Output and Expenditure in the Short Run

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1 Chapter 11 (23) Output and Expenditure in the Short Run Chapter Summary Chapter 10 examined the determinants of long-run economic growth. In the short run, however, the economy experiences fluctuations in economic activity, or business cycles, around the long-run upward trend in real GDP. Aggregate expenditure (AE) is the total amount of spending in the economy. The aggregate expenditure model focuses on the relationship between total spending and real GDP in the short run, assuming that the price level is constant. The four components of aggregate expenditure are: 1. consumption (C) 2. planned investment (I) 3. government purchases (G) 4. net exports (NX) When aggregate expenditure is greater than GDP, there is an unplanned decrease in inventories, which are goods that have been produced but not yet sold, and GDP and total employment will increase. The five determinants of consumption are: 1. current disposable income 2. household wealth 3. expected future income 4. the price level 5. the interest rate The consumption function is the relationship between consumption and disposable income. The marginal propensity to consume (MPC) is the change in consumption divided by the change in disposable income. The marginal propensity to save (MPS) is the change in saving divided by the change in disposable income. The determinants of planned investment are expectations of future profitability, the real interest rate, taxes, and cash flow, which is the difference between the cash revenues received by a firm and the cash spending by the firm. The 45 -line diagram shows all the points where aggregate expenditure equals real GDP. On the 45 -line diagram, macroeconomic equilibrium occurs where the line representing the aggregate expenditure function crosses the 45 line. The economy is in recession when the aggregate expenditure line intersects the 45 line at a level of GDP that is below potential GDP. Autonomous expenditure is expenditure that does not depend on the level of GDP. An autonomous change is a change in expenditure not caused by a change in income. An induced change is a change in

2 282 CHAPTER 11 (23) Output and Expenditure in the Short Run aggregate expenditure caused by a change in income. An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplier effect on equilibrium GDP. The multiplier effect is the process by which an increase in autonomous expenditure leads to a larger increase in real GDP. The multiplier is the ratio of the change in equilibrium GDP to the change in autonomous expenditure. Increases in the price level cause a reduction in consumption, investment, and net exports. This causes the aggregate expenditure function to shift down on the 45 -line diagram, leading to a lower equilibrium real GDP. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level. Learning Objectives When you finish this chapter, you should be able to: 1. Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. The aggregate expenditure model focuses on the relationship between total spending and real GDP in the short run, assuming the price level is constant. In any particular year, the level of GDP is determined by the level of total spending, or aggregate expenditure, in the economy. The four components of aggregate expenditure are: consumption (C), planned investment (I), government purchases (G), and net exports (NX). When aggregate expenditure is greater than GDP, there is an unplanned decrease in inventories (which are goods produced but not yet sold), and GDP and total employment will increase. When aggregate expenditure is less than GDP, there is an unplanned increase in inventories, and GDP and total employment will decline. Only when aggregate expenditure is equal to GDP will businesses sell what they expected to sell, production and employment will be unchanged, and the economy will be in macroeconomic equilibrium. 2. Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. The five determinants of consumption are: current disposable income, household wealth, expected future income, the price level, and the interest rate. The consumption function is the relationship between consumption and income. The marginal propensity to consume is the change in consumption divided by the change in income. The marginal propensity to save is the change in saving divided by the change in income. The determinants of planned investment are: expectations of future profitability, the real interest rate, taxes, and cash flow, which is the difference between the cash revenues received by the firm and the cash spending by the firm. Government purchases include spending by the federal government and by local and state governments for goods and services. Government purchases do not include transfer payments, such as social security payments by the federal government or pension payments by local governments to retired police officers and fire fighters. exports are purchases by foreign businesses and households of goods and services produced in the United States minus the purchases by U.S. businesses and households of goods and services produced in other countries. The three determinants of net exports are: the price level in the United States relative to the price levels in other countries, the growth rate of GDP in the United States relative to the growth rates of GDP in other countries, and the exchange rate between the dollar and other currencies. 3. Use a 45 o -line diagram to illustrate macroeconomic equilibrium. The 45 o -line diagram shows all the points where aggregate expenditure equals real GDP. On the 45 o -line diagram, macroeconomic equilibrium occurs where the line representing the aggregate expenditure function crosses the 45 o line.

3 CHAPTER 11 (23) Output and Expenditure in the Short Run Define the multiplier effect and use it to calculate changes in equilibrium GDP. An autonomous change is a change in expenditure not caused by a change in income. An induced change in expenditure is a change in expenditure caused by a change in income. An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplied effect on equilibrium GDP. The multiplier is the ratio of the change in equilibrium GDP to the change in autonomous expenditure. The formula for the multiplier is 1/(1 MPC), where MPC is the marginal propensity to consume. 5. Understand the relationship between the aggregate demand curve and aggregate expenditure. Increases in the price level cause a reduction in consumption, investment, and net exports. Price level increases cause the aggregate expenditure function to shift down on the 45 o -line diagram, leading to a lower equilibrium real GDP. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate demand expenditure other than the price level. Appendix: Apply the algebra of macroeconomic equilibrium. The chapter relies on graphs and tables to illustrate the aggregate expenditure model of short-run real GDP. The appendix uses equations to represent the aggregate expenditure model. Your instructor may cover or assign this appendix. Chapter Review Chapter Opener: Fluctuating Demand at Cisco Systems (pages ) In the spring of 2001, Cisco Systems, a leading seller of hardware for computer networks, discovered that a slowdown in the economy had reduced the demand for its products. This slowdown in the economy caused Cisco Systems to reduce its level of production and to reduce its level of employment (from 44,000 employees) by about 6,000 workers. In spring of 2007, Cisco announced record sales and profits with employment of more than 49,000 employees. Why the difference? In 2001, the economy was slowing down and in a period or recession. In early 2007, the economy was expanding. Helpful Study Hint Read An Inside Look at the end of the chapter for a discussion of the factors that caused U.S. GDP to change during the first quarter of 2007: 1. a slowdown in residential construction 2. a decline in exports 3. slow growth of business inventories Suppose that you work part time assembling desktop computers. Should you be worried about your job if consumer confidence falls? Economics in YOUR Life! at the start of this chapter poses this question. Keep the question in mind as you read the chapter. The authors will answer the question at the end of the chapter.

