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• 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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• 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 (I P )
– Government agencies --- government purchases (G)
– Foreigners --- net exports (NX)
• Nominal or real spending?
– Real terms
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• What factors affect households’ spending?
– Disposable income: Y d (= 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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Representing Consumption with an
Equation
• C = a + b 
Y d
• 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 Y d = 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 Consumption-
Income Line
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I P , 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 + I P + 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 > Full-
Employment 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 ΔI P
• Value of expenditure multiplier depends on value of MPC
Expenditur e Multiplier

1 -
1
MPC
• So, when the increase in planned investment spending is
ΔI P , the increase in total income (GDP) is calculated as:

GDP



( 1

1
MPC )


x

I
P
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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

GDP




1
(1 MPC) 

 x

I P

GDP


 (1 -
1
MPC)

 x

G

GDP



1
(1 MPC)


x

NX

GDP



1
(1 MPC)


x
 a
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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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