Econ Chapter 12 Lecture Notes
Econ Chapter 12 Lecture Notes Econ 1012
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This 10 page Class Notes was uploaded by Gwendolyn Cochran on Thursday March 10, 2016. The Class Notes belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 25 views. For similar materials see Macroeconomics in Economcs at George Washington University.
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Date Created: 03/10/16
Chapter 12 Lecture Notes 12.1 The Aggregate Expenditure Model Aggregate expenditure mode l: A macroeconomic model that focuses on the shortrun relationship between total spending and real GDP, assuming that the price level is constant. Aggregate expenditure (AE) : Total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports. Total spending in an economy in a given year is the sum of consumption spending, investment spending, government spending, and net export spending. But no matter what it is called, planned aggregate expenditures, or aggregate demand, or planned aggregate expenditures is the sum of C + I + G + NX. Aggregate spending and output rise and fall together. When aggregate spending increases, output increases, and when aggregate spending falls, output falls. And here we have what Keynesian economics is really all about: when aggregate spending changes, output changes. When output changes, employment changes. And when employment changes, unemployment changes. All of this means that a change in aggregate spending ultimately changes unemployment. Remember that our interest in the shortrun is with unemployment. Keynes said that unemployment is determined by employment, employment is determined by the amount of goods and services an economy is producing, and the amount of goods and services an economy is producing is determined by aggregate spending or total spending. One more important point to make. In most textbooks, planned aggregate expenditures and aggregate expenditures are used interchangeably. However, aggregate demand and planned aggregate expenditures sometimes have different meanings. What is the difference between aggregate demand and planned aggregate expenditures? The difference is that planned aggregate expenditures refers to total spending at a specific level of prices (or inflation rates). So when prices change, there is a change in planned aggregate expenditures. In other words, planned aggregate expenditure (AE) is the sum of C + I + G + NX at a particular level of prices (the particular level of prices meaning the average price level of final goods and services). When the price level (GDP Deflator) rises, planned aggregate expenditures fall, and viceversa. Four Components of Aggregate Expenditure The four components in our model will be the same four that we introduced in a previous chapter as the components of GDP: • Consumption (C): Spending by households on goods and services • Planned investment (I): Planned spending by firms on capital goods, and by households on new homes • Government purchases (G): Spending on all levels of government on goods and services • Net exports (NX): The value of exports minus the value of imports Aggregate expenditure is the sum of these: AE = C + I + G + NX Planned investment vs. actual investment Our aggregate expenditure model uses planned investment, rather than actual investment; in this way, the definition of aggregate expenditures is slightly different from GDP. The difference is that planned investment spending does not include the buildup of inventories: goods that have been produced but not yet sold: Planned investment = Actual investment – unplanned change in inventories Although the Bureau of Economic Analysis measures actual investment, we will assume that their measurement is close enough to planned investment to use in our estimates of aggregate expenditures. If . . . then . . . and . . . aggregate expenditure the economy is in is inventories are macroeconomic equal to GDP unchanged equilibrium. aggregate expenditure is GDP and employment less than GDP inventories rise decrease. aggregate expenditure is GDP and employment greater than GDP inventories fall increase. 12.2 Determining the Level of Aggregate Expenditure in the Economy Consumption tends to follow a relatively smooth, upward trend; its growth declines during periods of recession. What affects the level of consumption? • Current disposable income • Household wealth • Expected future income • The price level • The interest rate We will proceed by examining how each of these affects the level of consumption. Current disposable income Consumer expenditure is largely determined by how much money consumers receive in a given year. We measure this by personal income, minus personal income taxes, plus government transfer payments such as Social Security. Income expands most years; hence so does consumption. Household wealth A household’s wealth can be thought of as its assets (like homes, stocks and bonds, and bank accounts) minus its liabilities (mortgages, student loans, etc.). Households with greater wealth will spend more on consumption, even with similar incomes. Recent studies estimate that an extra $1,000 in wealth will result in $40$50 in extra annual consumption spending, holding constant the effect of income. Expected future income Most people prefer to keep their consumption fairly stable from year to year, a process known as consumptionsmoothing. Example: Salespeople working on commission might have high incomes in some years, and low incomes in others. In order to predict their consumption, we would need to know what they believed their income would be in the future. The price level As prices rise, household wealth falls. If you have $100,000 in the bank, that will buy fewer products at higher prices. Consequently, higher prices result in lower consumption spending. The interest rate Higher real interest rates encourage saving rather than spending; so they result in lower spending, especially on durable goods. consumers seem to have a relatively constant marginal propensity to consume: the amount by which consumption spending changes when disposable income changes. This marginal propensity to consume (MPC) is the slope of the consumption function, the relationship between consumption spending and disposable income. We can therefore estimate the MPC by estimating the slope of the production function: Change∈consumption ∆C MPC= Change∈disposableincome = ∆YD Investment has increased over time, but unlike consumption, it has not increased smoothly, and recessions decrease investment more. What affects the level of investment? • Expectations of future profitability • Interest rate • Taxes • Cash flow We will proceed by examining how each of these affects the level of planned investment. Expectations of future profitability Investment goods, such as factories, office buildings, machinery, and equipment, are longlived. Firms build more of them when they are optimistic about future profitability. Recessions reduce confidence in future profitability, hence during recessions, firms reduce planned investment. Purchases of new housing are included in planned investment. In recessions, households have reduced wealth, and less incentive to invest in new housing. Interest rate Since business investment is sometimes financed by borrowing, the real interest rate is an important consideration for investing. A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. 