Chapter 10: The S/R Macro Model
„
Consumption Spending
Spending is very important in the S/R
Largest component of economy’ s spending
„
What determines consumption?
Spending
depends on income and income depends
on spending
„
„
Assumption
spending determines the output level
Prices do not change
Income after taxes
Disposable income = Income – Net taxes
= Income – (Taxes – Transfers)
Wealth (+)
Types of spending
„
Consumption
Investment
Exports
Total value of HH assets – outstanding liabilities
Interest rate (-)
Expectations about future
„
Government
Net
Disposable income (+)
„
Only
„
2/3 of total spending
„
As r ↑ C ↓
Optimism (+) or pessimism (-)
1
The Consumption Function
The Consumption Function
„
„
Represent consumption with an equation
Real Consumption Spending
($billions)
„
D
a: autonomous consumption
Part
of consumption spending that is independent of
income
„
b: marginal propensity to consume (MPC)
Slope
of consump. function =
Figure 1 The Consumption Function
8,000
C = a + b × (Disposable Income)
C = a + b×Y
2
ΔConsumption
ΔDisposable income
7,000
The consumption function shows the (linear)
relationship between real consumption
spending and real disposable income
Consumption
Function
6,000
5,000
600
4,000
3,000
2,000
1,000
1,000
The vertical intercept ($2,000
billion) is autonomous
consumption spending . . .
and the slope of the line
(0.6) is the marginal
propensity to consume.
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Real Disposable Income ($ billions)
3
4
1
Consumption and Income
The Consumption Function
„
MPC: the amount by which C rises when YD
rises by one dollar
„
0 < MPC < 1
Convert the relationship into ConsumptionIncome relationship
_
C = a + b × (Income)
_
Ex:
Robinson collects coconuts and eats 80% of
them. What is his MPC?
„
C = a + b×Y
„
What happens to his Consumption function if he becomes
optimistic about future?
Consider figure 2
5
The Consumption-Income Line
„
6
Consumption-Income Line
Figure 2 The Consumption-Income Line
Real Consumption
Spending ($ billions)
5,600
5,000
2. The line has the same
slope as the consumption
4,000
function in Figure 2 . . .
Movement along C-Y line
Y
↑ → YD ↑ → C ↑
in income
Change
„
Shifting C-Y line
T
3,000
1. To draw the consumption- 2,000
income line, we measure
real income (instead of real 1,000
disposable income) on the
horizontal axis.
„
ConsumptionIncome Line
B
A
↓ → YD at each income level ↑ → C at each income
level ↑
600
1,000
„
„
„
2,000
4,000
6,000
Transfers …
Also
3. but a different
vertical intercept.
8,000
„
Real Income ($ billions)
7
changes in
Wealth (+)
Interest rate (-)
Expectations (+ or -)
Changes
autonomous consumption
8
2
Other components of Total Spending
„
Other components of Total Spending
Investment = Planned investment or Investment
Spending
„
Total
Exports – Total Imports
in C, IP and G—gives us an
exaggerated measure of U.S. output
Treat it as fixed
Business
purchases of plant and equipment and
construction of new homes
Treat it as fixed
„
„
Net Exports
Imports—included
Determined outside the model
„
G: all goods and services that government
agencies buy during the year
„
Treat
it as a fixed given value
Changes with world politics
Can change due to changes in preferences towards foreign
goods, price of foreign currency (exchange rates)
AE = C + IP + G +NX
Similar
to GDP definition except for…
9
Equilibrium GDP
„
Change in Inventories
GDP level—that remains the same until
something we assumed constant begins to
change
AE
„
„
„
< GDP → ∆ Inventories > 0 → GDP ↓
AE > GDP → ∆ Inventories < 0 → GDP ↑
AE = GDP → ∆ Inventories = 0 → no change
in GDP
in the future
> GDP
Output will
„
in the future
∆Inventories = GDP – AE
AE
< GDP
Output will
AE
10
Graphing Equilibrium GDP
Consider
11
figures 3 and 4
12
3
Determining Equilibrium Real GDP
Deriving the Aggregate Expenditure Line
Figure 3 Deriving the Aggregate Expenditure Line
Real 8,000
Aggregate
Expenditure 7,000 5. to get the aggregate expenditure line.
($ billions)
6,000
4. and net exports (NX) . . .
5,000
„
„
Figure 4 Determining Equilibrium Real GDP
A
12,000
C + IP + G + NX
C + IP + G
C + IP
C
E
8,000
4,000
3. government purchases (G) . . .
4,000
2. then add planned investment (IP) . . .
1,000
1. Start with the
consumptionincome line,
Total
Output
K
2,000
2,000
4,000
6,000
Total
Output
8,000
Real GDP ($ billions)
J
Increase in
Inventories
H
Decrease in
Inventories
3,000
C+IP+G+NX
Aggregate
Expenditure
Aggregate
Expenditure
45°
4,000
8,000
12,000
13
Equilibrium GDP and Employment
Equilibrium GDP and Employment
„
14
„
Figure 5 Equilibrium GDP Can Be Less Than Full Employment GDP
Aggregate
Expenditure
($ billions)
Equilibrium GDP is not necessarily the fullemployment level of output
Spending
is important
unemployment is caused by insufficient
spending
When the aggregate
expenditure line is
low . . .
