The Historical Development of
Modern Macroeconomics
The Goods Market and the
Aggregate Expenditures Model
n
The Great Depression of the 1930s led to the
development of macroeconomics and
aggregate demand tools to deal with
recessions.
n
During the Depression, output fell by 30
percent and unemployment rose to 25
percent.
Chapter 8
2
The Historical Development of
Modern Macroeconomics
n
Classical Economists
Keynes is the author of The General Theory
of Employment, Interest and Money, which
provided the new framework for
macroeconomic policy.
n
The Classical economists' approach was
laissez-faire (leave the market alone).
n
They believed the market was self-adjusting.
n
They concentrated on the long run and
largely ignored the short run.
3
Classical Economics
4
Classical Economics
n
They used microeconomic supply and
demand arguments to explain the Great
Depression.
n
Classical economists opposed deficit
spending, arguing that the money to create
jobs had to be borrowed.
n
Their solution to the high unemployment was
to eliminate labour unions and government
policies that kept wages too high.
n
This money would have financed private
economic activity and jobs, so everything
would cancel out (called crowding out).
5
6
The Historical Development of
Modern Macroeconomics
The Essence of Keynesian Economics
n
n
Before the Depression, the prominent
ideology was laissez-faire -- keep the
government out of the economy.
n
After the Depression, most people believed
government should have a role in regulating
the economy.
Keynes thought that the economy could get
stuck in a rut as wages and price level
adjusted to sudden decreases in
expenditures.
7
The Essence of Keynesian Economics
n
8
Equilibrium Income Fluctuates
According to Keynes:
a decrease in spending ⇒
job layoffs ⇒
fall in consumer demand ⇒
firms decrease production ⇒
more job layoffs ⇒
further fall in consumer demand,
and so forth
n
Income is not fixed at the economy's long-run
potential income – it fluctuates.
n
For Keynes there was a difference between
equilibrium income and potential income.
9
Equilibrium Income Fluctuates
Equilibrium Income Fluctuates
n
n
10
Equilibrium income – the level toward which
the economy gravitates in the short run
because of the cumulative cycles of declining
or increasing production.
Potential income – the level of income that
the economy technically is capable of
producing without generating accelerating
inflation.
11
n
Keynes felt that at certain times the economy
needed help to reach its potential income.
n
He believed that market forces would not
work fast enough and would not be strong
enough to get the economy out of a
recession.
12
The Paradox of Thrift
n
n
The Paradox of Thrift
Incomes would fall as people lost their jobs
causing both consumption and saving to fall
as well.
n
Paradox of thrift – an increase in savings
can lead to a decrease in expenditures,
decreasing output and causing a recession.
The economy would reach a new low-level
equilibrium which could be at an almost
permanent recession.
13
The Aggregate Expenditures Model
14
The Aggregate Expenditures Model
n
Using a few simplifying assumptions,
economists can construct a model of the
economy.
n
The AE model assumes that the price level is
fixed, and explores how an initial shift in
expenditures changes equilibrium output.
n
The Aggregate Expenditures (AE) Model
looks at how real income is determined in an
economy.
n
The AE model quantifies the effect of
changes in aggregate expenditures on
aggregate output.
15
Aggregate Production
n
Aggregate production –the total amount of
goods and services produced in every
industry in an economy.
n
Production creates an equal amount of
income.
n
Thus, actual production and actual income
are always equal.
16
Aggregate Production
17
n
Graphically, aggregate production in the AE
model is represented by a 45° line through
the origin
n
At all points on this Aggregate Production
Curve, income equals production.
18
The Aggregate Production Curve
Aggregate Expenditures
n
Real
production
Aggregate production
(production = income)
C
A
$4,000
Aggregate expenditures – the total amount
of spending on final goods and services in
the economy:
q
q
q
0
q
Potential income
45º
$4,000
Real income
Consumption – spending by households.
Investment – spending by business.
Spending by government.
Net foreign spending on Canadian goods – the
difference between Canadian exports and
imports.
