The Goods Market and the Aggregate Expenditures Model

The Goods Market and the Aggregate Expenditures Model Chapter 8 The Historical Development of Modern Macroeconomics The Great Depression of the 1930s led to the development of macroeconomics and aggregate demand tools to deal with recessions. During the Depression, output fell by 30 percent and unemployment rose to 25 percent. 2 The Historical Development of Modern Macroeconomics Keynes is the author of The General Theory of Employment, Interest and Money, which provided the new framework for macroeconomic policy. Classical Economists The Classical economists' approach was laissez-faire (leave the market alone). They believed the market was self-adjusting. They concentrated on the long run and largely ignored the short run. 3 4 Classical Economics They used microeconomic supply and demand arguments to explain the Great Depression. Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high. Classical Economics Classical economists opposed deficit spending, arguing that the money to create jobs had to be borrowed. This money would have financed private economic activity and jobs, so everything would cancel out (called crowding out). 5 6

The Historical Development of Modern Macroeconomics Before the Depression, the prominent ideology was laissez-faire -- keep the government out of the economy. The Essence of Keynesian Economics Keynes thought that the economy could get stuck in a rut as wages and price level adjusted to sudden decreases in expenditures. After the Depression, most people believed government should have a role in regulating the economy. 7 8 The Essence of Keynesian Economics According to Keynes: a decrease in spending job layoffs fall in consumer demand firms decrease production more job layoffs further fall in consumer demand, and so forth Equilibrium Income Fluctuates Income is not fixed at the economy's long-run potential income it fluctuates. For Keynes there was a difference between equilibrium income and potential income. 9 10 Equilibrium Income Fluctuates Equilibrium income the level toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production. Potential income the level of income that the economy technically is capable of producing without generating accelerating inflation. Equilibrium Income Fluctuates Keynes felt that at certain times the economy needed help to reach its potential income. He believed that market forces would not work fast enough and would not be strong enough to get the economy out of a recession. 11 12

The Paradox of Thrift Incomes would fall as people lost their jobs causing both consumption and saving to fall as well. The economy would reach a new low-level equilibrium which could be at an almost permanent recession. The Paradox of Thrift Paradox of thrift an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession. 13 14 The Aggregate Expenditures Model Using a few simplifying assumptions, economists can construct a model of the economy. The Aggregate Expenditures (AE) Model looks at how real income is determined in an economy. The Aggregate Expenditures Model The AE model assumes that the price level is fixed, and explores how an initial shift in expenditures changes equilibrium output. The AE model quantifies the effect of changes in aggregate expenditures on aggregate output. 15 16 Aggregate Production Aggregate production the total amount of goods and services produced in every industry in an economy. Production creates an equal amount of income. Aggregate Production Graphically, aggregate production in the AE model is represented by a 45 line through the origin At all points on this Aggregate Production Curve, income equals production. Thus, actual production and actual income are always equal. 17 18

The Aggregate Production Curve Aggregate Expenditures Real production C Aggregate production (production = income) Aggregate expenditures the total amount of spending on final goods and services in the economy: $4,000 0 45º A $4,000 Potential income Real income Consumption spending by households. Investment spending by business. Spending by government. Net foreign spending on Canadian goods the difference between Canadian exports and imports. 19 20 Autonomous and Induced Expenditures Autonomous expenditures are expenditures that are independent of income. Autonomous expenditures change because something other than income changes. Induced expenditures expenditures that change as income changes. Autonomous and Induced Expenditures Autonomous expenditures is the level of expenditures that would exist at zero income and they remain constant at all levels of income. Induced expenditures are those that change as income changes, but they rise by less than the change in income. 21 22 Expenditures Function The relationship between expenditures and income can be expressed more concisely as an expenditures function. An expenditures function is a representation of the relationship between aggregate expenditures and income. The Expenditures Function The relationship between aggregate expenditures and income can be expressed mathematically: AE = AE o + mpcy AE = aggregate expenditures AE o = autonomous expenditures mpc = marginal propensity to consume Y = income 23 24

