Short run Output and Expenditure

Transcription

1 Short run Output and Expenditure

2 Short-run Output and Expenditure The Learning Objectives in this presentation are covered in Chapter 19: Output and Expenditure in the Short Run LEARNING OBJECTIVES 1 To understand how macroeconomic equilibrium is determined in the aggregate expenditure model 2 Discuss the determinants of the four components of aggregate expenditure and understand the marginal propensity to consume and save 3 Use a 45 line diagram to illustrate macroeconomic equilibrium 4 Define the multiplier effect and use it to calculate changes in equilibrium GDP and understand the relationship between the aggregate demand curve and aggregate expenditure 2

3 Fluctuating Demand in the Short-run A model of the short run economy where spending determines the output businesses produce Developed in the 1930s by John Maynard Keynes, this model generates important policy recommendations and a role for the government in stabilising the economy 3

4 The Aggregate Expenditure Model LEARNING OBJECTIVE: ONE Aggregate expenditure model A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming that the price level is constant Four types of spending in the economy: Aggregate Expenditure (AE): 1 Consumption (C) 2 Planned Investment (I p ) additions to capital stock and inventory 3 Government Purchases (G) 4 Net Exports (NX) 4

5 Four Parts of Aggregate Expenditure LEARNING OBJECTIVE: ONE Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports or AE = C + I p + G + NX 5

6 Difference between Planned and Actual Investment LEARNING OBJECTIVE: ONE One component of actual investment unplanned inventory change is partly determined by how much households decide to buy, which is not under the complete control of firms Inventories are goods that have been produced but not yet sold Planned investment refers to the additions to capital stock and inventory that are planned by firms Actual investment is the actual total amount of investment that takes place; it includes both the planned investment and items such as unplanned changes in inventories: Actual investment = Planned Investment + Unplanned Investment Unplanned Investment = Expected sales actual sales 6

7 Planned and Actual Investment an example LEARNING OBJECTIVE: ONE The difference between Planned Investment and Actual Investment Example: Apple plans to produce 162 million ipads this year It expects to sell 161 million and add 100,000 to its inventories in its stores Therefore what is Apple s Planned Investment? 100,000 ipads If Apple only sells 159 million, what is its Actual Investment? Planned investment + difference between expected and actual sales =100, ,000 = 300,000 ipads 7

8 Adjustments to Macroeconomic Equilibrium LEARNING OBJECTIVE: ONE Table The Relationship between Aggregate Expenditure (spending) and GDP (production) IF THEN AND Aggregate expenditure is equal to GDP (spending equals production) Aggregate expenditure is less than GDP (spending is less than production) Aggregate Expenditure is greater than GDP (spending is more than production) inventories are unchanged inventories rise inventories fall the economy is in macroeconomic equilibrium GDP and employment decrease GDP and employment increase Making the Connection Macroeconomic Equilibrium: Aggregate expenditure = GDP Planned aggregate spending = total output 8

9 Adjusting to Macroeconomic Equilibrium A Summary LEARNING OBJECTIVE: ONE Changes in unplanned inventories play an important role in the adjustment of the economy back to equilibrium: If AE is greater than GDP firms see their unplanned inventories fall and so they will increase production and hiring of workers If AE is less than GDP firms see their unplanned inventories rise and so they will decrease production and lay off workers If AE is equal to GDP firms sell what they expected to sell and there is no incentive for them to increase or decrease production 9

10 Determining the Level of Aggregate Expenditure LEARNING OBJECTIVE: TWO Table Components of Real Aggregate Expenditure,

11 Consumption (C) LEARNING OBJECTIVE: TWO The following are the five most important variables that determine the level of consumption: 1 Current disposable income 2 Household wealth 3 Expected future income 4 The price level 5 The interest rate 11

12 The Determinants of Consumption (1) LEARNING OBJECTIVE: TWO 1 Current Disposable Income The most important determinant of consumption is the current disposable income of households 2 Household Wealth Consumption also depends on the wealth of households A household s wealth is the value of its assets minus the value of its liabilities 12

13 The Determinants of Consumption (2) LEARNING OBJECTIVE: TWO 3 Expected Future Income Consumption also depends on expected future income Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly 4 The Price Level The price level measures the average prices of goods and services in the economy Consumption is affected by changes in the price level 5 The Interest Rate When the interest rate is high, the reward to saving is increased, and households are likely to save more and spend less 13

14 The Consumption Function LEARNING OBJECTIVE: TWO The Consumption Function The positive relationship between consumption spending and disposable income is known as the consumption function Marginal Propensity to Consume (MPC) The slope of the consumption function (The amount by which consumption spending changes when disposable income changes) MPC Change in consumption Change in disposable income C YD 14

