Topic 5
The Short – Run Macro Model
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The Short-Run Macro Model
• In short-run, spending depends on income, and income
depends on spending.
– The more income households have, the more they will spend.
– The more households spend, the more output firms will produce
• More income they will pay to their workers.
• Many ideas behind the model were originally developed by
British economist John Maynard Keynes in 1930s.
– Short-run macro model focuses on spending in explaining
economic fluctuations.
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Review the Categories of Spending
• Macroeconomists have found that the most useful
approach is to divide those who purchase the GDP into
four broad categories
–
–
–
–
Households --- consumption spending (C)
Business firms --- planned investment spending (IP)
Government agencies --- government purchases (G)
Foreigners --- net exports (NX)
• Nominal or real spending?
– Real terms
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Consumption
• What factors affect households’ spending?
– Disposable income: Yd (= Y – T)
– Wealth (= total assets – total liability)
– Price level
– Interest rate
• When interest rate falls, consumption rises
– Expectations about future
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Figure: U.S. Consumption and
Disposable Income, 1985-2002
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Figure: The Consumption Function
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Consumption and Disposable Income
• Autonomous consumption spending
– Consumption spending when disposable income is zero
• Marginal propensity to consume, or MPC
– The slope of the consumption function
– MPC = Δ Consumption ÷ Δ Disposable Income
– MPC measures by how much consumption spending rises when
disposable income rises by one dollar
• Logic and empirical evidence suggest that the MPC should
be larger than zero, but less than 1
– So, we assume that 0 < MPC < 1
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Consumption and Saving
• The marginal propensity to consume
(MPC) is equal to the change in
consumption associated with a given
change in income.
• The marginal propensity to save
(MPS) is equal to the change in saving
associated with a given change in income.
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Consumption and Saving
• MPC and MPS will always sum to 1,
since the only thing that can be done with
additional income is to either spend it
or save it.
MPC + MPS = 1
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Representing Consumption with an
Equation
• C = a + bYd
• Where C is consumption spending
• And a is the autonomous consumption spending
• And b is the marginal propensity to consume (MPC)
• Equation between consumption and total income
Since Yd = Y – T,
C = a + b(Y – T)
So, C = (a- bT) + bY
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Figure: The Consumption-Income Line
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Shifts in the Consumption-Income Line
– When a change in income causes consumption
spending to change, we move along consumptionincome line.
– When a change in anything else besides income
causes consumption spending to change, the line will
shift.
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Figure: A Shift in the ConsumptionIncome Line
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IP, G and NX
• For now, in the short-run macro model,
planned investment spending, government
purchases, and net exports are all treated
as given or fixed values.
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Summing Up: Aggregate Expenditure
• Aggregate expenditure (AE)
– Sum of spending by households, businesses,
government, and foreign sector on final goods and
services produced in United States
– Aggregate expenditure = C + IP + G + NX
• AE plays a key role in explaining economic
fluctuations
– Why?
• Because over several quarters or even a few years, business
firms tend to respond to changes in aggregate expenditure by
changing their level of output.
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Finding Equilibrium GDP
• When aggregate expenditure is less than GDP, inventories
will increase and output will decline in future.
• When aggregate expenditure is greater than GDP,
inventories will decrease and output will rise in future.
• In short-run, equilibrium GDP is level of output at which
output and aggregate expenditure are equal.
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Inventories and Equilibrium GDP
• When firms produce more goods than they sell, what
happens to unsold output?
– Added to their inventory stocks
• Find output level at which change in inventories is equal to
zero.
– AE < GDP  ΔInventories > 0  GDP↓ in future periods
– AE > GDP  ΔInventories < 0  GDP↑ in future periods
– AE = GDP  ΔInventories = 0  No change in GDP
• Equilibrium output level is the one at which change in
inventories equals zero.
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Figure: Deriving the Aggregate
Expenditure Line
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Figure: Using a 45° to Translate
Distances
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Figure: Determining Equilibrium Real
GDP
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Equilibrium GDP and Employment
• When economy operates at equilibrium, will it also be operating at full
employment?
– Not necessarily
For instance, insufficient spending causes business firms to decrease their demand
for labor.
– Remember, in the long run (classical) macro model, it takes time for labor
market to achieve full employment.
• In the short-run model, it would be quite a coincidence if our
equilibrium GDP happened to be the full employment output level.
• In short-run macro model, output can be lower or higher than the full
employment output level.
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Figure: Short-Run Equilibrium GDP < Full
Employment GDP
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Figure: Short-Run Equilibrium GDP > FullEmployment GDP
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A Change in Investment Spending
• Suppose the initial equilibrium GDP in an economy is
$6,000 billion.
• Now, business firms increase their investment spending
on plant and equipment by $1,000 billion.
• Then, firms that sell investment goods receive $1,000
billion as income, which is to be distributed as salary, rent,
interest, and profit.
• What will households do with their $1,000 billion in
additional income?
– Spend the money !
– How much to spend depends crucially on marginal propensity to
consume (MPC): let’s assume MPC = 0.6
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A Change in Investment Spending
• When households spend an additional $600 billion, firms
that produce consumption goods and services will receive
an additional $600 billion in sales revenue.
– Which will become income for households that supply resources to
these firms. At this point, total income has increased by
$1,000+$600=$1,600billion
– With an MPC of 0.6, consumption spending will further rise by 0.6 x
$600 billion = $360 billion, creating still more sales revenue for
firms, and so on and so on…
• At end of process, when economy has reached its new
equilibrium.
– Total spending and total output are considerably higher.
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Figure: The Effect of a Change in
Investment Spending
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The Expenditure Multiplier
• Whatever the rise in investment spending, equilibrium
GDP would increase by a factor of 2.5, so we can write
– ΔGDP = 2.5 x ΔIP
• Value of expenditure multiplier depends on value of MPC
Expenditur e Multiplier 
1
1 - MPC
• So, when the increase in planned investment spending is
ΔIP, the increase in total income (GDP) is calculated as:


