The Short-Run Macro Model. The Short-Run Macro Model. The Short-Run Macro Model

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1 The Short-Run Macro Model In the short run, spending depends on income, and income depends on spending. The Short-Run Macro Model Short-Run Macro Model A macroeconomic model that explains how changes in spending can affect real GDP in the short run The Short-Run Macro Model In the short-run macro model, we focus on spending in markets for currently produced U.S. goods and services that is, spending on things that are included in U.S. GDP. 1

2 Real Spending Four categories of buyers: Households: consumption spending (C) Businesses: investment spending (I P ) Government Agencies: government purchases (G) Foreigners: net exports (NX) Spending Disposable Income The part of household income that remains after paying taxes Disposable income = Income Taxes Spending Function A positively sloped relationship between real consumption spending and real disposable income 2

3 Spending Disposable Income Determinants of Spending Real Disposable Income Interest Rate Real Wealth Expectations of Future Income Real Spending Spending Function Shows the relationship between only one of the factors influencing consumption The impact of the other influences are represented by shifts in the consumption function 3

4 Spending Autonomous Spending The part of consumption spending that is independent of income; also, the vertical intercept of the consumption function Function Real 8,000 Spending ($ Billions) 7,000 The consumption function shows the (linear) relationship between real consumption spending and real disposable income. Function 6,000 5,000 The vertical intercept (here, $2,000 billion) is autonomous consumption spending... 4,000 3,000 2, and the slope of the line (here, 0.6) is the marginal propensity to consume. 2,000 3,000 4,000 5,000 6,000 7,000 8,000 Real Disposable Income ($ Billions) Spending Induced Spending The part of consumption spending that depends on income; equals total consumption spending less autonomous consumption spending 4

5 Spending Marginal Propensity to Consume (MPC) The amount by which consumption spending rises when disposable income rises by one dollar Marginal Propensity to Consume Marginal Propensity to Consume (MPC) is also: the slope of the consumption function the change in consumption divided by the change in disposable income ( C/ C/ Y D ) Function Real 8,000 Spending ($ Billions) 7,000 The consumption function shows the (linear) relationship between real consumption spending and real disposable income. Function 6,000 5,000 The vertical intercept (here, $2,000 billion) is autonomous consumption spending... 4,000 3,000 2, and the slope of the line (here, 0.6) is the marginal propensity to consume. 2,000 3,000 4,000 5,000 6,000 7,000 8,000 Real Disposable Income ($ Billions) 5

6 Equation C = a + by D where a = vertical intercept of the consumption function (representing theoretical level of consumption spending at Y D = 0) b = the slope of the consumption function (or the MPC) and Income -Income Line A line showing aggregate consumption spending at each level of income or GDP Income Line To draw the consumptionincome line, we measure real income (instead of real disposable income) on the horizontal axis. Real Spending ($ Billions) 5,600 5,000 4,000 3,000 2,000 The line has the same slope as the consumption function in Figure Income Line A B but a different vertical intercept. 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real Income ($ Billions) 6

7 Shifts in the Income Line When government collects fixed amount of taxes from households: line representing the relationship between consumption and income is shifted downward by amount of tax times MPC. The amount of tax is initially assumed to be fixed; ; therefore slope of the consumption- income line is unaffected by taxes, and is equal to the MPC. Movement Along the Income Line Income Disposable Income Spending Movement Rightward Along the - Income Line Shift in the Income Line Real 8,000 Spending ($ Billions) 7,000 Income Line When Taxes = 500 6,000 5,000 4,000 3,000 2,000 Income Line When T axes = 2,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real Income ($ Billions) 7

8 Shifts in the Income Line Taxes Disposable Income at any income level Shift Upward of the - Income Line Increases In Autonomous Autonomous consumption (a) at each level of disposable Income spending at each income level Shift Upward of the - Income Line Spending expenditure Increase in autonomous consumption spending Income 8

9 Spending When a change in income causes consumption spending to change, we move along the consumption-income line. When a change in anything else besides income causes consumption spending to change, the line will shift. Getting to Total Spending Investment Spending Government Purchases Net Exports Summing Up: Aggregate Expenditure Income and Aggregate Expenditure Investment Spending Investment spending: plant and equipment purchases by business firms, and new home construction Inventory investment: unintentional and undesired, therefore excluded from the definition of investment spending To begin with, we shall treat Investment Spending as fixed 9

10 Government Purchases In the short-run macro model, government purchases are treated as a given value (ie( ie. fixed), determined by forces outside of the model. Net Exports Net Exports = Total Exports Total Imports To begin with, also assumed fixed Aggregate Expenditure (AE) Aggregate Expenditure (AE) The sum of spending by households, business firms, the government, and foreigners on final goods and services produced in the United States 10

11 Aggregate Expenditure Aggregate expenditure = C + I p + G + NX Finding Equilibrium GDP The AE line is found by adding fixed amounts of investment, government purchases, and net exports to consumption, as determined by the consumption-income line. Finding Equilibrium GDP Real Aggregate Expenditure ($ Billions) 8,000 7,000 6,000 5,000 C+I p +G+NX p C+I +G C+I p C 4,000 3,000 2,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real GDP ($ Billions) 11

12 Aggregate Expenditure When income increases, aggregate expenditure (AE( ) will rise by the MPC times the change in income.this is because the other components of AE are assumed fixed. Finding Equilibrium GDP When aggregate expenditure is less than GDP, output will decline in the future. Thus, any level of output at which aggregate expenditure is less than GDP cannot be the equilibrium GDP. Finding Equilibrium GDP When aggregate expenditure is greater than GDP, output will rise in the future. Thus, any level of output at which aggregate expenditure exceeds GDP cannot be the equilibrium GDP. 12