15 The Consumption Function LEARNING OBJECTIVE: TWO We can also use the MPC to determine how much consumption will change as income changes: MPC Change in consumption Change in disposable income or Change in consumption = Change in disposable income MPC 15

16 Consumption and National Income LEARNING OBJECTIVE: TWO The Relationship between Consumption and National Income Disposable income = National income Net taxes We can rearrange the equation like this: National income = GDP = Disposable income + Net taxes 16

17 Consumption and National Income LEARNING OBJECTIVE: TWO Figure The Relationship between Consumption and National Income 17

18 Income, Consumption and Savings LEARNING OBJECTIVE: TWO National income = Consumption + Saving + Taxes Change in national income = Change in consumption + Change in saving + Change in taxes Y = C + S + T and Y C S T To simplify, we can assume that taxes are always a constant amount, in which case ΔT = 0, so the following is also true: ΔY = ΔC + ΔS 18

19 Income, Consumption and Savings LEARNING OBJECTIVE: TWO Marginal propensity to save (MPS) The change in saving divided by the change in disposable income or, Y C S Y Y Y 1 = MPC + MPS 19

20 Putting it into Practice Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save MPC C Y MPS S Y NATIONAL INCOME AND REAL GDP (Y) CONSUMPTION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) $9,000 $8,000 $1,000 10,000 8,600 1, ,000 9,200 1, ,000 9,800 2, ,000 10,400 2,

21 Planned Investment (I p ) LEARNING OBJECTIVE: TWO 21

22 The Determinants of Planned Investment (1) LEARNING OBJECTIVE: TWO The four most important variables that determine the level of investment are: 1 Expectations of future profitability 2 The interest rate 3 Taxes 4 Cash flow 22

23 The Determinants of Planned Investment (2) LEARNING OBJECTIVE: TWO 1 Expectations of Future Profitability The optimism or pessimism of firms is an important determinant of investment spending 2 The Interest Rate A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending 3 Taxes Firms focus on the profits that remain after they have paid taxes 4 Cash Flow Cash flow is the difference between the cash revenues received by a firm and the cash spending by the firm 23

24 Making the Connection The Construction Boom in the Gulf ( ) Induces Steel Production Capacity Growth The GCC countries have experienced an unprecedented growth in the spending on construction and real estate during Steel imports grew The optimistic growth expectations, the flow of capital, and a growing building momentum had led investors to quickly take the opportunity to finance capacity expansions and new steel plants in the GCC area 24

25 Government Purchases (G) LEARNING OBJECTIVE: TWO 25

26 Net Exports (NX) LEARNING OBJECTIVE: TWO 26

27 The Determinants of Net Exports (1) LEARNING OBJECTIVE: TWO The following are the three most important variables that determine the level of net exports: 1 The price level domestically relative to the price levels in other countries 2 The growth rate of GDP domestically relative to the growth rates of GDP in other countries 3 The exchange rate between the dollar and other currencies 27

28 The Determinants of Net Exports (2) LEARNING OBJECTIVE: TWO 1 The Price Level in the United States Relative to the Price Levels in Other Countries If inflation in the United States is lower than inflation in other countries, prices of US products increase more slowly than the prices of products of other countries 2 The Growth Rate of GDP in the United States Relative to the Growth Rates of GDP in Other Countries When incomes in the United States rise more slowly than incomes in other countries, net exports will rise 3 The Exchange Rate Between the Dollar and Other Currencies As the value of the US dollar rises, the foreign currency price of US products sold in other countries rises, and the dollar price of foreign products sold in the United States falls 28

29 Macroeconomic Equilibrium An Example LEARNING OBJECTIVE: THREE Figure Example of a 45 -Line Diagram 29

30 Macroeconomic Equilibrium The Whole Economy LEARNING OBJECTIVE: THREE Figure The Relationship between Planned Aggregate Expenditure and GDP on a 45 -Line Diagram 30

31 Macroeconomic Equilibrium The Keynesian Cross LEARNING OBJECTIVE: THREE Figure Macroeconomic Equilibrium 31

32 Modelling Macroeconomic Equilibrium LEARNING OBJECTIVE: THREE Figure Macroeconomic Equilibrium on the 45 -Line Diagram 32

33 Modelling a Recession LEARNING OBJECTIVE: THREE Figure Showing a Recession on the 45 -Line Diagram 33

34 Modelling Macroeconomic Equilibrium LEARNING OBJECTIVE: THREE The Important Role of Inventories Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories Whenever planned aggregate expenditure is more than real GDP, some firms will experience and unplanned decrease in inventories 34