4 284 CHAPTER 11 (23) Output and Expenditure in the Short Run 11.1 The Aggregate Expenditure Model (pages ) 11.1 LEARNING OBJECTIVE Learning Objective 1 Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. The aggregate expenditure model explains many aspects of business cycles. This model looks at the relationship in the short run between total planned spending and real GDP. An important assumption of the model is that the price level is constant. The main idea behind the aggregate expenditure model is that, in any year, real GDP is determined mostly by aggregate expenditure. We define aggregate expenditure (AE) as: Aggregate expenditure = Consumption + Planned Investment + Government Purchases + Exports where: Consumption (C): Spending by households on goods and services, such as automobiles and haircuts. Planned Investment (I): Spending by businesses on capital goods, such as factories, office buildings, and machine tools, and spending by households on new homes. Helpful Study Hints Remember that investment expenditure includes the purchase of plant and equipment by firms, residential construction, and any changes in business inventories. Planned investment includes only planned inventory changes. Unanticipated or unplanned changes in business inventories are called unplanned investment. Government Purchases (G): Spending by local, state, and federal governments on goods and services, such as aircraft carriers, bridges, and the salaries of FBI agents. Exports (NX): Spending by foreign businesses and households on goods and services produced in the United States minus spending by U.S. businesses and households on goods and services produced in all other countries. In equation form: AE = C + I + G + NX Planned investment in the AE function may differ from the actual level of investment. Actual investment will include any unplanned changes in inventories caused by differences between production and sales. If a firm produces $100 of output and only sells $80 of that output, the $20 of output produced but not sold ends up in inventories. This $20 is included in actual investment but not in planned investment. For the economy as a whole, equilibrium occurs when aggregate expenditure equals total production or: AE = real GDP. In this model, equilibrium real GDP will not change unless aggregate expenditure changes.

5 CHAPTER 11 (23) Output and Expenditure in the Short Run 285 If AE is less than real GDP, firms are producing more output than is being purchased and there will be an unplanned increase in inventories. Firms will respond to the increase in inventories by reducing production and employment. If AE is more than production, firms are producing less output than is being purchased. The only way a firm can sell more than it produces is by selling part of its inventory. Firms will respond to this unplanned decrease in inventories by increasing production and employment. In either case, the economy moves toward an equilibrium in which AE = real GDP. The following table Table 11.1 in the main text summarizes the relationship between AE and GDP: If Then And Aggregate Expenditure is Equal to GDP There is no unplanned inventory change the economy is in Macroeconomic Equilibrium. Aggregate Expenditure is There is an unplanned Less than GDP inventory increase GDP and employment decrease. Aggregate Expenditure is There is an unplanned Greater than GDP inventory decrease GDP and employment increase. Extra Solved Problem 11-1 Chapter 11 in the textbook includes three Solved Problems. Here is an extra Solved Problem to help you build your skills solving economic problems: Supports Learning Objective 1: Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. Unplanned Investment To meet any unexpected increases in demand, Whirlpool would like to keep an inventory of 5,000 refrigerators. Whirlpool expects to sell 50,000 refrigerators this month, and so to keep its inventories constant, it manufactured 50,000 refrigerators this month. What will happen to Whirlpool s inventories if it sells only 49,000 refrigerators? What if it sells 52,000 refrigerators? SOLVING THE PROBLEM Step 1: Step 2: Review the chapter material. This problem is about inventories and unplanned investment, so you may want to review the section The Difference between Planned Investment and Actual Investment on page 349 of the textbook. Calculate inventory changes. Inventories are the goods that firms have produced but have not sold. This could be intentional. For example, Whirlpool wants to keep 5,000 refrigerators on hand to meet unexpected increases in demand. A change in inventories can be planned or unplanned. For example, a firm may not have accurately forecast its sales. Unexpectedly high sales will cause an unplanned decrease in inventories and unexpectedly low sales will cause an unplanned increase in inventories. The change in inventories is calculated as production minus sales. If this difference is positive, inventories will rise. If the difference is negative, inventories will fall. Given the numbers above,

