The Short – Run Macro Model

1. The Short – Run Macro Model

2. 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.

3. 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

4. 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

5. Figure: U.S. Consumption and Disposable Income, 1985-2002

6. Figure: The Consumption Function

7. 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

8. 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

9. Figure: The Consumption-Income Line

10. Shifts in the Consumption-Income Line • When a change in income causes consumption spending to change, we move along consumption-income line. • When a change in anything else besides income causes consumption spending to change, the line will shift.

11. Figure: A Shift in the Consumption-Income Line

12. 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.

13. 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.

14. 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.

15. 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.

16. Figure: Deriving the Aggregate Expenditure Line

17. Figure: Using a 45° to Translate Distances

18. Figure: Determining Equilibrium Real GDP

19. 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.

20. Figure: Short-Run Equilibrium GDP < Full Employment GDP

21. Figure: Short-Run Equilibrium GDP > Full-Employment GDP

22. 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

23. 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.

24. Figure: The Effect of a Change in Investment Spending

25. 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 • So, when the increase in planned investment spending is ΔIP, the increase in total income (GDP) is calculated as:

26. 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.

27. 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.

28. Spending Shocks • The effect of a change in spending on total income through expenditure multiplier

29. Figure: A Graphical View of the Multiplier

30. Application: The Recession of 2007-09 • December 2007 recession began • Aggregate expenditures declined • Consumption spending declined • Investment spending declined • Recessionary expenditure gap

31. Application: The Recession of 2007-09 • Federal government undertook Keynesian policies • Tax rebate checks • $787 billion stimulus package

32. 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

33. 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

34. 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.

35. 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.