The ShortRun Macro Model

1
The Short-Run Macro Model

• Spending is very important in short-run
• The more income households have, the more they
  will spend
• Spending depends on income
• But the more households spend, the more output
  firms will produce
• More income they will pay to their workers
• Thus, income depends on spending
• In short-run, spending depends on income, and
  income depends on spending
• In the long run, spending depends on income

2
The Short Run or Keynesian Macro Model

• 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
• Explains how shocks that affect one sector
  influence other sectors
• Causing changes in total output and employment

3
Thinking About Spending

• Spending on what?
• In short-run macro model, focus on spending in
  markets for currently produced U.S. goods and
  services
• Things that are included in U.S. GDP
• 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)
• Should we look at nominal or real spending?
• Always real spending

4
Consumption Spending

• Largest component is consumption spending
• Sum of spending by over a hundred million U.S.
  households
• What determines total amount of consumption
  spending?
• One way to answer is to start by thinking about
  yourself or your family
• What determines your spending in any given month,
  quarter, or year?

5
Disposable Income

• First thing that comes to mind is your income
• The more you earn, the more you spend
• Its not exactly your income per period that
  determines your spending
• But rather what you get to keep from that income
  after deducting any taxes you have to pay
• If we start with income you earn, deduct all tax
  payments, and then add in any transfer received,
  would get your disposable income
• Income you are free to spend or save as you wish
• Disposable Income Income Tax Payments
  Transfers Received
• Can be rewritten as
• Disposable Income Income (Taxes Transfers)
  or
• Disposable Income Income Net Taxes
• For almost any household, a rise in disposable
  incomewith no other changecauses a rise in
  consumption spending

6
The Spending-Saving Decision Wealth

• Given your disposable income, how much of it will
  you spend and how much will you save?
• Will depend, in part, on your wealth
• Total value of your assets minus your outstanding
  liabilities
• In general, a rise in wealthwith no other
  changecauses a rise in consumption spending

7
The Spending-Saving Decision Interest Rate

• Interest rate is reward people get for saving, or
  what they have to pay when they borrow
• All else equal, a rise in interest rate causes a
  decrease in consumption spending
• Whether you are earning interest on funds youve
  saved, or paying interest on funds youve
  borrowed
• The higher the interest rate, the lower is
  consumption spending
• In macroeconomics, household saving is the part
  of disposable income that a household doesnt
  spend
• Whether its put in bank or used to pay off a loan

8
The Spending-Saving Decision Expectations

• Expectations about future affect spending as
  well
• All else equal, optimism about future income
  causes an increase in consumption spending
• Other variables influence your consumption
  spending
• Inheritances you expect to receive over your
  lifetime
• Life expectancy
• Disposable income, wealth, and interest rate are
  the three key variables
• In macroeconomics, we use phrases like
  disposable income, wealth, or consumption
  spending to mean the total disposable income,
  total wealth, and total consumption spending of
  all households in the economy combined
• All else equal, consumption spending increases
  when
• Disposable income rises
• Wealth rises
• Interest rate falls

9
Figure 1 U.S. Consumption and Disposable
Income, 1985-2002
10
Consumption and Disposable Income

• Of all the factors that influence consumption
  spending, most important and stable determinant
  is disposable income
• Relationship between consumption and disposable
  income is almost perfectly linearpoints lie
  remarkably close to a straight line
• This almost-linear relationship between
  consumption and disposable income has been
  observed in a wide variety of historical periods
  and a wide variety of nations

11
Figure 2 The Consumption Function
12
Consumption and Disposable Income

• InterceptAutonomous Consumption Spending.
• Influence of everything other than income
  (wealth, interest rate, expectations)
• SlopeMarginal Propensity to Consume (MPC)
• Shows change along vertical axis divided by
  change along horizontal axis as we go from one
  point to another on the line
• Slope ? Consumption/ ? Disposable Income
• Three (equivalent) interpretations of MPC
• Slope of consumption function
• Change in consumption divided by change in
  disposable income
• Amount by which consumption spending rises when
  disposable income rises by one dollar
• 0ltMPClt1

13
Representing Consumption with an Equation

• Sometimes, well want to use an equation to
  represent straight-line consumption function
• C d b(YD)
• Where C is consumption spending, YD is disposable
  income
• The term d is the vertical intercept of
  consumption function
• Represents autonomous consumption spending
• Term b is slope of consumption function
• Marginal propensity to consume (MPC)

14
Consumption-Income Line

• If government collected no taxes, total income
  and disposable income would be equal
• So that relationship between consumption and
  income on the one hand, and consumption and
  disposable income on the other hand, would be
  identical
• Consumption-income line
• Line showing aggregate consumption spending at
  each level of income or GDP
• When government collects a fixed amount of taxes
  from household
• Line representing relationship between
  consumption and income is shifted downward by
  amount of tax times marginal propensity to
  consume (MPC)
• Slope of this line is unaffected by taxes and is
  equal to MPC
• Cdb(YD)db(Y-T)
• C(d-bT)bY
• CabY where a(d-bT)