6 286 CHAPTER 11 (23) Output and Expenditure in the Short Run If production is 50,000 and sales are 49,000, then the change in inventories is 1,000 refrigerators, and the level of inventories will rise to 6,000. If production is 50,000 and sales are 52,000, the change in inventories is 2,000, and the level of inventories will fall to 3, LEARNING OBJECTIVE 11.2 Determining the Level of Aggregate Expenditure in the Economy (pages ) Learning Objective 2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. Different variables influence each of the four major parts of aggregate expenditure. Consumption spending is determined by: 1. Current disposable income. Consumption will increase with increases in current disposable income. 2. Household wealth. Consumption will increase with increases in wealth. 3. Expected future income. If you expect your income to rise in the future, your consumption will be higher than if you do not expect your income to rise. 4. The price level. Consumption will fall with increases in the price level as a higher price level lowers the purchasing power of wealth. 5. The interest rate. Consumption will fall with increases in the real interest rate. Planned investment is determined by: 1. Expectations of future profitability. Planned investment spending will increase if firms expect profits to rise in future years. 2. The interest rate. Planned investment will fall with increases in the real interest rate. 3. Taxes. Planned investment spending will fall with higher taxes. 4. Cash flow. Planned investment will increase with higher levels of cash flow caused by increased profits. Government purchases are determined by: 1. The president, Congress, and state and local government decision makers. exports are determined by: 1. The price level in the United States relative to the price levels in other countries. exports will increase if U.S. inflation is less than inflation in other countries. If U.S. prices are rising less than prices in other countries, the foreign currency price of U.S. produced goods will fall compared to the prices of similar goods made in foreign countries. Foreigners will shift their purchases away from domestic production and toward U.S. production, causing exports to rise. Similar logic explains why U.S. imports will fall. An increase in exports and a decrease in imports cause net exports to rise.

7 CHAPTER 11 (23) Output and Expenditure in the Short Run Growth in real GDP relative to other countries. exports will fall if U.S. growth rates in real GDP are greater than growth rates in real GDP in other countries. Real GDP is equivalent to real income, so higher real income means greater spending on everything, including imports. If U.S. GDP grows faster than foreign GDP, then U.S. spending will also grow faster than foreign spending. This will increase U.S. imports. U.S. exports will also rise, but our exports are determined by foreign income. Therefore, U.S. imports will rise by more than exports and net exports will fall. 3. The exchange rate. exports will fall as the value of the U.S. dollar increases relative to other currencies (a dollar appreciation). A dollar appreciation raises the foreign currency price of goods produced in the United States and lowers the domestic price of goods produced in other countries. The impact on net exports is the same as a change in domestic prices compared to foreign prices (but in the opposite direction). The relationship between current real disposable income (YD) and real consumption spending (C) is called the consumption function. An increase in YD causes an increase in C. The change in consumption caused by a change in YD is called the marginal propensity to consume (MPC). Using the Greek letter delta,, to represent change in : or, C MPC = YD C = MPC YD. Real GDP is the same as national income. National income minus net taxes equals disposable income (YD): YD = National income taxes = Real GDP taxes. The following table and graph show these relationships. The assumption is that the MPC = 0.75 and net taxes = $1,000. National Income or Real GDP (billions of dollars) Taxes (billions of dollars) Disposable Income (billions of dollars) Consumption (billions of dollars) Change in National Income (billions of dollars) Change in Disposable Income (billions of dollars) $1,000 $1,000 $0 $750 $2,000 $2,000 3,000 1,000 2,000 2,250 2,000 2,000 5,000 1,000 4,000 3,750 2,000 2,000 7,000 1,000 6,000 5,250 2,000 2,000 9,000 1,000 8,000 6,750 2,000 2,000 11,000 1,000 10,000 8,250 2,000 2,000 13,000 1,000 12,000 9,750 2,000 2,000

8 288 CHAPTER 11 (23) Output and Expenditure in the Short Run If we draw a graph with real consumption spending on the vertical axis and real national income on the horizontal axis, it looks like Figure 11-3 below: Consumers can either spend their income, save it, or use it to pay taxes. For the economy as a whole, we can write the following equation relating income (Y), consumption (C), saving (S), and taxes (T): Y = C + S + T. This equation implies that any change in total income must be equal to the sum of changes in consumption, saving, and taxes: Y = C + S + T. If we assume for simplicity that taxes are a constant amount, then T = 0 and Y = C + S. The marginal propensity to save (MPS) is the amount by which saving increases when disposable income increases. If we divide both sides of the last equation by Y, we get an equation that shows the relationship between the marginal propensity to consume and the marginal propensity to save (MPS): Y Y = C Y S + Y or, 1 = MPC + MPS. This last equation tells us that when taxes are constant, the marginal propensity to consume plus the marginal propensity to save must always equal 1. They must add up to 1 because part of any increase in income is consumed, and whatever remains must be saved.

9 CHAPTER 11 (23) Output and Expenditure in the Short Run 289 Helpful Study Hints Work through Solved Problem 11-2 in the main text to practice how to calculate MPC and MPS. Making the Connection: Cisco Rides the Roller Coaster of Information Technology Spending explains how the business cycle affects firms such as Cisco. When the economy is expanding, firms increase their levels of investment expenditures. When firms buy more information technology equipment, they often buy more products from Cisco. Cisco s sales depend on how investment expenditures are changing. As investment spending fell in 2001, Cisco s sales and profits declined. As the economy began to expand again, Cisco s profits and sales increased. Extra Solved Problem 11-2 Chapter 11 in the textbook includes three Solved Problems. Here is an extra Solved Problem to help you build your skills solving economic problems: Calculating the MPC and MPS Supports Learning Objective 2: Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. Using the data in the table below, calculate national income, the MPC, and the MPS. Step 1: Review the chapter material. This problem is about calculating the MPC and MPS, so you may want to read the section Determining the Level of Aggregate Expenditure in the Economy, which begins on page 351 of the textbook. Real GDP (Y) Taxes Disposable Income Consumption Saving MPC MPS $10,000 $1,000 $8,000 10,500 1,000 8,350 11,000 1,000 8,700 11,500 1,000 9,050 12,000 1,000 9,400 12,500 1,000 9,750