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. Similarly, investment tax incentives tend to increase investment. Cash flow Firms often pay for investments out of their own cash flow, the difference between the cash revenues received by a firm and the cash spending by the firm. The largest contributor to cash flow is profit. During recessions, profits fall for most firms, decreasing their ability to finance investment. Net exports equals exports minus imports. The value of net exports is affected by: • Price level in U.S. vs. the price level in other countries • U.S. growth rate vs. growth rate in other countries • U.S. dollar exchange rate U.S. net exports have been negative for the last few decades. The value typically becomes higher (less negative) during a recession, as spending on imports falls 12.3 Graphing Macroeconomic Equilibrium You should practice graphing these equilibrium, there are practice problems in My Econ Lab 12.4 The Multiplier Effect Planned investment, government purchases, and net exports are autonomous expenditures: their level does not depend on the level of GDP. • But consumption has both an autonomous and induced effect. So its level does depend on the level of GDP, and this produces the upwardsloping AE line. An increase in an autonomous expenditure shifts the aggregate expenditure line upward. When this happens, 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. • We cannot say how long this adjustment to macroeconomic equilibrium will take —how many “rounds”, back and forth. • But we can calculate the value of the multiplier, as the eventual change in real GDP divided by the change in autonomous expenditures (planned investment, in this case): Y Change in real GDP $400 billion 4 I Change in investment spending $100 billion The multiplier can work in reverse too, like it did during the Great Depression of the 1930s. Several events, including the stock market crash of October 1929, led to reductions in investments by firms. Real GDP fell, so consumers cut back on spending, prompting firms to reduce production more, so consumers spent even less… How can we know the eventual value of the multiplier? • In each “round”, the additional income prompts households to consume some fraction (the marginal propensity to consume). The total change in equilibrium real GDP equals: The initial increase in planned investment spending = $100 billion Plus the first induced increase in consumption = MPC × $100 billion Plus the second induced increase in consumption = MPC × (MPC × $100 billion) = MPC × $100 billion Plus the third induced increase in consumption = MPC × (MPC × $100 billion) = MPC × $100 billion Plus the fourth induced increase in consumption = MPC × (MPC × $100 billion) 4 = MPC × $100 billion And so on … Change in equilibrium real GDP 1 Multiplier Change in autonomous expenditur e 1MPC Summarizing the multiplier effect: 1. The multiplier effect occurs both for an increase and a decrease in planned aggregate expenditure. 2. Because the multiplier is greater than 1, the economy is sensitive to changes in autonomous expenditure. 3. The larger the MPC, the larger the value of the multiplier. 4. Our model is somewhat simplified, omitting some realworld complications. For example, as real GDP changes, imports, inflation, interest rates, and income taxes will change. The last point generally means that the value we estimate for the multiplier, from the MPC, is too high. In the next chapter, we will address some of these shortcomings. Recall the savings identity: 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 to change, production will change. Production will increase when inventories are depleted, and fall when inventories accumulate. At the equilibrium level of GDP, inventories do not change and spending equals production. • This implied that savings were the key to longterm growth. But consider what happens in the shortterm if people save more: consumption decreases, and incomes decrease, so consumption decreases more… potentially pushing the economy into recession. • John Maynard Keynes referred to this as the paradox of thrift: what appears to be favorable in the longrun may be counterproductive in the shortrun. Economists debate whether this paradox of thrift really exists; increasing savings decreases the real interest rate; the consequent increase in investment spending may offset the decrease in consumption spending. • This is a realworld datadriven debate, unable to be settled by our simple model. 12.5 The Aggregate Demand Curve As demand for a product rises, we expect that two things will occur: production will increase, and so will the product’s price. • Our model has concentrated on the first of these, but what about price changes? In the larger economy, we also expect that an increase in aggregate expenditure would increase the price level. Will this price level change have a feedbackeffect on aggregate expenditure? • We generally expect that it will: increases in the price level will cause aggregate expenditure to fall, and decreases in the price level will cause aggregate expenditures to rise. The price level affects aggregate expenditure in three ways: 1. Rising price levels decrease the real value of household wealth, causing consumption to fall. 2. If price levels rise in the U.S. faster than in other countries, U.S. exports fall and imports rise, causing net exports to fall. 3. 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. Of course, these effects work in reverse if the price level falls. Each effect works in the same direction; so rising price levels decrease aggregate expenditure, while falling price levels increase aggregate expenditure. Consequently, there is an inverse relationship between the price level and real GDP. This relationship is known as the aggregate demand curve. Aggregate demand (AD) curve: A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.
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