AELOW
F
$10,000
E
Cyclical
„
Production is low, unemployment is high
Economy
„
overheats because spending is too high
45°
Production is high (booms), unemployment is unusually low
Real GDP
($ billions)
B
$10,000
$8,000
equilibrium output
($8,000) is less than
potential output,
A
Aggregate
Production
Function
cyclical
unemployment
= 50 million
Real GDP
Number of
150
$10,000
Workers
Million
Potential GDP ($ billions)
$8,000
Full Employment
100
and equilibrium employment
is less than full employment. Million
15
16
4
Figure 6: Equilibrium GDP and Employment
When the aggregate
Aggregate expenditure line is high . . . Real GDP
Expenditure
($ Billions)
AEHIGH
($ Billions)
E'
$12,000
$10,000
$10,000
F
$2,000
equilibrium output ($12,000) is
greater than potential output,
$10,000
Potential GDP
$12,000
Real GDP
($ Billions)
H
B
Finding Equilibrium GDP Algebraically
C = a + bY D ⎫⎪
⎬ ⇒ C = a + b(Y − T )
Y D = Y − T ⎪⎭
C = (a − bT ) + bY
⎫
a − bT + I P + G + NX
⎪
P
AE = C + I + G + NX ⎬ ⇒ Y =
1− b
⎪
Y = AE
⎭
Aggregate
Production
Function
and equilibrium employment is greater than full
employment.
150
Million
Full Employment
Number of
Workers
200
Million
Exogenous variables: a, b, T, IP, G, NX
17
Finding Equilibrium GDP Algebraically
„
18
A Change in Investment Spending
Suppose the following equations describe the economy
of Round Island in millions of dollars.
„
Sales
Net taxes (T) are taxes minus transfer payments.
„
revenue ↑
Income/disposable
income ↑
C↑
C = 55 + 0.8(Y - T)
I = 52
G = 50
NX = 5
Net taxes = 15
„
Increase investment spending
Chain
reaction
spending and income
Increased
„
„
Equilibrium GDP ↑ more than original ↑ in IP
Decrease investment spending
Equilibrium
Equilibrium GDP?
If T raises to $ 90 million, what is the equilibrium GDP?
19
GDP ↓ more than original ↓ in IP
20
5
A Change in Investment Spending
„
Expenditure Multiplier
Figure 7 The Effect of a Change in Investment Spending
Increase in
Annual GDP
2,306
2,176
2,500
„
Change
1,960
For
1,600
in equilibrium real GDP
$1 change in a, IP, G, or NX
Multiplier =
1,000
Initial
Rise in
IP
Expenditure multiplier
After
Round
2
After
Round
3
After
Round
4
After
Round
5
1
(1 − MPC)
1
⎡
⎤
P
ΔGDP = ⎢
⎥ × ΔI
⎣ (1 − MPC) ⎦
After
All
Rounds
21
A Graphical View of the Multiplier
Other Spending Changes
„
22
„
An increase in a, IP, G, or NX
Shift
the AE line upward by the initial increase
in spending
Equilibrium GDP rises:
1
⎡
⎤
ΔGDP = ⎢
⎥ × ΔSpending
⎣ (1 − MPC) ⎦
Figure 8 A Graphical View of the Multiplier
Real Aggregate
Expenditure 12,000
($ billions)
8,000
F
AE2
AE1
$1,000
E
Increase in
Equilibrium GDP
4,000
$2,500
Billion
45°
4,000
23
8,000
12,000
Real GDP
($ billions)
24
6
Automatic Stabilizers and the Multiplier
„
Automatic stabilizers
Reduce
„
„
„
„
„
„
„
the size of the multiplier
Time
Most
important automatic stabilizer
In the L/R, our multipliers have a value of zero
Output = Potential output (∆GDP=0)
Smaller multiplier → smaller change in GDP
Real
„
Automatic Stabilizers and the Multiplier
world automatic stabilizers
Taxes
Transfer payments
Interest rates
Imports
Forward-looking behavior
In the real world, due to automatic stabilizers, spending
changes have much weaker impacts on the economy
25
Countercyclical Fiscal Policy
Countercyclical Fiscal Policy
„
„
Real Aggregate
Expenditure
($ billions)
effects on output and employment
A
AE1
AE2
B
economy will reach full-employment level
Countercyclical fiscal policy
Change
„
„
Figure 9 Countercyclical Fiscal Policy
Long-run
Eventually
„
„
Short-run
Demand-side
26
G or T
To reverse or prevent a recession or a boom
ΔGDP=Multiplier×ΔG
45°
27
9,000
(Recession
Output)
Real GDP ($ billions)
10,000
(Full-Employment
Output)
28
7
Tax Multiplier
Problems with Countercyclical Fiscal Policy
„
Timing Problems
Takes
„
„
many months for fiscal changes to be enacted
might as well destabilize the economy
is difficult
„
Tax multiplier = -(Spending multiplier-1)
Tax Multiplier =
Irreversibility
Reversing
„
changes in government purchases or taxes
ΔGDP =
Reaction of the Federal Reserve
FED
can act more rapidly and flexibly than can
Congress
29
- MPC
1 - MPC
- MPC
× ΔT
1 - MPC
30
8