The Marginal Propensity to Consume Marginal propensity to consume (mpc) the change in consumption that occurs with a change in income. The mpc is between 0 and 1 because individuals tend to save a portion of an increase in income. The Marginal Propensity to Consume The mpc is the fraction spent from an additional dollar of income or mpc is the ratio of a change in consumption (DC) to a change in income (D Y). change in consumption C mpc = = change in income Y 25 26 Graphing the Expenditures Function Graphing the Expenditures Function The graphical representation of the expenditures function is called the aggregate expenditures curve. The slope of the expenditures function tells us how much expenditures change with a particular change in income. Real expenditures (AE) $12,200 10,000 8,000 6,000 5,000 4,000 2,000 1,000 0 45º D AE = 2,000 D Y = 2,500 AE 2,000 slope = = Y 2,500 AE mpc = = 0.8 Y Aggregate production AE = 1,000 + 0.8Y $5,000 $8,750 $11,250$14,000 Real income 27 28 Shifts in the Expenditures Function The aggregate expenditure curve shifts when autonomous C, I, G, or (X IM) change. Autonomous Consumption expenditures respond to changes in factors other than a change in real income, for example: interest rates household wealth expectations of future conditions Shifts in the Expenditures Function Autonomous Investment is the most volatile component of GDP. It responds to changes in: interest rates capital goods prices consumer demand conditions expectations regarding future economic conditions 29 30

Shifts in the Expenditures Function Autonomous exports and imports depend on foreign and domestic incomes and relative prices. Autonomous Government expenditures may also change as policies change. Determining the Equilibrium Level of Aggregate Income At equilibrium, planned expenditures must equal production. Graphically, it is the income level at which AE equals AP. 31 32 Solving for Equilibrium Graphically Solving for Equilibrium Algebraically Real expenditures (AE) $14,000 12,200 10,000 8,000 5,000 2,600 1,000 0 E AE 0 = $1,000 45 $2,000 $5,000 $10,000 $14,000 Aggregate production Aggregate expenditures AE = 1,000 + 0.8Y Real income In equilibrium, Y = AE. Substituting in for aggregate expenditures, we have Y = AE 0 + mpcy 33 34 Solving for Equilibrium Algebraically The Multiplier Equation Now solve for equilibrium income: Y mpcy = AE 0 The multiplier equation tells us that income equals the multiplier times autonomous expenditures. Y = Multiplier X Autonomous expenditures Y (1 mpc) = AE 0 Y = [ 1/ (1 mpc) ] * AE 0 35 36

The Multiplier Equation The Multiplier Process The multiplier process amplifies changes in autonomous expenditures. What forces are operating to ensure that the income level we determined is actually the equilibrium income level? When aggregate production do not equal aggregate expenditures: Businesses change production levels, which changes income, which changes expenditures, which changes production, which changes income, which changes... etc. 37 38 The Multiplier Process The Multiplier Process The process ends when aggregate production equals aggregate expenditures. Firms are selling all they produce, so they have no reason to change their production levels. Real expenditures (AE) C, I, G, (X IM) $14,000 $13,200 10,000 6,000 B 1 B2 C A 1 A 2 Aggregate production Aggregate expenditures AE = 1,000 + 0.8Y 2,000 0 45 $2,000 $5,000 $10,000 $14,000 Real income 39 40 The Circular Flow Model and the Multiplier Process The circular flow model provides the intuition behind the multiplier process. The flow of expenditures equals the flow of income. The Circular Flow Model and the Multiplier Process Expenditures are injections into the circular flow. The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow. But there are withdrawals. 41 42

The Circular Flow Model and the Multiplier Process Economists use the term the marginal propensity of save (mps) to represent the percentage of income flow that is withdrawn from the economy for each round of the circular flow. The Circular Flow Model and the Multiplier Process By definition: mpc + mps = 1 Alternatively expressed: mps = 1 - mpc multiplier = 1/mps 43 44 The Circular Flow Model and the Multiplier Process The AE Model in Action Aggregate income The AE model illustrates how a change in autonomous expenditures changes the equilibrium level of income. Households Firms Aggregate expenditures 45 46 The Multiplier Model in Action Autonomous expenditures are determined outside the model and are not affected by changes in income. When autonomous expenditures shift, the multiplier process is called into play. The Steps of the Multiplier Process The income adjustment process is directly related to the multiplier. Any initial shock (a change in autonomous AE) is multiplied in the adjustment process. 47 48

