A Basic Model of the Determination of GDP in the Short Term Chapter 16

1. A Basic Model of the Determination of GDP in the Short TermChapter 16 LIPSEY & CHRYSTAL ECONOMICS 12e

2. Learning Outcomes • The macroeconomic theory that we now study explains the deviation of actual from potential GDP, that is the GDP gap. • The determination of GDP in the short run depends on the behaviour of key categories of aggregate spending: consumption, investment, government spending, and net exports.

3. Learning Outcomes • Consumption spending depends on disposable income and wealth. • Investment spending depends on real interest rates and business confidence. • A necessary condition for GDP to be in equilibrium is that desired domestic spending equals actual output.

4. A BASIC MODEL OF THE DETERMINATION OF GDP What Determines Aggregate Expenditure • Desired aggregate expenditure includes desired consumption, desired investment, and desired government expenditures, plus desired net exports. • It is the amount that economic agents want to spend on purchasing the national product. • In this chapter we consider only consumption and investment.

5. A BASIC MODEL OF THE DETERMINATION OF GDP What Determines Aggregate Expenditure • A change in personal disposable income leads to a change in private consumption and saving. • The responsiveness of these changes is measured by the marginal propensity to consume [MPC] and the marginal propensity to save [MPS], which are both positive and sum to one. • This indicates that, by definition, all disposable income is either spent on consumption or saved.

6. A BASIC MODEL OF THE DETERMINATION OF GDP • A change in wealth tends to cause a change in the allocation of disposable income between consumption and saving. The change in consumption is positively related to the change in wealth, while the change in saving is negatively related to this change.

7. A BASIC MODEL OF THE DETERMINATION OF GDP • Investment depends, among other things, on real interest rates and business confidence. In our simple theory investment is treated as autonomous, or exogenous, as is the constant term in the consumption function, called autonomous consumption. • The part of consumption that responds to changes in income is called induced spending.

8. A BASIC MODEL OF THE DETERMINATION OF GDP Equilibrium GDP • At the equilibrium level of GDP, purchasers wish to buy exactly the amount of national output that is being produced. • At GDP above equilibrium, desired expenditure falls short of national output, and output will sooner or later be curtailed.

9. A BASIC MODEL OF THE DETERMINATION OF GDP Equilibrium GDP • At GDP below equilibrium, desired expenditure exceeds national output, and output will sooner or later be increased. • In a closed economy with no government, desired saving equals desired investment at equilibrium GDP.

10. A BASIC MODEL OF THE DETERMINATION OF GDP • Equilibrium GDP is represented graphically by the point at which the aggregate expenditure curve cuts the 450 line, that is, where total desired expenditure equals total output. • This is the same level of GDP at which the saving function intersects the investment function.

11. A BASIC MODEL OF THE DETERMINATION OF GDP Changes in GDP • With a constant price level, equilibrium GDP is increased by a rise in the desired consumption or investment expenditure that is associated with each level of national income. • Equilibrium GDP is decreased by a fall in desired spending.

12. A BASIC MODEL OF THE DETERMINATION OF GDP Changes in GDP • The magnitude of the effect on GDP of shifts in autonomous expenditure is given by the multiplier. • It is defined as K = Y/A, where A is the change in autonomous spending and Y the resulting increase in GDP.

13. A BASIC MODEL OF THE DETERMINATION OF GDP • The simple multiplier is the multiplier when the price level is constant. • It is equal to 1/[1 - z], where z is the marginal propensity to spend out of national income. • Thus the larger z is, the larger is the multiplier. It is a basic prediction of macroeconomics that the simple multiplier, relating £1 worth of increased spending on domestic output to the resulting increase in GDP, is greater than unity.

14. UK real GDP growth, 1886-2014

15. Terminology of Business Cycles

16. Costumers’ spending and personal disposable income UK 1948-2008

17. Calculation of average and marginal propensity to consume

18. The Consumption and Saving Functions 450 2000 500 S C 1500 250 0 1000 Desired Consumption Expenditure Desired saving -100 500 -500 500 1000 1500 2000 450 Real Disposable Income (ii). Saving Function [£ million] 500 1000 1500 2000 Real Disposable Income (i). Consumption Function [£ million]

19. Consumption and savings schedules (£millions)

20. The consumption and saving functions • Both consumption and saving rise as disposable income rises. • Line C relates desired consumption to disposable income. • Its slope is the marginal propensity to consume (MPC). • Saving is all disposable income that is not spent on consumption. • The relationship between disposable income and desired saving is shown by line S.

