February 18, 2016

We say that the economy as a whole is in macroeconomic equilibrium if?

Chapter 12 Homework  

1. The aggregate expenditure model can be written in terms of four  spending categories. Which equation shows the relationship between  aggregate expenditure and the four spending categories?  a. AE = C + I + G + NX

i. Aggregate expenditure = Consumption + Planned  

investment + Government purchases + Net exports  

2. Aggregate expenditure represents  

a. The amount of spending that occurs in an economy  

3. We say that the economy as a whole is in macroeconomic equilibrium  if  

a. Aggregate expenditure equals GDP  

b. Total spending equals total production  

c. Aggregate expenditure equals total production  

d. Total spending equals GDP

Aggregate expenditure represents what?

4. If inventory is rising due to the overproduction of crops, then it does  not signal bad times  

a. Inventory is not increasing because of a fall in demand  5. Determinant of investment  Don't forget about the age old question of What is oxidation-fermentation (o-f) test?

a. Taxes

b. Interest rates

c. Expectations about future profitability  

6. Total government purchases include  

a. Spending on goods and services by all federal, state and local  governments  

7. Relationship between the marginal propensity to consume and the  marginal propensity to save can best be described as  

a. MPC + MPS = 1  

b. MPC = 1 – MPS

c. MPS = 1 – MPC

8. The multiplier represents  

a. The total amount of additional increases in consumption  spending induced by an initial change in aggregate expenditure  

Relationship between the marginal propensity to consume and the marginal propensity to save can best be described as?

Chapter 12 Textbook  

∙ Aggregate expenditure model  

o Focuses on the short-run relationship between total spending and real GDP  

o Assumption of the model  price level is constant  

o In any particular year, the level of GDP is determined mainly by  the level of aggregate expenditure  

∙ Aggregate Expenditure  

o Early 1930s  US, UK and other industrial countries suffered  declines in real GDP of 20 percent or more

o Four components of aggregate expenditure that together equal  GDP  

 Consumption  Spending by households on goods and  services, such as automobiles and haircuts  

 Planned investment  planned spending by firms on capital goods, such as factories, office buildings, and machine  If you want to learn more check out How to distinguish sex from gender?

tools and on research and development, and spending by  household and firms on new houses  

 Government purchases  spending by local, state and  federal governments on goods and services, such as  

aircraft carriers, bridges, and the salaries of FBI agents  

 Net exports  spending by foreign firms and households on  goods and services produced in the US minus spending by  US firms and households on goods and services produced  in other countries  

o Aggregate expenditure = Consumption + Planned investment +  Government purchases + Net exports  

 AE = C + I + G + NX  

∙ Planned Investment vs. Actual Investment  If you want to learn more check out What is groupthink?

o Planned investment spending  

 Component of aggregate expenditure  

o Inventories  

 Goods that have been produced but have not yet been sold  Changes in inventories  included as part of investment  spending  

∙ Along with spending on machinery, equipment, office building, and factories  

o Amount businesses plan to spend on machinery and office  buildings  

 Equal to the amount they actually spend  

 Amount businesses plan to spend on inventories may be  different  

o Actual investment spending will be  

 Greater than planned investment spending WHEN there is  an unplanned increase in inventories  

 Less than planned investment spending WHEN there is an  unplanned decrease in inventories  

o Actual investment will equal planned investment only  when there is no unplanned change in inventories  ∙ Macroeconomic Equilibrium  If you want to learn more check out What marketing strategy is undifferentiated target strategy?

o Occurs when total spending, or aggregate expenditure equals  total production, or GDP  

 Aggregate expenditure = GDP  

o Why GDP fluctuates in the short run

∙ Adjustments to Macroeconomic Equilibrium  

o When aggregate expenditure is greater than GDP  total amount  of spending in the economy is greater than the total amount of  production  

 Many businesses will sell more goods and services than  they had expected to sell  

 Inventories will decrease  If you want to learn more check out What is the slope of the total product curve?