15
Figure 3 The Consumption-Income Line
16
Shifts in the Consumption-Income Line

• If income increases and net taxes remain
  unchanged, disposable income will rise, and
  consumption spending will rise along with it

But consumption spending can also change for
reasons other than a change in income, causing
consumption-income line itself to shift Mechanism
works like this
17
Shifts in the Consumption-Income Line

• By shifting relationship between consumption and
  disposable income, we shift relationship between
  consumption and income as well
• Increases in autonomous consumption work this way

18
Shifts in the Consumption-Income Line

• Can summarize our discussion of changes in
  consumption spending as follows
• 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
• All changes that shift the lineother than a
  change in taxeswork by increasing or decreasing
  autonomous consumption

19
Figure 4 A Shift in the Consumption-Income Line
20
Table 3 Changes in ConsumptionSpending and the
ConsumptionIncome Line
21
Investment Spending

• Investment has three components
• Business spending on plant and equipment
• Purchases of new homes
• Accumulation of unsold inventories
• In short-run macro model, we define (planned)
  investment spending (IP) as
• Plant and equipment purchases by business firms,
  and new home construction
• Inventory investment is treated as unintentional
• Excluded from definition of investment spending
• For now, we regard investment spending (IP) as a
  given value, determined by forces outside of our
  model in the short run.

22
Government Purchases

• Include all goods and services that government
  agenciesfederal, state, and localbuy during
  year
• In short-run macro model, government purchases
  are treated as a given value
• Determined by forces outside of model

23
Net Exports

• If we want to measure total spending on U.S.
  output, we must also consider international
  sector
• U.S. exports
• U.S. consumption also includes imports.
• In sum, to incorporate international sector into
  our measure of total spending, we must add U.S.
  exports, and subtract U.S. imports
• Net Exports Total Exports Total Imports
• We regard net exports as a given value,
  determined by forces outside of our analysis
• Important to remember that net exports can be
  negative
• United States has had negative net exports since
  1982

24
Summing Up Aggregate Expenditure

• Aggregate expenditure
• 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
• C stands for household consumption spending, IP
  for investment spending, G for government
  purchase, and NX for net exports
• 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

25
Income and Aggregate Expenditure

• Relationship between income and spending is
  circular
• Spending depends on income, and income depends on
  spending
• We take up the first part of that circle
• How total spending depends on income
• Aggregate expenditure increases as income rises
• the rise in aggregate expenditure is smaller than
  rise in income
• When income increases, aggregate expenditure (AE)
  will rise by MPC times change in income
• ?AE MPC x ? GDP
• Weve used ?GDP to indicate change in total
  income
• Because GDP and total income are always the same
  number

26
Inventories and Equilibrium GDP

• When firms produce more goods than they sell,
  what happens to unsold output?
• Added to their inventory stocks
• Change in inventories during any period will
  always equal output minus aggregate expenditure
• Find output level at which change in inventories
  is equal to zero
• AE lt GDP ? ?Inventories gt 0 ? GDP? in future
  periods
• AE gt GDP ? ?Inventories lt 0 ? GDP? in future
  periods
• AE GDP ? ?Inventories 0 ? No change in GDP
• Equilibrium output level is one at which change
  in inventories equals zero or aggregate
  expenditureGDP

27
Finding Equilibrium GDP With A Graph

• Figure 5 gives an even clearer picture of how
  equilibrium GDP is determined
• Lowest line, C, is consumption-income line
• Next line, labeled C IP, shows sum of
  consumption and investment spending at each
  income level
• Next line adds government purchases to
  consumption and investment spending, giving us C
  IP G
• Top line adds net exports, giving us C IP G
  NX, or aggregate expenditure

28
Figure 5 Deriving the Aggregate Expenditure Line
29
Finding Equilibrium GDP With A Graph

• Figure 6 shows a graph in which horizontal and
  vertical axes are both measured in same units,
  such as dollars
• Also shows a line drawn at a 45 angle that
  begins at origin
• 45 line is a translator line
• Allows us to measure any horizontal distance as a
  vertical distance instead
• Now we can apply this geometric trick to help us
  find the equilibrium GDP

30
Figure 6 Using a 45 to Translate Distances
31
Finding Equilibrium GDP With A Graph

• Figure 7 shows how we can apply geometric trick
  to help us find equilibrium GDP
• At any output level at which aggregate
  expenditure line lies below 45 line, aggregate
  expenditure is less than GDP
• If firms produce any of these out put levels,
  inventories will grow, and they will reduce
  output in the future
• At any output level at which aggregate
  expenditure line lies above 45 line, aggregate
  expenditure exceeds GDP
• If firms produce any of these output levels,
  inventories will decline, and they will increase
  their output in the future
• We have thus found our equilibrium on graph
• Equilibrium GDP is output level at which
  aggregate expenditure line intersects 45 line
• If firms produce this output level, their
  inventories will not change, and they will be
  content to continue producing same level of
  output in the future