13 Finding Equilibrium GDP Equilibrium GDP In the short run, the level of output at which output and aggregate expenditure are equal. Inventories and Equilibrium GDP The change in inventories during any period will always equal output minus aggregate expenditure. Inventories = GDP AE Inventories and Equilibrium GDP AE < GDP Inventories>0 GDP in future periods AE > GDP Inventories<0 GDP in future periods AE = GDP Inventories=0 GDP No change in GDP 13

14 Finding Equilibrium GDP C A 45 0 B Finding Equilibrium GDP A 45 degree line is a translator line: It allows us to measure any horizontal distance as a vertical distance instead. Finding Equilibrium GDP Real Aggregate Expenditure ($ Billions) 9,000 8,000 7,000 A H Increase in Inventories C+I p +G+NX 6,000 E 5,000 4,000 3,000 2,000 Decrease in Inventories Total Output K J Aggregate Expenditure Total Output Aggregate Expenditure 45 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real GDP ($ Billions) 14

15 Finding Equilibrium GDP At any output level at which the aggregate expenditure line lies below the 45 degree line, aggregate expenditure is less than GDP. If firms produce any of these output levels, their inventories will grow,, and they will reduce output in the future. Finding Equilibrium GDP At any output level at which the aggregate expenditure line lies above the 45 degree line, aggregate expenditure exceeds GDP. If firms produce any of these output levels, their inventories will decline,, and they will increase output in the future. Finding Equilibrium GDP Equilibrium GDP is the output level at which the AE line intersects the 45 line. If firms produce this output level, their inventories will not change, and they will be content to continue producing the same level of output in the future. 15

16 Equilibrium GDP and Employment In the short-run macro model, cyclical unemployment is caused by insufficient spending. As long as spending remains low, production will remain low and unemployment will remain high. Equilibrium GDP and Employment Aggregate Expenditure (a) AE low In the short run, equilibrium GDP can be too low so that equilibrium employment is less than full employment E Y e Y FE Real GDP (b) Employment Production Function L e E L FE L e E Y e Y FE Y e Real GDP Aggregate or too high so that equilibrium Expenditure employment is greater than full employment. (c) AE E high 45 Y FE Y e Real GDP Equilibrium GDP and Employment In the short-run macro model, the economy can overheat because spending is too high. As long as spending remains high, production will exceed potential output, and unemployment will be unusually low. 16

17 What Happens When Things Change? A A Change in Investment Spending The Expenditure Multiplier The Multiplier in Reverse Other Spending Shocks A A Graphical View of the Multiplier An Important Proviso About the Multiplier A Change in Investment Spending An increase in investment spending will set off a chain reaction, leading to successive rounds of increased spending and income. The Expenditure Multiplier Expenditure Multiplier The amount by which equilibrium real GDP changes as a result of a one-dollar change in autonomous consumption, investment, or government purchases. 17

18 The Expenditure Multiplier For any value of the MPC, the formula for the expenditure multiplier is 1/( 1 - MPC ). The multiplier effect of an increase in Investment Spending Total Spending Each Period ($ Billions) 1,960 2,176 2,306 2,500 1, Time Periods The Expenditure Multiplier Just as increases in investment spending cause equilibrium GDP to rise by a multiple of the change in spending, decreases in investment spending cause equilibrium GDP to fall by a multiple of the change in spending. 18

19 Other Spending Shocks Changes in planned investment, government purchases, net exports, or autonomous consumption lead to a multiplier effect on GDP. The expenditure multiplier is what we multiply the initial change in spending by in order to get the change in equilibrium GDP. Other Spending Shocks 1 GDP = I (1 MPC) P Other Spending Shocks 1 GDP = G (1 MPC) 19

20 Other Spending Shocks 1 GDP = NX (1 MPC) Other Spending Shocks GDP = 1 a (1 MPC) Real Aggregate Expenditure ($ Billions) A Graphical View of the Multiplier 9,000 8,000 F AE2 AE 1 7,000 6,000 E 5,000 $ 4,000 3,000 2,000 Increase in Equilibrium GDP $2,500 Billion 45 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real GDP ($ Billions) 20

21 A Graphical View of the Multiplier 1 GDP = Spending (1 MPC) Other Spending Shocks An increase in autonomous consumption spending, investment spending, government purchases, or net exports will shift the aggregate expenditure line upward by the increase in spending, causing GDP to rise. Automatic Stabilizers Automatic Stabilizers Forces that reduce the size of the expenditure multiplier and diminish the impact of spending shocks 21

22 Real-World Automatic Stabilizers Taxes which vary with Income Transfer Payments Interest Rates Prices Imports Forward-looking Behavior Real-World Automatic Stabilizers In the real world, due to automatic stabilizers, spending shocks have much weaker impacts on the economy than our simple multiplier formulas would suggest. Real-World Automatic Stabilizers In the long run, our multipliers have a value of zero: No matter what the change in spending or taxes, output will return to full employment, so the change in equilibrium GDP will be zero. 22

23 Comparing Models: Long Run and Short Run The Role of Saving The Effect of Fiscal Policy The Role of Saving In the long run,, an increase in the desire to save leads to faster economic growth and rising living standards. In the short run,, an increase in the desire to save can cause a recession that pushes output below its potential. The Effect of Fiscal Policy In the short run,, an increase in government purchases causes a multiplied increase in equilibrium GDP, so can change equilibrium GDP. In the long run,, fiscal policy is ineffective. 23

24 The Tax Multiplier The tax multiplier is 1.0 less than the spending multiplier, and negative in sign. Tax multiplier = (spending multiplier - 1) The Tax Multiplier Tax multiplier = MCP (1 MPC) The Tax Multiplier GDP MPC = T 1 MPC 24