10 290 CHAPTER 11 (23) Output and Expenditure in the Short Run Step 2: Solve the problem by filling in the values in the table. Disposable income is defined as real GDP less net taxes, so, for example, at a level of real GDP of $10,000 with net taxes of $1,000, disposable income is $9,000 (= $10,000 $1,000 = $9,000). The table should then look like: Real GDP (Y) Taxes Disposable Income Consumption Saving MPC MPS $10,000 $1,000 $9,000 $8,000 10,500 1,000 9,500 8,350 11,000 1,000 10,000 8,700 11,500 1,000 10,500 9,050 12,000 1,000 11,000 9,400 12,500 1,000 11,500 9,750 Saving is the difference between disposable income and consumption (or the part of disposable income that is not consumed). At real GDP = $10,000, with net taxes of $1,000, disposable income is $9,000. If consumption is $8,000, then saving will be $1,000 (= $9,000 $8,000 = $1,000). Using this calculation, the table will look like: Real GDP (Y) Taxes Disposable Income Consumption Saving MPC MPS $10,000 $1,000 $9,000 $8,000 $1,000 10,500 1,000 9,500 8,350 1,150 11,000 1,000 10,000 8,700 1,300 11,500 1,000 10,500 9,050 1,450 12,000 1,000 11,000 9,400 1,600 12,500 1,000 11,500 9,750 1,750 The MPC is defined as the change in consumption for a dollar change in disposable income; so between real GDP of $10,000 and $10,500, disposable income increased $500 (= $9,500 $9,000 = $500). For the same change in income, consumption spending increased by $350 (= $8,350 $8,000 = $350), which means that the MPC equals $350/$500 = 0.7. The MPS is defined as the change in saving for a dollar change in disposable income, so between real GDP of $10,000 and $10,500, disposable income increased $500 (= $9,500 $9,000 = $500). Saving increased by $150 (=$1,150 $1000 = $150), so the MPS equals $150/$500 = 0.3.

11 CHAPTER 11 (23) Output and Expenditure in the Short Run 291 Using these calculations, the table will look like: Real GDP (Y) Taxes Disposable Income Consumption Saving MPC MPS $10,000 $1,000 $9,000 $8,000 $1,000 10,500 1,000 9,500 8,350 1, ,000 1,000 10,000 8,700 1, ,500 1,000 10,500 9,050 1, ,000 1,000 11,000 9,400 1, ,500 1,000 11,500 9,750 1, Notice that at all levels of real GDP, the MPC + MPS = LEARNING OBJECTIVE 11.3 Graphing Macroeconomic Equilibrium (pages ) Learning Objective 3 Use a 45 o -line diagram to illustrate macroeconomic equilibrium. The graphical view of macroeconomic equilibrium starts with a line defining all possible points of equilibrium. Because equilibrium is AE = Y, the line will intersect the origin at an angle of 45 degrees. This is shown in textbook Figure 11-8 below. At points below the line, AE is less than Y, and at points above the line, AE is greater than Y.

12 292 CHAPTER 11 (23) Output and Expenditure in the Short Run In this graph, the 45 line shows all possible points of macroeconomic equilibrium, where Y = AE. During any particular year, only one of these points will represent the actual level of equilibrium real GDP, given the actual level of planned expenditure. To find the macroeconomic equilibrium, we need to add a line representing the aggregate expenditure function to the graph. This is done in textbook Figure 11-9 below. Equilibrium will occur at the level of real GDP where the AE line (which is equal to C + I + G + NX) intersects the 45 line. Helpful Study Hints We ve assumed that net exports (NX) are positive. For over 30 years, U.S. net exports have been negative. See Figure 11-6 on page 362 of the textbook, which graphs real net exports from

13 CHAPTER 11 (23) Output and Expenditure in the Short Run 293 Equilibrium occurs at the level of real GDP that makes AE = Y. At production levels less than this level of real GDP, inventories will decline and firms will respond by increasing production. At production levels above the equilibrium level of real GDP, inventories will increase and firms will reduce production. This adjustment is shown in textbook Figure below: Helpful Study Hints Work through Extra Solved Problem 11-3 in this Study Guide to practice finding equilibrium real GDP.

14 294 CHAPTER 11 (23) Output and Expenditure in the Short Run Extra Solved Problem 11-3 Chapter 11 in the textbook includes three Solved Problems. Here is an extra Solved Problem to help you build your skills solving economic problems: Supports Learning Objective 3: Use a 45 -line diagram to illustrate macroeconomic equilibrium. Calculating Equilibrium Real GDP The table below has several values of real GDP. The goal is to determine the level of equilibrium real GDP where Y = AE. To do this, assume that net taxes are $1,000 at every level of real GDP. Calculate disposable income (YD). You are also given consumption for one level of YD. If the MPC is 0.6, determine consumption at all levels of real GDP. Suppose that planned investment, government purchases, and net exports are $2,000, $2,000, and $900, respectively, at all levels of real GDP. Using these values, calculate AE. Based upon these levels of AE, determine unplanned changes in inventories. From these levels of unplanned changes in inventories, determine if Y will rise or fall, or remain unchanged at each level of real GDP. Fill in values in the table below. Real GDP (Y) Taxes (T) Disposable income (YD) Consumption (C) Planned investment (I) Government purchases (G) exports (NX) AE = C+I+G+NX Unplanned changes in inventories Y will: $8,000 $1,000 $4,700 $2,000 $2,000 $900 9,000 10,000 11,000 12,000 13,000 14,000 SOLVING THE PROBLEM Step 1: Step 2: Review the chapter material. This problem is about determining macroeconomic equilibrium, so you may want to review the section Graphing Macroeconomic Equilibrium, which begins on page 363 of the textbook. Calculate the level of disposable income. For this economy, net taxes are $1,000 at each level of real GDP. The level of disposable income is calculated as real GDP net taxes. With this information you complete the net taxes and disposable income columns.