19
Autonomous and Induced
Expenditures
n
n
Autonomous and Induced
Expenditures
Autonomous expenditures are
expenditures that are independent of income.
q
20
n
Autonomous expenditures is the level of
expenditures that would exist at zero income
and they remain constant at all levels of
income.
n
Induced expenditures are those that
change as income changes, but they rise by
less than the change in income.
Autonomous expenditures change because
something other than income changes.
Induced expenditures – expenditures that
change as income changes.
21
Expenditures Function
22
The Expenditures Function
n
n
The relationship between expenditures and
income can be expressed more concisely as
an expenditures function.
n
An expenditures function is a
representation of the relationship between
aggregate expenditures and income.
The relationship between aggregate
expenditures and income can be expressed
mathematically:
AE = AEo + mpcY
AE = aggregate expenditures
AE o = autonomous expenditures
mpc = marginal propensity to consume
Y = income
23
24
The Marginal Propensity to Consume
The Marginal Propensity to Consume
n
Marginal propensity to consume (mpc) –
the change in consumption that occurs with a
change in income.
n
The mpc is between 0 and 1 because
individuals tend to save a portion of an
increase in income.
n
The mpc is the fraction spent from an
additional dollar of income or mpc is the ratio
of a change in consumption (∆ C) to a change
in income (∆ Y).
mpc =
change in consumptio n ∆C
=
change in income
∆Y
25
Graphing the Expenditures Function
n
Graphing the Expenditures Function
The graphical representation of the
expenditures function is called the aggregate
expenditures curve.
Aggregate production
AE = 1,000 + 0.8Y
$12,200
Real expenditures (AE)
n
26
The slope of the expenditures function tells
us how much expenditures change with a
particular change in income.
10,000
∆ AE = 2,000
8,000
∆ Y = 2,500
∆AE 2,000
slope =
=
∆Y
2,500
∆AE
mpc =
= 0.8
∆Y
6,000
5,000
4,000
2,000
1,000
0
45º
$5,000
$8,750 $11,250$14,000
Real income
27
Shifts in the Expenditures Function
Shifts in the Expenditures Function
n
The aggregate expenditure curve shifts when
autonomous C, I, G, or (X – IM) change.
n
Autonomous Consumption expenditures
respond to changes in factors other than a
change in real income, for example:
n
n
n
28
n
Autonomous Investment is the most volatile
component of GDP.
n
It responds to changes in:
n
n
n
interest rates
household wealth
expectations of future conditions
n
29
interest rates
capital goods prices
consumer demand conditions
expectations regarding future economic conditions
30
Determining the Equilibrium Level of
Aggregate Income
Shifts in the Expenditures Function
n
n
Autonomous exports and imports depend on
foreign and domestic incomes and relative
prices.
Autonomous Government expenditures may
also change as policies change.
n
At equilibrium, planned expenditures must
equal production.
n
Graphically, it is the income level at which AE
equals AP.
31
Solving for Equilibrium Graphically
Real expenditures (AE)
Solving for Equilibrium Algebraically
Aggregate
production
$14,000
Aggregate
expenditures
AE = 1,000 + 0.8Y
12,200
10,000
32
n
In equilibrium, Y = AE.
n
Substituting in for aggregate expenditures,
we have
Y = AE0 + mpcY
8,000
E
5,000
2,600
1,000
0
AE0 = $1,000
45°
$2,000
$5,000
$10,000
$14,000
Real income
33
Solving for Equilibrium Algebraically
n
34
The Multiplier Equation
Now solve for equilibrium income:
n
Y – mpcY = AE 0
The multiplier equation tells us that income
equals the multiplier times autonomous
expenditures.
Y = Multiplier X Autonomous expenditures
Y (1 – mpc) = AE 0
Y = [ 1/ (1 – mpc) ] * AE 0
35
36
The Multiplier Equation
n
The multiplier process amplifies changes in
autonomous expenditures.
n
What forces are operating to ensure that the
income level we determined is actually the
equilibrium income level?
