Macroeconomics: Principles, Applications, and Tools

Transcription

1 Macroeconomics: Principles, Applications, and Tools NINTH EDITION Chapter 11 The Income- Expenditure Model

2 Learning Objectives 11.1 Discuss the income-expenditure model Identify the two key components of the consumption function Calculate equilibrium income in a simple model Explain how government spending and taxes affect equilibrium income Discuss the role of exports and imports in determining equilibrium income Explain how the aggregate demand curve is related to the income-expenditure model.

3 John Maynard Keynes English economist ( ) Advocated government spending/deficits were essential during periods of recession Most governments reluctant to consider deficit spending Multiplier effect The General Theory of Employment, Interest, and Money (1936) Aggregate demand determines overall level of economic activity Stickiness Faced with unemployment and excess capacity (decreased C/I) government intervention required to stimulate demand

4 The Great Depression ( ) Worldwide economic contraction/collapse Roaring 20s Stock market crash Oct 1929 Prior to crash: low wages, high consumer debt, rising unemployment, decreasing production, falling prices for agricultural production, large #s of outstanding loans, margin trading Oct 24 DJ lost 11% value Oct 29 DJ lost 15% value ($14B)

5 The Great Depression ( ) worldwide GDP fell by ~ 15% <1% during Great Recession of International trade decreased >50% US unemployment ~25% Uncertainty: reluctance to borrow, C & I decreased Deflationary spiral

6 The Great Depression ( ) Year Real GDP ($T) GDP Growth (%)

7 11.1 A SIMPLE INCOME-EXPENDITURE MODEL Equilibrium Output At any point on the 45 line, the distance to the horizontal axis is the same as the distance to the vertical axis.

8 11.1 A SIMPLE INCOME-EXPENDITURE MODEL Equilibrium Output At equilibrium output y*, total demand y* equals output y*. Planned expenditures Another term for total demand for goods and services. Equilibrium output The level of GDP at which planned expenditure equals the amount that is produced. equilibrium output = y* = C + I = planned expenditures

9 11.1 A SIMPLE INCOME-EXPENDITURE MODEL Adjusting to Equilibrium Output Equilibrium output (y*) is determined at a, where demand intersects the 45 line. If output were higher (y 1 ), it would exceed demand and production would fall. If output were lower (y 2 ), it would fall short of demand and production would rise. TABLE 11.1 Adjustments to Equilibrium Output (in Billions of Dollars) C + I Production Inventories Direction of Output $100 $80 Depletion of inventories of $20 Output increases No change Output stays constant Excess of inventories of $20 Output decreases

10 11.2 THE CONSUMPTION FUNCTION Consumer Spending and Income Consumption function The relationship between consumption spending and the level of income. Autonomous consumption The part of consumption that does not depend on income. Marginal propensity to consume (MPC) The fraction of additional income that is spent.

11 11.2 THE CONSUMPTION FUNCTION Consumer Spending and Income The consumption function relates desired consumer spending to the level of income. Output is equal to income that flows to households

12 FIGURE 11.5 Moments of the Consumption Function

13 11.2 THE CONSUMPTION FUNCTION Changes in the Consumption Function Two factors that can cause autonomous consumption to change: Increases in consumer wealth will cause an increase in autonomous consumption. Increases in consumer confidence will increase autonomous consumption. Factors that can cause MPC to change Income/taxes Interest rates Inflation

14 APPLICATION 1 FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING APPLYING THE CONCEPTS #1: How do changes in the value of homes affect consumer spending? Home equity is the difference between the home value and what is owed on the mortgage. The largest component of net wealth for most families. Changes in home equity like other forms of wealth affect consumer spending. From 1997 to mid-2006 housing prices rose by about 90 percent and consumer wealth grew by $6.5 trillion. This ended in 2006 as housing prices began to fall. According to a review of studies by the Congressional Budget Office, each $1 decline in consumer wealth would lower consumption spending between $.02 and $.07, or $21 to $72 billion of spending. This would reduce economic growth 0.1 to 0.5 percent during 2007.

15 11.3 EQUILIBRIUM OUTPUT AND THE CONSUMPTION FUNCTION Equilibrium output is determined where the C + I line intersects the 45 line. At that level of output, y*, desired spending equals output.

16 11.3 EQUILIBRIUM OUTPUT AND THE CONSUMPTION FUNCTION Saving and Investment Savings function The relationship between the level of saving and the level of income. S = y C y = C + I y C = I S = I

17 11.3 EQUILIBRIUM OUTPUT AND THE CONSUMPTION FUNCTION Saving and Investment Equilibrium output is determined at the level of output, y*, where savings equals investment. S = S = 40

18 11.3 EQUILIBRIUM OUTPUT AND THE CONSUMPTION FUNCTION Understanding the Multiplier When investment increases from I 0 to I 1, equilibrium output increases from y 0 to y 1. The change in output (Δy) is greater than the change in investment (ΔI). In general, the increase in output is always greater than the increase in investment because of the multiplier effect.