15 CHAPTER 11 (23) Output and Expenditure in the Short Run 295 Real GDP (Y) taxes (T) Disposable income (YD) Planned investment (I) Government purchases (G) exports (NX) Consumption (C) $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 9,000 1,000 8,000 10,000 1,000 9,000 11,000 1,000 10,000 12,000 1,000 11,000 13,000 1,000 12,000 14,000 1,000 13,000 AE = C+I+G+NX Unplanned changes in inventories Y will: Step 3: Calculate consumption. The MPC is 0.6. This means that for each $1,000 increase in disposable income, consumption will increase by $600. For example, as YD increases from $7,000 to $8,000, consumption will increase by $600 from $4,700 to $5,300. After calculating consumption for the remaining levels of disposable income, the table should look like: Real GDP (Y) taxes (T) Disposable income (YD) Planned Investment (I) Government Purchases (G) exports (NX) Consumption (C) $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 9,000 1,000 8,000 5,300 10,000 1,000 9,000 5,900 11,000 1,000 10,000 6,500 12,000 1,000 11,000 7,100 13,000 1,000 12,000 7,700 14,000 1,000 13,000 8,300 AE = C+I+G+NX Unplanned changes in inventories Y will: Step 4: Fill in the values for planned investment, government purchases, and net exports. Planned investment, government purchases, and net exports are autonomous expenditures and are assumed to have constant values of $2,000, $2,000, and $900. Using these values, the table should look like: Real GDP (Y) taxes (T) Disposable income (YD) Planned investment (I) Government purchases (G) exports (NX) Consumption (C) $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 9,000 1,000 8,000 5,300 2,000 2, ,000 1,000 9,000 5,900 2,000 2, ,000 1,000 10,000 6,500 2,000 2, ,000 1,000 11,000 7,100 2,000 2, ,000 1,000 12,000 7,700 2,000 2, ,000 1,000 13,000 8,300 2,000 2, AE = C+I+G+NX Unplanned changes in inventories Y will:

16 296 CHAPTER 11 (23) Output and Expenditure in the Short Run Step 5: Calculate the values of AE. AE is defined as C + I + G + NX, so when real GDP = $8,000, the value of AE will be $4,700 + $2,000 + $2,000 + $900 = $9,600. Filling in the values for AE at every level of real GDP results in the table looking like this: Real GDP (Y) taxes (T) Disposable income (YD) Planned investment (I) Government purchases (G) exports (NX) Consumption (C) AE = C+I+G+NX $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 $9,600 9,000 1,000 8,000 5,300 2,000 2, ,200 10,000 1,000 9,000 5,900 2,000 2, ,800 11,000 1,000 10,000 6,500 2,000 2, ,400 12,000 1,000 11,000 7,100 2,000 2, ,000 13,000 1,000 12,000 7,700 2,000 2, ,600 14,000 1,000 13,000 8,300 2,000 2, ,200 Unplanned changes in inventories Y will: Step 6: Calculate unplanned changes to inventories. At real GDP = $8,000 and AE = $9,600, total demand for output is $9,600, but firms are only producing $8,000. For firms to meet demand, they must sell $1,600 of products held as inventories. This $1,600 when added to real GDP will allow firms to meet the total level of demand ($8,000 + $1,600 = $9,600). Thus at real GDP = $8,000, unplanned changes in inventories are $1,600. In general, unplanned changes in inventories equal Y AE. A negative value for unplanned changes in inventories means there is an unplanned decrease in inventories. If Y AE is positive, there is an unplanned increase in inventories. Using these calculations, the table should look like: Real GDP (Y) taxes (T) Disposable income (YD) Planned investment (I) Government purchases (G) exports (NX) Unplanned changes in inventories Consumption (C) AE = C+I+G+NX $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 $9,600 $1,600 9,000 1,000 8,000 5,300 2,000 2, ,200 1,200 10,000 1,000 9,000 5,900 2,000 2, , ,000 1,000 10,000 6,500 2,000 2, , ,000 1,000 11,000 7,100 2,000 2, , ,000 1,000 12,000 7,700 2,000 2, , ,000 1,000 13,000 8,300 2,000 2, , Y will:

