominal prices by believing that it is profitable to produce more
workers react to higher nominal wages by searching more intensively for jobs and working more hours
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24. The Multiplier Process
If prices are sticky, higher aggregate demand boosts production
Incomes rise
Higher incomes give a further boost to production which increases aggregate demand even more
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25. Figure 9.5 - The Multiplier Process
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26. Building Up Aggregate Demand
Aggregate demand (planned expenditure) has four components
consumption (C)
investment (I)
government purchases (G)
net exports (NX)
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27. The Consumption Function
As incomes rise, consumption spending rises
less than dollar for dollar
The share of an extra dollar of income that shows up as additional consumption is equal to the marginal propensity to consume times the share of income that escapes taxation
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28. Figure 9.6 - The Consumption Function and the Marginal Propensity to Consume
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29. The Consumption Function
The slope of the consumption function is smaller than the marginal propensity to consume (Cy)
because of the tax system, a one-dollar increase in national income means less than a one-dollar increase in disposable income
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30. Figure 9.7 - Consumption as a Function of After-Tax Disposable Income
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31. The Consumption Function
Example
Cy = 0.75
t = 0.40
when Y = $8 trillion, C = $5.5 trillion
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32. Other Components of Aggregate Demand
Investment is determined by the real interest rate and assessments of profitability made by firms’ managers
Government purchases is set by politics
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33. Other Components of Aggregate Demand
Net exports are equal to gross exports minus imports
gross exports are a function of the real exchange rate () and the level of foreign real GDP (Yf)
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34. Figure 9.8 - Components of Aggregate Demand, 1995
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35. Components of Expenditure
The components of aggregate demand can be divided into two groups
autonomous spending (A)
components of aggregate demand that do not depend directly on national income
the marginal propensity to expend (MPE) times the level of national income (Y)
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36. Components of Expenditure
A = autonomous expenditure [A=C0+I+G+GX]
MPE=marginal propensity to expend [MPE=Cy(1-t)-IMy]
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37. Figure 9.9 - The Income-Expenditure Diagram
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38. The Income-Expenditure Diagram
The intercept of the planned expenditure or aggregate demand line is the level of autonomous spending (A)
a change in the value of any component of autonomous spending will shift the planned expenditure line up or down
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39. Figure 9.10 - An Increase in Autonomous Spending
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40. The Income-Expenditure Diagram
The slope of the planned expenditure or aggregate demand line is the marginal propensity to expend (MPE)
changes in the marginal propensity to consume (Cy), the tax rate (t), or in the propensity to spend on imports (IMy) will change the MPE and the slope of the planned expenditure line
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41. Figure 9.11 - An Increase in the Marginal Propensity to Expend
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42. Calculating the MPE Example Cy = 0.75 t = 0.40 IMy = 0.15
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43. Sticky-Price Equilibrium
The economy will be in equilibrium when planned expenditure equals real GDP
there will be no short-run forces pushing for an immediate expansion or contraction of national income, real GDP, and aggregate demand
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44. Figure 9.12 - Equilibrium in the Income-Expenditure Diagram, 1996
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45. Sticky-Price Equilibrium
Equilibrium occurs when planned expenditure (E) is equal to real GDP (Y)
Example
A = $5,600 billion
MPE = 0.30
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46. Sticky-Price Equilibrium
If the economy is not on the 45-degree line, the economy is not in equilibrium
planned expenditure (E) does not equal real GDP (Y)
If Y>E
there is excess supply of goods
If Y<E
there is excess demand for goods
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47. Figure Inventory Adjustment and Equilibrium: Goods Market Equilibrium and the Income-Expenditure Diagram
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48. Inventory Adjustment Excess supply Excess demand
production > aggregate demand
inventories are rising rapidly
firms will cut production
Excess demand
production < aggregate demand
inventories are being depleted
firms will expand production
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49. Figure 9.14 - The Inventory Adjustment Process: An Income-Expenditure Diagram
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50. The Multiplier Suppose that autonomous spending increases
the planned expenditure line will shift up
planned expenditure > national income
inventories would fall
businesses would boost production
how much production would expand depends on the magnitude of the change in autonomous spending and the value of the multiplier
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51. Figure 9.17 - The Multiplier Effect
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52. The Multiplier
The value of the multiplier depends on the slope of the planned expenditure line
the higher is the MPE, the steeper is the planned expenditure line and the greater is the multiplier
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53. Figure 9.18 - Determining the Size of the Multiplier
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54. The Multiplier Equilibrium means that
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55. The Multiplier 1/[1-MPE] is the multiplier
it multiplies the upward shift in the planned expenditure line into a change in the equilibrium level of real GDP, total income, and aggregate demand
because autonomous spending is influenced by many factors, almost every change in economic policy or the economic environment will set the multiplier process in motion
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56. The Multiplier Example A = $5.6 trillion MPE = 0.3 A = $0.1 trillion
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57. The Multiplier
One factor that tends to minimize the multiplier is the government’s fiscal automatic stabilizers
proportional taxes
social welfare programs
An economy that is more open to world trade will have a smaller multiplier than a less open economy
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58. Chapter Summary
Business-cycle fluctuations can push real GDP away from potential output and unemployment far away from its average rate
If prices were perfectly and instantaneously flexible, there would be no such thing as business cycle fluctuations
models in which prices are sticky must play a large role in macroeconomics
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59. Chapter Summary
There are a number of reasons that prices might be sticky
menu costs, imperfect information, concerns of fairness, or money illusion
there is no overwhelming evidence as to which is most important
In the short run, while prices are sticky, the level of real GDP is determined by the level of aggregate demand
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60. Chapter Summary
The short-run equilibrium level of real GDP is that level at which aggregate demand (as a function of national income) is equal to the level of national income (real GDP)
Two quantities summarize planned expenditure as a function of total income
the level of autonomous spending and the marginal propensity to expend (MPE)
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61. Chapter Summary
The level of autonomous spending is the intercept of the planned expenditure function on the income-expenditure diagram
tells us what the level of planned expenditure would be if national income was zero
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62. Chapter Summary
The MPE is the slope of the planned expenditure function on the income-expenditure diagram
tells us how much planned expenditure increases for each one dollar increase in national income
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63. Chapter Summary
The value of the MPE depends on the tax rate (t), the marginal propensity to consume (Cy), and the share of spending on imports (IMy)
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64. Chapter Summary
In the simple macro models, an increase in any component of autonomous spending causes a more than proportional increase in real GDP
the result is the multiplier process
The size of the multiplier depends on the MPE
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