19 11.4 GOVERNMENT SPENDING AND TAXATION Fiscal Multipliers Planned expenditures including government = C + I + G

20 11.4 GOVERNMENT SPENDING AND TAXATION Fiscal Multipliers Multiplier for government spending = 1 1 MPC The consumption function with taxes is C = C a + b(y T) The formula for the tax multiplier is tax multiplier = MPC 1 MPC

21 11.4 GOVERNMENT SPENDING AND TAXATION Using Fiscal Multipliers Although it is very simple, our income-expenditure model illustrates some important lessons: An increase in government spending will increase total planned expenditures for goods and services. Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in planned expenditures for goods and services. Policymakers need to take into account the multipliers for government spending and taxes as they develop policies. In the long run, of course, we are better off if government spends the money wisely, such as on needed infrastructure such as roads and bridges. This is an example of the principle of opportunity cost. PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it.

22 APPLICATION 2 MULTIPLIERS IN GOOD TIMES AND BAD APPLYING THE CONCEPTS #2: Are multipliers for government spending higher during recessions? A common belief is that fiscal multipliers are larger during recessions, when there is more slack in the economy. But, it is quite difficult to estimate government multipliers accurately. Valerie Ramey and Sarah Zubiary find no evidence of greater multipliers during slack times in the U.S. Daniel Riera-/Crichton, Carlos Veigh, and Guillermo Vuletin found different results. By carefully looking at periods when both government spending increased and the economy had slower or negative growth, they found the multiplier to be 2.3. This is larger than conventionally calculated multipliers.

23 APPLICATION 3 THE BROKEN WINDOW FALLACY AND KENSESIAN ECONOMICS APPLYING THE CONCEPTS #3: How does Keynesian Economics change our normal ideas of economic scarcity? Austrian economist, Henry Hazlitt, popularized the Broken Windows fallacy in economics. Imagine that a hoodlum threw a brick through a store window. While at first this seems to be a tragedy, the store owner has to hire a firm to fix the window. That generates business for the window repair firm and, through a multiplier, additional business throughout the community. Was the broken window good for society? The fallacy here is that the money that the store owner paid to have the window repaired would have been spent elsewhere in the economy, say on clothing. Hazlitt applies a similar argument to public spending financed by taxes. A government spending program may appear to increase business, but the taxes needed to finance the spending either paid now or in the future will mean less business for other firms. Government spending and the taxes necessary to finance it will just crowd out other production of goods and services in the economy. But in the Keynesian world, where resources are underemployed, the story is quite different. Here the increase in spending even financed by taxes will bring resources that are not being utilized into the economy. As long as there is excess capacity in the economy, the extra spending will increase output and not crowd out other goods and services.

24 11.4 GOVERNMENT SPENDING AND TAXATION Understanding Automatic Stabilizers After World War II, fluctuations in GDP growth became considerably smaller. SOURCE: Angus Maddison, Dynamic Forces in Capitalist Development (New York: Oxford University Press, 1991); U.S. Department of Commerce.

25 11.4 GOVERNMENT SPENDING AND TAXATION Understanding Automatic Stabilizers An increase in tax rates decreases the slope of the C + I + G line. This lowers output and reduces the multiplier. C = C a + b(1 t)y adjusted MPC = b(1 t)

26 11.5 EXPORTS AND IMPORTS To modify our model to include the effects of world spending on exports and U.S. spending on imports, we need to take two steps: 1. Add exports, X, as another source of demand for U.S. goods and services. 2. Subtract imports, M, from total spending by U.S. residents. We will assume that imports, like consumption, increase with the level of income. M = my Marginal propensity to import The fraction of additional income that is spent on imports.

27 11.5 EXPORTS AND IMPORTS (2 of 2) Output is determined when the demand for domestic goods equals output.

28 FIGURE How Increases in Exports and Imports Affect U.S. GDP

29 APPLICATION 4 THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY S OUTPUT APPLYING THE CONCEPTS #4: How do countries benefit from growth in their trading partners? From the early 1990s until quite recently, the United States was what economists term the locomotive for global growth. Our demand for foreign products increased. U.S. imports increased along with output during this period. The increased demand fueled exports in foreign countries and promoted their growth. Studies have shown that the increase in demand for foreign goods was actually more pronounced for developing countries than for developed countries. Conclusion: The United States was truly a locomotive, pulling the developing countries along.

30 11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE The aggregate demand curve shows the combination of prices and equilibrium output. As the price level falls from P 0 to P 1, planned expenditures increase, which increases the level of output from y 0 to y 1. At any price level, the incomeexpenditure model determines the level of output.

31 11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE As government spending increases from G 0 to G 1, planned expenditures increase, which raises output from Y 0 to Y 1. At the price level P 0, this shifts the aggregate demand curve to the right from AD 0 to AD 1. The aggregate demand curve shows the combination of prices and equilibrium output.

32 Learning Objectives 11.1 Discuss the income-expenditure model Identify the two key components of the consumption function Calculate equilibrium income in a simple model Explain how government spending and taxes affect equilibrium income Discuss the role of exports and imports in determining equilibrium income Explain how the aggregate demand curve is related to the income-expenditure model.

33 KEY TERMS Autonomous consumption Consumption function Equilibrium output Marginal propensity to consume (MPC) Marginal propensity to import Planned expenditures Savings function

34 Questions? Homework Ch11, pp , 2.7, 3.5, 4.5, 5.1, 6.5