 Total employment will increase

o When aggregate expenditure is greater than GDP, inventories  will decline, and GDP and total employment will increase  o Aggregate expenditure is less than GDP  spending is less than  production

 Many businesses will sell fewer goods and services than  expected  

 Inventories will increase

 GDP and total employment will decrease  

o Aggregate expenditure equals GDP  

 Firms sell what they expected  

 Inventories unchanged  

 Not have an incentive to increase or decrease production   Macroeconomic equilibrium  

o Macroeconomic policies  

 Federal government may implement these if economists  forecast that aggregate expenditure is likely to decline and  that the economy is headed for a recession

∙ Determining the Level of Aggregate Expenditure in the Economy  o Components measured in real terms  

o Consumption

 Follows a smooth, upward trend  

 Only in period of recession does the growth in consumption decline If you want to learn more check out What is sales revenue?

 Variables

∙ Current disposable income

o Most important determinant  

o Income remaining to households after they  

have paid the personal income tax and  

received government transfer payments  

o Macroeconomic consumption  total of all  

consumption of US households  

o Increase when the current disposable income  

of households increases  

o Decrease when the current disposable income  

of households decreases  

∙ Household wealth

o Value of its assets minus the value of its  

liabilities  

o Wealth of households increases  consumption  

should increase  

o Stock increases  wealth of households  

increase

o Permanent increases in wealth have a larger  

impact than temporary increases  

∙ Expected future income

o Current income explains current consumption

 Only when current income is not  

unusually high or unusually low  

compared with expected future income  

∙ The price level  

o Measures the average prices of goods and  

services in the economy  

o As price level rises, the real value of wealth  

declines  

 So will consumption  

∙ The interest rate  

o When interest rate is high, the reward for  

saving is increased  

 Households are likely to save more and  

spend less

o Nominal interest rate  

 States interest rate on a loan or a  

financial investment  

o Real interest rate  

 Corrects the nominal interest rate for the  

effect of inflation and is equal to the  

nominal interest rate minus the inflation  

rate  

 Consumption spending

∙ Spending on services  

∙ Spending on nondurable goods

∙ Spending on durable goods  

o Most likely to be affected by changes in the  

interest rate  

 Consumption function  relationship between income and  consumption  

∙ Households spend a consistent fraction of each dollar of real disposable income on consumption

∙ Marginal Propensity to Consume

o Amount by which consumption spending changes when  disposable income changes  

o Slope of the consumption function

 Relationship between consumption spending and  

disposable income  

o Estimate the MPC by estimating the slope of the production  function

 MPC = (change in consumption)/(change in disposable  income)

∙ Average Propensity to Consume  ratio of consumption to disposable  personal income  

∙ Consumption and National Income  

o Disposable income = National income – Net taxes  

o National income = GDP = Disposable income + Net taxes  ∙ Income, Consumption and Saving  

o National income = Consumption + Saving + Taxes  

o 1 = MPC + MPS

o A part of every increase in income is consumed, and with taxes  constant, what is left over is saved

∙ Marginal Propensity to save  1 = MPC + MPS  

o Marginal propensity to consume plus the marginal propensity to  save must equal 1  

∙ Planned Investment  

o Expectations of future profitability  

 Investment goods are long-lived  

∙ Firms build more when they are optimistic about  

future profitability  

 Recessions reduce confidence  firms reduce planned  investment  

 Purchases of new housing included in planned investment  ∙ In recession  households have reduced wealth  

∙ Less incentive to invest in new housing  

o Interest rate

 A higher real interest rate results in less investment  

spending and a lower real interest rate results in more  

investment spending  

o Taxes  

 Higher corporate income taxes on profits decrease the  money available for reinvestment and decrease incentives  to invest by diminishing the expected profitability of  

investment

 Investment tax incentives tend to increase investment  o Cash flow

 The difference between the cash revenues received by a  firm and the cash spending by the firm  

 Largest contributor to cash flow is profit  

 Recessions  profits fall for more firms, decreasing their  ability to finance investment  

∙ Government Purchases  

o Include purchases at all levels  federal, state and local  o Does not include transfer payments, only purchases for which  the government receives some good or service