17 CHAPTER 11 (23) Output and Expenditure in the Short Run 297 Step 7: Determine if Y will rise, fall, or remain unchanged at each level of real GDP. If inventories are falling, then firms will increase production (real GDP). If inventories are rising, then firms will decrease production (real GDP). Knowing this, we can fill in the last column of the table: Real GDP (Y) taxes (T) Disposable income (YD) Planned investment (I) Government purchases (G) exports (NX) Unplanned changes in inventories Consumption (C) AE = C+I+G+NX Y will: $8,000 $1,000 $7,000 $4,700 $2,000 $2,000 $900 $9,600 $1,600 increase 9,000 1,000 8,000 5,300 2,000 2, ,200 1,200 increase 10,000 1,000 9,000 5,900 2,000 2, , increase 11,000 1,000 10,000 6,500 2,000 2, , increase not change 12,000 1,000 11,000 7,100 2,000 2, , ,000 1,000 12,000 7,700 2,000 2, , decrease 14,000 1,000 13,000 8,300 2,000 2, , decrease Equilibrium real GDP will be $12,000. At this level of real GDP, AE also equals $12,000, so AE = Y and unplanned changes in inventories are zero, so production (real GDP) will not change. Helpful Study Hints Making the Connection: Business Attempts to Control Inventories, Then and Now explains how a firm with too high a level of inventory will have higher costs and lower profits. Today, most firms use inventory control systems to reduce costs and increase profits. Dell will not build a computer until it is ordered. Dell orders parts from its suppliers only when they are needed so that it only has a day or two of parts inventory. This tight control of inventory reduces Dell s costs and increases its profits. Read Don t Let This Happen to YOU! to keep clear the difference between aggregate expenditure and consumption spending: Aggregate expenditure (AE) includes more than just consumption expenditures (which is the largest component of AE). Also included in aggregate expenditure are planned investment, government purchases, and net exports The Multiplier Effect (pages ) 11.4 LEARNING OBJECTIVE Learning Objective 4 Define the multiplier effect and use it to calculate changes in equilibrium GDP. The aggregate expenditure model predicts that, in the short run, the level of real GDP is determined by the level of aggregate expenditure (C + I + G + NX). Changes in aggregate expenditure cause real GDP to change. This is shown in Figure 11-12:

18 298 CHAPTER 11 (23) Output and Expenditure in the Short Run Suppose the economy is in equilibrium at point A in the figure. If AE increases to AE 2, at point A, the new level of spending, AE 2, will be greater than output (AE > Y). There will be an unplanned decrease in inventories. In response, firms will increase output and employment. Real GDP will therefore rise. The new equilibrium will be at point B, where AE = Y again. What can cause AE to increase? Increases in autonomous expenditure, spending that does not depend on the level of real GDP, cause AE to increase. In the simple model developed in this chapter, planned investment, government purchases, and net exports are autonomous. Any rise in autonomous expenditure will cause real GDP to increase by more than the increase in autonomous expenditure. This is true because increases in expenditure lead to increases in production and income, which in turn cause increases in consumption spending as household disposable income rises. The series of induced increases in consumption spending that result from an initial increase in autonomous expenditure is called the multiplier effect. The multiplier effect is the process by which an increase in autonomous expenditure leads to an increase in real GDP. The size of the multiplier depends upon the size of the MPC. The formula for the simple multiplier is: 1 1 MPC There are several important points you should know about the multiplier effect: The multiplier works for both increases and decreases in autonomous expenditure. The multiplier effect implies that the economy is more sensitive to changes in autonomous spending than it would otherwise be. The larger the MPC (or smaller the MPS), the larger the multiplier. The multiplier derived in this chapter is based on a very simple model of the economy. There are several real world complications caused by rising real GDP and its effect on (for example) interest rates and inflation. Also, we ve assumed some variables are autonomous that are not constant in the real world. For example, we expect net exports to actually fall as income rises.

19 CHAPTER 11 (23) Output and Expenditure in the Short Run 299 But our model assumes net exports are constant. Our simple multiplier formula overstates the true value of the multiplier. Helpful Study Hints Making the Connection: The Multiplier in Reverse: The Great Depression of the 1930s explains that while an increase in autonomous expenditure can cause an increase in real GDP, a decrease in autonomous expenditure can do the reverse, causing a decrease in real GDP. When the stock market crashed in October 1929, households and firms reduced consumption and investment. The Smoot-Hawley Tariff in June 1930 reduced net exports. As a result of these and other actions, aggregate expenditure fell, sending the economy into a downward spiral. Real GDP fell by over $225 billion between 1929 and 1933, and the unemployment rate increased from 3.2 percent to 24.9 percent The Aggregate Demand Curve (pages ) 11.5 LEARNING OBJECTIVE Learning Objective 5 Understand the relationship between the aggregate demand curve and aggregate expenditure. As the price level increases, the level of autonomous expenditure will fall, and through the multiplier process, the level of aggregate expenditure and equilibrium real GDP will also fall. An increase in the price level will reduce autonomous expenditure for three reasons: 1. A higher price level will reduce the purchasing power of household wealth, reducing consumption spending. 2. A higher price level will make products produced in the United States more expensive than products produced in the rest of the world. This will reduce exports and increase imports, reducing net exports. 3. An increase in the price level will increase real interest rates, causing consumption and planned investment to fall. In the aggregate expenditure model, a higher price level shifts the AE line down. In panel (a) of textbook Figure below, a higher price will shift AE from AE 1 to AE 2, causing equilibrium real GDP to fall. In panel (b), a lower price level will shift AE from AE 1 to AE 2, causing equilibrium real GDP to rise.

20 300 CHAPTER 11 (23) Output and Expenditure in the Short Run The relationship between the price level and the resulting level of real GDP is shown in an aggregate demand curve. The aggregate demand curve is illustrated in textbook Figure below: Helpful Study Hints The aggregate demand curve is different from the demand curve for a single product, like a Bic pen. The demand curve for a Bic pen shows what happens to the quantity of Bic pens that will be purchased at different prices for Bic pens, holding other prices, income, and other factors affecting demand for Bic pens constant. On the AD curve, the price level changes, not just the price of one product, so that all prices are changing at the same time. But like the microeconomic demand curves we encountered in Chapter 3, a change in the price level will cause a movement along the AD curve rather than a shift of the AD curve.