The Steps of the Multiplier Process The multiplier process repeats and repeats until a new equilibrium level is finally reached. Shifts in the Aggregate Expenditure Curve C, I $4,200 4,160 4,100 E 1 Aggregate production E 0 20 AE 0 = 832 +.8Y AE 1 = 812 +.8Y 4,060 20 832 E 1 812 $100 0 $4,060 $4,160 Real income E 0 D AE A = $20 $20 $16 D AE A = $16 12.8 D AE A = $12.8 100 49 50 First Five Steps of Four Multipliers First Five Steps of Four Multipliers mpc = 0.5 mpc = 0.75 mpc = 0.8 mpc = 0.9 100 100 100 100 90 81 50 25 12.5 6.25 75 56.25 42.19 31.64 80 64 51.2 40.96 72.9 65.61 Multiplier = 1/(1-0.5) = 2 Multiplier = 1/(1-0.75) = 4 Multiplier = 1/(1-0.8) = 5 Multiplier = 1/(1-0.9) = 10 51 52 Examples of the Effect of Shifts in Aggregate Expenditures There are many reasons for shifts in autonomous expenditures: The Effect of Shifts in Aggregate Expenditures An understanding of these shifts can be enhanced by tying them to the formula: Natural disasters. Changes in investment caused by technological developments. Shifts in government expenditures. Large changes in the exchange rate. AE = C + I + G + X - IM 53 54

Upward Shift of AE Downward Shift of AE Real expenditures $4,210 Aggregate production AE 30 1 AE 0 Real expenditures $4,152 Aggregate production AE 0 30 AE 1 4,090 1,052.5 1,022.5 30 $120 Y = = 4 1 1-0.75 0 $4,090 $4,210 Real income [ AE 0] [ AE 0] = 120 4,062 1,412 1,382 30 $90 Y = = 3 1 1-0.66 0 $4,062 $4,152 Real income [ AE 0] [ AE 0] = 90 55 56 Real World Examples Canada in 2000. Japan in the 1990s. The 1930s depression. Canada in 2000 Consumer confidence rose substantially causing autonomous consumption expenditures to increase more than economists had predicted. While economists had expected the economy to grow slowly, it boomed. 57 58 Japan in the 1990s The 1930s Depression Aggregate income and production fell during the 1990s. A dramatic rise in the yen cut Japanese exports. Autonomous consumption decreased as consumers confidence fell Suppliers responded by laying off workers and cutting production. The 1929 stock market crash, which continued into 1930, threw the financial markets into chaos. This resulted in a downward shift of the AE curve as wealth decreased. 59 60

The 1930s Depression Frightened business people decreased investment and laid off workers. Frightened consumers decreased autonomous consumption and increased savings, thereby increasing withdrawals from the system. Governments cut spending to balance their budgets, as tax revenue declined. The 1930s Depression Business people responded by decreasing output, which decreased income, starting a downward cycle, thereby confirming the fears of the businesspeople. The process continued until the economy settled at a low-level equilibrium, far below the potential level of income. 61 62 The 1930s Depression The process caused the paradox of thrift, whereby individuals attempting to save more, spent less, and caused income to decrease. They ended up saving not more, but less. AE Model Is Not a Complete Model The AE model determines income given autonomous expenditures. These autonomous expenditures, however, are determined by economic variables which are not in our simple model. 63 64 AE Model Is Not a Complete Model The AE model uses aggregate expenditures to determine equilibrium income. It does not explain production. It assumes firms can supply the output demanded. Model of Aggregate Demand Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers responding to changes in demand. Expansion of this line of thought has led to the real business cycle theory of the economy. 65 66

Model of Aggregate Demand Real business cycle theory of the economy changes in aggregate supply are the principle way for real income to change. Prices are Fixed The multiplier model assumes that the price level is fixed. In reality, the price level can change in response to changes in aggregate demand. 67 68 Does Not Include Expectations People's forward-looking expectations make the adjustment process much more complicated. Most people, however, act upon their expectations of the future. Business people may not automatically cut back production and lay-off workers if they think a fall in sales is temporary. Forward-Looking Expectations Complicate the Adjustment Process Rational expectations model captures the effect expectations have on individuals behaviour. Expectations can be self-fulfilling. 69 70 Consumption Behaviour Expanded AE Model People may base their spending on lifetime income, not yearly income. Permanent income hypothesis -- the hypothesis that expenditures are determined by permanent or lifetime income. We can increase the power of our AE model by adding more detail. For example, adding taxes to the model Changes consumption expenditures. Introduces government budget deficits and surpluses. Changes the multiplier. 71 72

Expanded AE Model Expanded AE Model Adding income-induced imports Changes import spending. Changes net exports, and introduces trade surpluses and deficits. The marginal propensity to import (mpi) gives the increase in import spending from an additional $1 of disposable income. Disposable = after-tax Mpi lies between 0 and 1 Changes the multiplier. 73 74 The Goods Market and the Aggregate Expenditures Model End of Chapter 8