The Historical Development of Modern Macroeconomics • The Great Depression of the 1930s led to the development of macroeconomics and aggregate demand tools to deal with recessions. • During the Depression, output fell by 30 percent and unemployment rose to 25 percent.
The Historical Development of Modern Macroeconomics • Keynes is the author of The General Theory of Employment, Interest and Money, which provided the new framework for macroeconomic policy. • Keynes is pronounced “canes”
Classical Economists • The Classical economists' approach was laissez-faire (leave the market alone). • They believed the market was self-adjusting. • They concentrated on the long run and largely ignored the short run.
Classical Economics • They used microeconomic supply and demand arguments to explain the Great Depression. • Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.
The Historical Development of Modern Macroeconomics • Before the Depression, the prominent ideology was laissez-faire -- keep the government out of the economy. • After the Depression, most people believed government should have a role in regulating the economy.
The Layperson's Explanation for Unemployment • Laypeople believed that the depression was caused by an oversupply of goods that glutted the market. • They wanted the government to hire the unemployed even if the work was not needed.
The Layperson's Explanation for Unemployment • Classical economists opposed deficit spending, arguing that the money to create jobs had to be borrowed. • This money would have financed private economic activity and jobs, so everything would cancel out.
The Essence of Keynesian Economics • Keynes thought that the economy could get stuck in a rut as wages and price level adjusted to sudden decreases in expenditures.
The Essence of Keynesian Economics • 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
Equilibrium Income Fluctuates • Income is not fixed at the economy's long-run potential income – it fluctuates. • For Keynes there was a difference between equilibrium income and potential income.
Equilibrium Income Fluctuates • Equilibrium income – the level toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production.
Equilibrium Income Fluctuates • Potential income – the level of income that the economy technically is capable of producing without generating accelerating inflation.
Equilibrium Income Fluctuates • Keynes felt that at certain times the economy needed help to reach its potential income. • He believed that market forces would not work fast enough and would not be strong enough to get the economy out of a recession
Equilibrium Income Fluctuates • Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.
The Paradox of Thrift • Incomes would fall as people lost their jobs causing both consumption and saving to fall as well. • The economy would reach a new equilibrium which could be at an almost permanent recession.
The Paradox of Thrift • Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.
The Aggregate Expenditures Model • Using a few simplifying assumptions, economists can construct a model of the economy. • The Aggregate Expenditures (AE) Model looks at how real income is determined in an economy.
The Aggregate Expenditures Model • The AE model assumes that the price level is fixed, and explores how an initial shift in expenditures changes equilibrium output. • The AE model quantifies the effect of changes in aggregate expenditures on aggregate output.
Aggregate Production • Aggregate production –the total amount of goods and services produced in every industry in an economy. • Production creates an equal amount of income. • Thus, actual production and actual income are always equal.
Aggregate Production • Graphically, aggregate production in the AE model is represented by a 45° line through the origin • At all points on this Aggregate Production Curve, income equals production.
Aggregate production (production = income) Real production C A $4,000 Potential income 45º 0 $4,000 Real income The Aggregate Production Curve
Aggregate Expenditures • Aggregateexpenditures – the total amount of spending on final goods and services in the economy: • Consumption – spending by households. • Investment – spending by business. • Spending by government. • Net foreign spending on Canadian goods – the difference between Canadian exports and imports.
Autonomous and Induced Expenditures • Autonomous expenditures are expenditures that are independent of income. • Autonomous expenditures change because something other than income changes. • Induced expenditures – expenditures that change as income changes.
Autonomous and Induced Expenditures • Autonomous expenditures is the level of expenditures that would exist at zero income. • They remain constant at all levels of income.
Autonomous and Induced Expenditures • Induced expenditures are those that change as income changes. • When income rises, induced expenditures rise by less than the change in income.
Expenditures Function • The relationship between expenditures and income can be expressed more concisely as an expenditures function. • An expenditures function is a representation of the relationship between aggregate expenditures and income.