∙ Net Exports  

o Price level in US vs the price level in other countries  

o US growth rate vs growth rate in other countries  

o US dollar exchange rate  

o Determinants of Net Exports  

o

∙ 45-degree Line Diagram  

o Also known as the Keynesian Cross

o GDP on x-axis and real aggregate expenditure on the y-axis  o Based on the analysis of John Maynard Keynes  

o Only points on the 45-degree line can be a macroeconomic  equilibrium

 Planned aggregate expenditure equal to GDP

o Determining the Equilibrium  

 When they receive additional income, households consume some of it and save some of it  

 Resulting consumption function tells us how much  

consumers will spend (real expenditure) when they have a  particular income (real GDP)

 Real GDP must equal planned aggregate expenditure

 Find the “right” level of C  

 If there is no other expenditure, the equilibrium is wherever the consumption function crosses the 45 degree line  

∙ Income equals expenditure  

 Macroeconomic equilibrium is the point at which  

∙ Income equals expenditure  Y = C + I + G + NX

∙ The level of consumption is consistent with the level  of income, according to the consumption function  

 We call this top most line the aggregate expenditure  function

o Recession

 If equilibrium happens at the level of potential GDP  

∙ Unemployment will be low  

∙ It will be at the natural rate of unemployment or the  

full employment level  

 When the aggregate expenditure line intersects the 45  degree line at a level of GDP below potential GDP 

recession

∙ Important Role of Inventories  

o When planned aggregate expenditure is less than real GDP, firms will experience unplanned increases in inventories  

 Even if spending returns to normal  firms have excess  inventories to sell

 They will do this instead of increasing production to normal levels  

o Economics estimate that almost half of this decline was due to  firms cutting production as they sold off their unintended  accumulation of inventories  

∙ Autonomous and Induced Expenditures  

o Small change in planned aggregate expenditure causes a larger  change in equilibrium real GDP  

o Autonomous expenditures  their level does not depend on the  level of GDP  

 Planned investment, government purchases, and net  exports  

o Consumption has both an autonomous and induced effect   Its level does depend on the level of GDP  

∙ Produce the upward-sloping AE line  

o Increase in an autonomous expenditure shifts the aggregate  expenditure line upward  

 Real GDP increases by more than the change in  

autonomous expenditures  

∙ This is the multiplier effect

 The value of the increase in equilibrium real GDP divided  by the increase in autonomous expenditures is the  

multiplier  

∙ 1 / 1 – MPC or 1/MPS

∙ Eventual Effect of the Multiplier  

o Eventual change in real GDP divided by the change in  autonomous expenditures  

 (Change in real GDP)/(Change in investment  

spending)

∙ The Multiplier and the Marginal Propensity to Consume  o In each “round”, the additional income prompts households to  consume some fraction  

 The marginal propensity to consume  

o The total change in equilibrium real GDP equals  

 Initial increase in planned investment spending

 Plus the first, second, third, etc., induced increase  

∙ Formula for the Multiplier  

o Multiplier = (Change in equilibrium real GDP)/(Change in  autonomous expenditure)  

 1 / (1 – MPC)

∙ Multiplier Effect  

o Occurs both for an increase and a decrease in planned aggregate expenditure  

o Because multiplier is greater than 1, the economy is sensitive to  changes in autonomous expenditure  

o Larger the MPC, larger the value of the multiplier  

o Model is somewhat simplified

 Omits some real-world complications  

 The value we estimate for the multiplier, from the MPC, is  too high  

∙ The Paradox of Thrift  

o Savings equals investment  

 If saving does not equal investment, there is a discrepancy  between spending and production that will result in  

unplanned inventory changes  

 Since firms are not in favor of seeing inventory levels  change, production will change  

 Production will increase when inventories are deplete and  fall when inventories accumulate  

 At the equilibrium level of GDP, inventories do not change  and spending equals production

o Savings were the key to long term growth  

o Paradox of thrift  what appears to be favorable in the long-run  may be counterproductive in the short run

 Short run if people save more  consumption decreases,  income decrease, consumption decreases more 

potentially pushes economy into recession  

 An increase in saving is good, because saving is borrowed  and spend on investment goods  

 More plant and equipment increases the capacity of the  economy to produce goods and services  