21 CHAPTER 11 (23) Output and Expenditure in the Short Run 301 Extra Solved Problem 11-5 Chapter 11 in the textbook includes three Solved Problems. Here is an extra Solved Problem to help you build your skills solving economic problems: Supports Learning Objective 5: Understand the relationship between the aggregate demand curve and aggregate expenditure. The Aggregate Demand Relationship Using the table below, determine the equilibrium level or real GDP. What is the value of the multiplier for the economy? Then suppose that because of a price level increase, net exports fall to $1,650. What will be the new equilibrium real GDP at the new higher price level? SOLVING THE PROBLEM Real Planned Government GDP Consumption investment purchases exports (Y) (C) (I) (G) (NX) $8,000 $6,050 $2,500 $2,000 $1,350 9,000 6,750 2,500 2,000 1,350 10,000 7,450 2,500 2,000 1,350 11,000 8,150 2,500 2,000 1,350 12,000 8,850 2,500 2,000 1,350 13,000 9,550 2,500 2,000 1,350 14,000 10,250 2,500 2,000 1,350 Step 1: Review the chapter material. This problem is about aggregate demand and aggregate expenditure, so you may want to review the section The Aggregate Demand Curve, which begins on page 377 of the textbook.

22 302 CHAPTER 11 (23) Output and Expenditure in the Short Run Step 2: Calculate equilibrium real GDP. Equilibrium income is where AE = Y. To find this level of Real GDP, calculate AE as C + I + G + NX. The results of this calculation are shown in the column labeled AE: Real Planned Government GDP Consumption investment purchases exports AE = (Y) (C) (I) (G) (NX) C+I+G+NX $8,000 $6,050 $2,500 $2,000 $1,350 $9,200 9,000 6,750 2,500 2,000 1,350 9,900 10,000 7,450 2,500 2,000 1,350 10,600 11,000 8,150 2,500 2,000 1,350 11,300 12,000 8,850 2,500 2,000 1,350 12,000 13,000 9,550 2,500 2,000 1,350 12,700 14,000 10,250 2,500 2,000 1,350 13,400 AE is equal to Y at a level of real GDP of $12,000. Step 3: Step 4: Calculate the multiplier. The multiplier is defined as 1/MPS or 1/(1 MPC). For this economy, a $1000 increase in real GDP increases consumption by $700. Therefore, the MPC = 0.7, and the MPS = 0.3, because the MPC + MPS = 1. The multiplier is 1/(1 MPC) = 1/(1 0.7) = 1/0.3 = Calculate the new equilibrium real GDP at the new level of net exports. With the new level of net exports, AE = Y at a level of real GDP = $11,000. Real GDP Consumption Planned investment Government purchases exports AE = New AE = (Y) (C) (I) (G) (NX) C+I+G+NX Exports C+I+G+NX $8,000 $6,050 $2,500 $2,000 $1,350 $9,200 $1,650 $8,900 9,000 6,750 2,500 2,000 1,350 9,900 1,650 9,600 10,000 7,450 2,500 2,000 1,350 10,600 1,650 10,300 11,000 8,150 2,500 2,000 1,350 11,300 1,650 11,000 12,000 8,850 2,500 2,000 1,350 12,000 1,650 11,700 13,000 9,550 2,500 2,000 1,350 12,700 1,650 12,400 14,000 10,250 2,500 2,000 1,350 13,400 1,650 13,100 An increase in the price level will reduce net exports and cause real GDP to fall. Notice that the fall in real GDP is the multiplier (1/0.3) times the change in net exports ( $300), or $1,000 = (1/0.3) x ( $300).

23 CHAPTER 11 (23) Output and Expenditure in the Short Run 303 Helpful Study Hint At the start of the chapter, the Economics in Your Life! feature asked you to suppose you work part-time assembling desktop computers and you learn that because of a reduction in consumer confidence, households expect future income to fall. Should you be worried about your job? Yes, you should be somewhat concerned. As households expect lower future income, they often cut back on current consumption expenditures, which will lower aggregate demand. If your employer has to reduce production because of smaller sales, part-time jobs may be the first to go. Appendix The Algebra of Macroeconomic Equilibrium (pages ) LEARNING OBJECTIVE: Apply the algebra of macroeconomic equilibrium. It is possible to view the determination of equilibrium using basic algebra. In equations, the aggregate expenditure model is: 1. C = C + MPC(Y ) Consumption function 2. I = I Planned investment function 3. G = G Government spending function 4. NX = NX export function 5. Y = C + I + G + NX Equilibrium condition The letters with bars represent fixed or autonomous values. Solving for equilibrium we get Y = C + MPC( Y ) + I + G + NX, or, or, Y MPC( Y ) = C + I + G + NX, Y ( 1 MPC) = C + I + G + NX,

24 304 CHAPTER 11 (23) Output and Expenditure in the Short Run or, Y C + I + G + NX = 1 MPC. Remember that 1/(1 MPC) is the multiplier, and all four variables in the numerator of the last equation represent autonomous expenditure. Therefore, an alternative expression for equilibrium GDP is: Key Terms Equilibrium real GDP = Autonomous expenditure x multiplier. Aggregate demand curve (AD). A curve showing 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. Aggregate expenditure (AE). The total amount of spending in the economy: the sum of consumption, planned investment, government purchases, and net exports. Aggregate expenditure model. A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant. Autonomous expenditure. Expenditure that does not depend on the level of GDP. Cash flow. The difference between the cash revenues received by the firm and the cash spending by the firm. Consumption function. The relationship between consumption spending and disposable income. Inventories. Goods that have been produced but not yet sold. Marginal propensity to consume (MPC). The slope of the consumption function: the amount by which consumption spending increases when disposable income increases. Marginal propensity to save (MPS). The change in saving divided by the change in disposable income. Multiplier. The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect. The series of induced increases in consumption spending that result from an initial increase in autonomous expenditure.