32
Figure 7 Determining Equilibrium Real GDP
33
Equilibrium GDP and Employment

• When economy operates at equilibrium, will it
  also be operating at full employment?
• Not necessarily
• In short-run macro model, cyclical unemployment
  is caused by insufficient spending
• As long as spending remains low, production will
  remain low, and unemployment will remain high
• In short-run macro model, economy can overheat
  because spending is too high
• As long as spending remains high, production will
  exceed potential output, and unemployment will be
  unusually low
• Aggregate expenditure line may be low, meaning
  that in short-run, equilibrium GDP is below full
  employment
• Or aggregate expenditure may be high, meaning
  that in short-run, equilibrium GDP is above
  full-employment level

34
Figure 8 Equilibrium GDP Can Be Less Than Full
Employment GDP
35
Figure 9 Equilibrium GDP Can Be Greater Than
Full-Employment GDP
36
A Change in Investment Spending

• Suppose equilibrium GDP in an economy is 6,000
  billion, and then business firms increase their
  investment spending on plant and equipment
• What will happen?
• Sales revenue at firms that manufacture
  investment goods will increase by 1,000 billion
• This will generate 1,000 billion in household
  income (total outputtotal factor payments)
• What will households do with their 1,000 billion
  in additional income?
• Depends on marginal propensity to consume (MPC)
• Assume MPC 0.6, so households spend 600
  billion.

37
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
• With an MPC of 0.6, consumption spending will
  rise by 0.6 x 600 billion 360 billion,
  creating still more sales revenue for firms, and
  so on and so on
• Increase in investment spending will set off a
  chain reaction
• Leading to successive rounds of increased
  spending and income
• At end of process, when economy has reached its
  new equilibrium
• Total spending and total output are considerably
  higher

38
Figure 10 The Effect of a Change in Investment
Spending
39
The Expenditure Multiplier

• 1,000 billion increase in investment created
  2,500 billion
• This 2.5 times increase is called the expenditure
  multiplier.
• How do we derive this multiplier?
• Depends crucially on MPC

40
The Expenditure Multiplier

• ?GDP1000600360216
• 1000(0.61000)(0.6)21000(0.6)31000..
• 1000(10.60.620.63..)
• 1000(1/(1-0.6))
• In general the multiplier is equal to
• (1/(1-MPC))

41
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

42
Other Spending Shocks

• Shocks to economy can come from other sources
  besides investment spending
• Suppose government agencies increased their
  purchases above previous levels
• Besides planned investment and government
  purchases, there are two other components of
  spending that can set off the same process
• An increase in net exports (NX)
• A change in autonomous consumption
• Changes in planned investment, government
  purchases, net exports, or autonomous consumption
  lead to a multiplier effect on GDP
• Expenditure multiplier is what we multiply
  initial change in spending by in order to get
  change in equilibrium GDP

43
Other Spending Shocks

• The following four equations summarize how we use
  expenditure multiplier to determine effects of
  different spending shocks in short-run macro model

44
A Graphical View of the Multiplier

• Figure 11 illustrates multiplier using aggregate
  expenditure diagram

• An increase in autonomous consumption spending,
  investment spending, government purchases, or net
  exports will shift aggregate expenditure line
  upward by increase in spending
• Causing equilibrium GDP to rise
• Increase in GDP will equal initial increase in
  spending times expenditure multiplier

45
Figure 11 A Graphical View of the Multiplier
46
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 weve
  ignored in the simple, short-run macro model of
  this chapter
• Taxes
• Transfer payments
• Interest rates
• Imports
• Forward-looking behavior
• Each of these automatic stabilizers reduces size
  of multiplier
• Making it smaller than simple formulas given in
  this chapter

47
Automatic Stabilizers and the Multiplier

• In real world, due to automatic stabilizers,
  spending shocks have much weaker impacts on
  economy than our simple multiplier formulas would
  suggest
• One more automatic stabilizerperhaps the most
  important of all
• Passage of time
• In long-run, multipliers have a value of zero
• No matter what the change in spending or taxes,
  output will return to full employment, so change
  in equilibrium GDP will be zero

48
Comparing Long and Short Rum Models 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 by
  reducing aggregate expenditure
• Two sides to the saving coin
• Impact of increased saving is positive in
  long-run and potentially dangerous in short-run

49
The Effect of Fiscal Policy

• In classical model fiscal policychanges in
  government spending or taxes designed to change
  equilibrium GDPis completely ineffective
• 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
• Except as a last resort.