1
P
GDP  
x

I

 (1  MPC ) 
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The Expenditure Multiplier
• A sustained increase in investment
spending will cause a sustained increase in
GDP.
• Multiplier process works in both directions.
– 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.
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Spending Shocks
• Shocks to economy can come from other sources besides
investment spending.
– Government purchases (G)
– Net exports (NX)
– Autonomous consumption (a)
• Changes in planned investment, government purchases,
net exports, or autonomous consumption lead to a
multiplier effect on GDP.
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Spending Shocks
• The effect of a change in spending on total
income through expenditure multiplier


1
GDP  
x IP

 (1 - MPC) 


1
GDP  
x G

 (1 - MPC) 


1
GDP  
x NX

 (1 - MPC) 


1
GDP  
 x a
(1
MPC)


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Tax Multiplier
• A change in taxes will have less of a direct impact
on income, employment, and output than will an
equivalent change in I, G, NX, or autonomous
consumption.
𝑀𝑃𝐶
∆𝐺𝐷𝑃 = −
× ∆𝑇
1 − 𝑀𝑃𝐶
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Balanced Budget Multiplier
• Foundations of the balanced budget multiplier:
 Equal changes in government spending and
taxation lead to an equal change in income.
Equivalently, the balanced budget multiplier is
equal to 1.
 If spending and taxes are increased by the
same amount, income grows by this amount.
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Figure: A Graphical View of the
Multiplier
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Application: The Recession of 2007-09
•
•
December 2007 recession began
Aggregate expenditures declined
• Consumption spending declined
• Investment spending declined
• Recessionary expenditure gap
Application: The Recession of 2007-09
• Federal government undertook Keynesian
policies
• Tax rebate checks
• $787 billion stimulus package
Say’s Law vs. Keynesian Theory
• Classical economics
• Say’s Law
• Economy will automatically adjust
• Laissez-faire
• Keynesian economics
• Cyclical unemployment can occur
• Economy will not correct itself
• Government should actively manage
macroeconomic instability
Automatic Stabilizers and the Multiplier
• Automatic stabilizers reduce size of multiplier and
therefore reduce impact of spending shocks.
– With milder fluctuations, economy is more stable.
• Some real-world automatic stabilizers we’ve ignored in the
simple, short-run macro model of this chapter
–
–
–
–
–
Taxes
Transfer payments
Interest rates
Imports
Forward-looking behavior
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The Role of Saving
• In long-run, saving has positive effects on economy.
• But in short-run, automatic mechanisms of classical model
do not keep economy operating at its potential.
• In long-run, an increase in desire to save leads to faster
economic growth and rising living standards.
– In short-run, however, it can cause a recession that pushes output
below its potential.
• Two sides to the “saving coin”
– Impact of increased saving is positive in long-run and potentially
dangerous in short-run.
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The Effect of Fiscal Policy
• In classical model fiscal policy—changes in government
spending or taxes designed to change equilibrium GDP—
is completely ineffective – crowding out effect.
• In short-run, an increase in government purchases causes
a multiplied increase in equilibrium GDP.
– Therefore, in short-run, fiscal policy can actually change
equilibrium GDP.
– Observation suggests that fiscal policy could, in principle, play a
role in altering path of economy.
• Indeed, in 1960s and early 1970s, this was the thinking of
many economists.
– But very few economists believe this today.
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