The Multiplier Process
n
When aggregate production do not equal
aggregate expenditures:
Businesses change production levels,
which changes income,
which changes expenditures,
which changes production,
which changes income,
which changes . . . etc.
n
37
The Multiplier Process
n
The Multiplier Process
C, I, G,
(X – IM)
The process ends when aggregate
production equals aggregate expenditures.
A1 Aggregate
production
Aggregate
A2 expenditures
AE = 1,000 + 0.8Y
$14,000
$13,200
Real expenditures (AE)
n
38
Firms are selling all they produce, so they
have no reason to change their production
levels.
10,000
C
B1
6,000
B2
2,000
45°
0
$2,000
$5,000
$10,000
$14,000
Real income
39
The Circular Flow Model and the
Multiplier Process
n
The circular flow model provides the intuition
behind the multiplier process.
n
The flow of expenditures equals the flow of
income.
40
The Circular Flow Model and the
Multiplier Process
41
n
Expenditures are injections into the circular
flow.
n
The mpc measures the percentage of
expenditures that get injected back into the
economy each round of the circular flow.
n
But there are withdrawals.
42
The Circular Flow Model and the
Multiplier Process
n
The Circular Flow Model and the
Multiplier Process
n
Economists use the term the marginal
propensity of save (mps) to represent the
percentage of income flow that is withdrawn
from the economy for each round of the
circular flow.
By definition:
mpc + mps = 1
n
Alternatively expressed:
mps = 1 - mpc
multiplier = 1/mps
43
The Circular Flow Model and the
Multiplier Process
The AE Model in Action
n
Aggregate income
Households
44
The AE model illustrates how a change in
autonomous expenditures changes the
equilibrium level of income.
Firms
Aggregate expenditures
45
The Multiplier Model in Action
n
Autonomous expenditures are determined
outside the model and are not affected by
changes in income.
n
When autonomous expenditures shift, the
multiplier process is called into play.
46
The Steps of the Multiplier Process
47
n
The income adjustment process is directly
related to the multiplier.
n
Any initial shock (a change in autonomous
AE) is multiplied in the adjustment process.
48
Shifts in the Aggregate Expenditure
Curve
The Steps of the Multiplier Process
n
The multiplier process repeats and repeats
until a new equilibrium level is finally reached.
Aggregate production
C, I
$4,200
E0
4,160
20
E0
AE0 = 832 + .8Y
AE1 = 812 + .8Y
$20
12.8
4,100
4,060 20
832
812
0
D AEA = $20
$16 D AEA = $16
D AEA = $12.8
E1
E1
$100
$4,060
$4,160 Real income
100
49
First Five Steps of Four Multipliers
mpc = 0.5
50
First Five Steps of Four Multipliers
mpc = 0.75
100
mpc = 0.8
100
100
100
80
75
81
72.9
65.61
51.2
42.19
31.64
25
90
64
56.25
50
mpc = 0.9
40.96
12.5 6.25
Multiplier = 1/(1-0.5) = 2
Multiplier = 1/(1-0.75) = 4
Multiplier = 1/(1-0.8) = 5
Multiplier = 1/(1-0.9) = 10
51
The Effect of Shifts in Aggregate
Expenditures
Examples of the Effect of Shifts in
Aggregate Expenditures
n
n
There are many reasons for shifts in
autonomous expenditures:
q
q
q
q
52
An understanding of these shifts can be
enhanced by tying them to the formula:
AE = C + I + G + X - IM
Natural disasters.
Changes in investment caused by technological
developments.
Shifts in government expenditures.
Large changes in the exchange rate.