25 CHAPTER 11 (23) Output and Expenditure in the Short Run 305 Self-Test (Answers are provided at the end of the Self-Test.) Multiple-Choice Questions 1. Aggregate expenditure, or the total amount of spending in the economy, equals a. household spending on durable goods plus household spending on nondurable goods. b. household spending on durable goods plus business investment spending. c. consumption spending plus planned investment spending plus government purchases plus net exports. d. total spending by households plus total spending by businesses. 2. Fluctuations in total spending in the economy may affect a. the level of employment in the short run. b. the level of production in the short run. c. both employment and production in the short run. d. neither the level of employment nor the level of production in the short run. 3. The aggregate expenditure model focuses on the relationship between total spending and a. nominal GDP in the short run. b. nominal GDP in the long run. c. real GDP in the short run. d. real GDP in the long run. 4. The key idea of the aggregate expenditure model is that in any particular year, the level of gross domestic product (GDP) is determined mainly by a. the economy s endowment of economic resources and the current state of technology. b. the level of the interest rate for the economy as a whole. c. the level of aggregate expenditure. d. the level of government expenditures. 5. Economists and business analysts usually explain fluctuations in GDP in terms of fluctuations in these four categories: a. interest rates, exchange rates, inflation rates, and government purchases. b. inflation rates, unemployment rates, interest rates, and consumer spending. c. investment spending, unplanned inventory changes, government transfer spending, and government purchases. d. consumption, planned investment, government purchases, and net exports. 6. Which of the following statements is correct? a. Actual investment and planned investment are always the same thing. b. Actual investment will equal planned investment only when inventories rise. c. Actual investment will equal planned investment only when there is no unplanned change in inventories. d. Actual investment equals planned investment only when inventories decline.

26 306 CHAPTER 11 (23) Output and Expenditure in the Short Run 7. Macroeconomic equilibrium occurs where a. the unemployment rate is zero. b. total spending, or aggregate expenditure, equals total production, or GDP. c. consumption equals investment, and investment equals government expenditure. d. total production, or GDP, equals total planned investment. 8. Which of the following makes up the largest fraction of GDP? a. consumption b. investment c. government expenditures d. net exports 9. When aggregate expenditure is greater than GDP a. inventories will rise. b. inventories will fall. c. unplanned inventory adjustment will remain the same. d. the total amount of production in the economy is greater than the total amount of spending. 10. If aggregate expenditure is equal to GDP, then a. inventories are rising. b. GDP and employment will fall. c. the economy is in macroeconomic equilibrium. d. inventories are falling. 11. When aggregate expenditure is greater than GDP, inventories will and GDP and total employment will. a. rise; increase b. rise; decrease c. fall; increase d. fall; decrease 12. The most important determinant of consumption is a. current disposable income. b. household wealth. c. the price level. d. the interest rate. 13. An increase in stock prices will a. increase the consumption component of aggregate expenditure. b. decrease the investment component of aggregate expenditure. c. increase the government purchases component of aggregate expenditure. d. not cause any change in the components of aggregate expenditure. 14. Which of the following causes saving to increase? a. an increase in consumption b. an increase in the interest rate c. an increase in unemployment d. an increase in the price level

27 CHAPTER 11 (23) Output and Expenditure in the Short Run If the marginal propensity to consume (MPC) is 0.9, how much additional consumption will result from an increase of $80 billion of disposable income? a. $88.89 billion b. $800 billion c. $72 billion d. $7.2 billion 16. If the MPC is 0.75, then a $100 increase in government expenditures will increase equilibrium GDP by a. $100. b. $75. c. $400. d. $ Which of the following equalities is correct? a. Disposable income is equal to national income plus government transfer payments plus taxes. b. Government transfer payments minus taxes equals net taxes. c. Disposable income is equal to national income minus net taxes. d. Disposable income equals national income. 18. When national income increases, there must be some combination of an increase in household a. consumption and saving. b. consumption, saving, and taxes. c. consumption and investment. d. saving and investment. 19. The amount by which consumption spending increases when disposable income increases is called a. marginal consumption. b. autonomous consumption. c. the marginal propensity to consume. d. disposable national consumption. 20. The sum of the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) equals a. disposable income. b. zero. c. one. d. national income. 21. Which of the following is not correct? a. MPS + MPC=1 b. 0 < MPS < 1 c. MPS = 1 ( C/ YD) d. MPS = 1 (C/YD) 22. The behavior of consumption and investment over time can be described as follows: a. investment follows a smooth, upward trend, but consumption is highly volatile. b. consumption follows a smooth, upward trend, but investment is subject to significant fluctuations. c. both consumption and investment fluctuate significantly over time. d. neither consumption nor investment fluctuates significantly over time.

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