35 An Example of Macroeconomic Equilibrium LEARNING OBJECTIVE: THREE Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government (G) + Net exports (NX) Table Macroeconomic Equilibrium Real GDP (Y) Consumption (C) Planned Investment (I) Government Purchases (G) Net Exports (NX) Planned Aggregate Expenditure (AE) Unplanned Change in Inventories Real GDP Will $8,000 $6,200 $1,500 $1,500 $500 $8,700 $700 increase 9,000 6,850 1,500 1, , increase 10,000 7,500 1,500 1, ,000 0 be in equilibrium 11,000 8,150 1,500 1, , decrease 12,000 8,800 1,500 1, , decrease Unplanned change in inventories = Real GDP (Y) Planned aggregate expenditure (AE) 35

36 Modelling the Multiplier Effect (1) LEARNING OBJECTIVE: THREE Figure The Multiplier Effect 36

37 Modelling the Multiplier Effect (2) LEARNING OBJECTIVE: THREE Multiplier effect = The process by which an increase in autonomous expenditure leads to a larger increase in real GDP because of a series of induced changes in consumption Autonomous expenditure = An expenditure that does not depend on the level of GDP: G, I, NX & C Non Autonomous expenditure = An expenditure that does depend on the level of GDP: C Multiplier = The increase in equilibrium real GDP divided by the increase in autonomous expenditure 37

38 The Multiplier Effect A Numerical Example LEARNING OBJECTIVE: THREE Table The Multiplier Effect in action ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP ROUND 1 $100 billion $0 $100 billion ROUND billion 175 billion ROUND billion 231 billion ROUND billion 273 billion ROUND billion 305 billion ROUND billion 377 billion ROUND billion 395 billion ROUND billion 398 billion n 0 0 $400 billion 38

39 A Formula for the Multiplier LEARNING OBJECTIVE: THREE The Multiplier formula: 1 1 MPC Multiplier Change in equilibriu m real GDP Change in autonomous expenditur e 1 1 MPC 39

40 The Algebra of Macroeconomic Equilibrium LEARNING OBJECTIVE: FOUR The letters with bars over them represent fixed, or autonomous, values So, represents autonomous consumption, which had a value of 1,000 in our original example Now, solving for equilibrium, we get: Y C MPC(Y) I G NX or, or, or, Y - MPC(Y) C I G NX Y( 1 MPC) C I G NX Y C I G NX 1 MPC 40

41 The Algebra of Macroeconomic Equilibrium LEARNING OBJECTIVE: THREE 1 Remember that is the multiplier Therefore an alternative expression for 1 MPC equilibrium GDP is: Equilibrium GDP = Autonomous expenditure x Multiplier 41

42 Summarizing the Multiplier Effect LEARNING OBJECTIVE: THREE 1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases 2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be 3 The larger the MPC, the larger the value of the multiplier 4 The formula for the multiplier, 1/(1 MPC), is oversimplified because it ignores some real world complications, such as the effect that increasing GDP can have on imports, inflation, and interest rates 42

43 Making the Connection The Multiplier in Reverse The Great Depression of the 1930s The multiplier effect contributed to the very high levels of unemployment during the Great Depression YEAR CONSUMPTION INVESTMENT NET EXPORTS REAL GDP UNEMPLOYMENT RATE 1929 $737 billion $102 billion -$11 billion $977 billion 32% 1933 $601 billion $19 billion -$12 billion $716 billion 249% 43

44 LEARNING OBJECTIVE: FOUR Putting it into Practice Using the Multiplier Formula (Part 1) REAL GDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) $8,000 $6,900 $1,000 $1,000 $500 9,000 7,700 1,000 1, ,000 8,500 1,000 1, ,000 9,300 1,000 1, ,000 10,100 1,000 1,

45 LEARNING OBJECTIVE: FOUR Putting it into Practice Using the Multiplier Formula (Part 2) REALGDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) PLANNED AGGREGATE EXPENDITURE (AE) $8,000 $6,900 $1,000 $1,000 $500 $8,400 9,000 7,700 1,000 1, ,200 10,000 8,500 1,000 1, ,000 11,000 9,300 1,000 1, ,800 12,000 10,100 1,000 1, ,600 MPC C Y 1 1 MPC 45

46 The Multiplier Effect - The Paradox of Thrift LEARNING OBJECTIVE: FOUR In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving Keynes referred to this outcome as the paradox of thrift because what appears to be something favourable to the long run performance of the economy might be counterproductive in the short run 46

47 Deriving the Aggregate Demand Curve LEARNING OBJECTIVE: FOUR Figure The Effect of a Change in the Price Level on Real GDP 47

48 The Aggregate Demand Curve LEARNING OBJECTIVE: FOUR Figure The Aggregate Demand Curve Aggregate demand curve: A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure 48

49 Key Terms» Aggregate demand curve» Aggregate Expenditure (AE)» Aggregate expenditure model» Autonomous expenditure» Cash flow» Inventories» Marginal Propensity to Consume (MPC)» Marginal Propensity to Save (MPS)» Multiplier» Multiplier effect» Consumption function 49