53
54
Upward Shift of AE
Real
expenditures
$4,210
Downward Shift of AE
∆Y =
4,090
1,052.5
1
[∆AE 0]
1 - 0.75
1,412
1,382
$120
$4,090
$4,210
Aggregate production
AE0
30 AE1
∆Y =
4,062
= 4 [∆AE 0 ] = 120
30
1,022.5
0
Real
expenditures
$4,152
Aggregate production
AE
30 1
AE0
Real income
0
1
[∆AE 0]
1 - 0.66
= 3 [∆AE 0 ] = 90
30
$90
$4,062
$4,152
Real income
55
Canada in 2000
Real World Examples
n
Canada in 2000.
n
Japan in the 1990s.
n
The 1930s depression.
56
n
Consumer confidence rose substantially
causing autonomous consumption
expenditures to increase more than
economists had predicted.
n
While economists had expected the economy
to grow slowly, it boomed.
57
Japan in the 1990s
n
The 1930s Depression
Aggregate income and production fell during
the 1990s.
q
q
q
58
A dramatic rise in the yen cut Japanese exports.
Autonomous consumption decreased as
consumers’ confidence fell
Suppliers responded by laying off workers and
cutting production.
59
n
The 1929 stock market crash, which
continued into 1930, threw the financial
markets into chaos.
n
This resulted in a downward shift of the AE
curve as wealth decreased.
60
The 1930s Depression
The 1930s Depression
n
Frightened business people decreased
investment and laid off workers.
n
Frightened consumers decreased
autonomous consumption and increased
savings, thereby increasing withdrawals from
the system.
n
n
Business people responded by decreasing
output, which decreased income, starting a
downward cycle, thereby confirming the
fears of the businesspeople.
n
The process continued until the economy
settled at a low-level equilibrium, far below
the potential level of income.
Governments cut spending to balance their
budgets, as tax revenue declined.
61
The 1930s Depression
62
AE Model Is Not a Complete Model
n
The process caused the paradox of thrift,
whereby individuals attempting to save more,
spent less, and caused income to decrease.
n
They ended up saving not more, but less.
n
The AE model determines income given
autonomous expenditures.
n
These autonomous expenditures, however,
are determined by economic variables which
are not in our simple model.
63
Model of Aggregate Demand
AE Model Is Not a Complete Model
n
The AE model uses aggregate expenditures
to determine equilibrium income.
n
It does not explain production.
n
64
It assumes firms can supply the output
demanded.
65
n
Shifts may be simultaneous shifts in supply
and demand that do not necessarily reflect
suppliers responding to changes in demand.
n
Expansion of this line of thought has led to
the real business cycle theory of the
economy.
66
Model of Aggregate Demand
n
Prices are Fixed
Real business cycle theory of the
economy – changes in aggregate supply are
the principle way for real income to change.
n
The multiplier model assumes that the price
level is fixed.
n
In reality, the price level can change in
response to changes in aggregate demand.
67
Does Not Include Expectations
n
Forward-Looking Expectations
Complicate the Adjustment Process
People's forward-looking expectations make
the adjustment process much more
complicated.
n
Most people, however, act upon their
expectations of the future.
n
Business people may not automatically cut
back production and lay-off workers if they
think a fall in sales is temporary.
68
n
Rational expectations model – captures the
effect expectations have on individuals’
behaviour.
n
Expectations can be self-fulfilling.
69
Consumption Behaviour
70
Expanded AE Model
n
People may base their spending on lifetime
income, not yearly income.
n
We can increase the power of our AE model
by adding more detail.
n
Permanent income hypothesis -- the
hypothesis that expenditures are determined
by permanent or lifetime income.
n
For example, adding taxes to the model
q
q
q
71
Changes consumption expenditures.
Introduces government budget deficits and
surpluses.
Changes the multiplier.
72
Expanded AE Model
n
Expanded AE Model
Adding income-induced imports
q
n
Changes import spending.
The marginal propensity to import (mpi) gives
the increase in import spending from an
additional $1 of disposable income.
q
q
Changes net exports,
n
q
Disposable = after-tax
and introduces trade surpluses and deficits.
n
Mpi lies between 0 and 1
Changes the multiplier.
73
The Goods Market and the
Aggregate Expenditures Model
End of Chapter 8
74