 Savings will be borrowed and spent for investment  

purposes  

 If an increase in saving doesn’t lead to more investment,  we have the Paradox of Thrift  

∙ The attempt to save more may reduce GDP and  

leave actual saving unchanged  

∙ Price Level and Aggregate Expenditure  

o As demand for a product rises  production will increase, so will  the product’s price  

o Expect that an increase in aggregate expenditure would increase the price level

 Increases in the price level will cause aggregate  

expenditure to fall and decreases in the price level will  

cause aggregate expenditures to rise  

∙ How does the Price Level Affect Aggregate Expenditure? o Rising price levels decrease the real value of household wealth  consumption falls  

o If price levels rise in the US faster than in other countries, US  exports fall and imports rise, causing net exports to fall  o When prices rise, firms and households need more money to  finance buying and selling

 If the supply of money doesn’t change, the interest rate  must rise

 This will cause investment spending to fall  

o These effects work in reverse if the price level falls  

∙ Aggregate Demand Curve  

o Inverse relationship between price level and real GDP  o 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  

∙ Consumption spending is only a part of aggregate expenditure  ∙ Graphical analysis of macroeconomic equilibrium tells us the  qualitative changes that take place  

o Equation-based model allows us to make quantitative or  numerical estimates ‘

o Rely on econometric models

 Statistically estimate the relationships between economic  variables  

∙ Aggregate Expenditure Equations  

o C = C + MPC(Y)  

 Consumption function

o I = I

 Planned investment function

o G = G

 Government spending function

o NX = NX

 Net export function

o Y = C + I + G + NX

 Equilibrium condition  

o Italicized letters are fixed (autonomous) values  

o Y = C + MPC(Y) + I + G + NX

 Y – MPC(Y) = C + I + G + NX  

 Y(1-MPC) = C + I + G + NX  

 Y = (C + I + G + NX) / (1-MPC)  

 (C + I + G + NX) x (1/(1-MPC))

o Equilibrium GDP = Autonomous expenditure x Multiplier  ∙ An unplanned increase in inventories results from actual investment  that is great than planned investment  

∙ When aggregate expenditure is more than GDP  

o There was an unplanned decrease in inventories  ∙ Disposable Income  national income + transfers – taxes  ∙ US net export spending rises when  

o The growth rate of US GDP is slower than the growth rate of GDP in other countries  

Chapter 13

o Aggregate demand and aggregate supply model  

o Explains short run fluctuations in real GDP and the price level  o Aggregate demand curve  relationship between the price level and  the quantity of real GDP demanded by households, firms and the  government  

o Short-run aggregate supply curve  relationship in the short run  between the price level and the quantity of real GDP supplied by firms  o Why is the Aggregate Demand Curve Downward Sloping?  o A fall in the price level increases the quantity of real GDP  demanded

o Change in Price Affects Consumption  

 Current income is the most important variable determining  consumption by households  

∙ Income rises  consumption will rise

∙ Income falls  consumption will fall  

 Household wealth  difference between the value of a  household’s assets and the value of its debts  

∙ Sometimes held in cash or other nominal assets  ∙ As total household wealth rises, consumption will rise  When the price level rises, the real value of household  wealth declines  

∙ So will consumption  

∙ Reduces the demand for goods and services  

 When price level falls, the real value of household wealth  rises

∙ So will consumption and the demand for goods and  services

 Called the wealth effect  

o Change in Price Affects Investment  

 When price level rises, households and firms will try to  increase the amount of money they hold  

∙ Withdrawing funds from banks, borrowing from banks or selling financial assets such as bonds  

∙ Tend to drive up the interest rate banks charge on  loans and the interest rate on bonds  

 Higher interest rate raises the cost of borrowing for firms  and households  

∙ Firms will borrow less  

∙ Households will borrow less  

 Consumption will also fall as households borrow less to  finance spending on durable goods  

 Higher price level increases the interest rate and reduces  investment spending  

∙ In turn, it also reduces the quantity of goods and  services demanded  

 Lower price level will decrease the interest rate and  increase investment spending  

∙ Increases the quantity of goods and services  

demanded

 Called the interest-rate effect  

o Change in Price Affects Net Exports