The Expenditures Function • The relationship between aggregate expenditures and income can be expressed mathematically: AE = AEo + mpcY AE = aggregate expenditures AEo = autonomous expenditures mpc = marginal propensity to consume Y = income
The Marginal Propensity to Consume • Marginal propensity to consume (mpc) – the change in consumption that occurs with a change in income. • The mpc is between 0 and 1 because individuals tend to save a portion of an increase in income.
The Marginal Propensity to Consume • The mpc is the fraction spent from an additional dollar of income.
The Marginal Propensity to Consume • The marginal propensity to consume (mpc) is the ratio of a change in consumption (C) to a change in income (Y).
Expenditures Function • Autonomous expenditures is the sum of the autonomous components of expenditures: AE = C + I+ G + X – IM
Graphing the Expenditures Function • The graphical representation of the expenditures function is called the aggregate expenditures curve. • The slope of the expenditures function tells us how much expenditures change with a particular change in income.
Aggregate production AE = 1,000 + 0.8Y AE = 2,000 Y = 2,500 45º $8,750 $11,250 $14,000 Graphing the Expenditures Function $12,200 10,000 8,000 Real expenditures (AE) 6,000 5,000 4,000 2,000 1,000 0 $5,000 Real income
Shifts in the Expenditures Function • The aggregate expenditure curve shifts when autonomous C, I, G, or (X – IM) change. • Autonomous Consumption expenditures respond to changes in: • interest rates • household wealth • expectations of future conditions
Shifts in the Expenditures Function • Autonomous Investment is the most volatile component of GDP. • It responds to changes in: • interest rates • capital goods prices • consumer demand conditions • expectations regarding future economic conditions
Shifts in the Expenditures Function • Autonomous exports and imports depend on foreign and domestic incomes and relative prices. • Autonomous Government expenditures may also change as policies change.
Determining the Equilibrium Level of Aggregate Income • At equilibrium, planned expenditures must equal production. • Graphically, it is the income level at which AE equals AP.
Aggregate production $14,000 Aggregate expenditures 12,200 10,000 Real expenditures (AE) 8,000 5,000 2,600 AE0 = $1,000 1,000 45° 0 $2,000 $5,000 $10,000 $14,000 Real income Solving for Equilibrium Graphically AE = 1,000 + 0.8Y E
Solving for Equilibrium Algebraically • In equilibrium, Y = AE. • Substituting in for aggregate expenditures, we have Y = AE0 + mpcY
Solving for Equilibrium Algebraically • Now solve for equilibrium income: Y – mpcY = AE0 Y (1 – mpc) = AE0 Y = [ 1/ (1 – mpc) ] * AE0
The Multiplier Equation • The multiplier equation tells us that income equals the multiplier times autonomous expenditures. Y = Multiplier X Autonomous expenditures
The Multiplier Equation • The multiplier process amplifies changes in autonomous expenditures. • What forces are operating to ensure that the income level we determined is actually the equilibrium income level?
The Multiplier Process • 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.
The Multiplier Process • The process ends when aggregate production equals aggregate expenditures. • Firms are selling all they produce, so they have no reason to change their production levels.
Aggregate production A1 Aggregate expenditures A2 C B1 B2 45° The Multiplier Process C, I, G, (X – IM) $14,000 $13,200 AE = 1,000 + 0.8Y 10,000 Real expenditures (AE) 6,000 2,000 0 $2,000 $5,000 $10,000 $14,000 Real income
The Circular Flow Model and the Multiplier Process • The circular flow model provides the intuition behind the multiplier process. • The flow of expenditures equals the flow of income.
The Circular Flow Model and the Multiplier Process • Expenditures are injections into the circular flow. • The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow. • But there are withdrawals.
The Circular Flow Model and the Multiplier Process • 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.
The Circular Flow Model and the Multiplier Process • By definition: mpc + mps = 1 • Alternatively expressed: mps = 1 - mpc multiplier = 1/mps