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Chapter 21

Chapter 21. The Simplest Short-Run Macro Model. In this chapter you will learn to. 1. Describe the difference between desired expenditure and actual expenditure. 2. Explain how desired consumption and desired investment expenditures are determined.

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Chapter 21

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  1. Chapter 21 The Simplest Short-Run Macro Model

  2. In this chapter you will learn to 1. Describe the difference between desired expenditure and actual expenditure. 2. Explain how desired consumption and desired investment expenditures are determined. 3. Describe the definition of equilibrium national income. 4. Describe the effect of a change in desired expenditure on equilibrium income, and explain how this change is reflected by the multiplier.

  3. Desired Aggregate Expenditure The national accounts divide actual GDP into its components: • Ca, Ia , Ga, and NXa. Total desired expenditure is divided into the same categories: • desired consumption, C • desired investment, I • desired government purchases, G • desired net exports, NX

  4. Desired Aggregate Expenditure The sum is called desired aggregate expenditure: AE = C + I + G + NX Two types of expenditures: - autonomous expenditures do not depend on the level of national income - induced expendituresdo depend on the level of national income

  5. Desired Consumption Expenditure Two possible uses of disposable income: - consumption (C) or saving (S) In the simplest theory, consumption is determined primarily by current disposable income (YD). In more advanced theories, individuals are forward looking, and so consumption depends more on “lifetime” income.

  6. Figure 21.1 Consumption and Disposable Income in the United States, 1980-2005

  7. Figure 21.2 The Consumption and Saving Functions The simple consumption function is written as: C = a + bYD Note: the slope of this simple consumption function (b) is less than one.

  8. Marginal Propensity to Consume The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about. MPC = C/YD The MPC is the slope of the consumption function. In the previous diagram, the MPC is the same at any level of income.

  9. Average Propensity to Consume The average propensity to consume(APC) is equal to total consumption divided by total disposable income. APC = C/YD In the previous diagram, the APC falls as the level of income rises. EXTENSIONS IN THEORY 21.1 The Theory of the Consumption Function

  10. The Saving Function • Average propensity to save (APS): • APS = S/YD • Marginal propensity to save (MPS): • MPS = S/YD • Since all disposable income is either consumed or saved, we have: • APC + APS = 1 • MPC + MPS = 1

  11. Figure 21.3 Shifts in the Consumption Function If consumption function shifts upward, the saving function must shift downward. What causes a shift? -  wealth -  interest rate -  expectations

  12. Desired Investment Expenditure • Investment expenditure is the most volatile component of GDP: • changes in investment expenditure are strongly associated with short-run fluctuations Three important determinants of aggregate investment expenditure are: • the real interest rate • changes in the level of sales • business confidence

  13. Figure 21.4 The Volatility of Investment, 1970–2006

  14. The Real Interest Rate The real interest rate is the opportunity cost for: - investment in new plants and equipment - investment in inventories - investment in residential construction Thus, all three components of desired investment expenditure are negatively related to the real interest rate, other things being equal.

  15. The Real Interest Rate Changes in Sales The higher the level of production and sales, the larger the desired stock of inventories: -changes in the rate of sales cause temporary bouts of investment in inventories Business Confidence When business confidence improves, firms want to invest now so as to reap future profits. Business confidence and consumer confidence may feed off of one another.

  16. Figure 21.5 Desired Investment as Autonomous Expenditure

  17. The Aggregate Expenditure Function The AE function: - relates desired aggregate expenditure to actual national income In the absence of government and international trade, desired aggregate expenditure is: AE = C + I

  18. The Aggregate Expenditure Function: Example The consumption function is: C = 30 + (0.8)Y The investment function is: I = 75 The AE function is then given by: AE = C + I = 30 + (0.8)Y + 75 = 105 + (0.8)Y

  19. Figure 21.6 The Aggregate Expenditure Function The slope of the AE function = marginal propensity to spend: - in this simple model, it is just MPC

  20. Equilibrium National Income If desired aggregate expenditure exceeds actual output: - what is happening to inventories? - there is pressure for output to rise If desired aggregate expenditure is less than actual output: - what is happening to inventories? - there is pressure for output to fall

  21. Table 21.1 Equilibrium National Income

  22. Figure 21.7 Equilibrium National Income

  23. 45º line Desired AE AE 900 600 • 300 105 300 600 900 Actual National Income Equilibrium National Income In this model, output is said to be demand determined. The equilibrium condition: Y = AE(Y) Equilibrium national income is the level of national income where desired aggregate expenditure equals actual national income.

  24. Figure 21.8 Shifts in the Aggregate Expenditure Function

  25. The Multiplier The multiplier is a measure of the size of the change in equilibrium Y that results from a change in autonomous expenditure. In our simplest of macro models, the multiplier exceeds one. APPLYING ECONOMIC CONCEPTS 21.1 The Multiplier: A Numerical Example

  26. Figure 21.9 The Simple Multiplier Simple multiplier = Y 1 = A 1-z Where z is the marginal propensity to spend out of national income and A is the change in autonomous expenditure.

  27. Figure 21.10 The Size of the Simple Multiplier The larger is z, the steeper is the AE curve and the larger is the simple multiplier.

  28. Economic Fluctuations as Self-Fulfilling Prophecies Households and firms base their desired investment and consumption partly on their expectations of the future: - changes in expectations can lead to real changes in the current state of the economy Example: - imagine that firms feel optimistic about the future - this increases their desired investment, shifting up the AE curve - this increases Y, justifying the initial optimism

  29. The Simple Multiplier EXTENSIONS IN THEORY 21.2 The Algebra of the Simple Multiplier

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