21. The consumption and saving functions • Its slope is the marginal propensity to save (MPS). • Any given amount of disposable income must be accounted for by consumption plus saving. • Consumption and saving schedules (Table) show the numerical values of desired consumption and saving at each level of income, and correspond to the C and S lines in the figure.

22. The aggregate spending function in a closed economy with no government (£million)

23. An Aggregate Expenditure Function 5000 AE Desired Expenditure (£m) 4000 3000 2000 1000 350 1000 2000 3000 4000 5000 Real National Income Function [GDP] [£m]

24. An aggregate expenditure function • The aggregate expenditure function relates total desired expenditure to national income. • Here desired expenditure is the sum of desired consumption and desired investment. • It is assumed that desired investment is £250 million while consumption is £100 million plus 0.8 times income. • So when income is zero there is autonomous expenditure of £350 million. • The marginal propensity to spend is 0.8.

25. The determination of equilibrium GDP (£million)

26. Equilibrium GDP [ii]. Saving Function[S = I] [i]. An Aggregate Expenditure Function[AE = Y] 500 S 3000 450 [AE = Y] I 250 E0 2000 0 -100 Desired aggregate expenditure (£m) -500 Desired saving (£m) 1000 Y0 1000 2000 3000 Real National Income [GDP] [£m] 350 450 0 Y0 2000 1000 3000 Real National Income [GDP] [£m]

27. Equilibrium GDP • GDP is in equilibrium where aggregate desired expenditure (AE) equals national output. • In the figure equilibrium GDP occurs at E0 where AE intersects the 450 line. • If GDP is below Y0 desired AE will exceed national output and production will rise.

28. Equilibrium GDP • If GDP is above Y0 desired AE will be less than national output and production will fall. • When saving is the only withdrawal and investment is the only injection, the equilibrium level of GDP is also that where saving equals investment.

29. The Simple Multiplier AE = Y Desired Expenditure 450 Real National Income [GDP] 0

30. The Simple Multiplier AE = Y Desired Expenditure AE0 e0 E0 450 Y0 Real National Income [GDP] 0

31. The Simple Multiplier AE = Y AE1 E1 e1 a e’1 Desired Expenditure AE0 A e0 E0 Y 450 Y0 Y1 Real National Income [GDP] 0

32. The simple multiplier • An increase in the autonomous component of desired aggregate expenditure increases equilibrium GDP by a multiple of the initial increase. • The initial equilibrium is at E0, where AE0 intersects the 450 line. Here desired expenditure equals national output.

33. The simple multiplier • An increase in autonomous expenditure of A then shifts the AE function up to AE1. • Because desired spending is now greater that output, production and GDP will rise. • Equilibrium occurs when GDP rises to Y1. • Here desired expenditure e1 equals output Y1.

34. The multiplier – A numerical example

35. The multiplier – A numerical example

36. A numerical example of the multiplier • Assuming that the marginal propensity to spend out of national income is 0.8 and there is an autonomous expenditure increase of £100m. • National income and output initially rises by £100m.

37. A numerical example of the multiplier • Those receiving £100m in income then spend £80m. • This £80m of income leads to further spending of £64m. • This £64m of income lead to a further increase in spending of £51.2m. • If we carry on this process it will converge to an extra income and output totalling £500m. • The multiplier in this case is 5.

38. UK Household savings as a % of GDP (1955Q1 to 2009Q3)

39. Total UK Business Investment(1955Q1 to 2009Q1)

40. A BASIC MODEL OF THE DETERMINATION OF GDP The macroeconomic problem: inflation and unemployment • Models of the short-term determination of GDP explain why actual GDP deviates from potential GDP. • Actual GDP above potential can be associated with inflation, while actual GDP below potential is associated with unemployment and lost output.

41. A BASIC MODEL OF THE DETERMINATION OF GDP Key Assumptions • For simplicity we aggregate all industrial sectors into one, so the economy produces only one type of output good. • We explain GDP determination through the major expenditure categories: private consumption, investment, government consumption, and net exports.